We're sure that it's possible to make a reasonable case for supply-side economics, that is, showing that well targeted tax cuts and deregulation can have a positive effect on growth. We're also sure that there is a considerable amount that can be brought to bear against Keynesian policies.
But we're stuck with an article by well known supply-siders Larry Kudlow and Heritage Foundation chief economist Stephen Moore that does one nor the other. What it does is:
- Providing no analysis of the causes of the crisis
- Declaring the present recovery as a bad one
- Listing a host of disjointed policies, throwing them under the banner Keynesianism, and declaring them guilty of the bad recovery
- Simply assuming that supply-side policies can do better.
For sure, Kudlow and Moore can do better than that. Let's look at these one by one.
The nature of the crisis and recovery
Well, yes, compared to some previous recoveries, this one isn't particularly spectacular. First of all, it's still a lot better than almost anywhere else in the developed world:
Second, as we set out in greater detail here, there are reasons why the present recovery isn't as strong as many previous ones. This has less to do with the policies that have been tried to get the recovery going, and more to do with the nature of the recession.
In short, there is an 800 pound gorilla here which Kudlow and Moore conveniently paper over in the form of a housing crash. This left a whopping $9 trillion hole in household balance sheets, and they reacted to this by cutting borrowing and spending and increasing savings and paying off debt.
Companies reacted to the lower demand by firing people and investing less, so did local and state governments (and, after a couple of years, the Federal government) reinforcing these effects. If you don't believe us, there is a simple figure that sums this up:
You see here how the 2008 crisis threw the private sector from financial deficit (investment exceeding savings) into surplus (savings exceeding investments). Note especially how uncannily the unemployment rate correlates with this.
The first, and most important take-away from this is that the crisis is very Keynesian in nature, that is, it is caused by a sudden and rather massive drop in aggregate demand, due to a sudden and rather massive decline in household balance sheets (and second round effects of this).
The policy response
Textbook economics argues that when the private sector moves from financial surplus into a (rather large) financial deficit, the public sector needs to do the opposite. Part of this is automatic:
- Decline in spending, employment, profits and incomes result in lower tax income
- Public expenditures increase on aid to the victims, unemployment benefits, food stamps and the like.
Kudlow and Moore seem to mistake this for discretionary policy changes when they speak of a "vast expansion of the welfare state" (see quote below), but this is confusing cause and effect. The crisis simply made more people unemployed and eligible for welfare benefits. This would have happened without any policy change whatsoever.
The Federal government also embarked on discretionary policy in the form of the stimulus bill, but from the beginning this was offset by lower spending on the state and local level, and after a couple of years the Federal government did the same.
What do Kudlow and Moore say? This:
It would be hard to conceive of a worse set of policy prescriptions than the ones Larry Summers and his Keynesian collaborators have conjured up. We've had bailouts, massive spending-stimulus plans, tax increases on "the rich," Obamacare, rudderless monetary policy that has collapsed the dollar, the Dodd-Frank bill, anti-carbon policies, a vast expansion of the welfare state, and on and on. These measures have flat-lined the economy. It's as simple as that.
Well, no, if only it was as simple as that. First of all, much of these measures have very little to do with Keynesianism. Second, there is zero analysis of the effects of any of these measures. In fact, one could, with equal if not more justification, list the same measures, combine it with the table above that shows that the US recovery has been much stronger than anywhere else in the developed world, and argue that these policies are responsible for that.
It would be equally dodgy economics (which requires at least a modicum of analysis of the effects of these policies individually), but one is not hard pressed to come up with additional corroborating evidence:
- Austerity has waged considerably harder in the eurozone, and look what happened.
- The ECB has been much more reluctant to stimulate compared to the Fed (in fact, the ECB balance sheet has shrunk by a trillion euro in the last couple of years), and look what happened.
Second, when hit by a very Keynesian crisis, one should really produce a little more than just declare supposedly Keynesian responses as "hard to conceive a worse set of policy prescriptions," or say stuff like:
We're still waiting for the government-spending multipliers and the Fed's escape-velocity rebound to kick in.
They might want to check IMF studies about government spending multipliers, otherwise it would not hurt to see what actually happened with government spending:
That is, in 11 out of the last 12 quarters, public spending has been a drag (that is, austerity has reduced GDP). Or public employment:
The fact is that from 2008/9 onwards, we have a massive output gap, that is, there is a large difference between what the economy can produce if all production factors are employed and what it actually does produce.
There are basically four ways to close a large output gap:
- Liquidate: that is, slash "unproductive" supply, which is the Austrian recipe
- Fiscal stimulus: the Keynesian response
- Monetary stimulus: the Monetarist response
- Helicopter money: which can be constructed as both fiscal or monetary policy and is therefore advocated by some Keynesians and some monetarists.
Kudlow and Moore seem to argue that all these policies have had bad effects on the workings of incentives and markets and that this has prevented the economy from closing the output gap. We don't disagree that some supply-side measures could produce some benefits, although the onus is on the authors to substantiate these claims.
First, if lack of demand really isn't a problem and the economy is held back by structural impediments that need to be eliminated through supply-side measures one would expect inflation to be significantly higher than it is.
And it still leaves the authors papering over the fact that these supposedly Keynesian policies happened after the crisis, so they didn't cause it. And lest we forget, supply side measures can help the economy but the crisis originated very much from the demand side.
How easy it is to simply assume that supply-side measures could close a large output gap becomes clear when they start talking specifics:
Imagine for a moment that we abolished the corporate income-tax rate, slashing it from 35 percent to zero. The positive results would be near instant. In a matter of weeks, a tidal wave of capital and businesses would flow across our borders and deep into the United States.
Again, the beneficial effects are merely assumed, no single study is shown in support. You might also want to keep in mind that US corporations pay surprisingly little in taxes, just 1.6% of GDP, despite record profits.
Click to enlarge
Does one really think that abolishing these will unleash a tidal wave of investments? Since US corporations sit on record cash levels and produce record profits and can borrow at record low interest rates, why don't they do so already.
There doesn't seem to be a lack of funds, but corporations seem to prefer things like buying their own shares back, rather than to expand capacity. Could it be that it's not a lack of funds, but a lack of demand that is holding corporations back? Moreover, this is an international phenomenon:
Companies, together with private equity firms, are coming under mounting pressure to delve into a global cash mountain of $7 trillion (£4.1 trillion) that has been amassed since the dark days of the financial crisis. [Business Insider]
So it's unlikely the whopping corporate cash holdings are produced by the peculiarities of US corporate taxes, so perhaps abolishing these will not quite generate the spectacular effects that the authors assume.
We don't deny that supply-side measures can have a useful effect on the economy, but one really has to go into the nitty gritty of specific proposals. We're much less sure that a generalized supply-side approach consisting of tax cuts and deregulation is the right answer to what is a distinctly Keynesian crisis.
It is often argued that the US economic renaissance from the 1980s was the product of a supply-side revolution, but while we think some measures have been useful and positive, there hasn't really been much of a supply side revolution and the 1980s recovery could have been just as easily the result of interest rates falling from the 20% Volcker heights back to normal in quick order.
Without further ado, the authors also rubbish a set of theories under the banner of secular stagnation, which try to explain whether the economy is on a more or less permanent lower growth path (even before the financial crisis).
We fear that they do this a little too hastily and with little analysis. So we think that they overestimate the effects of a supply-side approach and underestimate the forces of secular stagnation, both of which might have longer-term consequences for stocks.
In a low-growth environment where stocks are richly valued already, unless companies manage to continue to increase profit margins or investors continue to tolerate even higher valuations, the environment for stocks and indexes (NYSEARCA:SPY) might very well not be as good in the coming years as it was in the past years.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.