Thinking that He’s Learned Keynes, He Writes the Wrong Prescription

The New American Economy

The Failure of Reaganomics and a New Way Forward

  • Bruce Bartlett
  • Palgrave McMillan, 2009; 266 pages; $28.00

It is a shame that John Maynard Keynes isn’t alive to defend himself against Bruce Bartlett’s praise. The great English economist, who did not suffer sycophants lightly, would have abominated posthumous ones. Bartlett has reconsidered his long association with supply-side economics and decided that he should have been a Keynesian, without, however, understanding Keynes’s views. His new book calls to mind the joke about the Chinese waiter in a kosher restaurant who speaks perfect Yiddish; the owner explains, “He thinks he’s learning English.”

The Great Depression occurred, Bartlett informs us, because the Roosevelt Administration failed to follow Keynes’s counsel, that is, to increase the money supply fast enough to prevent deflation and raise government spending to support monetary expansion. Today, Bartlett adds, the government is spending too much money and should increase revenue through a value-added tax in order to reduce federal deficits. Raising taxes in the middle of a severe recession is a brave position, but in Bartlett’s case a badly argued one.

What Keynes understood quite well, but Bartlett doesn’t seem to grasp, is that the model he put forward in his 1936 General Theory was a short-run model of a closed economy. If savings cannot find an outlet in investment and a liquidity trap forms, Keynes argued, the government should provide the investment by running a deficit. Today America suffers from the culmination of long-term problems in the context of a highly integrated world economy.

Considering the problem that Keynes posed on a global scale rather than within the mythical framework of a closed economy, the matter looks quite different. Robert Mundell of Columbia University won the Nobel Prize in 1999 for doing just that. Mundell, as Bartlett observes, also fathered the supply-side economics behind the quarter-century economic expansion that began with the Reagan tax cuts. Despite his long sojourn among the supply-siders, though, Bartlett has not grasped how Mundell generalized Keynes’s model.

From a global perspective, Mundell showed, one country’s excess of saving may match another country’s excess of investment requirements; their respective imbalances turn into a current-account deficit: the country with more savings invests in the country with more investment needs. But once we turn to world capital markets to correct the Keynesian imbalance of savings and investment, other aspects of the model must be adjusted. Currency stability becomes critical, because without it investors cannot easily invest across national borders. That insight informed Mundell’s famous recommendation, adopted by the Reagan Administration and the Volcker Federal Reserve, of a tight monetary policy combined with tax incentives for economic growth.

Having extracted Keynes’s model from the misleading assumption of a closed economy, Mundell went a step further and showed that long-run rather than short-run factors may be decisive. Demographics, he argued, cause most imbalances between investment and savings, for countries with an aging population have excess savings, and countries with a young population do not have sufficient savings to fund their own investment requirements. Old people in one country must lend money to young people in another in order to correct the imbalance. Issues as currency stability come to the fore in the global version of the Keynes model, in a way that Keynes never addressed.

Bartlett should know this, because he worked briefly at the consulting firm founded by Jude Wanniski, the publicist who coined the term “supply-side economics” and played Boswell to Mundell’s Dr. Johnson. Bartlett had left the firm shortly before I joined it in 1988 (I stayed until 1993 as chief economist), so I do not know quite what he learned. Not to have absorbed Mundell’s generalization of the Keynes model would have required a single-minded sort of insularity. Bartlett mentions Mundell’s Nobel Prize, but does not seem to understand why it was awarded. Even within the narrow focus of Keynes’s concerns during the 1930s, Bartlett is not conversant enough with Keynes’s position. In June 1933, President Roosevelt devalued the dollar against gold, the first effective step towards reversing the devastating deflation of the preceding three years. Famously, Keynes supported Roosevelt’s action, writing under a headline in the London Daily Mail, “President Roosevelt is Magnificently Right.” Roosevelt’s devaluation would “lead to the managed currency of the future,” Keynes wrote. That much every schoolboy knows. Bartlett is no schoolboy, though; his book contains elementary errors that would invite a failing grade from an undergraduate program in economics.

In fact, June 1933 was the turning point in the efforts to reverse American deflation. The consumer-price index had fallen from 17.3 in October 1929, the month of the stock market crash, to a low of 12.6 in May 1933—after which it climbed almost without interruption to a level of 14 in 1939. Strangely, Bartlett devotes several pages to a polemic against Roosevelt’s hike in the dollar price of gold, without observing either that it appears to have helped, or that Keynes was its most enthusiastic supporter—and this in a chapter praising Keynes. A footnote on Keynes’s monetary views refers to statements made in 1930, in apparent ignorance of his famous Daily Mail declaration of 1933.

