Supply-side economics revisited

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In my recent post on Obama’s “bottom-up economics” I referred to supply-side economics and largely positive but with shortcomings. My reference to shortcomings generated multiple comments and questions on- and off-line. Let me explain—at the risk of oversimplifying some complicated issues.

Economics is about supply and demand, but most “mainstream economists” tend to emphasize the latter. When consumers demand more goods and services the economy grows. This is true to a point, but Keynesians and other demand-side economists are shortsighted. Their solution to a stagnant economy is always about increasing demand and they prefer government spending to tax cuts because they can directly control how the money is spent. This ultimately leads to more centralized control, large deficits, and the like.

Supply-side economists like famous Reagan advisor Art Laffer emphasize the other side of the equation. From this perspective, lower barriers to production and greater access to capital increase supply and grow the economy. Laffer is known for the “Laffer curve,” a simple but powerful supply-side concept about tax rates and tax revenues. According to the Laffer curve, when tax rates become too high, a cut in taxes can actually increase government tax revenues by increasing incentives for companies to produce and individuals to work. There are a lot of other factors that influence government tax revenues, but the Laffer curve helps explain why Reagan’s tax cuts spurred both economic growth and increased government revenues. Reagan fell short of tackling the deficit, but that was largely a spending problem, then as it is today.

There’s no question that supply-side economists offer a breath of fresh air to a Keynesian-dominated world. Supply-siders attack burdensome regulations and confiscatory tax rates, both of which are byproducts of a demand-side approach. Unfortunately, they don’t go far enough. Most supply-siders don’t object to Federal Reserve intervention in an economy. While they tend to be more sensitive than demand-siders to Fed abuses, they take a middle-of-the-road approach and fail to see the long-term problems with an activist Fed.

Second, supply-siders don’t directly address the problem of cronyism, the ongoing collusion between politicians/bureaucrats and private interests. While a regulation rollbacks and tax cuts tend to reduce the influence of cronyism, most supply-siders are satisfied with a tax system with certain elements of social engineering (i.e., special deals designed to favor special interests) and heavy government control in select industries like healthcare and education.

My views are more closely aligned with the Austrian school of economics. Austrians realize that most—not just some—government intervention in the economy is detrimental. They don’t just favor tax cuts, but instead a complete overhaul of the tax system in favor of a fair tax or a flat tax with low rates and few deductions. They also insist on substantial reductions in government spending, not just minor tweaks, reductions in spending increases, or spending freezes. Government spending has always been and continues to be the number one problem. Austrians understand the importance of addressing this head-on.

At the end of the day, I agree with much of what supply-side economists have to say. Reaganomics was certainly a step in the right direction, but the current situation is dire and requires stronger medicine. The Austrian approach offers a more complete solution.

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Obama’s Bottom-Up Economics

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In a Labor Day political push for a minimum wage increase, President Obama ridiculed trickle-down economics and reiterated his support for what he calls bottom-up economics. The former is the pejorative frequently associated with former President Reagan’s supply-side economics, a philosophy built on lower business/corporate tax rates and reduced regulation. While Reagan’s approach was largely positive, it’s fair to say that supply-side economics has some shortcomings. That’s a topic for another post. What’s interesting here is that Obama seems to have backed into the truth with a catchy, but poorly understood quip.

I’m sure bottom-up economics has been thoroughly tested with focus groups or the President would not be using it. While it rings of concern for the common man–the “bottom” of the supply chain–Obama is anything but willing to let individuals determine their own economic fate. His proposed minimum wage hike is a top-down, centrally planned approach to economic growth. It would cost jobs by raising the cost of labor for employers. Prices of products and services generated by minimum wage workers would also rise as employers pass along the increased labor costs to consumers. There’s nothing bottom-up about raising the minimum wage, or about health care mandates, carbon taxes, or most of his fixes for our stagnant economy. Obamanomics is top-down economics.

Many on the left think that corporations control free markets, but consumers have the last say in a free economy. At the end of the day, buyers decide what to buy and companies must compete to win their favor. While many corporations wield lots of power these days, this is due to cronyism–collusion between firms and government–not the free enterprise system. The President has is backwards.

Contrary to the President’s rhetoric, a bottom-up approach to the economy should mean letting individuals make their own choices in the marketplace. Government interference picks winners and losers, and constitutes the very cronyism that is stifling economic growth. I’m all for bottom-up economics. The President is the one who doesn’t understand it.

