Friday, July 08, 2011

What went wrong with supply-side economics?

The economic crisis of 2008/2009 had confronted the mainstream economic theory with an unpalatable task of revisiting the notions and perils of the ideas which dominated the course of economic theory in the last few decades. In 2003, delivering a speech to the American Economic Association, Robert Lucas famously noted that the central problem of depression prevention had been solved by mainstream macroeconomic theory which was built by combining the rational expectation hypothesis with New Keynesian macroeconomics. Although one should not obscure the achivements of new classical macroeconomics and new Keynesian macroeconomics, the criticism of contemporary macroeconomic theory is not uniform. It stems from the unrecognized role of systemic shocks in the financial sector and the spillovers from Wall Street to the Main Street. In contemplating the the linkages of over-leveraging and biased financial deregulation, it should not come as a surprise that early warnings of the financial crisis, mainly leveraged borrowing in the U.S subprime mortgage market, were earmarked in the mainstream economic theory.

In fact, in 1970, George Akerlof's influential paper on the issue of adverse selection in the market for lemons, was a landmark achievment in the economic theory since it demonstrated the falacies of perfectly competitive market mechanism when the information on quality of various commodities is distributed unevenly. In addition, a series of papers in 1970s by Joseph Stiglitz on screening theory and asymetric information, has dealt exactly with the central origins of the 2008/2009 financial crisis. Subprime loans and highly-complex derivate schemes which enabled the exponential growth of overleveraging of the banking sector were most likely to be used by the least sophisticated and accordingly the most risky borrowers. The only difference is that in normal circumstance, banks would recognize adverse selection by rationing credit to risky borrowers but the continuous obsession with home-ownership and the reluctance of the Federal Reserve to "remove the bowl of punch when the party started" - to use the analogy of Preston Martin, former Vice President of the FED - added to the turbulence of overleverage that turned into the most disastrous financial meltdown after the Great Depression.

The fact is that contemporary macroeconomics had little to offer to predict the subsequent financial meltdown although Robert Shiller of Yale University has repeatedly warned against unstable stock market fundamentals, particular notorious price-earnings ratios after the dot-com bubble came to burst. However, the central element of the critic of mainstream economic theory should revisit the notorious paradigm of supply-side economics whose intelectual melange of fervent belief in tax cuts and a dangerous preoccupation with deregulation as the cure of the malaise which led to stagflation in early 1970s, have proved how dangerous the conclusions could become.

First, the rise of the supply-side economics in the political economy began in early 1980s. But the intelectual influence of the supply-side economics should not be confined to the theoretical paradigm itself. The field of the political economy of taxation manifested itself as the intelectual triumph of supply-side economics. The original idea of the Laffer curve, the relationship between tax rate and tax revenues, was not disputable after all. In fact, if tax rates reached predatory levels, decreases in total tax burden would yield considerable gains, not only in total tax revenue but also in terms of higher level of productivity. However, when average and marginal tax rates were at moderate levels, it would be foolish to believe immense revenue gains would ensue by reducing the rates of taxation to bottom-levels, arguing for significant gains in terms of employment growth, productivity boost and total tax revenues. Even though cross-country empirical evidence does suggest an increase in tax revenues amid the decline in average tax rate, the pattern is confined to the episodes where average and marginal tax rates were very high, exceeding 70 percent threshold. Once tax rates were reduced, there is no evidence of higher revenue gains.

The major peril of supply-side economics is the claim that tax reduction would boost the aggregate supply and stimulate productivity growth. On the other hand, the valuable contribution of supply-side economics is the notion that additional tax increases do not generate much higher revenue. One should not feel reluctant to recall the 1964 Kennedy-Johnson tax cut which decreased marginal tax rates substantially. Although supply-side economics has repeatedly blasted the intelectual heritage of Keynesian macroeconomics, the 1964 tax reform was itself a Keynesian prescription for the U.S recession in the years prior to Vietnam war. Back in early 1960s, Paul Samuelson wrote that "Congress could legislate, for example, a cut of three or four percentage points in the tax applicable to every income class, to take effect immediately under our withholding system in March or April, and to continue to the end of the year." (link). Therefore, Samuelson's mindful observation that additional spending would not automatically counteract the recession unless complemented by tax reductions, probably would not come due in the framework of supply-side economics. Moreover, what distinguished the supply-side economics from the framework of sound economic analysis taught in microeconomic and macroeconomic textbooks, was adverse propensity to enforce tax cuts for the rich while leaving the middle class and low-income households no pie from tax reductions. The striking features of income inequality in the U.S. suggest that from 1970s, median household income stagnated (link) while top 5 percent of households have received disproportionately windfall gains from tax reductions up the point where more than 85 percent of total income was earned by top 5 percent of households (link). Moreover, one should distinguish between patterns of good and bad inequality as Gary Becker recently suggested (link). It is envitable that income inequality has some great value in the society when market outcomes lead to better overall health, less stress and higher standard of living and the evidence is yet inconclusive whether the narrowing of income inequality would return health improvements for the poor - since poor health outcomes of low-income households are mainly attributed to deteriorating dietary habits and dangerous lifestyle.

While bad inequality, especially rents from non-market outcomes, have precipitated the decline in good inequality in the last two decades, there is an overwhelming evidence that stagnation of median household income (despite moderate productivity improvements) caused a somehow lower quality of the U.S. labor force and a widening gap in educational achievments of American children. The drawbacks of widening inequality were largely ignored by supply-side economics or justified on the hands-off approach to the issues of the poor. It should not be forgotten that negative income tax, which favored low-income families, was suggested by Milton Friedman, whom supply-siders have taken for the intelectual father without a detailed knowledge of his precious contribution to economics.

Second, supply-side economics has been perhaps known for favoring the deregulation as the cure for social ills and staggering income growth. Despite substantial euphoria caused by the pioneers of deregulation of banking and financial sector, the regulatory framework eventually jeopardized sound regulation that could prevent hazardous outcomes as shown in the seminal work of George Akerlof and Joseph Stiglitz. In fact, deregulation of the banking sector, hailed by supply-side economics as the triumph of its own ideology, laid the basis for rigorous financial innovation by special investment vehicles (SIV) and shadow banking institutions.

In fact, deregulation of the banking and financial sector was not the central issue per se. The main systemic flaw was rather the adoption of unsound regulation that did not predict the perils of over-leveraged banking sector and especially the system-wide spillovers during the financial crisis. Moreover, the loosening of the monetary policy and the series of fiscal stimulus have notified two main drawbacks in the macroeconomic outlook. The first is the invariant postponement of taxation fuelled by the mountain of government debt. And the second is the hidden explosive potential for inflation following the flood of money supply in the balance sheet of the banking sector.

Generally speaking, the intelectual adventure of supply-side economics has overlooked the possibility of pitfalls brought up by rigorous tax cuts to the wealthy and deregulation of banking and financial sector. It would not come due to label mainstream economic theory as a cataclysm which the financial crisis proved accordingly. It would be either insensible to tarnish the useful contribution of supply-side economics. In fact, tax cuts do generate systemic incentives, particularly in the response of the labor supply to tax reductions. However, the elusive quest for higher growth and job creation after reducing tax rates for the wealthy, is an important lesson we should learned from the unfortunate turn of supply-side economics in favoring deregulation without acknowledging the possibility of systemic banking collapse and the consequences carried over by society at large.