Monday, February 02, 2004

Voodoo Economics II: Why Supply Side Economics says Bush's plans won't work!

INTRODUCTION: MARKET EFFICIENCY AS A DISCRIMINATING TOOL

In delving into so controversial a topic let us pose two elementary principles that will guide us in our discussions. The first is that supply and demand determine pricing only in an efficient market. The second important principle is that economic stability and growth depends upon neither supply or demand wholly but a balanced progress in both. The second principle definition derives from the first one. Economic stability and growth can only occur when a sufficiently efficient market can create a reciprocal shift to either a change in demand or a change in supply by changing the other. When the market response is to restore equilibrium this produces stability. When the market redistributes value, this creates growth. However, the problem is that in real life markets are not completely efficient or are as the oldman has discussed markets are not stable.

As the oldman has written of before, Keynesian economics advocates short term stimulation of demand in an economy in order to "cushion" shocks to the economic system and restabilize (cause them to approach efficiency) markets that have been destabilized (become more inefficient). Supply side economics advocates that growth and stability should be produced by encouraging the maximization of production and therefore the investment of capital to pursue that end. 'Free Market' or 'Free Trade' economists advocate that nothing should be done, since markets are already sufficiently efficient to restore their own stability.

As it turns out none or all of the above schools are correct depending upon the circumstance. If markets truly were perfectly efficient at the distribution of value then no intervention would ever be needed. Yet since people are irrational, speculative, and make choices based upon biased or incomplete information Keynesian demand stimulation cannot restore stability or growth if markets remain inefficient at distributing value. Likewise theoretically if we had more stuff (Supply side theory) then intuitively we'd be richer. But because of inefficiencies in markets in distributing value, often over-production can set off a "supply-shock" that will cause a deflationary price spiral and a market collapse in demand.

The appeal of each is pretty simple. Keynesians basically say that "Well if we spend more money now, then people will use it to buy stuff which will spur business growth to supply their demand.". Supply-siders basically say "Well if we make more stuff, people will have more to buy and they'll be more stuff to go around - making everyone richer." As mentioned above, in a perfectly efficient market either solution would work. Stimulating demand would create a compensating supply increase to meet it. Increasing production would cause prices to drop so that everyone could buy more goods and services. However inefficient markets and imperfect distribution means that sometimes neither solution will work straight-fowardly.

So as it turns out, what theory of advice one should follow depends entirely upon the current state of market efficiency and distribution of value or the likely prospects of restoring them.

UMM... WHAT IS MARKET EFFICIENCY OR VALUE DISTRIBUTION?

An efficient market is a theoretical ideal where all participants act rationally on perfect information that they all have about the true conditions of supply and demand in an economy, and all their actions are also transmitted transparently and instantly throughout the system. The theory of distribution was pioneered by David Ricardo, a truly great economist though he had his critics and detractors. The Distribution of Value is just a long-hand way of saying who get's paid what and what their labor should be worth.

SUPPLY SIDE TAX CUTS: DO THEY BRING GROWTH OR DEBT?
The present historical impetus for delving into all this economic arcana is a basic question: Do Supply-side inspired tax cuts stimulate the economy or just increase debt? Supply side advocates often refer to the "successful" Kennedy tax cuts as an example of a successful supply side tax cuts. Opponents of supply-side economics often argue that supply-side tax cuts enrich the wealthy. Who is right?

First let's correct some historical errors. Kennedy's tax cut did reduce the rate on the richest Americans, but it was primarily aimed toward increasing aggregate demand in the economy. In other words, it was Keynesian in aim and not meant directly to increase the investment of capital and production. That it did do so indirectly only supports the second principle proposed above, namely that supply and demand have to both progress for growth to occur.

Secondly, Bush's tax cuts were not supply-side tax cuts. The reason is that they were not matched by cuts in spending. Supply side theory calls for reduced taxes in order to spur investment and growth in production. The idea mainly is that the private sector can better utilize limited money as investment capital to produce higher returns than government social spending. If instead of cutting spending however, the Federal government borrows money and accumulates debt through the Federal Deficit then something worse happens. You see the money the government spends comes from being borrowed from the private sector so this is money not available to be used elsewhere. Not only that, but the money spent accrues interest which must be paid back. In addition, the ability to spend using borrowed money tends to produce fiscal immoderation causing growth in spending by government.

So for the growth stimulated by investment to be positive it must be a rate of return greater not only than the interest accrued by the debt borrowed by government, it must also outpace the growth in unchecked government spending. As anyone can see, this is an impossible task. Ironically all the modern tax cuts by Reagan and Bush43 have fallen into this pattern. So the Bush43 tax cuts are not supply side tax cuts!!! Whether or not one agrees that Supply Side economic theory works, it doesn't matter because even according to Supply Side economic theory the Bush43 tax cuts when not followed by cuts in government spending are simply prescriptions for disaster.

WILL AT LEAST THE TAX CUTS SPUR INVESTMENT AND GROWTH?

The answer is unfortunately, no. You can ask how the oldman can be so categorically sure of that. The answer is quite simply the subject first touched upon: market efficiency. Markets are not perfectly efficient even in their ordinary course of operation. When a market receives some sort of exogenous shock, it becomes even more inefficient. And government intervention into markets such as interest rate manipulation or changing monetary supply can actually prevent a return to market efficiency and equilibrium. As pointed out many many times, the Bush tax cuts are primarily slanted toward the rich. There are many arguments about why this is regressive or socially unjust. What the oldman would like to argue however, is that doing this kind of tax cut at this time is not unjust but moreover plain stupid.

Pretty much everyone can agree that the very wealthy already have more money than they can spend easily. Therefore having them keep more of their income doesn't directly boost demand. What happens to this money? Well the wealthy are wealthy partly because they invest. It's fairly noncontroversial to assume that the money they got from the tax cuts will be reinvested into the economy through businesses, stocks, bonds, etc. whoa! Isn't that exactly what Bush43 claimed however?

Well yes, but the problem is that the market hasn't returned to efficiency because of the Federal Reserve's intervention. In everyday plain talk what that means is that financial speculation or gambling with the money chasing ever higher short term returns is the major activity driving the financial markets right now. Investments always balance risk versus return, and this is necessary for a healthy market efficiency to prevail. But with the Federal Reserve promoting 'moral hazard' or basically the idea that the Central Bank will bail out investors if they get in over their heads then the perception of investment risk decreases. However precisely this attitude leaves them free of the fear of risks to pursue ever higher and higher returns. When this occurs to the majority of equity investors then speculation dominates the markets. The markets then cease to be efficient at pricing the "fundamental value" of actual aggregate supply-demand balance, and the market value rises so high as to be unsustainable and a crash inevitably follows.

So a series of tax cuts that feed a large amount of money into speculative market investments right into the teeth of a Keynesian intervention by the Federal Reserve is a "perfect storm" and threatens to cause a meltdown of the entire economic system. The oldman prefers like anyone else sane that work and innovation be rewarded, and that taxes be kept to a minimum needed to provide beneficial services. The oldman is also in favor of investment and growth, but the timing and execution in this case is god-awful and a recipe for a catastrophe. In this case, the money could have been much better spent in regulatory, trade, and structural economic reform that would have put a "bottom" into aggregate demand and deflated the bubble that the Fed only delayed and did not disappate by its intervention. After the economy recovered its equilibrium then give back the money in tax cuts to spur growth. (Note: No one but loonies thinks that if you expand government spending, borrow money, and cut taxes that it will spur economic growth.)

That would have been the right way to do it. As of now, it's just breeding a serious set of negative consequences that will have to be dealt with.

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