How the Economy Was Lost: The War of the Worlds (Counterpunch) (20 page)

Part Two: The War of the Worlds

Chapter 48: Where Economics (Mainly) Succeeds

E
conomics can successfully explain the efficient allo-
cation of resources by the price system and the allocation of investment by profitability. Relatively speaking, these successes are new. It was Alfred Marshall at the turn of the 20th century who explained price formation. Prior to Marshall, economists debated whether price was determined by the cost of production or by demand—what people were willing to pay. Marshall ended the controversy by pointing out that supply and demand are the two blades of the scissors. Together they determine price.

Profit is the normal return on capital. A normal profit depends on time and circumstances. It is the profit necessary to retain capital in an activity. If capital cannot earn a normal rate of return in an activity, capital is not supplied to that activity. This ensures that capital is not wasted in low value uses. Whenever capital earns a higher than normal return, it is a sign that it is employed in a high value use. The excess profits will lead to an expansion of investment in that use until profits are reduced to normal.

Without price and profit signals, there is no way of knowing how to efficiently use resources to produce the highest valued output. The Soviet economy failed because the system’s gross output indicators, the main signal of managerial and plan success, could not tell if inputs were more valuable than outputs.

The study of the price system is known as microeconomics. It is the soundest field of economics. “Free prices” simply means the freedom of prices to change with supply and demand. It does not mean laissez faire or no rules and regulations. The “free market” means the freedom of prices to change as conditions change.

Economists concluded from the Great Depression that a price system could function without ensuring full employment. This conclusion led to the rise of macroeconomics, the study of the factors leading to the overall level of prices and employment.

John Maynard Keynes was the first macroeconomist. With his 1936 book,
The General Theory of Employment, Interest and Money
,
he spawned the Keynesian economics, of which the American economist Paul Samuelson is doyen. Keynesian macroeconomists concluded that employment and the price level depend on the level of total spending. If consumers saved more than investors invested, it would result in a leakage from the spending stream and a shortage of aggregate demand (the total demand for resources from consumption and investment). The shortfall in spending would cause a decline in employment and prices.

On the other hand, if somehow there was an excess of spending, the demand on resources would drive up prices and the economy would experience inflation.

Macroeconomists concluded that the way to manage the economy was for the government to manage demand. If there was insufficient spending to maintain full employment, the government would fill in the gap by running a deficit in its budget. That is, the government would spend more than it received in tax revenues, thus adding to aggregate demand.

If there was too much spending, the government would reduce the amount by running a budget surplus. In other words, the government would collect more in tax revenues than it would spend, thus contracting the spending stream.

The Keynesians were on to something, but the only economist (a physical chemist actually) who got it right was Michael Polanyi in his 1945 book,
Full Employment and Free Trade
(Cambridge University Press). Polanyi correctly interpreted Keynes’ theory to mean that widespread unemployment meant that there was a dearth of money. What the government needed to do was to expand the monetary circulation. It could do this, Polanyi noted, simply by printing money to pay its bills.

Polanyi was on to more important deductions than the Keynesians. He said that it was pointless and expensive for the government to borrow money, on which it had to pay interest, in order to spend, when it could far more cheaply provide the missing purchasing power by printing the money to cover its budget deficit. Polanyi saw fiscal policy as a way to expand the money supply when reluctance or impaired ability to borrow and lend prevented the central bank from expanding the supply of money.

At that time, Polanyi’s conclusions were over the head of the economics profession. But two decades later, in the 1960s, Milton Friedman and Anna Schwartz made it clear that the depression in the U.S. during the 1930s was caused by Federal Reserve mistakes that resulted in one-third shrinkage in the supply of money. The depression in the U.K. following World War I resulted from the decision by the British government to go back on the gold standard at the prewar parity of the British pound sterling and gold. As the money supply had expanded so much, the return to gold at prewar parity required shrinkage in the money supply, a shrinkage that collapsed employment and prices.

