During her campaign to become Prime Minister, Liz Truss drew a lot of comparisons to Margaret Thatcher as she promised to pursue economic policies that went beyond the elimination of a scheduled corporate tax rate increase. However, once elected and having announced her economic program, her detractors attacked it as unsound and her inabilty to effectively defend the program added fuel to the criticism. Opponents argued that the Truss economic program was the source of the incipient budgetary crisis and not the prior UK monetary policy combined with risky leveraged investments of the British pension system. She became a convenient scapegoat for the crisis.
Liz Truss proved to be no Iron Lady; in fact, she turned out to be a female version of George H W Bush – read my lips. Looking back there are a few things that Liz Truss could have done to salvage her economic program and her reputation. We view her demise as a teachable moment for pro-growth incentive-focused politicians and hope that supply side advocates may learn from her experience and avoid repeating her mistakes.
Lesson 1: If you believe that you are on the right side of the issues, keep your principles, integrity, and dignity.
Hailed as the new Margaret Thatcher, Liz Truss announced a supply side program aimed at restoring growth and prosperity in the UK. The economic program was anathema to the orthodoxy and she was quickly and savagely attacked in the press. Sadly, instead of channeling the Iron Lady and the Gipper she folded like a cheap suit and channeled George H W Bush.
Both Bush and Truss betrayed their campaign promises and succumbed to the economic orthodoxy as Truss resigned, and Bush lost his reelection bid. Bowing to the consensus and media pressure does not, apparently, save a political career.
But that begs the question, when is it appropriate to change course? If one believes to be on the right side of an issue, it is appropriate to fight for the issues. In the long run one may be vindicated. The classic example is that of Galileo Galilei, who was tried for his belief in heliocentrism during the inquisition, found guilty of heresy and forced to spend the rest of his life under house arrest. After being forced to recant under duress, he uttered the famous phrase eppur se mouve, “and yet it moves”. Eventually he was proven right – the sun is in fact at the center of the universe with planets orbiting around it.
Fortunately, politicians do not need to wait as long as Galileo to find out whether their policies are vindicated or refuted. The Iron Lady and the Gipper both went against the orthodoxy when they faced strong opposition. Mrs. Thatcher endured union strikes but held firm to her views and implemented her agenda. President Reagan and Paul Volcker also endured a tough transition. The phase-in of the tax rate cuts produced a strong incentive to delay income recognition, which in our view contributed to the recession in 1980.
Bob Dole led the charge to get rid of the third year of the scheduled Reagan tax rate cut which Reagan disagreed with. Once the rate cuts were fully in place the US economy took off and the recovery began in earnest. On the monetary side, Paul Volcker was also under pressure to ease, but Wayne Angell and his former student Manley Johnson, both Fed members, held firm and supported the Volcker new operating procedure. By the mid 1980’s the inflation rate began to decline to the low single digits.
The Thatcher and Reagan episodes show that the orthodoxy are not always right and eventually the policy can be proven right. But these two episodes also raise the issue of the possibility that the voters’ patience is exhausted if the benefits do not materialize quickly enough. If that is the case, the policymakers have two options: first, stay the course and try to convince the voters that in the long run the polices will be vindicated. If that does not work, then the alternative option is to change course and follow the voters. Let us consider examples illustrating each of these possibilities.
The Clinton Administration during its first two years in office pursued an aggressive progressive agenda. The economic and stock market performance were lackluster at best. The voters did not like the direction the Clinton Administration policies were taking the country. The Republicans under Newt Gingrich offered a clear and contrasting choice, the famous Contract with America, CWA. The voters liked what they saw, and the Republicans took over Congress and forced the Clinton Administration to come to the table. The Clinton Administration changed course and negotiated and astutely coopted some of the best ideas the opposition offered. The outcome was a faster growth rate, lower inflation, lower deficit and a reduction of the poverty rate and welfare rolls. The triangulation policy implemented by the Clinton Administration was a brilliant maneuver that illustrates how an administration should pivot.
