Refuting Reaganomics, Part 3 – Reality, Keynes, and “Demand Side” Theory

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Milton Friedman (Spooner)

The math is easy: the federal budget over the next decade cannot be made to square without raising a lot more money. The nonpartisan Congressional Budget Office estimates that if we stay on our current path, federal debt held by the public will grow from about two-thirds of gross domestic product today to roughly 100 percent in a decade and twice that much by 2040. It is unlikely that even the most committed Republicans could reverse the trend without higher taxes.

But an equally compelling reason relies on a new understanding of the economics of taxation. For 30 years, any proposal to raise taxes had to overcome an unshakable belief that higher taxes inevitably led to less growth. The belief survived the Clinton administration, when taxes rose and the economy surged. It survived George W. Bush’s administration, when taxes were cut yet growth sagged.

But now, a growing body of research suggests not only that the government could raise much more revenue by sharply raising the top tax rates paid by the richest Americans, but it could do so without slowing economic growth. Top tax rates could go as high as 80 percent or more.

Admittedly, it seems inconceivable that our political system could stomach a tax increase that big. Today, the richest 1 percent of Americans pay a top federal rate of 29 percent, according to Emmanuel Saez, an economist at the University of California, Berkeley. That’s because almost a third of their income derives from capital gains and dividends — which are taxed at a 15 percent rate — while the rest is ordinary income taxed at a top marginal rate of 35 percent.

Nonetheless, the research suggests there is much more money available to close the budget deficit than we previously thought, if only we were willing to raise tax rates to where they were back in the early ’70s, in the administration of Richard M. Nixon.

Taxpayers always want to pay less to the tax man. Still, there’s nothing inevitable about low taxes. In the early 1950s, coming out of World War II, the top federal income tax rate exceeded 90 percent. In 1980, the top marginal rate was 70 percent for families making more than $215,400 — about $587,000 in current dollars. And these families pocketed a much smaller share of the nation’s income than they do now. Today, people earning over $200,000 a year capture more than a third of national income.

— , “The Case for Raising Top Tax Rates,” The New York Times, March 27, 2012.  

Introduction

This is a solid, realistic report, signifying a new awakening to economic reality and mainstream media’s growing attention to the consequences of inequality.  If I were Emmanuel Saez or one of his associates, however, I might not be pleased with how the implications of their work are cautiously understated in Porter’s report.

It’s not just unlikely that the growth of federal debt can be reversed without raising taxes, it’s otherwise impossible, without destroying the federal government and the economy. And to suggest they have shown there is “much more money available to close the budget deficit than we previously thought” is misleading. “We” never thought the money wasn’t there.  As Michael Moore correctly stated in Wisconsin more than a year ago:

America is not broke. Not by a long shot. The country is awash in wealth and cash. It’s just that it’s not in your hands. It has been transferred, in the greatest heist in history, from the workers and consumers to the banks and the portfolios of the uber-rich. Today just 400 Americans have more wealth than half of all Americans combined.

Nor did “we” collectively believe that attempts to raise more tax revenue from the uber-rich would be doomed to failure.  And “we” certainly did not share the “unshakable belief” of Reaganomists that “higher taxes inevitably led to less growth.”

I can’t blame reporter Porter, I suppose, for trying to sugar-coat the bad news for trickle-down theorists, but with house Republicans having just passed what Paul Krugman calls “the most fraudulent budget in American history” (more on that later), this is no time to mince words:  This “growing body of research” doesn’t just suggest, it proves that the federal government could sharply raise the top tax rates paid by the richest Americans without slowing economic growth.  In fact, this research has shown that back when the top income tax rate was 91% after WW II there was both much lower inequality and much higher growth than after the top income tax rate was substantially reduced beginning 30 years ago.

This “new understanding of the economics of taxation” is not some new theory about how the economy works (although it does show the implications of extreme income inequality for the economic models we already have); it is a thorough econometric proof that the long-term application of regressive taxation has dampened growth, as Keynesian economics predicts.

This scientific, econometric research does nothing less than prove the validity of Keynesian “demand-side” economics and disprove “supply-side” Reaganomics.

Keynes v. Friedman

The element of caution in Porter’s report is understandable given the stranglehold the “supply-side” ideology has had on the economics profession over the last thirty years. Milton Friedman himself enlisted the emotional content of the words “free” and “freedom” (his books are entitled “Capitalism and Freedom” and “Free to Choose”) and his “free-market” bias in support of his theories and policies, undermining his apparent objectivity and connection with reality. [1]  In the article linked to the above photo of Milton Friedman, Nassim Khadem wrote:

Before the rise of Friedman’s influence, the theories of John Maynard Keynes had held sway over much of the economic profession. Keynes argued that governments should best tackle joblessness by increasing demand for goods and services, even if that meant accepting higher inflation.  Friedman rejected this approach. * * * Friedman’s central thesis [was] that inflation was generated by excessive growth in the supply of money.  * * *

Yes, Friedman and his followers did reject the Keynesian approach, but Khadem obfuscates the issue.  He adds that:

The Great Depression, Friedman argued, was a result of bad decision-making by the directors of the US Federal Reserve when they reduced the amount of money in circulation.

