(This item originally appeared at Forbes.com on August 11, 2016.)
I wish we had a better term for the great advances in economic understanding that began in the mid-1970s and became known as “supply-side economics.” One president, and not a socialist either, called it “voodoo economics,” which shows just how weird it seemed at the time. It was really an expansion of the Classical school of economics, which most people trace to Adam Smith and his precursors such as Cantillon or Hume.
If you could sum up the insights of the 1970s and 1980s in two words, it would be that “taxes matter.” Today, the importance of this insight is still not very well understood, even by those think tank researchers who craft detailed tax reform proposals, and certainly not by academics today, or the economic hit men of the IMF or World Bank who blow up one economy after another with their “austerity” plans. Taxes really do matter, either in a negative, destructive way, or in a positive, prosperity-inducing way.
From 1950 to 1970, the Japanese government reduced tax rates, and introduced various business-friendly adjustments such as accelerated depreciation, every single year. Every single year, by their own “static” calculations, these changes were supposed to reduce tax revenue. It won’t surprise anyone when I say that tax revenues actually went up. It might be surprising, however, when I say that tax revenues rose by sixteen times, even with the yen linked to gold, while the tax revenue/GDP ratio didn’t change much at all. Tax revenue, in 1970, was multiples of total GDP in 1950.
This is good, but it is just one aspect of a much broader picture. In the 1950s and 1960s, economists didn’t really have any way at all of explaining this phenomenon. One popular explanation was that it was caused by the rebuilding effort after the widespread destruction of physical assets in World War II. This was Frederic Bastiat’s “broken window fallacy” on a galactic scale.
Before 1870 or so, people discussed “political economy,” which basically meant: government economic policy. Since taxation is the government’s biggest economic policy, except for communistic central-planning regimes and those governments (rare in history; common today) who engage in fiat currency manipulation, taxation was often a topic of discussion though one that was not understood very well.
The “marginal revolution” of the 1870s, beginning with people like Carl Menger and Leon Walras, created the modern study of “economics” – and with it, a number of gross errors that continue to the present day. Driven by physics-envy, they created new mathematical models of “pure economics” that mimicked ideal gas laws and other insights then revolutionizing engineering and physics. In the process, the elements of economics that seemed mathematical and quantifiable in nature – Prices, Interest and Money – became the focus, and everything else largely disappeared.
The economy was imagined, in their “general equilibrium theories,” to be a sort of self-regulating machine. Changes in prices or interest rates (returns on capital) would alter supply and demand, production and consumption, investment and the allocation of capital. It seemed a self-regulating system, which would naturally return to “equilibrium”. Visions of steam engines danced in their heads. Money was supposed to be a neutral agent of commerce, this goal best achieved with a gold standard system. Distortions of money would distort the mechanisms of price and interest, causing all kinds of problems.
Recessions were seen to be relatively mild and self-correcting. Governments had no real role here. They were to “do nothing,” and let the self-regulating system of Prices and Interest return to General Equilibrium. Government intervention in the process – through Price controls or manipulations of Interest or Money – would only cause problems.
Thus, the study of “political economy,” or government economic policy, became a vision in which governments had no role at all. Nobody discussed government economic policy anymore, because, in effect, it didn’t exist: the correct policy was “do nothing.”
Despite this incredible blindness, government policy still existed. An explosion of tariffs and domestic taxes around the world, combined with new regulations that were often stridently anti-business, created the onset of the Great Depression. But, perhaps because there was no obvious intervention with Prices or Interest, economists mostly didn’t even notice that this had happened; that governments were definitely Doing Something. Nevertheless, the disastrous results could not be ignored. This led to a fracturing of the “do nothing” consensus. One side, the Keynesians, saw Prices, Interest and Money – especially, monetary manipulation to affect Interest and Prices – as the way out of the grave difficulties of the time.
Another side, rapidly dwindling in stature as their “do nothing” stance proved mistaken, tended to claim that, since there were no interventions in Prices and Interest, of the sort of heavy-handed statist sort that might cause economic breakdown within the context of their model, then the problem must be something with the Money. Thus, the “Austrian explanation of the business cycle,” which is entirely monetary in nature. Such things do exist, even on a continuous basis in today’s environment of floating fiat currencies. But the question of how this was supposed to have occurred with the gold standard, which was supposed to prevent such things, was a problem they mostly ignored, or papered over with some quick hand-waving. The Keynesians, on the other hand, claimed that there was no such monetary distortion – rather, they wailed that “golden fetters” prevented them from doing much of anything at all.
Along the way, government economic policy was reduced to a single quantity, Spending. What the money was for, or where it went, apparently mattered little. Even this one-variable version of government economic policy fell out of favor, especially among deficit-hawk conservatives who pointed out that governments that tried it on a grand scale – notably, Japan – gained no clear rewards for their gigantic expenditures.
It took a hundred years, from the original removal of government economic policy from “economics” in the 1870s, until the first glimmerings of its re-emergence in the 1970s. Taxes mattered. Regulation, in all of its details, mattered. Spending — in all of its details, not just as a gross quantity – mattered. Government economic policy (outside of monetary manipulation) mattered. A lot.
Practical people – businessmen, and the Congresspeople they supported – always had an instinctive sense of this, born of direct experience. Great debates ensued, over questions of economic policy. Was Glass-Steagall a good thing or a bad thing? Did welfare programs help the underclass, or actually undermine it? Did the burdens of Sarbanes-Oxley kill venture capital’s traditional exit strategy? Is a Flat Tax the best way to solve chronic underemployment? But, these specific discussions were rarely codified into a broader vision. “Macroeconomics” still seemed a continent apart from “microeconomics.”
Governments should definitely “do something,” to improve economic health and prosperity, whether in good times or bad. Understanding what could be done would eliminate the reliance on two tools – monetary manipulation, and undifferentiated government “spending” – to achieve all goals. In practice, these create more problems than they solve. Abandoning them, in favor of much more productive avenues of government policy reform, would thus allow us to return to a Stable Money policy – in practice, a gold standard system – and cease the endless destructive distortion of the economy via floating fiat currencies. On this, the classical economists were right: Money is one place where governments should “do nothing.”
During the fourth century B.C., the Confucian philosopher Mencius traveled China telling princes that they should adopt the “well-field system,” an effective 11% tax rate on agricultural production. It was a relatively low rate for the time; and also, simple and predictable, compared to the common practice of princes simply taking what they wanted on any pretense. Taxes mattered.
Academic economists today are still mostly stuck in a self-referential perpetuation of dogma that has little relation to the outside world; mostly, it is an empty ceremony of career advancement within the university system. But, here and there, quite a lot of good research has been done on the effects of government economic policy, for good and bad. “Supply side economics” showed the way out of the box of Prices, Interest and Money that economists had fallen into a century earlier. Still, very few people really appreciate this advance – not even, I would say, some of its early creators. This is the path forward in the study of economics today, which is otherwise piteously retarded. I hope that at least a few people follow this path, and see where it leads.