Unfortunately, not all administrations change course when the voters rebuke them. We find a recent example in the Obama Administration. President Obama called the 2010 midterm outcome a “shellacking.” Yet, instead of heeding the voters’ signal he doubled down in pursuing his progressive agenda. His polices delivered a below average real GDP growth rate dubbed the “new normal”.
The parallel between the Obama and Biden administration is obvious to us. Both have pursed progressive policies. All indications point to a dissatisfaction with the state of the economy and the policies of this administration. If the midterm election outcome is as projected, will the Biden Administration double down as the Obama Administration did or will it triangulate as the Clinton Administration did? Will doubling down on its policies carry the Biden administration to a second term? The reelection likelihood will depend on how the Republicans react to their anticipated November mid-term success.
Lesson 2: Beware of the media coverage and the economic orthodoxy.
We are not questioning the integrity or the partisanship of the press. To make our point we just need to point out that there are many conservative economists, pundits and outlets who subscribe to the economic orthodoxy articulated by the UK press. What we are questioning is the assumptions made implicitly and/or explicitly by advocates of the traditional or consensus economic orthodoxy.
Some UK background is in order before we address these questions. The UK economy and inflation rate was deteriorating before the election of Liz Truss and there was no way to know during that time that Boris Johnson would resign, and that Liz Truss would be chosen as Prime Minister. Nor was there a way to know that she would propose a tax rate cut. Hence the temporal precedence of the economic deterioration to the Truss policy proposal suggests that the argument that the Truss economic proposal caused the crisis is tenuous at best.
The question of how to pay for the Truss economic program is a valid one. Here we have several observations to make. The first one is that the traditional orthodoxy estimates of the revenue effects of the tax rate changes are usually made on a static revenue basis that tends to ignore dynamic effects because they are controversial and difficult to estimate. On a static revenue basis, a tax rate cut and/or an increase in government spending results in a higher budget deficit.
Here we would like to make a point. A deficit is a deficit, and the funding needs are the same irrespective of how the deficit is generated, i.e., an increase in spending or a reduction in taxes. If the static revenue metric is applied fairly, the obvious question to ask is where were the detractors when the western government increased their spending, which were financed either by printing money or issuing public debt?
How come spending increases financed by deficits are ok while tax cuts are not. Shame on the orthodoxy for not making the equivalency. The orthodoxy argues that these spending increases are “investments.” But people with higher after-tax income and higher after-tax returns, a result of tax cuts, also invest. Then there is the fact that according to President Biden, the impact of his “investments” will not be felt for another year or two. This assertion raises a simple question, how come the press and orthodoxy give the President the benefit of time that they failed to give to supply side pro-growth economic policies?
Another orthodox assumption is that budget deficits lead to rising interest rates which in turn crowd out investments and result in lower levels of GDP. The evidence does not support this widely held view. Over the last few years, the budget deficits and public debt have expanded all over the western world and yet interest rates did not increase. There are also theoretical arguments that explain the lack of correlation between budget deficit and interest rates.
While it is true that people receiving the government largesse are better off and their aggregate demand increases, a budget deficit means future higher taxes and as those higher income taxpayers anticipate the impact of those taxes on their net worth, this leads to a decline in their aggregate demand. Put the two groups together and their impact on the economy’s aggregate demand is a wash. There is no meaningful change in aggregate demand. All the policy accomplishes is an income redistribution that makes the recipients better off and the taxpayers worse off, and that may be a desirable outcome.
So far, the analysis focuses solely on the aggregate demand/income effect of a government policy. But supply siders contend that in addition to income effects, there is a potential additional effect – the substitution or income effects. A reduction in tax rates such as the one proposed by the Liz Truss program would have increased the after-tax return of work, savings, and investment. The increased incentives would, according to the supply siders, provide incentives to work, save and invest resulting in a higher level of output. The critical issue now becomes whether the increase in incentives result in an economic expansion large enough whereby the tax revenue base increases thereby offsetting some or all of the static revenue loses. Hence, at least from a theoretical point of view the orthodox case is not as tight as the press and establishment economists report.
