The Fed Can't Get No Respect From Supply-Siders

(Bloomberg) -- Have you ever noticed how upbeat the supply-siders are, unfazed by the twists and turns in Federal Reserve policy? As long as there's been a tax cut --specifically, a cut in marginal tax rates or on capital gains -- in the last three to five years, nothing can go wrong with the economy.
Supply-side economics is based on the idea of using tax cuts as incentives to increase, as the name suggests, the supply side of the economy, or its productive capacity.
Cut the tax on capital, for example, and you get more capital investment, a larger capital stock, and higher potential gross domestic product, which means the economy can accommodate a faster pace of growth without generating inflationary pressures.
The same holds true for reductions in marginal income-tax rates. Allow workers to keep more of their take-home pay, and it will encourage them to work harder -- and nudge some deadbeats to enter the labor force. Because an economy's potential is circumscribed by the growth in the labor force and the growth in productivity, more workers equal higher potential GDP.
That said, tax cuts aren't the only force holding sway over the economy. The Fed is entrusted with the conduct of monetary policy, whose most obvious manifestation is the setting of the benchmark overnight rate.
If fiscal policy is all that matters for economic growth, why do folks in the financial markets spend so much time and energy obsessing over the appropriate level for the federal funds rate? Based on some of the breathless commentary following last week's Fed meeting, the decision to leave the funds rate at 5.25 percent is something that Chairman Ben Bernanke will take with him to his grave!
A Laffer Moment
The issue of why supply-siders deny the growth-retardant effects of higher interest rates had been knocking around in the back of my mind for a while and was catapulted to consciousness following a conversation I had last month with Art Laffer, the father of supply-side economics.
I had called Laffer, chairman of Laffer Associates in San Diego, to talk about the government's mid-year budget review, which projected a 30 percent decline in the 2006 deficit from an inflated February estimate. Almost all the improvement was due to a surge in tax receipts from individuals and corporations.
Laffer is smart, warm, charming and a great talker on a wide range of issues. So the conversation quickly moved from the question of tax cuts paying for themselves (supply-side dogma) to other subjects. My ears perked up when he said that monetary policy could not affect production, employment or output; that all it could do was create ``asset price disturbances.''
Aha!
Fiscal policy, on the other hand -- tax and spending initiatives -- does have an effect on production, employment and output, Laffer said.
That's it! No wonder the supply-siders give short shrift to monetary policy. If it has no role in determining economic growth, who cares? All monetary policy can do is affect prices.
In the long run, that's correct. Changes in monetary policy can have ``real'' effects (on employment and output) in the short run. In the long run, the central bank can only affect the price level, or inflation.
Short and long are relative terms. Following the Great Depression, there was lots of room for above-trend growth before the economy bumped up against capacity constraints.
No one (well, maybe someone) will challenge the idea that tax cuts increase the incentive to work, invest and save, thereby raising the economy's potential. When it comes to the supply side of the economy, fiscal policy reigns supreme.
Incentives to Demand
Central banks work by altering incentives, too. By raising and lowering interest rates, the monetary authority changes the incentive to spend and to save.
For example, when interest rates were at miniscule levels in 2003 and 2004, consumers weren't being compensated for saving. So they borrowed to finance spending.
The Fed, in other words, affects aggregate demand, or the economy-wide demand for goods and services. In so doing, it can affect employment, encouraging companies to hire more workers to meet that demand.
Eventually, however, the economy will bump up against its potential. At that point, lowering interest rates, or increasing the money supply, won't generate more ``stuff,'' only higher prices.
Given their exclusive focus on the effect of monetary policy on inflation in the long run, supply-siders tend to underestimate the central bank's ability to affect growth in the short run. In 1993, they predicted death to the economy when President Bill Clinton raised marginal income tax rates.
The Long Run
Instead, the 1990s turned out to be a decade of strong growth (yes, there was a capital gains tax cut in 1997), the response to a sustained period of very low interest rates. The Fed held the funds rate at 3 percent for 17 months -- a rate unimaginable for bond traders who'd come of age in the 1970s.
Fast forward to the present and the supply-siders' assumption that the higher interest rates they claim are necessary to quell inflation won't have an effect on growth seems equally misplaced.
When the economy does downshift to below-trend growth, they can always throw up those Clinton tax increases as the reason.

To contact the columnist on this story:
Caroline Baum in New York at cabaum@bloomberg.net.