Saturday, June 3, 2017

Mankiw v. Mankiw on the 1981 Tax Cut

Greg Mankiw’s first macroeconomic textbook correctly noted that the mix of Volcker’s tight monetary policies and the 1981 tax cut led to a fall in national savings driving up real interest rates and crowding out investment and net export demand. Yes – there was some messy short-run Keynesian events but his early account captured the long-run effect of what was an anti-supply-side fiscal policy. But now Mankiw sings the Keynesian praises of the 1981 tax cut:
When Mr. Reagan moved into the Oval Office in January 1981, the economy had recently experienced a recession. The recovery was just six months old. Unemployment was still elevated at 7.5 percent. Worse yet, another downturn was on the horizon. Within six months, the economy would again be in recession. Unemployment rose to 10.8 percent at the end of 1982, its highest level since the Great Depression. In August 1981, Mr. Reagan signed into law a bill that phased in tax cuts over three years. These cuts helped usher in a robust recovery. By the end of 1988, as Mr. Reagan was leaving office, the unemployment rate had fallen to 5.3 percent.
Revisionist history or just plain intellectual garbage? Yes – Volcker engineered what was supposed to be a temporary recession in 1979 but was reversing his tight monetary policy even before Reagan took office. The reason we had the 1982 recession was that the FED overreacted to the ill-advised Reagan stimulus. The reason the economy later recovered was that the FED later reversed course. Volcker had kept asking the Reagan White House to end their toxic mix of tax cuts for the rich and offsetting monetary restraint. Greg Mankiw knows this all too well so why would he write this nonsense?
When George W. Bush became president in January 2001, he faced a situation that, in some ways, was similar to that of 1981. (Disclosure: I was one of his economic advisers from 2003 to 2005.) The economy was heading toward a recession, attributable largely to the bursting of the dot-com bubble. From March 2000 to April 2001, the tech-heavy Nasdaq composite average lost about two-thirds of its value. A recession officially began in March 2001. Unemployment rose from 3.9 percent at the end of 2000 to 6.3 percent by the middle of 2003. Without the tax cuts President Bush signed into law, unemployment would have probably gone higher.
That must be the reason but then his defense of the 2001 tax cut has a couple of problems. The FED recognized the same events and was actively lowering interest rates even before this tax cut. But OK – a little more consumption demand may have been in order. The real problem, however, is that the rest of Team Bush was selling this tax cut as a means for raising national savings but Mankiw insists it was designed to lower national savings. And we thought they had multiple and conflicting reasons for invading Iraq. But why write about this now?
Yet Mr. Trump faces a vastly different set of circumstances. The economy has not experienced a recent recession…The Federal Reserve is responding to these events by raising interest rates. It believes, correctly in my judgment, that incipient inflation is a greater risk than recession. Keynesian pump-priming is not what the economy needs now. The main macroeconomic problem the nation faces is slow productivity growth, which in turn leads to slow growth in average incomes. Increased budget deficits would only make this problem worse. They would cause the Fed to raise interest rates even faster than otherwise. Higher interest rates would discourage capital investments, further depressing productivity.
The old Greg Mankiw resurfaces! Of course some of us wonder if we are really at full employment and hence are critical of the recent increase in interest rates. Brad DeLong strikes the right tone:
today’s weak inflation outlook suggests that the Fed’s monetary policies, in combination with fiscal policies, are not providing sufficient stimulus for the US economy – as was the case in 2013. Unfortunately, the FOMC does not appear to be particularly concerned about this possibility. Among FOMC members, Neel Kashkari, the impressive president of the Federal Reserve Bank of Minneapolis, is the only one who has dissented, calling on the Fed to pursue more stimulative policies. The FOMC’s blind spot stems from the fact that it is relying more on its assessment of the labor market, which it considers to be at or above “full employment,” than on noisy month-to-month inflation data. But “full employment” is a rather tenuous and unreliable construct.
In lieu of more monetary stimulus, a little fiscal stimulus now might be a good thing. But if we go big on infrastructure investment then we would likely have all the fiscal stimulus we need for full employment and more. Mankiw’s title might suggest a tax cut would be nice but I would argue tax cuts for the rich would be the wrong form of fiscal stimulus.

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