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Blitz Bearcat ECON 301 Final Paper February 11, 20xx A Comparison of Keynes and Friedman’s Approach to Stimulus Taxation Keynes and Friedman on economic stimulus and taxes In 2001 President Bush pushed tax cuts through Congress in order to jump-start the economy after the 2000 stock market bubble had burst. The critics and supporters of such an initiative often rely on rationale based on demand-side economists such as John Maynard Keynes or supply-side economists such as Milton Friedman. This paper will highlight the assumptions of both Keynes and Friedman and explore how they influence economic decisions. Keynes Keynesian economics is based on the theories of John Maynard Keynes, a British economist who lived from 1883 to 1946. Known as the father of modern economics, Keynes's theories were the first to encourage the government's involvement in solving the problems of unemployment and were used as the bases of President Roosevelt's New Deal programs, designed in response to the Great Depression.1 An economic debate in the US involves identifying what caused the Great Depression of 1928 – 1932. Keynes proposed that in a good economy money circulates freely between people who buy and sell. A shoemaker sells his products to a tailor, while the tailor sells her products to the baker, and the baker sells his products to the shoemaker, and so forth. Their earnings through exchange increases everyone’s wealth. Everyone’s spending is part of everyone’s earnings. But if there is a disruption in this cycle of spending and earning because of difficult times, people began to hold back on spending their money. When this occurs, people cannot earn a living, so everyone reduces spending. This creates problems for everyone.2 1 Keynes, John. (nd) The End of Laissez-faire. From the BMGT 610 student reader. Binder, Alan. (nd) Keynesian Economics. Retrieved Jan 18, 2004 from The Library of Economics and Liberty The Concise Encyclopedia Web site http://www.econlib.org/library/Enc/KeynesianEconomics.html 2 1 Keynes suggested that expanding the supply of money would return consumer confidence and people would once again start up the circular flow of money. Keynes proposed that recessions are caused by people hoarding money and depressions are caused by a liquidity trap. A liquidity trap occurs when people save money and refuse to spend it even if the government increases the money supply through the central bank. Events such as earthquakes, drought, floods or stock market declines can prompt decreased consumer confidence. Increased confidence arises from high employment, strong markets, and optimistic projections. Keynes suggested that during downward situations the government can revive the circular flow of money again by spending. Some believe that the main cause of the Great Depression is that the government restricted the money flow too much for too long. Most economists agree that World War II cured the Great Depression. Keynes attributed this to the fact that large sums of money circulated through government spending on the military for the war.3 Keynes explains that the Great Depression was followed by one of the greatest economic booms because of large military spending. Keynesian economics gained strong support Before World War II. Eight U.S. recessions worsened into depressions (as happened in 1807, 1837, 1873, 1882, 1893, 1920, 1933, and 1937). Since World War II, under Keynesian policies, there have been nine recessions (1945-46, 1949, 1954, 1956, 1960-61, 1970, 1973-75, 1980-83, 1990-92), and not one has turned into a depression.4 The success of Keynesian economics was such that even Richard Nixon once declared, "We are all Keynesians now." In the chart below, the yellow bars represent the proportion by which the duration of the expansions exceeds the duration of contractions. Inflation, Deflation and the Relative Durations of Expansions and Contractions (4) 3 Heilbroner, Robert L. The Worldly Philosophers. (1999). Touchstone New York, NY. p. 276 4 Banerji, Aniryan. (2001) Deflation Ahead? If So, It's a New Page in History. Retrieved January 19, 2004 from the Web site The Street.com http://www.thestreet.com/comment/spincycle/10000549.html 2 The U.S. government can expand and contract the money supply in different ways. The Federal Reserve banks can buy debt from commercial banks, which allows commercial banks to increase lending from those government securities. Banks can also make it easier to obtain credit so that consumers will obtain more money to circulate. The Federal Reserve can also cut the prime lending rate to commercial banks which makes credit more appealing to consumers. In order to reduce the flow of money the government takes the opposite of these actions. When there is too much money in the economy, inflation occurs. Prices rise and it takes more money to consume products. In response, the government raises lending rates, raises standards for obtaining credit, and buys less debt from commercial banks. Many Keynesian politicians voted for the tax cuts in 2001 and most mainstream economists support the Keynesian approach to stimulus policy. They offer various interpretations of why the Reagan years were strong and why the Clinton years outperformed Reagan’s. 5 When Reagan cut taxes Congress also closed tax loopholes resulting in a higher yield of tax income on those who previously avoided taxes. That lasted a few years until new loopholes could be exposed. This is an important point that many tax-cut advocates ignore. 