There’s nothing anti-Keynesian about that: The converse, of course, is that stimulating the economy would involve increasing the amount of money in circulation.  Keynes’ insights were foreshadowed by Marriner Eccles, a banker and wealthy industrialist who became Governor of the Federal Reserve Board from 1934-1948.  As discussed by Robert Reich, [2] Eccles too was concerned about the amount of money in circulation, and advocated a Keynesian solution.  Eccles realized that increased aggregate demand would be needed to stimulate investment:

Economists and leaders of business and Wall Street – including financier Bernard Baruch; W.W. Atterbury, president of the Pennsylvania Railroad; and Myron Taylor, chairman of the United States Steel Corporation – sought to reassure the country that the market would correct itself automatically, and that the government’s only responsibility was to balance the federal budget.  Lower prices and interest rates, they said, would inevitably “lure ‘natural new investments’ by men who still had money and credit and whose revived activity would produce an upswing in the economy.” Entrepreneurs would put their money into new technologies that would lead the way to prosperity.  

But Eccles wondered why anyone would invest when the economy was so severely disabled.  Such investments, he reasoned, “take place in a climate of high prosperity, when the purchasing power of the masses increases their demands for a higher standard of living and enables them to purchase more than their bare wants.  In the America of the thirties what hope was there for developments on the technological frontier when millions of our people hadn’t enough purchasing power for even their barest needs?” [pp. 12-13]

Accordingly, he insisted on the means to increase the money supply, for the stimulation of Main Street:

[W]hen the president summoned him to the White House to ask if he’d be interested, Eccles told Roosevelt he’d take the job if the Federal Reserve in Washington had more power over the supply of money, and the New York Fed (dominated by Wall Street bankers) less.  Eccles knew Wall Street wanted a tight money supply and correspondingly high interest rates, but the Main Streets of America – the real economy – needed a loose money supply and low rates.  Roosevelt agreed to support new legislation that would tip the scales toward Main Street. Eccles took over the Fed. [pp. 16-17]    

Monetary policy

Keynes, of course, understood and advanced economic theory regarding how interest rates relate to the stimulation of investment and growth. [3] It was his view that monetary policy, i.e. promoting low interest rates, was not the best way to encourage investment and growth.  The best way, he concluded, is to increase the economy’s “propensity to consume” through taxation:

The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways.  Furthermore, it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. [4]

Here is where Eccles’ observation that investment in the economy requires the expectation of consumer demand channels Keynes’ theories: However inexpensive it may be to borrow money, a potential investor still must expect commercial success before deciding to invest.  As Warren Buffet (August 14, 2011) puts it: “People invest to make money.”

In Part 1 and  Part 2 of this series, we showed that the ideology behind the Laffer curve’s assertion that high income taxes discourage investment is unfounded.  In Part 1, we pointed out that investment for production and growth instead depends upon the marginal propensity to invest, which, in turn, depends upon the amount of income in the economy available to provide demand for goods and services.  As explained by Encyclonomic WEBpedia, the standard formula for calculating marginal propensity to invest (MPI) is:

MPI = change in investment/change in income

The marginal propensity to invest is another term for the slope of the investment line. * * * The investment line is positively sloped, indicating that greater levels of income generate greater investment expenditures by the business sector. 

Investment Line:
Investment Line


Supply-side economics provides no theory for the stimulation of investment, beyond the assertion that investment responds to low interest rates, and the incorrect assertion discussed earlier that it responds to low taxes.  We are left only with the demand-side explanation, namely that the investment is needed to serve aggregate demand.

Fiscal Policy

Keynes recognized that income is either saved or spent, according to the economy’s aggregate “propensity to consume.” Fiscal policy is the means by which government pursues the Keynes/Eccles objective of putting more money into circulation to increase aggregate demand and stimulate growth.  The government can borrow money, and increase the amount of money in circulation through deficit spending, or it can increase the tax revenue collected from the rich, and inject revenue into the economy so as to increase the aggregate “propensity to consume.”

As explained previously here on this site, when after-tax incomes rise following a tax reduction, people spend portions of the increment according to what economists call their “marginal propensity to consume.”  Keynes explained that to increase economic activity and jobs via a tax reduction, the community’s overall “propensity to consume” must be increased. [5]  Very wealthy people spend a lot of money, but they save a very high percentage of their incomes, so when their incomes rise, they save most of the increase: They have a very low “marginal propensity to consume.”  Reducing their taxes, therefore, reduces the economy’s overall propensity to consume.