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Revisiting Cash for Clunkers

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In 2009, President Obama and the Democrat Congress colluded to pass the Car Allowance Rebate System (CARS)—better known as CASH FOR CLUNKERS. As part of this economic/environmental stimulus program, car buyers who traded-in their gas guzzlers could get a $3500 or $4500 government cash voucher, depending on MPG ratings. The program was supposed to get inefficient polluters off the road and “jumpstart the economy.” Several studies, including one just published by Mark Hoekstra and colleagues at Texas A&M (http://papers.nber.org/tmp/22808-w20349.pdf), should put the final nails in the coffin of this ill-fated idea.

CARS was discussed extensively on this blog. There were several problems from the outset

  • CARS was arbitrary. Only those who owned a vehicle worth less than the $3500/$4500 voucher amount would benefit from the program. Cars worth more could be sold outright or traded anyway.
  • CARS encouraged debt with marginal buyers. By providing an inflated trade-in value of $3500 or $4500, low-income consumers were encouraged to purchase a new car. Dealers and banks are eager to provide financing because the vouchers provided a sufficient down payment, even though low-income buyers were more likely to default down the road.
  • Only certain new cars qualified, so most buyers had to incur debt to benefit. Consumers only received the voucher if they purchased a new car, something less desirable for low-income Americans.

Many on the left (and sadly a few on the right) initially called this program a success because many Americans predictably took the free money. U.S. Transportation Secretary Ray LaHood called it a “wildly successful run.” But clear evidence points to the failure. The Hoekstra study—and others—underscores the flaws.

  • About 677,000 vehicles were sold in the U.S. as part of the $2.9 billion CARS program. Vehicle sales to buyers with marginal incomes rose about 50% during the period, but according to a University of Delaware study, each vehicle traded in actually cost the government a net of about $2000.
  • Some dealers appear to have raised prices on eligible vehicles because the subsidy was sufficient to attract buyers. In other words, part of the subsidy benefitted dealers, not consumers.
  • According to the analysis by Hoekstra and his colleagues, most of the sales were “pulled forward” and would have occurred anyway, and the entire increase due to CARS was actually offset by declines 7-9 months after the program ended. Not surprisingly, U.S. auto sales declined by 23% the following month, led by GM and Chrysler with drops of 45% and 42% respectively.
  • Because CARS encouraged buyers to purchase higher MPG vehicles, most of the cars sold in the program were less expensive, low-margin models. Customers spent about $4600 than they would have if the program did not exist, resulting in an annual decline in auto industry revenues by about $3 billion a year.
  • CARS resulted in an increase in used car prices. Older vehicles with values in the “clunker” range rose in value because they could be exchanged for government vouchers. As more Americans participated in the program, the supply of “cheap cars” declined, raising prices on the market.
  • The program destroyed functioning vehicles. Typically, low-MPG vehicles are not driven as much anyway, but they provide essential transportation to low-income, occasional drivers. These vehicles were eliminated from the market, forcing prospective customers in the used car market to spend more.

CARS was a classic attempt by central planners to “fix problems” in the market, pick winners and losers, and stimulate the economy overall. Washington has passed many such programs, including the infamous “shovel-ready jobs that ended up not being shovel-ready.” Their proponents always claim success when the funds are flowing, but usually disappear when the unintended consequences become apparent. These programs squander tax revenues (or create more government debt) in the short term and disrupt markets over the long term. Fundamentally, they are part of the cronyism that is plaguing our nation.

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FRAT, the Fed, and the Stock Market

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Why does the stock market rise or fall? The prospects of individual firms included in the Dow, the S&P 500, and other indexes move on their own, but up and down swings in an entire index are usually based on broader perceptions about the economy. If reports suggest that people expect a stronger economy, you would expect these indexes to rise. The Fed often inverts this expectation, however, making it more difficult and risky for investors.

For example, if an economic report suggests that businesses expect a more robust economy, markets may actually fall because investors worry that this will bring about inflation and a tighter Fed policy. In contrast, if an economic report suggests weakness, markets can rise because investors anticipate looser Fed policy. Hence, producers in our economy and the investors who provide them with needed capital are often less interested in legitimate market news and more interested in how the Fed will respond to it. Stocks and other securities are only partially market-based, leading to all sorts of misperceptions about how they should be priced and resulting in stock market volatility.

