October 14, 1999

Commentary

Mundell on Supply-Side Economics

Robert A. Mundell, a Columbia University economist, won the Nobel economics prize yesterday. Following are excerpts from an article he published in the July-August 1990 issue of the Rivista di Politica Economica, an Italian economics journal. (Reprinted with permission.)

Supply-side economics emerged as a political force partly as a reaction against the steep progressivity of personal and corporate income taxes and partly as a result of the breakdown of the international monetary system in 1971. The principal features of the supply-side program were a reform of the tax system, featuring a drastic slashing of marginal tax rates, and a reform of the international monetary system to one based on stable exchange rates anchored by gold or some alternative international asset.

The United States had enacted high income tax rates after it entered World War I, and they were only gradually lowered, to a maximum rate of 25% under [Treasury] Secretary [Andrew] Mellon. But in June 1932, during the last year of the Hoover administration, marginal income tax rates were suddenly raised again to a maximum level of 60%. They remained at or (frequently) considerably above this level for half a century. The grand bargain entered into by both Democratic and Republican administrations up to 1981 was the exchange of punitive marginal income tax rates to satisfy the political left in exchange for sweeping tax loopholes to placate the political right.

The collapse of monetary discipline with flexible exchange rates in 1973 and the subsequent oil embargo and increase in oil prices led to an inflation that further exacerbated the progressivity of the tax system. At the same time the absence of a stable monetary environment led to rising interest rates and exchange rate fluctuations that, almost arbitrarily, altered relative labor costs and international competitiveness. The exchange rate was determined increasingly by volatile international capital movements rather than the requirements of international trade. Reform of the international monetary system was therefore the second pillar in the platform of supply-side economics.

Supply-side economics addressed itself directly to policy considerations rather than theoretical abstractions. It would be a mistake, however, to believe that it lacks any less of a scientific foundation than the older demand-side schools of monetarism and Keynesianism, or the new classical school. Its own academic credentials lie in the solid allocation-theoretic literature of neo-classical economics and the policy-oriented models of global monetarism and macroeconomics.

Supply-side economics shares much in common with each of the three schools but nevertheless rejects certain features of each and adds elements of its own. With Friedmanism, it accepts the importance of the quantity theory of money but rejects the policy program of fixed growth and flexible exchange rates so dear to the hearts of monetarists. With Keynesianism it accepts the multiplier and the possibility of using tax cuts to spur growth in the midst of a recession; but it takes account of reverse multiplier effects associated with bond-financing of budget deficits and it rejects inflation as counterproductive. With neo-Ricardianism it accepts the importance of expectations and time-consistency, but rejects the extreme super rationality and altruistic form of the equivalence proposition.

Supply-side economics achieved major victories in monetary and tax policy in an amazingly short period of time. From its beginnings in 1971 through its first success in indexing tax brackets in Canada in 1973, to the first credited implementation in the United States in 1981, considerable success was achieved in less that a decade. The Economy Recovery Act in 1981, based on the Kemp-Roth bill, cut income taxes by about 25%, and its sequel, the Tax Reform Act of 1986, made sweeping changes in the tax code that included an elimination of many loopholes and a slashing of tax rates in the highest income brackets to 28%.

One of the important tools of analysis, and a strong selling point of supply-side analysis was the Laffer curve, relating tax rates and tax revenues. . . . The proposition that tax rates increase revenue up to a point of maximum revenue after which they fall was by no means new. It must have been known to wise chancellors of the ancient world devising tax systems. David Hume, referring to indirect taxation wrote that "a duty upon commodities checks itself; and a prince will soon find that an encrease of the impost is no encrease of his revenue."…

Nevertheless, if not new, it was certainly forgotten in the half century between 1932 and 1981 when marginal tax rates were never less than 60% and hovered at times near 100%. . . .

The Carter administration had followed an easy money policy along the lines of the neo-classical synthesis. It aggravated inflation and, because of the progressive income tax, tightened fiscal policy. The result was a steep depreciation of the dollar.

The neo-classical synthesis proved to be an appropriate policy mix as it had been in the early years of the Kennedy administration. The Reagan administration reversed the Carter policy mix in favor of the Mundell-Fleming policy mix of tight money (to stop the inflation) and fiscal ease (supply-side tax cuts to spur economic growth and increase defense spending).

Because the tight money was implemented before the tax cuts could take the effect, the economy moved into a steep recession, reaching bottom in November 1982. From this point on, the economy moved into an expansion that has continued into the Bush administration, the longest peacetime expansion on record.

In the first term of the Reagan-Bush administrations, the dollar appreciated strongly in the face of the strengthening economy (after 1982), having the beneficial effect of slowing the inflation at the same time the economy was accelerating. In 1984, however, growth in the economy slowed and the Federal Reserve shifted to a more expansionary monetary policy. The dollar peaked in February 1985 at about DM 3.4 and 230 yen. It then began a descent that continued through the 1987 stock market crash. Nevertheless, in 1988 and 1989, with the economy still expanding, the dollar became strong again, recovering against the yen and the European currencies, only to depreciate again in 1990.

Supply-siders had recommended a reform of the international monetary system and a movement to stable exchange rates. This would have prevented the overshooting of the yen and mark in 1987. Only a limited success of the supply-side program was achieved in the field of international monetary reform with the Plaza and Louvre agreements to coordinate exchange rates. Missing from this arrangement was an anchor for the major currencies (to prevent all countries from inflating together under fixed exchange rates). In lieu of an anchor, the Group of Seven attempted to devise a criterion in the form of a price index to adjudicate whether surplus countries should expand or deficit countries contract. Intensive discussions were held at the IMF meeting in September 1987, but progress in this field got side-tracked after the 1987 stock market crash. . . .

I have already noted that supply-side economics stressed the usefulness of a fixed exchange rate system tied to a stable monetary unit. In the early years of international relations, it was not possible to think in terms of a world currency because there was no possibility of organizing one among nations who went to war against each other. No international monetary system is warproof. In lieu of an international currency, trading nations settled on one or more of the precious metals, and throughout the ages, the coins of a major economic power became important units of account.

The gold standard represented such a system and the gold sovereign, the currency of the leading economic power, became the most important unit of account. But the gold standard broke down in 1914, and despite attempts to reconstruct it, conditions were never appropriate. The gold exchange standard established in the 1920s broke down because it was erected on too slender a gold base, a casualty of World War I inflation. History repeated itself in the post-World War II period after inflation had again undervalued gold. This led to a run on the gold stock of the United States, the only power with even a partially gold-convertible currency. In the decade of the 1970s, the decision by IMF members to adopt a managed flexible exchange rate system was accompanied by a commitment to emphasize the role of the SDR and to reduce and banalize the role of gold. . . .

In the days of the Cold War, national security took priority over monetary systems. But in the post-Cold War era there is likely to be both less opposition and more to gain from a stable international currency. The emerging muiti-polar world has in many respects more in common with the patterns of world power in the heyday of the gold standard than with the recent bi-polar past. It presents a better opportunity to create a world central bank with a stable international currency than at any previous time in history. There is no reason why the gold stocks held by governments and central banks should not be utilized to create an international money.

There are numerous options. A trillion-dollar central bank, producing its own currency, backed by gold and foreign exchange reserves (and, if necessary, other convertible currencies) could be made the central institution around which a stable international monetary system could be erected.

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