The middle section of Bartlett’s book rehashes the history of supply-side economics, but his account doesn’t measure up with the one set forth by Brian Domitrovic’s 2009 book, Econoclasts. Although supply-side economics got America out of the slump of the early 1980s, Bartlett allows, it failed to rein in the growth of government spending. Now, the United States faces an explosion of debt due to Social Security, Medicare, and other entitlement programs, not to mention the ticket for the present administration’s fiscal stimulus programs. “Insofar as the federal government has insufficient assets to cover its debts, it would be reasonable to say that it is bankrupt,” Bartlett writes.

The solution, he avers, is an increase in taxes. “In practice, the only way Congress can cut the deficit quickly and meaningfully is by raising taxes,” he writes, adding, “It is a pipe dream to  think that our nation’s looming fiscal problems can be dealt with solely on the spending side of the budget.”

It takes a peculiar kind of self-confidence, the kind we admire in Mr. Magoo, to plunge ahead with a plan to increase taxes when the “all-in” unemployment rate exceeds 17 percent (22 percent counting so-called long-term discouraged workers). But Bartlett does have a point: when Ronald Reagan signed the Kemp-Roth tax cut bill in 1981, the U.S. savings rate stood at 10 percent, the “current account” was in surplus, and the United States was the world’s largest creditor. Now, the savings rate has climbed up to 5 percent from zero, the current account has been in chronic deficit for a decade and a half, and the United States is the world’s largest net debtor. The top marginal federal-tax rate stood at 70 percent in 1981; it is 35 percent today. It is harder to sacrifice revenues, harder to finance the deficits that would result from tax cuts, and less likely that tax cuts will influence behavior with a starting point of 35 percent rather than 70 percent.

Repeating the Reagan prescription of 1981, as some conservative economists propose, is problematic for an even more obvious reason. Think of the Yankees, who won the American League pennant in 1981 (but lost the World Series to the Dodgers). Now consider the same team in 2010—exactly the same team, with exactly the same players, including a 59-year-old Goose Gossage. Americans have aged as well. The Baby Boomers were in their twenties and thirties in 1981, ready to take risks; now they are in their fifties and sixties, and ready to retire.

It isn’t just that Americans are older. The foundation on which our civil society rests, the family, is dangerously weaker. Although America’s population has risen from 200 million to 300 million since 1968, when Richard Nixon took office, the total number of two-parent families with children is the same today as it was when Richard Nixon took office, at 25 million, while the number of one-parent families with children has tripled. Dependent children made up half the U.S. population in 1960, against only 30 percent today. The dependent elderly have doubled as a proportion of the population to 30 percent today from 15 percent in 1960. No wonder that the problems of America’s home market appear so intractable. In 1973, the United States had 36 million housing units with three or more bedrooms, about as many as the number of families with children. In 2005, the country had the same number of two-parent families with children, but the number of housing units with three or more bedrooms had doubled to 72 million.

These long-run problems have come home to roost. Aging Americans must increase savings to replace the estimated $6 trillion in home equity that has been wiped out since 2007 and to compensate for a decade and a half of zero savings. To raise taxes under such circumstances would crush the economy and reduce tax revenues. There are alternatives, which Bartlett does not seem to have considered. There is only one way to drastically increase savings while increasing economic growth: export more, provided the proceeds of exports are saved. But for America to export more, she first would have to invest in productive capacity.

A combination of tax incentives for investment and consumption taxes might help achieve this. In the short run, moreover, the United States must continue to attract foreign-capital inflows. As Mundell observed, monetary stability is the sine qua non for making U.S. investments attractive to foreigners. In the long term, America’s economic position will continue to deteriorate unless the decline in family formation is reversed. Family-oriented tax incentives—for example, a substantial increase in the deduction for dependent children—are indispensable.

Bartlett certainly has a point that the supply-side solution of the 1980s cannot be applied like patent medicine. But having failed to understand why the medicine worked so well in the past, he does not know how to adjust the prescription for the problems of 2010.

Mr. Goldman is senior editor of First Things, in New York, New York. Previously he was global head of fixed income research for Bank of America, global head of credit strategy at Credit Suisse, and chief economist for a supply-side consulting firm.