What's So Mysterious About The Rip Roaring Economy?

Some people are perplexed that the economy is entering its seventh year of expansion with high employment, rising profits, and low inflation. They see this as a new economy from which the Phillips curve tradeoff between employment and inflation has been banished. But we have seen it all before in the record 92-month Reagan expansion, which commenced with double-digit and ended with 4% inflation.

Supply siders do not get credit for the transformed economy they forecast. But their explanation for the new economy is nearly 30 years old and a matter of record. In the '70s, supply siders were already saying that the Phillips curve was the product of a peculiar policy mix that squashed incentives while pumping up demand through monetary policy. They said that if the government would just stop trying to stimulate the economy with easy money and rely instead on larger after-tax rewards for workers, savers, investors, and risk-takers, the economic malaise that demoralized the country could be ended.

But what about the '90s? Didn't Clinton actually raise taxes and shouldn't this have thrown a wrench into the supply-side works? The tax increase didn't help growth, and the economy would have done better without it. But more important things are happening to offset it: an ongoing revolution in communication and information technology and two important tax cuts that are independent of Clinton's policies.

MISERLY WRITE-OFFS. Improved technology is always a source of lower costs and a spur to economic growth. Obviously, if the new technology had been regulated out of existence or delayed, the economy would have suffered. Fortunately, supply siders, not industrial policy advocates, carried the day.

The continuing decline in inflation is, in effect, an automatic tax cut for capital investment, because it raises the present value, after taxes, of the projected income stream from new investments. Depreciation allowances are not indexed, and a low and falling inflation rate enhances the real values of the allowances, making it possible for investors to realize higher real returns from investments. In the '70s, this was not the case. Then, high and rising inflation combined with miserly permissible write-offs to prevent the recovery of the real value of invested capital.

Another de facto tax cut is the lifting of the socialist blanket, which smothered economic activity in vast areas of the world for a half century or more. The barriers to trade, private property, and capital flows limited the world economy primarily to North America, parts of Western Europe, and Japan. Privatizations in Britain, China, Eastern Europe, France, Italy, Latin America, and the former Soviet Union have greatly enhanced the value of assets and have created business opportunities that have globalized the economy. Today, even labor markets are global, making it impossible for wage growth to outpace productivity growth.

PASSIVE ROLE. To grasp the importance of the free market's advent in a formerly socialized economy, consider the removal of a tariff that is high enough to prevent trade. When the tariff is removed, economic activity expands. When the greatest tariff of all--socialism--was removed from the world economy, the supplies of inputs and outputs increased. In supply-side terms, there is an outward shift in the global supply function.

Until the advent of the supply-side revolution, economists believed that aggregate supply played a passive role in responding to shifts in aggregate demand. Economists taught that increased demand raised output, but that sooner or later costs and inflation would rise as the economy reached full capacity and employment. In this one-dimensional theory, output was affected only through changes in demand. Even changes in taxation left the supply function undisturbed. Higher taxes would reduce demand, and the economy would move to a lower rate of output, while a tax cut would increase demand, moving the economy along its supply function to a higher rate of output.

Supply-side economics has shown this to be unambiguously wrong. Changes in taxation shift the supply function. Tax increases that raise the cost of capital, labor, or other inputs reduce aggregate supply. Tax reductions that raise the returns to labor and capital increase aggregate supply. The supply-side revolution is as fundamental as the global economic revolution, which is the direct consequence of the removal of barriers that restrict supply. The lower costs resulting from global markets mean that even an economy burdened with Clinton's tax and regulation policies can prosper.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE