President-Elect Donald J. Trump
In Part I of this two-part series, we discussed the huge spending problem the federal government has, the current deficit situation, the fiscal consolidation plans of Republicans in the US House, and the three successful episodes of supply-side stimulus that occurred in the 1920s under Treasury Secretary Andrew Mellon, in the 1960s under President John F. Kennedy, and in the 1980s under President Ronald Reagan. In Part II, we will discuss the arguments against supply-side stimulus that arose when the George W. Bush Administration's tax cuts were widely recognized to have failed.
Then we will revisit the question of balance between Republican fiscal consolidation plans and supply-side reforms. Finally, we will take a stab at resolving some of the issues being debated, arguing in favor of an internally consistent plan that is mindful of the theoretical constraints on supply-side policy.
ARGUMENTS AGAINST THE EFFICACY OF SUPPLY-SIDE STIMULUS
Now we come to an episode in the history of supply-side economics that remains a real sore spot for both proponents and opponents of the theory. This is of course the cautionary tale of the failed Bush Administration tax cuts of the early 2000s. Keynesians have roundly criticized supply-side economics based on the generally acknowledged failure of George W. Bush's tax cutting policies (Mark Thoma, 2012; Rex Nutting, 2012).
Some criticisms are purely political, but the remaining arguments have enough substance to require some careful consideration (Matthew Mitchell & Andrea Castillo, 2012). Economic growth was slower in the years after the Bush tax cuts than in the years before (Chart 1). Population-adjusted job growth, which had soared (Chart 2) under the supply-side stimulus plans of Presidents Kennedy (1964-1968) and Reagan (1982-1988), actually plummeted under President George W. Bush's tax cutting plans (2001-2008).
Chart 1: Lackluster GDP Growth Under President George W. Bush
Chart 2: Population-Adjusted Job Growth Plummeted Under President George W. Bush (2001-2008)
In Part I of this series, I pointed out that in the current debate about supply-side economics, opponents argue that since substantial increases in the national debt have occurred in conjunction with all three of the previous successful supply-side episodes, and the debt also went up dramatically amidst the unsuccessful Bush stimulus program, it may be a limiting factor going forward. Yet the first three episodes of supply-side stimulus were still successful in spite of rapidly increasing debt. So, as I said before:
Does this matter? Liberals say it doesn't when they are in power, and conservatives say it does when they are out of power. These roles reverse when power changes hands. Separate from the politics though, there must be a practical answer to this question."
There are some economists (e.g., Van R. Hoisington & Lacy H. Hunt, 2014; Reinhart and Rogoff (2009; It's Different This Time: Eight Centuries of Financial Folly, Princeton University Press, Princeton, NJ, 463p) who believe that debt can reach levels where it impedes growth more or less permanently, as suggested by the trends seen in Chart 3.
Chart 3: Apparent Negative (Positive) Impact of Rapid Debt Increases (Decreases) on GDP Growth
Now, if rapid debt increases affect GDP growth negatively, then this should be a limiting factor whether the stimulus is supply-side ("Mundellian"), Keynesian, or anything else. Indeed, the most rapid debt increase observed since World War II has been the one under President Obama, whose attempts at Keynesian stimulus have unsurprisingly had muted success, as shown in Chart 4. There are perhaps some other contributing factors to consider in this example, like demographics, but still, recent economic trends support the argument that massive increases in debt are not conducive to growth.
This debt-limiting factor has given rise to the argument that the Bush tax cuts directly blew out the deficit (Jon Perr, 2010), killing off economic growth in the process. However, an evaluation of the data suggests that spending really took off under the Bush Administration (Chart 5), with debt/GDP leaping 7% over the 8 years of Bush's two terms.
The debt/GDP ratio continued to rise under the Obama Administration, and it is this increase under the two most recent presidents that had the biggest impact on the national debt. In detail though, we can see in Chart 5 that in Bush's first term, the tax cuts were predominant, whereas in Bush's second term, spending took the lead and was still the dominant factor all the way through to 2011.
