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Do Do That Voodoo That They Did So Well

Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity
By Brian Domitrovic
(ISI Books, 368 pages, $27.95)

“The verdict on supply-side economics is mixed,” wrote Harvard economist Greg Mankiw in the New York Times in early November. “The most striking claim associated with the theory — that cuts in marginal rates could generate so much extra work effort that tax revenue would rise — is unlikely to apply except in extreme cases. But substantial evidence supports the more modest proposition that high marginal tax rates discourage people from working to their full potential.”

Is Mankiw correct that the verdict on supply-side economics is “mixed”? There is a new authoritative history of supply-side economics to help us answer that: Brian Domitrovic’s magnificent Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity. Domitrovic demonstrates conclusively that, the verdict on supply-side economics isn’t really mixed at all. It was an enormous triumph, a policy and intellectual success without rival in contemporary history.

And to an extent Mankiw can be forgiven for his on-the-one-hand-on-the-other assessment. Supply-side economics has been so distorted by partisan critics of President Reagan and the Reagan years — particularly pundit Paul Krugman and editors at the New Republic magazine — that it has been difficult at times to remember precisely what it was and how and why it came about. There have been efforts before now to tell the tale — most notably Robert Bartley’s The Seven Fat Years and Steve Moore and Art Laffer’s recent The End of Prosperity. But no book until now has offered an authoritative history of the supply-side movement. Domitrovic fills the void.

And what a history it is. “Supply-side economics was the centerpiece of the most consequential revolution in economic policy since the New Deal,” Domitrovic writes. “The prima facie case that supply-side economics, implemented as it was in the Reagan years, played a causative role in the most significant development in American — arguably world — economic history of recent times is so strong that if we were not curious about it, we would be intellectually negligent….It is a story that we must know, however, if we are to understand the foundation of the summit of prosperity and geopolitical significance that America has occupied until very recently, and from which America appears to be stepping away in the current financial crisis.”

Robert Mundell emerges as the most significant intellectual figure in this tale, while in some ways being the least appreciated. The Canadian economist won the Nobel Prize in economics in 1999 and it is his work that laid the philosophical and empirical foundation for supply-side success. The economist Arthur Laffer is arguably better known today (for his famous Laffer Curve) and is also a major figure in the field. But in Domitrovic’s telling, it was Mundell whose contributions must be wrestled with and understood to fully appreciate how the supply-side current swept Washington and changed the world.

“Supply-side economics was never meant to be a sustained policy requiring annual recalibration and reapplication,” Domitrovic writes. “In this it differed markedly from Keynesianism. Rather, the purpose of supply-side economics was to solve one problem: the great stagflation.”

And this it did. The twin evils of high inflation and unemployment that plagued the American economy in the 1970s were the dragon the supply-siders hoped to slay. Mundell and others traced the root of the problem all the way back to 1913, which Domitrovic describes — implausibly at first, but on reconsideration quite convincingly — as what “may well be the most important year in modern American — if not modern world-history.” Why? “In 1913, the last three major reforms of the Progressive era were enacted: the direct election of senators; the federal income tax…: and the Federal Reserve System of central banking. Today, the direct election of senators is a footnote to history. The income tax and the Federal Reserve, however, have shaped life as we have known it in the century since 1913. One thing is certain: there would have been no supply-side economics without the changes of 1913. For restraining the institutions created that year — the income tax and the Federal Reserve — is the essence of supply-side-thinking” (emphasis added).

Armed with this insight, the supply-side story begins to fall quite naturally into place. The fiscal
and monetary policies set in motion under Lyndon Johnson were a combination of loose money and high marginal taxes. Both were required to pay for the escalating costs of the Vietnam War and Johnson’s ambitious domestic spending agenda. But the unintended result was the late 1970s stagflation-raging inflation and high unemployment.

Policymakers were paralyzed by this state of affairs. Attacking inflation, it was believed, might exacerbate the lamentable employment situation. Meanwhile, lowering unemployment by goosing economic growth might make inflation even worse. It seemed there were no good options.

This is where Mundell’s considerable talent for research and power of imagination came into play. Mundell had been conducting interesting work on economic history and the nature of open economies in the 1950s and early 1960s. This work became directly relevant to the precarious situation the United States found itself in during the Nixon, Ford, and Carter years.

“The realization that Mundell had begun to have in 1958,” Domitrovic writes, “may be summarized as follows. Monetary tightening produces a rise in the rate of interest. A rise in the rate of interest attracts foreign capital. Tax cuts bring about domestic expansion and a reduction in unemployment. Domestic expansion does not, however, produce inflation. For inflation, by definition, is absent if capital is flowing into the country. Capital inflows are a sign that the currency is not depreciating, as under inflation, but appreciating. With the Mundell policy mix, you get an inflation-free boom.”

The quest for an inflation-free boom — a  restoration of earlier American economic success — became the rallying vision for the supply-side “rebels,” including pioneering journalists, such as the Wall Street Journal‘s Bob Bartley and Jude Wanniski; economists such as Arthur Laffer, Norman Ture, and Alan Reynolds; and political entrepreneurs, most notably Jeff Bell, Jack Kemp and, ultimately, Ronald Reagan.

In hindsight it is clear that Reagan’s commitment to taming inflation and cutting marginal
tax rates to unlock the nation’s economic potential contributed directly to the economic boom of the mid-1980s through the early 2000s. This was the “inflation-free boom” Mundell had argued was possible given the right policy mix.

Supply-side critics to this very day have a strong interest in obscuring the movement’s intellectual roots and its undeniable success. This explains the efforts to boil supply-side economics down to cheap slogans, such as “tax cuts pay for themselves.”

And to be fair, there are some ostensible supply-siders who do not fully understand its nuances and history enough to know better and who provide grist for the anti-supply-sider mill by advancing extravagant claims about the power of tax cuts. But as this history makes abundantly clear, the brains behind the movement never advanced such a simplistic argument.

Either way, supply-side economics’ critics have no interest in appreciating the real history of the supply-side intellectual and policy successes, in large measure because those successes cast doubt on the wisdom of their preferred policy prescriptions, which include sustained loose monetary policies and higher marginal tax rates.

As the country faces mounting deficits and unemployment that is high and rising — with only inflation yet to head north — it may be that supply-side ideas will once again be ripe for rediscovery and resurrection. If so, the battles will surely be no less contentious than they were when Reagan’s proposed policies were dubbed “voodoo economics” by members of his own political party. But they will be no less important to wage than they were those dark days a generation ago.

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