In an efficient market economy, private investment is channelled to the most capable firms, and business and investment decisions are based on market factors. Basing decisions on guesses about government or Fed policy disrupts this process and misallocates these resources. Firms best positioned to deal with government regulations or changes in Fed policy–not necessarily those best able to produce what consumers want–get more resources when this occurs. In this way, central planners in Washington are indirectly picking winners and losers. Ultimately, this hampers the ability of our firms to compete globally, expand their operations, and hire more workers.

Measures designed to limit Washington’s control of our economy are essential if it to be strong over the long term. FRAT is a move in the right direction.

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FRAT part 2: The Fed and uncertainty

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In my last post I expressed my support for the Federal Reserve Accountability and Transparency Act (FRAT). Thursday’s 317-point stock market decline underscores my point.

I don’t think it’s possible for Fed intervention to stabilize the economy. Even if I am wrong, the right intervention could only occur if economists at the Fed could actually determine where the economy is going. Describing yesterday’s economy is not very difficult, but understanding today’s and predicting tomorrow’s is very complicated, if not impossible. Investors and business owners often base their decisions on “economic indicators,” which tell us more about the past than the future. Thursday’s stock market decline illustrates this point. Just one day earlier, investors had a different view on the economy.

While the Fed attempts to predict and influence the future state of the economy, investors, business owners, and everyone else are left to predict the future actions of the Federal Reserve. For example, if the Fed raises interest rates, anyone associated with the housing business will likely suffer, and anyone planning to buy or sell a home will find it more costly. For this reason, many analysts are more concerned with the Fed’s reaction to its perception of the economy than with the actual economy. This adds to uncertainty, giving business owners more reasons to stay on the sidelines and not grow the economy.

Just to be clear, I am not arguing that a stock market decline is imminent. Rather, the volatility of the market tells us how investor sentiment changes daily. My point is that the Fed’s overzealous intervention into the economy adds more uncertainty to the economy than it reduces. If we are going to have a federal reserve bank, its actions should be much more subdued. This is only possible if we actually know what the Fed is doing, which is why legislation like FRAT is sorely needed.

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The Federal Reserve Accountability and Transparency Act (FRAT)

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Congress is currently considering a reform measure that looks seriously into the inner workings of the Fed. The Federal Reserve Accountability and Transparency Act (FRAT) is long overdue and doesn’t go far enough, but it’s already getting criticism from Keynesians. The argument is really quite simple.

The Federal Reserve was established in 1913 for a number of reasons, most notably to lend stability to the U.S. banking system and control inflation. However, U.S. banking has experienced considerable instability since the Fed’s creation.  The dollar increased in value by 13% in all of the years prior to 1913, but has decreased by 92% since the establishment of the central bank. Keynesian economists argue that Fed intervention through changes in the money supply and interest rates has kept the inherent capitalist business cycle under control. Austrian economists argue that Fed activity has actually caused much of the inflation and economic instability we’ve experienced. This issue has been addressed in previous posts so I won’t discuss it in detail here. Suffice to say that one’s position on this issue likely determines one’s view on FRAT.

Keynesian Alan Blinder’s op-ed in the Wall Street Journal summarizes the argument against FRAT. For Keynesians, the central issue here is the extent to which the Fed can operate “free of political influence.” If Congress “audits” the Fed, then Congress—not economists—will politicize the Fed. It might sound good to “keep the politicians from screwing up the economy,” but this argument is severely flawed. Of course, the politicians have already screwed up the economy to the tune of a $17 trillion deficit, and the same crowd that doesn’t want politicians involved in Fed activity is calling for Congress to raise the minimum wage, pass an amnesty plan for illegal immigrants, and raise taxes on “the rich.” The hypocrisy of this argument should be obvious.

There’s a deeper argument here that’s more disconcerting. Liberals argue that “independent experts” should control the economy through the Fed in the same way that the so-called experts should be empowered to run other parts of the government. Individuals aren’t smart enough to decide what to eat, how much to exercise, and when to see a doctor, so healthcare experts should tell us. The marketplace cannot be trusted with protecting the environment, so climate change scientists should set policy. Workers aren’t capable of saving for retirement, so we should be required to cough up more than 12% of our paychecks and let the social engineers in Washington tell us what portion we can get back when we retire.

