Bruce Bartlett on Policy Mistakes: Let’s Review the Evidence

There is one more thing about this debate between Mark Thoma and Bruce Bartlett. After Paul Krugman corrected Bruce’s impression of what we were being taught in the 1970’s, Bruce fired off this rather pathetic remark:

If Paul Krugman is right, then where did all the policy mistakes of the 1970s come from?

Bruce of all people should know that policymakers do not always follow the advice given by economists. Or is Bruce suggesting that Bush’s fiscal fiasco due to the supply-side spin emanating from the likes of Lawrence Kudlow. Oh wait – Kudlow isn’t an economist so I need to do a little better, like presenting a couple of time series.

The first relates to business cycles. Our first graph shows real GDP versus the CBO estimate of potential GDP. With growing real GDP, we need a second graph showing the GDP gap to even see the business cycles of the 1970’s. But that 1982 recession certainly shows up quite clearly. So why did we have such a deep recession during Reagan’s second term? My view has to do with those tax cuts and tight money that Bruce thinks were wonderful. But the reality was that the Volcker FED had been easing up after its initial tight money burst to lower inflation. But when the FED saw the fiscal train wreck of Reagan’s fiscal policy, it stepped on the monetary brakes with a vengeance. With floating exchange rates, this macro-mix that raised real interest rates not only led to investment crowding-out but also net export crowding-out. So with this pressure of fiscal irresponsibility, one might see why the FED did want it did – even though it likely overreacted. Yes, maybe we economists should have reminded policymakers that fiscal policy multipliers are smaller and monetary policy multipliers are greater under floating exchange rates. But no one can doubt that the early 1980’s had massive policy mistakes.

But listening to the Laffer school of free lunch supply-siders cost us more than business cycle problems. Our last graph shows the difference between real GDP and the sum of consumption and government purchases aka gross savings – as well as investment and net exports (which of course must add up to savings). The legacy of the 1981 tax cut was a reduction in the national savings rate. The legacy of the 2001 and 2003 tax cuts was another reduction in the national savings rate. And the reduced wealth accumulation has had a negative impact on the growth rate of potential GDP. During the 1981 to 1992, potential GDP grew by less than 3% per year. During the past six years, potential GDP has been even lower.

Supply-siders love to tell us that tax cuts encourage more savings and investment leading to faster output growth. The only problem is that the evidence from their celebrated experiments shows there was less savings and less long-term growth.