5 Tax Cuts in Camelot? JFK lowered taxes, but supply-siders wrongly claim he's their patron saint. By David Greenberg Posted Friday, Jan. 16, 2004, at 8:00 AM PT http://slate.msn.com/id/2093947/ 3 Additionally, the Cold War was waging and computer technology was beginning to make an impact on workplace productivity. It is noteworthy that supply-side economists who oppose Keynesian policies predicted that there would be a severe recession when the Clinton administration increased taxes on upper-income families. Newt Gingrich predicted a recession while the Wall Street Journal and Forbes urged readers to get out of the stock market.6 However, the economy roared, technology investment multiplied because there was a wealth of investment money. Robert Rubin argues that tax increases moved the budget to a surplus, cut interest rates, and propelled corporate investment. The tax-cutting of 2001 and the Iraq war has created a deficit that many economists believe must get under control by means-testing entitlements, cutting farm subsidies and restoring some tax revenue. With the pending baby boomer retirement and the looming costs of Medicare and social security the U.S. will face possible problems paying back the deficit. To fund US foreign policy, President Bush would need to cancel virtually all of his proposed tax breaks. To guarantee the kind of competitive economy the US needs, Washington would have to do what it has been loath to consider: develop a broad set of government policies - other than tax cuts and deregulation - to increase the productivity of the economy7 Friedman Milton Friedman, recipient of the 1976 Nobel Prize for economics, has been a senior research fellow at the Hoover Institution and taught at the University of Chicago from 1946 to 1976.8 In opposition to Keynes, Friedman claimed that the best way to manage the economy was to keep the money supply steady by increasing it slightly each year rather 6 ibid. 7 Business Week). Business Week. New York: Nov 24, 2003. , Iss. 3859; pg. 160 The Debate Over Deficits 8 The Hoover Institution, Stanford University. Milton Friedman (2002) Retrieved January 18, 2004 from the Web site http://www-hoover.stanford.edu/bios/friedman.html 4 than trying to manage the economy by restricting or freeing up money by the Federal Reserve. As a result, inflation, unemployment and recessions would correct themselves through market trends. He believes that government should leave the market alone (the invisible hand) and that privatization works better than government regulation or provision of services. The term for this theory, monetarism, was tried in the US and Britain in the late 70’s and early 80’s. Interest rates were dropped and money supply was made available. What ensued was a sustained recession with high unemployment, high inflation, and manufacturing output shrunk. As chairman of the Federal Reserve under Jimmy Carter, Paul Volcker abandoned the monetary policies and instituted a process to restrict the economy to stop inflation.9 When Reagan was in office it appeared that inflation was controlled. The Reagan tax cuts and massive spending on government and military programs resulted in stimulating the economy just as Keynes would expect. Monetarists blamed the failed monetarism effort on the Central Bank for not allowing the market to play itself out sufficiently. But most people credited Keynesian theory as the reason for the good economic policies. Friedman also developed a theory that the natural rate of unemployment hovers around six percent. Neither monetary nor Keynesian policy can reduce it below that level. If the Federal Reserve tightens money to reduce inflation, it creates unemployment. If the Federal Reserve expands money to stimulate growth, employment lags behind business expansion. So we are constantly left with unemployment either reducing or expanding in response to economic conditions, and the level seems to be around six percent. There are three central premises of Friedman’s supply-side economics.10 First, supply-side focuses on suppliers rather than consumers. They recommend low taxes to keep investors motivated to create a strong supply of goods and services. Friedman suggests that taxes 9 Greenspan, Alan. Remarks at the Meeting of the American Economic Association, San Diego, California January 3, 2004 (2004) Cited from the web site http://www.stern.nyu.edu/globalmacro/ 10 Bartlett, Bruce (September 26, 2003 The Laffer Curve works, as cited from http://www.townhall.com/columnists/brucebartlett/bb20030926.shtml 5 should be cut “any time, for any reason.”11 This contradicts Keynesians and traditional monetarists who focus on creating a demand for goods and services by adjusting interest rates and flow of money. They are labeled demand-side economists. They want a tax system that creates demand for products and services by putting money in the hands of consumers. Second, supply-side monetary policy requires that the dollar remain stable and fixed to the value of an ounce of gold to avoid dragging the economy.12 By using the gold standard the Federal Reserve could keep the dollar stable and can then buy or sell bonds on the open market. If gold prices rise, the economy is liquid because excess dollars are going to purchase gold rather than into investments. At that point, the Fed can sell government securities to take in the excess dollars. A lowering gold price indicates a shortage of liquidity. Gold is sold to obtain dollars. The Fed should then purchase government securities on the open market with new printed dollars which encourages investment. Third, supply-side economic tax policy is built on the The Laffer Curve which projects government income through taxes.13 Arthur Laffer indicates that there is a tax rate nexus that produces the maximum amount of tax income while achieving