Source of this article:    http://www.andrew.cmu.edu/course/88-301/classical_model/who_supply.html

THE RISE OF SUPPLY-SIDE ECONOMICS

The central concept of supply-side economics is that tax cuts cause economic growth. Tax cuts allow entrepreneurs to invest their tax savings, which creates higher productivity, jobs and profits. This, ironically, allows the entrepreneur and his new workers to pay even more taxes, even at lower rates.

The supply-side idea is a simple one, and makes a popular political message. However, it is interesting to note that mainstream economists -- even conservative ones -- almost universally reject supply-side theory. In the early 80s, the influential and multi-partisan American Economics Association had 18,000 members. Only 12 called themselves supply-side economists.¹ In American universities, there is no major department that could be called "supply-side," and there is no supply-side economist at any major department.² This is significant, because academia in the 70s was dominated by conservative economic theory, and conservative economists normally welcome any ideas that make the case against government intervention. The fact that they scrutinized supply-side theory and rejected it wholesale gives eloquent testimony to the theory's bankruptcy. When candidate George Bush called it "voodoo economics" in the 1980 presidential campaign, he was doing so with the full backing of America's economic community.

Many people are surprised to learn that "conservative" does not necessarily equate to "supply-side" economics. The difference lies in spending. Mainstream conservative economists generally believe that tax cuts should be accompanied by spending cuts -- that is, fiscal responsibility. Supply-side economists believe that taxes should be cut -- period. Spending cuts and deficits, they believe, are not important considerations. The 1980 supply-siders claimed that the growth resulting from tax cuts would be so great, and the total tax collections increased so much, that America would simply outgrow its deficits. This did not happen, of course. Growth in the 80s was no greater than growth in the 70s, as the statistics here will show. But the national debt nearly tripled under Reagan. Who deserved blame for this is a controversy that continues to this day.

Supply-siders point out that their theories are not wrong simply because academia rejects them. This would be falling for the "argument from authority" fallacy. After all, it was once a scientific consensus that the earth was flat. Besides, scientific revolutions have always started out as minority opinions, which have often faced hostility from the consensus of the time. Although these are worthy points, they are not conclusive arguments against the value of scientific consensus. These are, after all, our best and brightest scholars, whose day jobs are to analyze these issues. Their theories should be among the first we consider. It does not mean that they are correct, of course, but more often than not their information is better, and their theories more coherent, than the average person's.

Who were the 1980 supply-siders? The following is my summary of Paul Krugman, one of the world's top economists, who gives an excellent account of their rise in his book, Peddling Prosperity. The supply-siders were what many have called "cranks," or people who stand outside the scientific mainstream and hurl accusations of basic stupidity and corruption at the entire scientific community. Cranks are people who are cut off from their academic colleagues, who neither argue before scientific conferences nor write for peer-reviewed journals. Instead, they speak before groups they themselves organize, and write for publications they themselves edit.

An unusually high percentage of supply-siders were not economists at all, but journalists with no formal training. Robert Bartley, who has run the editorial pages of The Wall Street Journal for nearly 25 years, was perhaps the movement's greatest spokesman. (His contempt for his critics can be seen in one of his chapters on the Reagan Years, entitled: "What You Learned If You Were Awake.") Other journalists included Jude Wanniski and Irving Kristol. Crusading in their national publications, they were able to reach a much wider and more popular audience than most economists could. Of course, journalists are normally reporters of stories, not creators of theories. You would expect them to report the latest cure for cancer -- but not claim that they had discovered such a cure themselves. This is common sense in most fields like biology and physics, but, for some reason, it is a line that many journalists like Bartley and Wanniski frequently cross when it comes to economics.

The movement did have a few intellectuals, but even here, its professors were far from the mainstream. Arthur Laffer has a Ph.D. in economics, but he has contributed little to scientific conferences or peer-reviewed journals, instead playing to crowds on the lecture circuit and writing for popular publications. He is famous for the Laffer Curve, which purports to show that productivity declines as taxation increases. Most economists agree that the general principle behind the Laffer Curve is correct, but widely disagree on how much taxation is necessary before productivity starts declining. Laffer believed that the effects of taxation were so heavy that cutting them would significantly boost productivity, thereby outgrowing any deficits caused by the tax cuts. Again, this prediction proved false.

Another supply-side economist was Paul Craig Roberts, a Congressional staffer for quarterback-turned-Congressman Jack Kemp. Another was Martin Anderson, who, stung by academia's refusal to hire supply-side economists, would go on to write a bitter tirade against academia in a book entitled Impostors in the Temple.

The movement has always claimed, however, that world-famous trade economist Robert Mundell was the father of supply-side theory. Although Mundell has never discouraged this impression, there is little evidence that it is true. Some of his beliefs -- for example, on the causes of the Great Depression -- go against the very fundamentals of supply-side theory. Mundell established his international reputation early in his career, but over the years his behavior has become increasingly bizarre and eccentric. He long ago dropped out of the academic circuit, and now accuses his former colleagues of "sheer quackery." But he remains more of a mascot than an intellectual founder of the movement.