Chart 4: Reagan vs. Obama Employment Trends
Chart 5: Profligate Spending Is What Drove the Deficit Up Under Bush (and Obama)
The lack of spending discipline during the Bush Administration is not the only factor that caused the Bush tax cuts to fail. Another major factor was the design of the tax cuts themselves, according to economists Matthew Mitchell & Andrea Castillo (2012). They argue that the tax cuts were phased in very slowly over five years, which had "the perverse effect of encouraging consumers… and investors to delay economic activity until the anticipated tax conditions were better." The same phenomenon was noticed with the initial 1981 Reagan tax cuts, and meaningful positive impact was delayed until these cuts were fully phased in (cf. Chart 2 above).
The Bush tax cuts were passed under a Budget Reconciliation measure, which means that they were expected to expire in ten years or face a renewal vote. This is also detrimental to supply-side goals because it suggests to people that it's not really a case of taxes being cut, but rather of taxes being deferred, which again would cause people to hesitate on major spending decisions.
Eventually, in 2012, the ten-year renewal vote came up and most of the Bush tax cuts were finally made permanent. Furthermore, another strike against the Bush tax cuts in 2001 is that they were small, cutting rates only 11%, and even that took a heck of a fight to get (Peter Ferrara, 2009).
Bush's tax cuts were actually designed to have a Keynesian tilt to them rather than a pure supply-side nature, as Bush himself mentioned repeatedly. Thus, a big part of the Bush tax plan included things like exemptions, deductions, and credits, rather than straightforward tax-rate reductions. But exemptions and such are not quite the same as cash in hand, and the effect on consumption was therefore much more muted than it would otherwise have been.
Another claim made by Bush's opponents is that the tax cuts favored the rich, unlike the Kennedy and Reagan tax cuts. If true, this would have been another mistake, because the perception of fairness affects how people feel about their own tax cuts, and thence how they spend. However, Timothy P. Carney (2015) has pointed out that the 2001 Bush tax cut moved about 7.8 million taxpayers to zero rates. Although the rich got big tax cuts too, their share of the federal income tax burden actually increased. In any case, the perception was still widespread that the cuts favored the rich.
President Bush rounded out his mistakes on tax policy by passing a Keynesian tax rebate plan through Congress when the economy began to slide into the Great Financial Crisis in 2008. This kind of thing has never worked, for the obvious reason that it is usually seen as a temporary measure that is in fact prima facie evidence of a crisis.
This induces people to hoard the money or pay down debt rather than spend it, and that is exactly what they did. All in all, President Bush's policies were not true supply-side measures, but rather a bizarre mixture of Keynesian and "Mundellian" stimulus that was poorly executed to boot. It is not really very surprising that the Bush tax cuts failed nor should the failure of the Bush tax cuts be construed to imply that supply-side economics in general cannot work.
THE TRUMP ADMINISTRATION'S STIMULUS PLANS
The new Congress has already been sworn in, and President-elect Trump will take office in less than two weeks. Big plans are afoot to do everything from more or less Keynesian infrastructure spending (discussed elsewhere), to purely supply-side measures like tax reform and deregulation. Of course, not everything will get done at once, and some ideas may never make it through the Congressional sausage-making process. Deregulation actually looks pretty promising, as it proved to be very effective when Presidents Carter and Reagan tried it (in the beer and airline industries respectively) almost 40 years ago (cf. Charts 6, 7).
There may be similar attempts by the Trump Administration to take on the problem of a highly regulated industry (like the financial sector) and see what happens when regulations are slashed. There are many issues to be considered when doing this, but there is no question that when done right, deregulation can provide a home run for certain segments of the economy. Deregulation is a pure supply-side form of stimulus and can be very fast-acting.
Chart 6: Beer Industry Deregulation Was a Tremendous Success
Chart 7: Airline Deregulation Was a Great Success
THE CONTRADICTION INHERENT IN THE HOUSE 2017 BUDGET
As I pointed out in Part I of this report, there has been a substantial effort by Speaker of the House Paul Ryan and the House Budget Committee to develop a fiscal consolidation plan. This plan is projected by the CBO (Chart 8) to cut federal spending really significantly by 2026, if enacted. The problem is that this plan seems to be in direct contradiction to Mr. Trump's plans for infrastructure spending, expanded defense spending, and tax cuts.