But leftists are providing a false choice. They frame the debate as one between politicians and experts, but they leave out the third option, the individual. It doesn’t really matter whether politicians or Fed economists centrally plan the economy. In either instance, the best option—individuals through the free market—is being thwarted. Both handouts from politicians and artificially low interest rates orchestrated by the Fed must be paid for sooner or later. We’d be much better off if both groups stayed on the sidelines and empower the invisible hand of the market.

The next time someone tells you that the Fed should be able to conduct its affairs without Congressional oversight, ask why it’s okay for politicians to be directly involved in so many other forms of economic central planning—but not the Fed.

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Government-Mandated Paid Medical Leave?

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On Monday the President hosted a Summit on Working Families, arguing that the business community is squeezing its workers and is not smart enough to adopt progressive policies without government mandates. One of the prominent issues is paid medical leave. “Many women can’t even get a paid day off to give birth—now that’s a pretty low bar…That, we should be able to take care of.”

I vigorously appose the President on this issue, which makes me “anti-family” to some. I’m all for family leave; I just don’t think others should be required to pay for it.

Life is difficult and people need time off for lots of reasons. A newborn is certainly one of them. But if companies are required to pay someone who is not working, then that cost must be paid for somewhere else. They could pay everyone less to begin with, cut other benefits, or just raise prices. Regardless, there is no free lunch. The companies are paying for it, so they should be free to create the set of benefits appropriate for their own industries and workers without government intrusion.

The President claims that paid maternity leave, increased job flexibility, and on-site child care help companies attract and retain the best workers, and ultimately outperform their competitors. This is partially true, but misleading. While there is research suggesting that many companies adopting such programs perform well financially, it depends on the type of company, its workforce, its strategy, and its operating environment. Smart companies consider offering extra benefits to get an competitive edge. One size does not fit all, however, which is precisely why some offer such benefits and others do not.

If businesses can benefit financially by offering paid leave, flex time, and on-site child care, they will do so without a summit or prodding from the President.

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Learning from Latin America

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The economic meltdown in many parts of Latin America is not receiving much attention in the mainstream media, except as the scapegoat for the influx of kids at the U.S. southern border. While gang and drug activity are big problems in some countries and have contributed to the crisis, it’s only part of the story in Latin America. Countries like Venezuela and Argentina have shifted to the political hard left. Their economies are wilting and should serve as sober warnings for the U.S.

Perhaps you think that economic problems in countries like Venezuela and Argentina can be attributed to a shortage of natural resources. Think again. Argentina has a rich agricultural base, outgrew Australia and Canada in GDP and per capita income in the early 1900s, and was actually ranked #10 in per capita income 100 years ago. Venezuela is blessed with massive oil reserves, currently ranked first in the world by some estimates. These nations should be strong economically today, but they are struggling. Both are currently ruled by hard socialists, Maduro in Venezuela and Kirchner in Argentina.

Life is not easy in Venezuela. Food and power are rationed in Caracas. There are even water shortages because the government lacks needed capital to fund a water-distribution network. Government regulations are so burdensome that many investors have left the country. The central planners have implemented a tiered foreign-exchange system that subsidizes dollars to some sectors of the economy at the expense of others. The exchange rate can range from 6.3 to 50 bolivares per U.S. dollar. In a word, it’s chaos.

Some industries are in total disarray. For example, the Venezuelan government has delayed $4 billion in payments to international airlines that serve the country. The government wants airlines to take their funds in bolivares, a currency inflating at 60-80% annually and virtually useless outside of the country. Some airlines like Air Canada have left altogether, while others like American and Lufthansa have cut back flights. The government is currently “negotiating” with a host of airlines for payment of past debts.

Of course, the U.S. has had for some time what is desperately needed in South America. Capitalism thrives where there is a stable monetary system, courts to enforce contracts, and respect for the rule of law. This foundation is eroding, however. Our monetary system continues to weaken with Fed meddling and a $17 trillion debt. The GM bailout demonstrated that courts are not always objective arbiters of private contracts. The ongoing illegal immigration fiasco undermines the rule of law. All of this breeds crony socialism, which is commonplace in Latin America. The U.S. is moving down the same path.

Perhaps you are one of those who thinks that what is happening in the emerging economies of South America can’t happen here. It’s already underway to some extent.

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Obama Tinkers with Student Loans Again

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As a member of the higher education community, I am supposed to support any and every effort made by the feds to increase funding to college students. I do not, and I have explained my opposition to much of what Washington does in detail in previous posts. Of interest in this post is Obama’s recent executive order to cap student repayment at 10% of the borrower’s monthly income, and a bill promoted by Senate Democrats to allow 25 million borrowers to refinance their loans at lower interest rates.