the highest possible levels of growth, production and employment. The curve shows that no taxes on capital gains and low upper brackets stimulates investment, which in turn cycles money through the economy to increase productivity and lower unemployment. High marginal tax rates encourage tax sheltering, and create disincentives for people to earn more which in turn reduces productivity and economic growth Fig. 1: The Laffer Curve: 11 Interview with Ronald Robinson, September 16, 2003 http://www.rsrobinson.net/archives/000046.html 12 ibid. 13 ibid. 6 When the government taxes the highest incomes at 100% of income (d) it does not pay to earn more money. At lowest incomes 0% (0) there is no income to the government, but high motivation to earn. Since people are willing to pay taxes for infrastructure such as roads, schools, etc. the people allow government to tax them. Laffer’s target is to find a level of taxes that take in adequate income without creating a disincentive to grow. That point is (b) on the above chart. Too high of a tax (c) produces shelters and low productivity. Too low of a tax (a) does not provide adequate income for infrastructure. It’s the government’s job to learn what tax the people will tolerate without creating disincentives to invest. Supply-side economists support their tax policy recommendations with logic and historical trend analysis. The logic behind the supply-side economics is that there is a distinction between tax rates and tax revenues. When tax rates are too high it decreases the payoff that people derive from work and from other taxable productive activities. When people are prohibited from reaping much of what they sow, they will sow more sparingly. These reductions in productive effort shrink the effective supply of resources and thereby reduce output.14 Supply-siders agree with Friedman that high marginal tax rates encourage sheltering in hobbies and personal luxury items that can be deducted but do not invest in productive enterprise. As a result of this tax evasion and reduction of work effort, higher taxes actually shrink the revenues of government. For instance, in the 1920’s Andrew Mellon, Secretary of Treasury, reduced the top marginal tax rate from 75 to 25 percent. Also, low 14 Gwartney, James. Supply-Side Economics. The Library of Economics and Liberty as cited from http://www.econlib.org/library/Enc/SupplySideEconomics.html 7 income recipients had a virtual zero tax rate. The economy grew and the taxes collected grew 63 percent from high income taxes. Revenues from low-income earners actually decreased to near zero. The Kennedy-Johnson tax cuts in the 1960’s reduced tax rates by approximately 25%. These lowered taxes in real dollars of the bottom 95% from $31.0 billion in 1963 to $29.6 billion in 1965, a 4.5 percent reduction. In contrast, the real tax revenues collected from the top 5 percent of taxpayers rose from $17.2 billion in 1963 to $18.5 billion in 1965, a 7.6 percent increase. As in the case of the tax cuts of the twenties, the rate reductions of the sixties reduced the tax revenue collected from low-income taxpayers while increasing the revenues collected from high-income taxpayers Building on Friedman, William Niskanen and Stephen Moore of the Cato Institute provided a defense of supply-side economics and tax cuts.15 They propose that the supply-side tax cuts of the Reagan years catalyzed growth in personal incomes, productivity, improved savings, interest rates, brought low inflation, and low unemployment. They propose that the Reagan era economy was strong until George Bush Sr., and Bill Clinton increased taxation and regulations that halted the boom years. Keynes vs. Friedman Discussion Friedman follows a strong tradition in the economic theories of Adam Smith and David Hume. The market-driven economy assumes that since everyone is looking out for their own self-interest (the invisible hand), eventually equilibrium will occur based on supply and demand. Individuals will refuse to pay high prices for items readily accessible, forcing sellers to negotiate downward to a reasonable limit. Human nature is selfish, and therefore the interaction of two selfish individuals will ensure that negotiations will equalize the transactions. The problem with this assumption is that due to the very nature of greed, humans will find ways to tip the balance in their favor by cheating, using power, or even 15 Cato Policy Analysis No. 261 Supply Tax Cuts and the Truth About the Reagan Economic Record by William A. Niskanen and Stephen Moore October 22, 1996 http://www.cato.org/pubs/pas/pa-261.html 8 violence. Daily newspapers are filled with accounts of people abusing their power or cheating for personal gain at the expensive of the common good. When executives at General Electric used their power and influence to dump millions of gallons of pollutants into the Hudson River, they destroyed whole industries such as fishing and recreation, and probably made many people sick. When they moved their plant, they left the taxpayers to clean up the environment. When wealth and power are concentrated, equilibrium is destroyed by the very “invisible hand” of selfishness that is supposed to ensure fairness The supply-side issue of creating stability of the dollar by linking it to gold has several criticisms. Since the US de-linked the dollar with gold in 1971 gold prices have varied widely, and would create deflations when gold stayed below the Dow. Gold availability is also determined by non-economic influences such as mining and dentistry.16 Another problem with supply-side economics is that many economists dispute the Laffer Curve. “After the Reagan tax cut, the U.S. economy sank into recession and federal tax collections dropped nearly 10%. The deficit soared and economic growth was tepid through much of Reagan's presidency, despite sharp hikes in military spending. Some of the Republican faithful continue to argue that tax cuts will unleash enough growth to pay for themselves, but most are embarrassed to raise the now discredited Laffer curve.” 