Nobel Economist Robert Mundell

Brian Domitrovic’s Econoclasts writes of the rise of supply side economics as proposed by Nobel prize winning economist Robert Mundell and his intellectual emissaries, most notably Arthur Laffer.

The core of Mundell’s theory was that monetary policy should do only one thing- stabilize prices AND that fiscal policy should focus on stimulating the economy, most notably through a stimulative tax policy.   Either without the other gets it wrong.

George W. Bush got the tax cut part right, initially,  but got the monetary part wrong. Because the tax cuts were destined to expire he later got that part wrong.  As the dynamics of the 2008 election became clear the voters EXPECTED the tax cuts to expire and thus his term ended getting both parts wrong.

Monetary policy should focus on the external, the strength of the currency in global markets, and tax policy should focus on the internal, economic growth.

A strong currency may entail an increase in interest rates. While many fear that this may kill economic growth it will not if business growth is promoted through lower taxes.  Furthermore, higher interest rates brings in foreign capital, and the additional capital helps to avoid strangulation of growth.

Lower inflation and lower taxes also encourages transfers of wealth from tangible assets to financial assets which provides capital for jobs and business growth.  This was a particularly important source of the securities boom in the 1980’s Reagan economy.

When monetary policy tries to stimulate growth with loose money you are more likely to get inflation.  In a system with progressive tax brackets, inflation pushes the same purchasing power into higher brackets increasing their taxes and the effects of lower growth and higher unemployment. Add higher taxes to inflation and you get the double growth killing power of both forces. This is how the stagflation of the 1970’s came to be.

The damage is furthered as capital is pushed from the more productive financial sector to the tangible asset part of our balance sheet, where it can both benefit from inflation and avoid taxes.

This economy faces three hurdles Mundell did not in the Reagan era.  First, while higher interest rates may attract foreign capital the rise of the third world gives the American economy a bit more competition for capital, and it may not attract as much of it as it did the last time.  Secondly, the business community feels a little burned from radical legislation and the uncertainty of any policy, no matter how sound, that is subject to change in every two or four year election cycle.

Third the debt is so large that higher interest rates, needed to stabilize the money, would increase the government debt by more than economic growth can provide, especially a business community skeptical from inconsistency in policy.

Mundell’s theory is sound but its success may not be assured without large cuts in government spending and the development of some consistency in economic policy.  What worked with one set of numbers may not work as fast or as well with another much larger set of numbers.

The mix of a stable currency and lower taxes is still a promising prescription, but it is not one this administration is prone to take.