College debt is a $1 trillion-plus problem, and I certainly don’t wish ill on any college students, past or present. It’s not easy facing a pile of student debt when you don’t have a job. But the federal government should not be tinkering with interest rates and payment schedules. College loans are serious business and should be enforced like any other contract. With Washington in complete charge of the student loan program, however, tossing out favors will continue to be a substantial part of the political process.

The President and his party have conditioned those with student loans to expect a constant renegotiation of terms. Many of my students tell me that they don’t actually expect to pay back everything they borrowed. If they are right, the obligation will be transferred to other taxpayers, including those who made different educational choices. While this is unfair to taxpayers, it’s not fair to students either. The lure of easy money entices some to overextend without realistic expectations for job prospects.

Senator Lamar Alexander rightly called the executive order a political stunt. Concerning the Senate bill, it’s not surprising that they Democrats propose to pay for the refinancing with a tax hike on top earners. It’s also not surprising that we’re in an election cycle.

What we’re witnessing is a dubious political cycle. The government takes over something (e.g., student loans, healthcare, etc.) because the private sector is deemed to be either incapable or unwilling to appropriately support the common good. Once politicians are in control, goodies are tossed out for political favors and ostensibly paid for by “the rich.” Anyone opposed to these favors are accused of penalizing the less fortunate. One American is pitted against another–class warfare at its finest. Taxpayers always pay for this charade in the end, but the process seems to keep the progressives in power.

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There is no such thing as “constitutional formality”

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I was watching ESPN the other day when the announcer referred to the process underway to remove Donald Sterling as owner of the LA Clippers franchise as a “constitutional formality.” The more I think about this, the more it bothers me.

At first I was taken aback by the casual use of this term. The process required by the NBA’s constitution is not a formality. It lays out steps that ensure a fair process for everyone involved, at least to some extent.

THERE IS NO SUCH THING AS A CONSTITUTIONAL FORMALITY. ANYONE WHO DOESN’T SEE THE INHERENT CONTRADICTION IN THIS TERM DOESN’T APPRECIATE THE NEED FOR A CONSTITUTION IN THE FIRST PLACE.

So why does the NBA–or the United States for that matter–have a constitution? Why not just vote on issues as they arise and let the majority rule? Isn’t this democracy?

Constitutions are established to establish basic standards on how things must be done, standards that cannot be overturned with an emotional 51% vote or overruled by a tyrannical leader. Constitutions can change, but only through an established process that requires more than a fleeting majority. The US has a constitution to protect individual liberties and restrain government. The Constitution is not universally respected, however, so all of us must insist that it be upheld. When the US government violated the Constitution when FDR interned Japanese-Americans shortly after the bombing of Pearl Harbor, it was up to other Americans and a court system to address this injustice.

We don’t live in a literal democracy because we don’t vote on every issue. Instead, we live in a representative democracy. We elect leaders to represent our views and vote on our behalf. These leaders are constrained by the Constitution, and the courts can step in when there are interpretational differences. It’s not a perfect system, but the checks and balances it provides are essential. A pure democracy without a strong Constitution would subject individuals to tyranny of the majority. Rights would be constantly negotiable, making them temporary privileges subject to the current whims of government leaders and public opinion at large.

Let’s return to the Sterling situation. The NBA’s constitution was designed to protect and balance the interests of the association and the individual owners. It does not allow the commissioner to remove an owner for making offensive comments. Instead, it lays out a process by which an owner can be removed. This process must be followed, and it cannot violate the US Constitution.

Constitutions are absolutely essential. Without established due process, justice is reduced to a lynch mob. Many who have commented on the Sterling situation don’t seem to get this point, ignoring issues such as the illegal recording of a private conversation and the rights of Donald Sterling’s wife. They only see the presence of mob rule when they disagree with the outcome. Perhaps this is why progressives cheered President Obama when he announced he would (unconstitutionally) bypass Congress when it did not take action he favored. Many of these individuals—including the President himself—constantly berated President Bush for alleged Constitutional discrepancies pertaining to issues such as the Iraq war, waterboarding, and Guantanamo.

Donald Sterling is ultimately responsible for his actions, but he has a right to established due process. Anything else is a travesty of justice.

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