Reagan + Friedman + Keynes

Lawrence Kudlow
Friday, October 24, 2008

Back in early 1981, when I went to Washington to work for President Reagan, one of the architects of supply-side economics, Columbia University’s Robert Mundell, visited my OMB budget-bureau office inside the White House complex. At the time we were suffering from double-digit inflation, sky-high interest rates, a long economic downturn, and a near 15-year bear market in stocks.

So I asked Prof. Mundell, who later won a Nobel Prize in economics, if President Reagan’s supply-side tax cuts would be sufficient to cure the economy. The professor answered that during periods of crisis, sometimes you have to be a supply-sider (tax rates), sometimes a monetarist (Fed money supply), and sometimes a Keynesian (federal deficits).

I’ve never forgotten that advice. Mundell was saying: Choose the best policies as put forth by the great economic philosophers without being too rigid.

Of course, John Maynard Keynes was a deficit spender during the Depression. Milton Friedman warned of printing too much or too little money. And Mundell, along with Art Laffer, Jack Kemp, and others, revived the importance of reducing high marginal tax rates to reward work, investment, and risk. The idea was to make each of these activities pay more after tax, and in the process boost asset values across-the-board. This incentive model of economic growth was used effectively by President John F. Kennedy and the great 1920s Treasury man, Andrew Mellon.

During the 1980s Reagan enacted Mundell’s three-legged approach. He slashed tax rates on the supply-side and was not afraid to run budget deficits in the Keynesian mold. At the same time, Reagan gave Paul Volcker carte blanche to practice the tough-minded monetarism that curbed excess money and vanquished inflation. This eclectic policy mix reignited economic growth, and it ushered in a three-decade prosperity boom that revived free-market capitalism.

Today, however, the economic naysayers are ignoring the advice of Prof. Mundell. Looking at our financial crisis, with its deflationary sweep from stock markets to home prices to energy, they want to lurch leftward to a big-government tax-and-spend regulatory approach. Instead, we need to put all three legs of the Mundell hypothesis in place. And we’re already two-thirds of the way there.

Treasury man Henry Paulson is using a $700 billion rescue package to prop up banks with new capital, purchase distressed assets, and backstop inter-bank lending. Keynesian deficits will finance it. But it’s working. While ankle biters on the left and right have dissed Paulson’s plan, important credit-market spreads have declined significantly in the last two weeks.

Fed head Ben Bernanke, meanwhile, is combating deflation with a Friedmanite monetarist approach -- the second leg of the Mundell mix. Over the past two months the Fed has doubled its balance sheet and spurred a major increase in the basic money supply in order to meet the enormous liquidity demands that always accompany deflation. The Fed should keep this up in the coming months until stocks, commodities, and credit show life-signs of recovery.

But what’s missing is Mundell’s third policy leg: supply-side tax cuts. And here we find the partisan debate of the closing days of the presidential and congressional elections.

Democrats want to tax the rich, redistribute the wealth, and spend our way out of the economic doldrums. It won’t work. Senators Barack Obama and Harry Reid, along with Speaker Nancy Pelosi, disdain supply-side tax incentives. But Sen. John McCain wants to reemploy them as a recovery tool. McCain is right, and now is the time for the Republican party to call for sweeping tax cuts that would reduce marginal rates by half for businesses, individuals, and investors. Yes, it would be bold. But no bolder than Reagan in the 1980s, Kennedy in the 1960s, or Mellon in the 1920s.

The corporate tax rate should be slashed from 35 percent to less than 25 percent, including capital-gains. (Corporations, let’s not forget, don’t pay taxes. Only individuals do, since business costs are passed along to consumers.) The top individual rate should similarly be lowered, with fewer income brackets to clutter up the tax code. And investment taxes on capital-gains and dividends should be cut from 15 percent to 7.5 percent to revive the dormant animal spirits of investors.

These tax cuts would mean all three legs of Robert Mundell’s pragmatic approach to policy are in place. Use the money supply to combat deflation (inflation is not the problem), employ deficits to rescue and stabilize the banking and credit system, and slash tax rates to reignite economic growth.

In effect, a successful rescue plan requires a drawdown of all the major economic schools of thought. Given the current economic emergency, we need all the help we can get. For a change, how about a little pragmatism in the policy mix? That just might do the trick.