So where did the supply-side ideas actually come from? From Laffer and Bartley, developed over a series of dinner conversations at Michael 1, a famous restaurant near Wall Street. It was here, scribbling on napkins, that Wanniski showed Bartley the magical effects of tax cuts. Krugman writes: "There it was that [Bartley] and Laffer discovered that Keynesian economics was logically inconsistent - an insight that had eluded [Nobel laureate] Paul Samuelson and a few thousand other people over the course of hundreds of academic conferences. They also discovered that Milton Friedman was wrong in believing that monetary policy could have important effects on the economy - an insight that had similarly eluded [Nobel laureates] Friedman, Lucas and the faculty of the University of Chicago over a generation of notoriously brutal conferences. And the results of these deep thoughts over dinner were for the most part published -- surprise -- on the editorial page of The Wall Street Journal, or in Kristol's Public Interest."³

Why Reagan by-passed thousands of qualified conservative economists for the council of a few supply-siders is a mystery. Perhaps the most likely reason was practical: the supply-siders told Reagan what he wanted to hear. To understand why, we should devote a paragraph to the economic problems that Reagan faced in 1980.

Until the 60s, there had been a tradeoff between inflation and unemployment. Government could achieve low unemployment by accepting high inflation; or it could achieve low inflation by accepting high unemployment. Earlier presidents had opted for low unemployment, which the Federal Reserve accomplished by expanding the money supply, thus giving people more money to spend. Extra spending means extra jobs. However, Milton Friedman and others pointed out that business people would eventually come to expect these inflationary increases, and they would simply compensate for them by raising their prices by the anticipated amount. This would not only negate the job-creating effect that more money in circulation would bring, but also make inflation worse. Eventually, they predicted, inflation would shoot up and then so would unemployment, breaking the tradeoff between them, and forming a twin monster that Paul Samuelson dubbed "stagflation." And, true enough, this is precisely what happened in the 70s.

Economists in the late 70s were at a loss for a cure. To fight high inflation, governments traditionally raise interest rates and cut government spending. To fight high unemployment, they do the opposite. Thus, fighting one dragon would only make the other worse. But the supply-siders told Reagan they had a solution. The Laffer Curve purported to show that tax cuts would actually increase tax collections. This meant that government could spend generously in an effort to curb unemployment, without requiring the burdensome taxes to pay for it. That was the first selling point.

The second selling point was Mundell's. Most economists believe that government spending and interest rates can only be used together, in tandem, to slay either one dragon or the other. But Mundell argued that they could be split up: government could spend generously to fight unemployment, and raise interest rates to fight inflation. Hedrick Smith writes: "...Mundell's argument was music to Reagan. A few advisors warned him that Mundell's approach would not work, could not work -- indeed, Reagan's own experience would prove that in 1982-83. But Reagan bought Mundell's theory anyway, for it told Reagan what he wanted to believe: that you could cut taxes, cut inflation, have economic growth, and balance the budget all at the same time." ⁴

The man charged to make this all work was David Stockman, Reagan's budget director. Stockman's genius and mastery of numbers was matched only by his relatively young age, which earned him the title of "whiz kid." Stockman, Roberts and Anderson came up with a massively optimistic forecast for the economy, which today Stockman derisively refers to as the "Rosy Scenario." The Rosy Scenario predicted that the 1981 tax cuts would produce 5 percent growth in 1982. (In fact, 1982 was the worst year since World War II, with negative growth of 2.2 percent.) Many budget-watchers pointed out that the tax cuts would only increase the deficit, but Stockman silenced all his critics with a blizzard of statistics and information. "Like a child prodigy chess champion playing fifty matches at once, Stockman answered every query, parried every countermove, checked every challenge," Smith writes. "Congress was mesmerized."⁵ Today, Stockman admits it was all a performance. "Even the appearance of being an expert is self-validating," he wrote five years later. "I didn't know much about budgets, but I knew more than the rest of them."⁶

But as early as August 1981, Stockman began having gnawing doubts about his budget. Computer simulations failed to project the tremendous growth he had predicted, and later he would admit to cooking the numbers (!) before selling the budget to Congress. That December, the Atlantic Monthly published an article in which Stockman made several damaging and embarrassing confessions about the entire supply-side philosophy. He admitted that the 1981 tax cut "was always a Trojan horse to bring down the top [tax] rate" for the wealthy. Cutting taxes for the rich had long ago been coined "trickle down economics" - and it was an unpopular concept with the middle class. "It's kind of hard to sell 'trickle down,'" Stockman told the interviewer. "So the supply-side formula was the only way to get a tax policy that was really 'trickle down.' Supply-side is 'trickle-down' theory."⁷

The Rosy Scenario failed to materialize. The economy did not grow out of its deficits. In 1986, Washington and the rest of the nation would again be surprised when Stockman confessed all in a book entitled The Triumph of Politics: Why the Reagan Revolution Failed.

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¹ James Carville, We're Right, They're Wrong: A Handbook for Spirited Progressives (New York: Random House, 1996), p. 12.
² Paul Krugman, Peddling Prosperity: Economic Sense and Nonsense in the Age of Diminished Expectations (New York: W.W. Norton & Company, 1994), p. 85.
³Ibid., p. 91.
⁴ Hedrick Smith, The Power Game: How Washington Works (New York: Ballantine, 1988), p. 345.
⁵ Smith, p. 353.
⁶ David Stockman, The Triumph of Politics: Why the Reagan Revolution Failed (New York: Harper & Row, 1986), p. 56.
⁷ William Greider, "The Education of David Stockman," The Atlantic Monthly, December 1981, pp. 46-47.