The Misleading Nature of the Republican-Democratic Economic Debate

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After the
weak third quarter GDP growth number
, the debate over the U.S.
economy between supply-side pro-Republican economists and left-wing
Democratic economists has again intensified.

First out was
Cesar
Conda in NRO
with an article that
appears to have been written before the actual release
. The
article contained the expected supply-side spin, arguing essentially
that the numbers were a mere blip and that the economy is really
fundamentally very strong. This, he claims, is a result of Bush’s
tax cuts.

Left-liberal
economist PGL replied
to this
on the Angry Bear blog. He pointed out that average
growth under Bush have been less than 2.5%, below the historical
average. This, he claims, proves that the Bush tax cuts have had
no positive effects.

Yet this debate
by partisan Republican and partisan Democratic economists’ rests
on two false premises. First, that the only thing Bush has done
is to cut taxes. Second, that tax and fiscal policy are the only
thing that affects the economy.

We know from
sound economic theory
that tax cuts will have a positive effect on the economy. We don’t
know from theory alone just how big that effect is, but studies
tend to show
that the effect is not insignificant. With regards
to the Bush tax cuts, there is also strong
evidence
that they contributed to increased dividend payout
and therefore more efficient allocation of capital.

But while the
effects of the tax cuts are clearly positive, supply-siders often
exaggerate just how big the effects are. Dividend payout and other
positive effects from the tax cuts simply haven’t increased sufficiently
to raise growth by more than perhaps a few tenths of a percent.

Moreover, while
Bush has cut (current) taxation, he
have also sharply increased government spending
. And the higher
budget deficit this produces will have a “crowding-out” effect on
investments that will lower growth. The negative effects from the
increased budget deficit have probably cancelled out the positive
effects from the tax cuts.

But the biggest
fallacy in this debate is that it does not recognize the destabilizing
effects of Alan Greenspan’s monetary policies. That the economy
was so weak during the first year of Bush’s term wasn’t really Bush’s
fault. Nor was it really Clinton’s fault. It was the result of the
bursting of the tech stock bubble, a bubble created by Greenspan’s
inflationary monetary policies. Similarly, the 2003–2006 boom
was the result of the housing bubble created by Greenspan’s inflationary
monetary policies.

That bubble
is now showing signs of bursting, which is why the economy was so
weak during the third quarter and why it may soon fall into a recession.
This will inevitably be blamed on Bush. But while we can blame Bush
for a lot of bad things (like the debacle in Iraq), it really won’t
be his fault. And it will certainly not be the fault of his tax
cuts. It will be Greenspan’s fault.

But because
the Republican defenders of the tax cuts refuse to recognize the
negative effects from the spending increases and Greenspan’s monetary
policies, tax cuts will appear discredited when the economy sinks
into a recession.

November
1, 2006

Stefan
M.I. Karlsson [send
him mail
] is an economist working in Sweden. Visit his
blog
.

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