Lafferian Keynesianism

By Chandrashekar (Chandra) Tamirisa, (On Twitter) @c_tamirisa

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The Washington power lunch and dinner story goes that economist Arthur Laffer, at some point during the Ford Administration, told Dick Cheney and Donald Rumsfeld about the inverted parabolic curve relating taxes and government revenues by sketching it on a napkin. It had become policy over meat and potatoes, venturing a guess about what they may have eaten. The economy is indeed meat and potatoes served with a side of bread and butter.

The Republicans since then have been agog with the idea that finally the misunderstood genius of economists on the right who are typically lampooned by the Ivy-educated Keynesian left had finally found its political voice in Washington to be duly recognized and Arthur Laffer never looked back. Still, what did Laffer really do?

His argument was very simple. It was based on Keynesian arithmetic out of the text book: lower taxes to raise disposable incomes. The higher the disposable income, higher the consumption, because some of that extra money in people’s pockets (also known as disposable income) can be attributed to the mathematical relationship of the marginal propensity to consume, rich, middle class or poor. Laffer had turned Keynesianism on its head, from deficit spending to tax cuts and frugal government, but he had not undone Keynes.

Since then left-leaning economists have criticized Laffer by saying that Laffer had exaggerated the growth effects of tax cuts to support the political intent of indiscriminately dismantling government. But did he? When government cuts taxes and raises the after tax incomes of both individuals and corporations, depending on what taxes it cuts, it lowers its revenues. If its spending is not adjusted down, correspondingly to the lower revenue, the budget deficits would still rise and the government will have to finance it by borrowing from the markets. If government spending outpaces the growth effects of tax cuts, the government deficits will continue to rise on net. This was the economy Bill Clinton had inherited after the Cold War.

Ronald Reagan and George Bush had both cut and raised taxes, on net lowering them since Carter and had deregulated the economy for businesses to thrive and they did. However, they were not as successful in reducing the size of government and government spending. Meaning, fiscal support whether that be through tax cuts or deficit spending or some combination of both which is usually the case, always increases government spending, no matter which party is in power, left or right. Its tendency to grow is higher if the left is in charge than when the right is in charge, but it always rises.

Now, the policy choice becomes one of cutting taxes to raise budget deficits or keeping the tax rates the same (or raise them) but still raise budget deficits, because taxes can never be sufficiently raised to meet all the budget deficits, unless spending comes down. At some point, higher tax rates will reduce growth and tax receipts, and deficits could rise higher than expected. This is the choice that is being faced by the Obama administration as it prepares for the second year of its administration.

When a country’s total debt is the same as its gross domestic product (GDP), which is where the United States is at the moment, even if it is the United States economy, interesting risks prop up, especially when those lending money to the government do not see it being efficiently used by it. Sometimes, paying down debt may be a better idea than taking on more because the government can pay down, especially the United States government.

We borrow in U.S dollars. It is a luxury no other country has. So, we can also pay back in the U.S dollars that the Fed prints and which the world still covets. And cut taxes in areas where it will raise investment while committing to hold the overall federal budget (including the fiscal year 2011 deficit) at the same level as at 2011 without indexing it to inflation for the next decade. The result is threefold: (a) Reduced national debt; (b) No new debt; and (c) Restructuring government to make it more efficient and effective. And all the three outcomes improve economic expectations, provided the government reforms forced on it by itself because of budget discipline over the next decade ensure that the debt buy back by the Fed will increase investment in the domestic economy to raise its speed limit (also known technically as the potential growth rate) back to the 4% annual level over the same period of 10 years to bring unemployment down to pre-crisis levels.

The result of improved economic expectations at a higher sustainable rate of annual economic growth is stable prices, as long as the Fed clearly communicates what price instability is. Under the current circumstances it is 5% CPI inflation, the same as it was when Paul Volcker had handed over the Fed to Alan Greenspan in 1987. So, the markets have about 2.4 percentage points to go before the Fed raises rates symmetrically or sharply (compared to how they were lowered beginning the fall of 2007) or about 1.4 percentage points to go before it begins the process of raising rates asymmetrically, meaning gradually.

Assuming the government makes all of the above choices to support the economy with the primary intent of job growth, higher rates for the markets would arrive based on how they choose to invest keeping inflation in mind. So, higher rates could be a year (gradual increases) or two years (sharp increases) away. If I were them I would invest so as to decrease my dependence on oil and keep food prices in check by raising its production and exports to keep a lid on prices, unlike how prices went up (which was why the Fed had to raise rates) before the crisis. God’s work is in keeping food prices affordable.

The Federal Reserve is telling the markets it is time to clean up the country’s energy act and feed the hungry around the world by becoming their prairie home companion, within the next 3 years, by 2012 because slowing economic growth is not a policy instrument to contain inflation which is how it was contained after 2007.

Ultimately it is a Manhattan Project run by the people of the United States to restore job growth in an environment of stable prices.


About Chandrashekar (Chandra) Tamirisa
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