Here’s why America needs to listen to Arthur Laffer.
Like any field, economics has its trends and fads. Recently, Keynesian economics has been in vogue. Based on the work of British economist John Maynard Keynes, Keynesian economics urge governments to increase their spending and to stabilize the economy in crisis periods. The Obama administration has tried to explain its response to the current financial crisis in terms of the application of Keynesian principles. But as many conclude that our government’s responses have been flawed as well as expensive, it’s time to listen to the advice of another major 20th century economist—Arthur Laffer.
If most Americans have heard of Arthur Laffer at all, it’s probably because of the Laffer Curve, a simple chart that shows that raising tax rates does not necessarily produce greater tax revenues. Laffer first demonstrated the idea to the White House during the Ford Administration; later, it became famous as the idea behind the Kemp-Roth tax cuts that fueled the tremendous economic boom of the Reagan years.
Laffer is one of the most important 20th century economists, but his greatest work may actually be in the 21st century. That’s because he is warning us now that if America doesn’t change its economic course, quickly, we are in for bad times ahead.
To explain, Laffer looks to a few simple axioms on which the field of economics is based – rules that predict how both economies and individuals will behave when faced with a set of choices. For instance, the law of supply and demand explains a great deal of how the economy works – when demand for a particular good increases, supply and demand will eventually equilibrate at a new equilibrium price and quantity.
Right now, Laffer warns that simple economic principles are pointing to a potential macroeconomic meltdown.
First, government borrowing continues at alarming rates. The federal budget deficit is expected to top $1.5 trillion this year, even exceeding last year’s staggering deficit of $1.4 trillion, and Congress recently expanded the national debt ceiling by a similar amount. Federal spending on bank and auto bailouts and stimulus all adds up. All this spending must be financed somehow, and the patience of our Chinese, Japanese, and Arab creditors may one day run out.
Laffer’s second point is that the supply of money continues to grow. The monetary base, which is the narrowest measure of the money supply or total amount of money in the economy at a particular point in time, has just reached an all time high. Left unchecked, the high supply of money could fuel inflation. Unfortunately, the Federal Reserve is caught in a Catch 22—if they decide to fight inflation they will have to sell about $1 trillion worth of government bonds alongside a Treasury auctioning off record amounts of bonds to finance record deficits. Given the fiscal backdrop, were the Fed to go from being a huge net purchaser of bonds in 2009 to a big net seller in 2010, interest rates would be sure to rise drastically, pushing the economy into recession yet again.
Laffer’s third point is that taxes are high and likely to go up from here. Our corporate taxes are already the second-highest among the advanced economies in the Organization for Economic Cooperation and Development. For individuals, the Bush tax cuts expire next year, which will send personal income tax rates, dividend and capital gains tax rates, and estate tax rates higher. Unless Congress passes another fix, the sharply higher Alternative Minimum Tax will snare millions of middle-class taxpayers, instead of the uber-wealthy it was originally designed to target. And that doesn’t even count proposed tax increases in relation to health care reform or climate change legislation. As the incentives to work, save, and invest are all decreased via increased marginal tax rates, economic growth is sure to suffer.
Finally, Laffer points to trade issues. Rather than opening ourselves to trade with the world, we are increasingly cutting ourselves off from it. It’s a basic principle of economics that trade benefits both parties to a transaction, but rather than seeking to negotiate trade agreements with countries around the world, we are not ratifying the ones we have negotiated, and we’re imposing tariffs on China – the very country we need to finance our budget deficit! Open trade will help us move toward the jobs of the future rather than inefficiently seeking to hold on to the jobs of the past.
Laffer is right: no economy can long prosper if it is overspending, increasing tax rates, printing too much money, restricting trade, and increasing regulations. It’s simple, really – but the potential consequences if we don’t change economic course soon could be profound. So the Lafferian response to the economic crisis is simply to take the opposite track and embrace pro-growth economic policies: reform the tax system by moving toward a broad-based, low flat-tax; address the looming unfunded liabilities crisis; decrease the size and cost of government; reinstate a sound and stable money; support free trade for all; and repeal ill-conceived regulations. By turning away from Keynes and toward Laffer, America can begin to grow again and we can all recover.