Keynesian, Monetarist and Supply-Side Policies: an Old Debate Gets New Life

Home , Goods and services, Money, Recession, Supply (economics)

M. Scott Niederjohn and William C. Wood

Debates over how to promote a healthy economy are pervasive once more, after demand. Unfortunately, the economy decades when it seemed such debates had been put to rest. The market meltdown has not quickly responded. Unlike the of 2008 ended a long string of years in which monetary policy reigned supreme. Great Depression—liquidity is not the Monetary policy is the regulation of money and the banking system to influence problem this time. The Federal Reserve’s economic variables. Its adherents, the “monetarists,” had faced little challenge as they unprecedented actions have assured that de-emphasized the role of fiscal policy, defined as the control of taxes and spending banks have plenty of money; they just to influence economic variables. aren’t lending it out. Aggregate demand has remained anemic. Activist use of fiscal policy was Depression-era economist’s playbook. Even as Keynesians and monetarists inspired by the work of British econo- The monetarist theory is also simple. have debated how to increase aggregate mist John Maynard Keynes. Keynesian Its intellectual father, eminent economist demand, supply-side economists and fiscal policy—out of fashion with econo- Milton Friedman, argued that properly their political allies have been insisting mists and policymakers for decades— regulating the supply of money and the that demand is typically not the problem. has enjoyed a stunning revival under banking system would allow the economy They believe that conventional policies President Obama’s new economic policy to cure itself when recession set in. His increasing spending will only give small team. The size of the stimulus package primary case in point was the Great upward bumps to the economy. Their started at $825 billion, even before con- Depression, when a shrinking money sup- cure, therefore, is tax cuts designed to gressional add-ons. The final package, ply and bank failures made an economic increase productivity, entrepreneurship, after debate and compromise, included a downturn into a national disaster. and risk-taking. The resulting increase in mix of spending on energy, infrastructure, Friedman argued that the Federal aggregate supply, they believe, will lead health care, tax cuts, and direct payments Reserve could have stopped the to economic recovery. to the unemployed and disadvantaged. Great Depression by providing banks To supply-siders, not all tax cuts are The Keynesian theory is simple. with more liquidity and stopping the equally good. They place their emphasis Keynes taught that economic downturns money supply from falling. In fact, Ben on the “marginal tax rate,” the percent- are caused by inadequate total demand Bernanke, the Federal Reserve chair- age taxed away from an extra dollar of (“aggregate demand”). His prescription man today, apologized to Friedman in a income earned. A marginal tax rate of 40 to solve this economic affliction was for famous declaration, saying: “You’re right. percent, for example, would mean that 40 government to provide the demand that We did it. We’re very sorry. But thanks cents of each additional dollar of income the private sector wouldn’t, even if that to you, we won’t do it again.” 1 Indeed, would be taxed away, leaving an after- required deficit spending. Recent discus- Bernanke’s Fed has been supplying tax reward of 60 cents for the person sions, covered extensively in the media, liquidity to the banking system in record who earned the dollar. High marginal have focused on the infrastructure spend- amounts. The monetarist prescription tax rates kill economic initiative, they ing component of Obama’s plan—such sees this liquidity as promoting lending, believe, and tax cuts that leave marginal policy is right out of the renowned Great lower interest rates and greater aggregate tax rates high are useless. As an example,

S o c i a l Ed u c a t i o n 68 A foreclosed home is shown in Stockton, California, on May 13, 2008. In some areas of California, so many foreclosed homes are available to buy on the cheap that real estate agents are discouraging prospective sellers from even putting their houses on the market. In Stockton, about 85 miles east of San Francisco, roughly three of every four homes for sale are in or on the path to foreclo- sure.

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a fixed $500 tax credit to everyone would that period of economic malaise didn’t effect on aggregate demand is less direct. not affect the after-tax reward of earning drive such an apparent conversion back The Obama administration argues that an additional dollar of income. It would to Keynesian deficit spending. the need for immediate impact tilts the leave marginal tax rates unaffected and This recession is likely—when it’s evidence towards more reliance on gov- therefore would have no direct effect on all said and done—to rank as particu- ernment spending. promoting aggregate supply. larly severe by any historical measure. It is no easy task for a government to Supply-siders have pointed to eco- However, it’s not only the depth of choose among the available policy cures. nomic results following the Reagan and this downturn that has returned us to Several comparisons are important. Bush tax cuts as evidence of success. 1930s-style fiscal policy. The failure of Effectiveness of government spend- Monetarists cited the accomplishments monetary policy to swiftly cure the coun- ing. Christina Romer, incoming chair of the Federal Reserve under former try’s economic woes, as it has in recent of the Council of Economic Advisors, chairman Alan Greenspan in the early downturns, provides some of the impetus estimates the multiplier associated with 2000s as evidence that monetary policy to revisit these theories of the past. government spending to be 1.57 ($1 of could keep an economy from faltering, Perhaps the inability of monetary government spending generates $1.57 of even under the stresses of 9/11 and its policy to solve the present crisis pro- demand for goods and services) in craft- aftermath. Now Greenspan is faulted vides ample justification for massive ing the stimulus plan. She estimates a 0.99 for allowing money to grow too much, fiscal stimulus. The pilot of an airplane multiplier for tax cuts. Such estimates inadvertently promoting the easy-money plummeting toward the ground cannot seem reasonable and conform to pres- rise of housing prices, followed by the be blamed for pulling levers and push- ent academic research. By themselves, collapse that brought on the current dif- ing buttons in hopes one of these actions they would tilt a decision in favor of a ficulties. helps. While critics would like the fiscal Keynesian government-spending stimu- This setting has brought about a stimulus directed toward tax cuts, the lus. remarkable Keynesian revival. President Obama economists argue—and rightly Choosing the “right” projects. Among Obama’s economic team forecasts the so—that the “multiplier effect” of govern- the most basic concepts in economics unemployment rate, without stimulus, ment spending exceeds that of a tax cut. is the importance of choosing alterna- will rise to 8.8 percent in the United When the government spends money, the tives where the benefits exceed the costs. States later this year. This is markedly money is spent. When the government Projects undertaken by the private sector lower than the 10.5 percent reached gives money back to the people in the cannot escape this straightforward rule; during the 1981-1982 recession; yet form of a tax cut, some is saved and the generally leading to efficient allocations of

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