Deficit spending also creates a financing need. One option is for the government to float debt and sell it in the public markets. Another option is to sell the debt to the central bank if it plays along. But the latter leads to an increase in the monetary base. Since we believe that inflation is too much money chasing too few goods, the excess money creation leads to an increase in the inflation rate.
During the 1970’s, Milton Friedman argued that a floating exchange rate would insulate the local economies from external monetary disturbances. But if the case for a floating exchange rate is as Friedman argued, what explains the worldwide inflation? One explanation is that these countries adopted similar policies. All of these countries pursued deficit spending that was mostly financed by their central banks, resulting in an excess money supply and a higher inflation rate. The similarities of policies produced similar results. But this does not mean that the countries are unable to solve the inflation problem. Friedman had the answer. A slowing of the domestic money growth would lead to a lower national inflation rate and an appreciation of the exchange rate would insulate the local economy from adverse external monetary shocks.
Lesson 3: Have a well-articulated plan.
The US and other western economies have unacceptable levels of inflation, a slow real GDP growth rate and a rocky stock market. The environment is such that the electorate here and abroad is likely to favor a change. Remember the joke about the definition of insanity? Well, the UK is about to test the definition. Those who choose not to follow the UK path have a simple choice. As a practical matter, if the current environment is the result of previous policies at least we know what not to do going forward. Yet we still must answer the question as to the appropriate policy path to pursue.
We believe that Liz Truss was on the right economic track. The UK needed lower tax rates. However, she failed to paint a complete picture of the economic solution she was articulating, nor was she fully prepared to defend the overall economic program. She did not address how her government was going to pay for the tax rate cuts. Or, how she was going to prevent the poor from getting hurt by the tax rate cut and how to reduce the UK budget deficit.
It is important to note that the Truss program was not focused on an income effect or the economy’s aggregate demand. Instead, the policy focused on the impact of a changing incentive structure on the economy. Lower tax rates increase the after-tax rates of return, the incentives to work, save and invest. Therefore, the lower tax rate leads to a higher GDP and a higher tax base. A static analysis of the tax rate cut would argue that under a progressive tax code, the lower rates would disproportionately benefit the higher income earners. That is correct but is not an insurmountable obstacle politically. One way to ensure that no one is made worse off is to increase the spending by the sum of the inflation rate and population growth. Such a spending policy allows the government to maintain the real spending per capita thereby ensuring that there is enough money to maintain the level of public services. This formula would ensure that in principle no one is worse off.
One big point to make here is that nominal GDP growth has three components: Inflation, population growth and productivity. It follows that tax revenue growth would also have the same three components. Inflation and public spending are used to maintain the same level of public services. The third source of revenue is devoted to paying down the debt. Furthermore, if one works the math of the debt paydown, the debt is paid at an accelerating rate. This allows us to counter some of the orthodox views and reveals that this proposed policy is not a chimera.
Examples abound: The second Reagan tax rate cuts and the Gramm-Rudman-Hollings spending limitation combined to deliver the goods as we have argued. Another example is what Canada experienced during the Harper Administration. Canada was able to dramatically lower its debt to GDP ratio. Past experience suggest that the policy mix of lower tax rates combined with the spending rule outlined above results in a lower deficit, faster growth rate and lower poverty rates. Another benefit is that as the deficit improves, the public debt will slow down and so will the need and likelihood of monetizing it.
Finally, it is also important to note that this will not solve the inflation problem. Inflation is a monetary phenomenon, and it is up to the entity that regulates the quantity of money to stop the inflation rate. It is up to the Fed to deal with and solve the US inflation.
Conclusion
The Republicans must be ready and able to answer many of the same questions that Liz Truss was unable to as they seek to enact pro growth policies in the days after the midterm elections and leading up to the presidential election in 2024.
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