Robert Mundell and Supply-Side Economics

I read an interview with Robert Mundell in the opinion section of the WSJ this morning. Robert Mundell is regarded as the father of supply-side economics and the euro. He won a Nobel Prize for Economics in 1999 (the same year the euro was introduced).

In the interview, Mundell offers some interesting commentary on the current state of the economy, including issues like the current marginal tax rate, the corporate tax rate, and the weak dollar. I figured it would also be an opportunity to explore supply-side economics a little further.

An aside - why focus on the "marginal" tax rate? The marginal tax rate is looking at the rate at which the next dollar that someone earns gets taxed. So basically, to what extent does someone have an incentive to make that next dollar? The distinction becomes important when you have a graduated or progressive tax system like you do in the U.S. (and many other countries for that matter). Here's a quick view of the progressivity of the tax system in the U.S.:


One of the things I found interesting was Mundell's quick history of the tax rates in the U.S. over the last century. Here's the excerpt on that:

Should taxes instead be cut again, I ask him, to stimulate the sluggish economy? Mr. Mundell replies that he favors a ceiling of 30% on marginal rates (the current top rate is 35%). He recounts how the past century experienced a titanic struggle over whether tax rates are too high or too low: from a 3% income tax in 1913; up to 60% during World War I; down to 25% before Congress and President Herbert Hoover raised taxes back to 60% in 1932 and "sealed the fate of our economy for a long, long time"; all the way up to 92.5% during World War II before falling in three steps, reaching 28% under President Ronald Reagan; and back to nearly 40% under Bill Clinton before George W. Bush lowered them to their current level.

I can't imagine a 92.5% marginal tax rate, but I suppose it was there at some time. There'd be no incentive to do anything at that point. In addition to the 30% ceiling on marginal tax rates, he also favors a cut of the corporate tax rate to 25% (or even lower). This is what McCain is proposing as well.

Back to supply-side economics. The basic premise is that economic growth can most effectively be spurred by creating incentives for people to produce (or supply) more goods into the market and that the general way to do this is by adjusting income and capital gains taxes. The idea is that more supply will create more demand - Keynes himself said "supply creates its own demand". I'm not sure if I entirely agree with that, but all the infomercials on TV for useless items would certainly suggest that it holds true. In terms of spurring production, if you have a marginal tax rate of 100%, no one has an incentive to produce beyond that point. Lower that and people will increase supply. Reagan put this into practice in the 80's ("trickle-down economics"), but there's really no consensus on whether that worked or not. The idea is, similar to the idea behind the Laffer Curve, if you decrease tax rates you can actually maintain or even increase revenue because of the increased production that is spurred. It seems essentially impossible for revenue to increase in the short-run (and probably even unlikely that you would break-even), but seems like you could break-even in the long-run.

Although it seems very similar to the Chicago School, supply-side economists differ significantly. The Chicago School (Milton Friedman included), although being similar in that they favor free market solutions rather than central planning, think the main lever is monetary policy (i.e. controlling the money supply). Supply-siders seem more interested in controlling the value of money rather than the supply of it, hence why many of them want a return to the gold standard or a global currency where there wouldn't be exaggerated swings in exchange rates.

Here's an excerpt from the Mundell interview that sheds some insight on this:

"What people have to realize is there's been a fundamental change in the way markets work in the past 20 years," Mr. Mundell says. "Now, exchange rates are driven not so much by trade but by capital accounts and capital movements, and the huge amount of liquidity that's sloshing around the world."

Central banks world-wide, he notes, are trying to reach an equilibrium between dollars and euros in their $6.5 trillion worth of foreign reserves. Roughly two-thirds of these reserves are kept in dollars now, so they have about $1 trillion left to move into euros.

"If you did a hundred billion dollars" annually, Mr. Mundell points out, "you'd need 10 years to build that up, and that amount of capital movement has a tremendous effect in keeping the euro overvalued. It's not good for Europe and . . . ultimately it would cause more inflation in the United States."

An aside on this topic - it seems that it's also supply-side economics that creates a tremendous amount of liquidity in the market. If you decrease taxes, you're making more money available for private investment. At what rate can that money be effectively invested by the private sector? Or at what rate can it be effectively consumed? Supply won't always increase fast enough to meet demand. If you have more dollars chasing fewer products, you get asset inflation or "bubbles". The housing bubble's a good example. But then finding the right balance between liquidity (or the money supply) and the amount of private and public investment (based on taxes) is really tough to find. And that's obviously why we have the Fed.

But back to the exchange rate issue. Mundell proposed a few solutions to the exchange rate issue. Here he talks about how the euro will correct itself over the next few years and why a global currency might be a good long-term solution:

As for the euro's overvalued status, he forecasts deflation in Europe, along with a slowdown and an end to its housing boom. The answer, he suggests, is for the Federal Reserve and the European Central Bank to cooperate in putting a floor and a ceiling on both the euro and the dollar. "You have to grope" to the appropriate range, he maintains, but a good starting point would be to keep the euro between 90 cents and $1.30.

Even better, in his mind – and now we're really talking long term – would be to have a global currency. This could take the form of a new money or a dominant existing one to which all others are fixed – probably the dollar. "As Paul Volcker says," Mr. Mundell relates, "the global economy needs a global currency."

Short of a global currency, he seems to advocate in the short-term regional currency standards with floors and ceilings between each (as opposed to it being totally floating) - the dollar in the Americas, the euro in Europe, and a new Asian currency to be shared by the east. And then long-term a global currency. I haven't read much about that, but seems like an interesting one.