Thus, the Keynesians, who had the right idea, initially did not understand that full employment was a monetary phenomenon. If government spent more by borrowing to finance its deficit, its borrowing reduced spending on consumption and investment just as taxation did. A budget deficit could boost consumer demand only if the central bank accommodated the deficit by expanding the money supply.

The Keynesians’ second mistake came from their failure to understand the impact of fiscal policy on supply. To maintain full employment, the Keynesians came to rely on monetary expansion. Keynesian demand management kept money and credit abundant to ensure sufficient spending. To restrain inflation, Keynesians relied on high tax rates to withdraw spending power from the population that the easy monetary policy provided. The Keynesian economists believed that high taxes served to reduce consumer demand to noninflationary levels. In fact, high tax rates reduced the supply of labor and the supply of goods and services, while easy money pushed up consumer demand. Consequently, prices rose.

The Keynesian demand management policy came unglued during the Carter administration in the late 1970s, when worsening trade-offs between inflation and unemployment left macroeconomists with no policy solution except wage and price controls. In other words, the failure of macroeconomics meant that the price system would not be allowed to allocate resources.

Congress had recently had an experience with fixing one price—the price of oil—and it had been a disaster. Congress was in no mood to fix all prices. Congress preferred to listen to new voices, the voices of “supply-side economists” (in contrast to Keynesian “demand-side economists”). Supply-side economists were new macroeconomists who had both blades of the scissors. They pointed out that, in Keynesian macroeconomics, fiscal policy (changes in tax rates or changes in government spending) only affects aggregate demand: higher taxes reduce consumer purchasing power and total spending declines, lower taxes increase consumer purchasing power and aggregate demand rises. Supply-side economists said that, in fact, changes in marginal tax rates (the rate of tax on additions to income) change aggregate supply.

Supply-side economics is a correction to Keynesian demand management. It has nothing to do with “trickle-down economics” or with a claim that tax cuts pay for themselves. Supply-side economics says that some fiscal policies shift the aggregate supply curve, not the aggregate demand curve. Specifically, if marginal tax rates are raised, there will be fewer goods and services supplied at every price. If marginal tax rates are lowered, there will be more goods and services available at every price.

Today, this conclusion is no longer controversial. But in the 1970s it was a new thought. Initially, Keynesians resisted it, but in the mid-1980s Paul Samuelson came to terms with supply-side economics in the 12th edition of his economics textbook and accepted in principle the relative price effects of fiscal policy.

By bringing relative prices that affect individual behavior into macroeconomics, supply-side economists integrated micro with macroeconomics, a long-standing goal that economics had not achieved. Supply-side economists showed that a shift in marginal tax rates changes relative prices and affects individual decisions whether to save more or to consume more, and whether to work more or to enjoy more leisure. The allocation of income between saving (investment) and consumption and the allocation of time between work and leisure affect the growth rate of the economy. (See Paul Craig Roberts,
The Supply-Side Revolution
, Harvard University Press, 1984.)

Think about it this way: The cost of current consumption is the foregone future income from saving and investment. Income is an after-tax phenomenon. The higher the tax rate on income, the less current consumption costs in terms of foregone future income or, in other words, the less future income is given up by today’s consumption. The lower the tax rate, the larger the amount of future income that is lost by consuming instead of investing.

For example, consider the 98 percent tax rate on investment income that was the rule in England prior to Prime Minister Margaret Thatcher. Suppose a person has £100,000. Shall he invest it or purchase a Rolls Royce? If he invests the money at, say, 10 percent, he would earn £10,000 before tax. But after-tax, his earnings would be reduced to £200. Thus, the opportunity cost of the Rolls Royce is a measly £200 a year in foregone income. The high tax rate on investment income makes current consumption extremely inexpensive in terms of foregone income.

If the tax rate on investment income is 15 percent, the cost of the Rolls Royce in terms of foregone income would be 8,500 pounds per year, or 42.5 times as much annually. The 98 percent tax rate on investment income makes the Rolls Royce essentially a free good. The 15 percent tax rate makes the car purchase expensive.