          On the other hand, low-income people have a very high marginal propensity to consume, so cutting their taxes or putting money in their hands increases the demand for goods and services and the community’s overall propensity to consume, stimulating employment and production.  In fact, the best stimulus is provided by unemployment insurance, because all or nearly all of that money is quickly spent, reentering the economy.

In short, cutting taxes for the rich tends to depress (reduce) the economy, and cutting taxes on lower incomes tends to stimulate (grow) the economy.

During the Reagan and G.W. Bush years, government engaged in deficit spending, taking in less tax revenue than it spent.  This factor in isolation tended to stimulate the economy.  If the economy’s propensity to consume had been maintained, this would have led to additional growth.  However, the top tax rate was also substantially reduced in these years, and this factor in isolation significantly reduced the economy’s propensity to consume, stifling additional growth.  Consequently, the use of expensive fiscal policy (deficit spending) to finance tax cuts for the rich, instead of promoting economic growth simply resulted in higher income inequality.

Concluding Thoughts on Friedman’s Supply- Side Bias

Before setting forth the cold, hard evidence that proves all of this, in a separate Part 4 to this series, the nagging question of why supply-side economics has gone so far wrong must be addressed.  Khadem writes:

It was not until 1979, when inflation was out of control, that former US Federal Reserve chief Paul Volcker used Friedman’s ideas. He beat inflation by curbing money supply and increasing interest rates.

In 2000, when Ben Bernanke, now chairman of the US central bank, acknowledged: “Regarding the Great Depression, you’re right. We did it. We’re very sorry. But thanks to you we won’t do it again.”

There is no doubt that Keynesian influence waned with the raging stagflation at the end of the Carter administration.  Alert economists, however, must have noticed that the classical assumption of automatic return from recession or inflation to an “equilibrium” condition of full employment with price stability was undermined as well.  And Keynes himself had said: “Our criticism of the accepted classical theory of economics has consisted not so much in finding logical flaws in its analysis as in pointing out that its tacit assumptions are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world.” [6]

In 1979, so far as I know, beating inflation by the recessionary approach of “curbing money supply and increasing interest rates” was the only sensible weapon in either the classical arsenal or the Keynesian arsenal.  We have since learned that cutting taxes for the rich also works well to curb the money supply (by increasing saving at the expense of consumption), but by the time Reagan cut the top income tax rate a few years later, cutting taxes on the rich was already being touted as the way to (somehow) stimulate growth.

What Bernanke might have been thinking twenty years later when he apologized to Friedman for the Great Depression  – We’re very sorry. But thanks to you we won’t do it again. – is mysteriously unclear.  A decade after that, they are doing it again.  The Great Recession has already been Great Depression 2 for the bottom 90% for four years and counting. And we’re right at the point — virtually zero interest rates and holding — that Keynes had warned would not likely “be sufficient by itself to determine an optimum rate of investment.”

Was this all designed from the beginning simply to free the uber-rich from the burden of taxation? In the absence of a demonstrated conspiracy, I’ll merely note how convenient this all is for the very wealthy, who have withdrawn so much of their support from the American society and economy from which they have taken so much.  How convenient, because as supply-siders like Arthur Laffer like to say, “nobody likes to pay taxes.”  How convenient, because rejection of Keynesian economics eliminates the main approach to raising aggregate demand in the economy — increasing their taxes.

We’ve been there before.  For Marriner Eccles, in the words of Robert Reich, “widening inequality was the main culprit” the last time around. [7]  As Yogi Berra might have said, “it’s deja vu all over again.”

JMH – 4/2/2012

______

[1]  How “free” do you think the markets really are?  How much do you think aggregate demand for gasoline affects the price Mobil/Exxon charges?  How much do you think aggregate demand for the ordinary necessities of every day life affect the prices mega-marketers like Walmart charge?  Do you think these prices are as low as they could be, or are these corporations making extraordinary profits?  For a thorough discussion of modern-day monopoly capitalism, see Cornered: The New Monopoly Capitalism and the Economics of Destruction, by Barry C. Lynn, John Wiley & Sons, 2010; See also  Thom Hartmann’s comments and this Barry Lynn speech.

[2] Aftershock: The Next Economy and America’s Future, by Robert Reich, Alfred A. Knopf, 2010, pp. 11-18.

[3] The General Theory of Employment, Interest, and Money,” by John Maynard Keynes, ch. 11-13;

[4] Id. at Ch. 23; Harcourt, Inc., 1964 edition, p. 378.

[5] Id. at pp. 245-248.

[6] Id. at 378.

[7] “Aftershock,” supra, p. 18.

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