Naturally, the Republicans will have to work something out, but the danger here is that some bizarre mixture of Keynesian stimulus, supply-side stimulus, and fiscal consolidation will be cobbled together in some kind of Rube Goldberg legislative push that will leave us with a plethora of partial measures, all of which fail. We already saw something like this during the Bush presidency, and we need to do better this time around.
Chart 8: CBO Projection of Republican Fiscal Consolidation Plan
Fiscal consolidation per se can be very effective, as the Clinton policies proved to be from 1993 to 2000 (Charts 9, 10). So it is not obvious that the only correct approach is a stand-alone supply-side stimulus package at this juncture. However, it should probably be mentioned also that part of President Clinton's success was due to his good fortune in having very loose Fed policy in place for most of his two terms in office. That is very unlikely to be the case for President-elect Trump over the next few years.
Indeed, we face a non-zero risk of a mild form of stagflation, in my opinion, and this may require something with some juice in it, like a supply-side stimulus involving major deregulation. It is possible in fact that the solution to our current slow growth dilemma is some combination of fiscal consolidation, deregulatory stimulus, and tax cutting stimulus that balances any tax cuts with equivalent or even bigger spending cuts that involve non-productive government programs. This actually might appeal to Mr. Trump, if his recent comments about government waste are any guide.
Chart 9: Note the Effects of the Clinton Era Fiscal Consolidation
Chart 10: Economic Growth During the Clinton Era Fiscal Consolidation
SUMMARY OF PART II
We have dealt with some of the criticisms of supply-side tax cuts, especially those put in place by President Bush. In my opinion, the efficacy of supply-side economics is not disproven by the Bush tax cut failure, because it was neither an entirely supply-side stimulus nor a well-executed plan. The previous successful applications of supply-side stimulus in the 1920s, 1960s, and 1980s indicate that supply-side stimulus, when properly designed, can be very effective in boosting economic growth.
It is problematical that personal income tax rates are much lower (on the federal level) than they were in previous tax-cutting episodes, as this diminishes the power of any tax cuts. Corporate income tax cuts could be larger, but it is not at all clear that corporations would use the money for investment rather than share buybacks and other boondoggles. But if states could somehow be induced to lower their personal income tax rates due to federal regulatory reforms and perhaps federal grants-in-aid, then a significant overall tax cut might still be achieved.
However, the deficit has grown significantly in every supply-side stimulus case after the 1920s, and it would be prudent to put in place some fiscal consolidation measures (spending cuts) that over time would tend to offset some of the increased spending expected under a supply-side stimulus. While this seems completely counter-productive at first glance, the elimination of some of the massive waste in the federal budget would hardly damage growth, since it serves no economic purpose, yet would help repair the fiscal deficit.
Examples of government waste are simply astounding, and surely a little spending discipline could cut many billions of dollars from the budget without hurting anything in the actual economy (cf. Eric Pianin, 2015). Mr. Trump is fairly likely to be able to do this, in my opinion. Combining these measures with aggressive deregulation might be just the combination of factors we need to really get things going. Therefore, I am in favor of keeping parts of all the plans that the Republicans have discussed. The key will be in obtaining the right mix to get the desired result.
Those who believe that the Trump Administration will be able to pull off improved growth and stable inflation under a range of supply-side policies should buy the dips in equities over the coming months. Expect these dips to be significant however, as the market appears to have already priced in strong earnings from Trump's first year, in spite of the fact that he has not even taken office yet.
Those in a more defensive frame of mind because of the expected dips should hold some intermediate to long Treasuries: the iShares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT), the Vanguard Intermediate Term Bond Fund (NYSEARCA:BIV), the PIMCO Total Return Active ETF (NYSEARCA:BOND), and the SPDR DoubleLine Total Return Tactical Bond Fund (NYSEARCA:TOTL). Also some liquid alternatives like the Otter Creek Prof. Mngd. Long/Short Portfolio (MUTF:OTCRX), the AQR Long/Short Equity Fund (MUTF:QLENX), the AQR Managed Futures Fund (MUTF:AQMNX), and even some sophisticated hedge-like Closed-End Fund strategies like the Nuveen S&P 500 Buy-Write Fund (NYSE:BXMX).
Disclosure: I am/we are long TLT, BIV, BOND, OTCRX, QLENX, AQMNX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.