Similarly, the cost of leisure is the income given up by not working. The higher the tax rate, the less the after-tax income lost by using time for leisure instead of work. The lower the tax rate, the more expensive is leisure in terms of foregone income. The marginal tax rate on earned income thus affects the supply of labor.

Supply-side economics also corrected a mistake in capital theory. Economists taught that the interest rate determines the cost of capital. If the interest rate is high, capital is costly and investment small. If the interest rate is low, capital is cheap and investment flourishes. At one time this theory made sense, and that time was prior to the income tax. Capital theory originated prior to the income tax, and until supply-side economists came along, no adjustment was made for the impact of taxation on the cost of capital. When there is an income tax, profits or the earnings of capital are an after-tax phenomenon. The higher the tax rates, the higher the cost of capital, and the less is investment and the growth of the economy. (See Paul Craig Roberts, Aldona Robbins, and Gary Robbins, “The Relative Impact of Taxation and Interest Rates on the Cost of Capital,” in
Technology and Economic Policy
, edited by Ralph Landau and Dale Jorgenson, 1986.)

Supply-side economists added supply to the macroeconomic scissors. Prior to supply-side economics in the 1970s, macroeconomics was stuck in the pre-Marshallian past. The stagflation that destroyed Jimmy Carter’s presidency was induced by policy. Demand-side Keynesians pumped up consumer demand with easy money, while they restrained output with high tax rates. The result was stagflation.

People unfamiliar with facts claim that it was Federal Reserve chairman Paul Volcker’s tight monetary policy that cured stagflation. This erroneous claim ignores that prior to the Reagan administration’s supply-side policy, tight monetary policy had had no effect on stagflation. Indeed, all Volcker’s tight money did was to drive interest rates on money market funds to 17 percent, thus providing plenty of consumer spending power to drive inflation higher while high tax rates suppressed investment.

Today, Keynesian economics has been reconciled with monetarism and with supply-side economics, making macroeconomics a coherent whole.

However, today macroeconomic policy faces new challenges. In the 21st century, the U.S. economy has been kept going by an expansion in consumer debt, not by rises in consumers’ real incomes. Consumers are up to their eyeballs in credit card and mortgage debt. They are no longer in a position to borrow more in order to spend more. Interest rates are very low, and the government’s budget deficit is very large; yet, the economy is sinking.

Monetary and fiscal policy cannot help when the problem is that American jobs have been relocated offshore. Because of offshore production, stimulating demand stimulates production in China and other offshore sites. As high-productivity jobs have been offshored, American incomes, except for the super-rich, have ceased to grow. Thus, there is no effective way to boost consumer spending short of printing money and giving it to the population, or handing out tax rebates accommodated by monetary expansion.

Prior to the collapse of world socialism and the rise of the high-speed Internet, it was not possible to offshore jobs or production for U.S. markets to any significant extent. In those prior times, American incomes rose with productivity. If a glitch in employment occurred, an expansionary demand-side or supply-side policy would boost employment and GNP. Today, the jobs have been moved abroad. They are no longer here waiting on an expansionary policy to call Americans back to work.

Trade deficits mean that consumers have spent their money on goods produced abroad at the expense of domestic GDP and employment growth. Writing on the
CounterPunch
website (Dec. 11, 2008), economist Peter Morici reports that U.S. GDP is $1.5 trillion smaller as a result of the record trade deficits accumulated over the last 10 years.

A country that gives away its productive capability and becomes dependent on foreign creditors to finance its budget and trade deficits is a country that has problems beyond the reach of monetary and fiscal policies. For example, no country’s borrowing ability is unlimited. The U.S. has been financing its trade and budget deficits by turning over the ownership of existing U.S. assets and their income streams to foreigners and by foreigners recycling their trade surplus dollars into the purchase of new U.S. Treasury debt. This dependence on foreign creditors now constrains U.S. monetary and fiscal policy.