17 An additional criticism is that tax cuts to the wealthy create an inflated stock market, and real estate bubbles. However, if cuts were given to working families or state governments then the money is immediately cycled through the economy through retail, automotive sales, etc. This in turn provides money for businesses to invest.18 The Gold Bug Variations. The gold standard – and the men who love it. by Paul Krugman, Nov. 23, 1996 http://slate.msn.com/id/1912/ 16 17 Frank, Ellen. (2003) Ask Dr. Dollar. Dollars and Sense. Somerville: Iss. 250; pg. 38 http://www.dollarsandsense.org/archives/2003/1103dollar.html 18 ibid. 9 Friedman and others have supported a variety of proposals to create a flat tax rate rather than the progressive one we currently have. Supply-side economists suggest that overtaxing the wealthy reduces investment, while demand-side economists tend to put money into the hands of consumers. An interesting fact is that the tax burden as a percentage of income is nearly flat already. It would seem unjust to develop tax policies that continue to burden the lowest income earners who can least afford it. Late in the 80’s it was obvious that neither monetarism nor rational expectations were adequate practices. After implementing their approaches the recession in the 70’s seemed intractable. Only after implementing Keynesian principles of tightening money, debt availability, and loans did the economy recover. The same appears to have happened recently. Interest rates are very attractive, people are refinancing homes at an unprecedented rate and purchasing large ticket items with the money they have drawn out on equity. The stock market has responded and employment shows some signs of 10 improving. The Federal Reserve’s actions helped this to occur. We are at least temporarily moving out from a recession. The Bush tax cuts put an average of $400 into taxpayer’s hand. It is unreasonable to think that such a small amount would make much difference in the economy. Surveys show that consumers spent just 25% of the 2001 tax rebate. The other 75% was either saved or used to pay down debt.19 Deregulation and poor oversight of energy and investment companies such as Enron and WorldCom has recently cost Americans dearly, but the US has survived these high-lever corruption debacles. Monetarists and supply-side theorists put too much faith in believing that leaving the market alone, deregulation, and cutting any tax they can will produce economic growth. The facts are not substantiating their theories. If that were the case then prolonged recessions and depressions would have been self-correcting in the past. The application of Keynes’ principles is once again proving effective. Economic theory provides a decent guide to what's likely to happen, but when government undertakes big policy changes, such as large or permanent tax cuts, there are always too many variables to predict the economic outcome in any detail or with much confidence.20 Economics is usually unable to do the one thing most non-economists expect it to: predict the future. Presidents take their chances anyway. The first President Bush raised taxes and cut spending in 1990, hoping it would produce strong growth in 1992. It didn't. President Clinton tried the same approach in 1993, and it worked spectacularly. Mainstream economics supported them both, but conditions wholly independent of their deficit reduction efforts - corporate debt levels, the price of computing power, and so on - led businesses to respond to lower deficits in the mid-'90s in ways they didn't a few years earlier.21 19 Taking the Voodoo Out of Tax Cuts by Brian S. Wesbury* June 2, 2003 The Library of Economics and Liberty. http://www.econlib.org/library/Columns/y2003/Wesburytaxcuts.html 20 Shapiro, Robert. Tuesday, June 10, 2003 Will the Tax Cut Work? Here's how we'll know if it does. Cited from Slate Magazine: http://slate.msn.com/id/2084135 21 Krugman, Paul (1996) the dismal science Supply-Side Virus Strikes Again Why there is no cure for this virulent infection. Cited from Slate. org. http://slate.msn.com/id/1910/ 11 Research across a broad group of countries has identified many determinants of economic growth, leading to the conclusion that successful explanations of economic performance have to go beyond narrow economic variables to encompass political and social forces. Economic growth has been found to depend on variables such as education, health, fertility rates, rule of law, and electoral rights. Also important factors are propensity to invest, size of government, international openness, macroeconomic stability and even religious beliefs.22 In the final analysis, Keynesian theory provides a more robust explanation of economic phenomena. Friedman makes important contributions by warning us that too much government can be inefficient, heavy tax burdens reduce motivation to produce, overregulation stifles creativity, and steep fluctuations in monetary value erode consumer confidence. However, Keynesian practices of stimulating the economy through Federal Reserve intervention and modest rather than drastic tax-cut policies has kept the economy much more stable than any time in history. 22 Robert J Barro. Spirit of Capitalism Harvard International Review. Cambridge: Winter 2004. Vol. 25, Iss. 4; pg. 64 12