Memo To: SSU Students
From: Jude Wanniski
Re: The Supply-Side Revolution Part I
Today I’m posting the first of a two-part brief history of the Supply-Side Revolution, written by a distinguished Los Angeles attorney, Wayne Jett, a 60-year-old man I’ve never met. He clearly has gone to a great deal of trouble to assemble this account, which he first sent to Professor Robert Mundell of Columbia University – Mundell being the prime mover in reviving classical theory. When Mundell gave it his seal of approval, Mr. Jett sent it to me, wondering if I could suggest a place where it might be published. It’s quite long, well over 5,000 words – which is why the few publications I suggested turned it down. It’s also why I decided to run it in two parts, at a natural break point. Hopefully it might get enough attention here to persuade some publication to run it in hard copy where it could reach a much wider audience than we have here. It really is quite an admirable job he has done and I thank Mr. Jett for his permission to run it here.
A Supply-Side History
And The Road Ahead
By Wayne Jett
On October 13, 1999, the Royal Swedish Academy of Sciences announced its award of the Nobel Prize in Economics to Robert A. Mundell, citing “… his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.” The announcement said further:
“Robert Mundell has established the foundation for the theory which dominates practical policy considerations of monetary and fiscal policy in open economies. His work on monetary dynamics and optimum currency areas has inspired generations of researchers. Although dating back several decades, Mundell's contributions remain outstanding and constitute the core of teaching in international macroeconomics.
“Mundell's research has had such a far-reaching and lasting impact because it … [produced] results with immediate policy applications. Above all, Mundell chose his problems with uncommon - almost prophetic - accuracy in terms of predicting the future development of international monetary arrangements and capital markets…”
These statements are remarkably sweeping when parsed in academic terms. Yet, they say very little to explain to ordinary people how Mundell’s work may have touched their lives and fortunes.
The Royal Swedish Academy credits Mundell’s theories as dominating practical policy-making for both monetary and fiscal [tax and budget] matters in all modern, market economies. And his theories have gained such eminence because Mundell has been “almost prophetic” in analyzing research problems that mirror the real world’s conditions before they happen.
Then Why The Mystery?
If that is so, how can it be that he has done such important work over several decades, was awarded the Nobel Prize in economics only four years ago, and yet the mainstream media (not to mention the public) would ask “Robert WHO?” By contrast, hardly a day passes that we do not hear of the exploits of Alan Greenspan, who, one might add, has not a single Nobel Prize to his name.
Is it possible that Robert Mundell has had a greater impact on our lives and well-being than we know? Or is this a case of the Royal Swedish Academy making another socialistically correct selection in the nature of Time Magazine’s “person of the year” awards?
People the world over want to know the causes of economic events that have dominated their lives. A study of the work of Dr. Mundell reveals facts that are surprising, even astonishing. These facts illuminate past successes and failures of U. S. monetary and fiscal policy. That illumination has important, if not profound, implications for current and future policy.
Robert Mundell is the person who furnished the theoretical genius behind “supply-side economics.” The ideas and premises of supply-side economics are described most lucidly in the writings of a political science and journalism graduate of UCLA, Jude Wanniski. Those writings, in turn, reveal that three individuals were primarily responsible for advancing the ideas of supply-side economics: Robert Mundell as the economic theoretician; Arthur Laffer as the pragmatic economist with a flair for public relations; and Jude Wanniski as the journalistic link between the two economists, the public, and the worlds of Wall Street finance and Washington politics.
The work of each of these three individuals is so important as to deserve detailed analysis. However, the challenge at hand requires spanning the three colleagues’ work in order to remedy a matter of urgency for the nation and the world. That urgent matter is the current, unsettled state of U. S. monetary policy and the unsatisfactory international monetary system.
The Struggle for Monetary Policy Influence
The American philosopher Francis Fukiyama has postulated that the “end of history” is at hand in the sense that all forms of government have been examined thoroughly, with republican capitalism proven to be the best design. Even if that is so, the end of history is certainly not at hand with respect to monetary policy.
To this day, monetary policy is the scene of a passionately contested struggle for primacy in influencing the central banking institutions that are responsible for national currencies. Yet, this struggle for influence of monetary policy is hardly discernible in the public media.
One thing can be said about this struggle with a fair degree of certainty: the views of Robert Mundell do not dominate monetary policy at the U. S. Federal Reserve Board. Indeed, Chairman Greenspan reportedly does not even maintain communications with Professor Mundell at present.
Is this because the Fed’s monetary policy is so well in hand that such communications are unwarranted? In his Nobel lecture of December, 1999, Professor Mundell put a pretty face on Fed performance by remarking that a period of relative stability in the dollar’s value had been reached.
But within three months of that hopeful assessment, the U. S. equity markets began a series of three consecutive years of precipitous declines in share prices. Since March, 2000, the Fed Chairman’s world has been tumultuous, to say the least. Mr. Greenspan now hopes for re-appointment next Spring to another term as Chairman, perhaps with the objective of burnishing his legacy.
Should we think that Robert Mundell could be helpful to Chairman Greenspan in restoring a degree of luster to the Fed’s performance? Let’s examine the record.
Since 1974, Robert Mundell has been Professor of Economics at Columbia University in New York. Canadian-born, he studied at the University of British Columbia and the London School of Economics before receiving his Ph.D. from MIT. He taught at Stanford University and the Bologna (Italy) Center of the School of Advanced International Studies of the Johns Hopkins University before joining, in 1961, the staff of the International Monetary Fund. From 1966 to 1971 he was a Professor of Economics at the University of Chicago and Editor of the Journal of Political Economy; he was also summer Professor of International Economics at the Graduate Institute of International Studies in Geneva, Switzerland. In 1974 he moved to Columbia University.
Mundell and the Kennedy Tax Cut
In the Fall of 1961, when Mundell joined the Research Department of the IMF, he was asked to analyze the monetary-fiscal policy mix of the U. S. economy. The economy at the time was experiencing sluggish growth and higher than acceptable unemployment, plus a worsening deficit in the foreign trade current account. President Kennedy had pledged in his 1960 campaign to get the country moving again.
Economists had split into three camps. Keynesians pushed for easy money and higher government spending. The U.S. Chamber of Commerce argued for tighter money and a balanced budget. The Council of Economic Advisors used the Samuelson-Tobin “neo-classical” analysis and urged low interest rates with a budget surplus to sop up excess liquidity.
Mundell’s analytical paper (circulated among IMF staff in late 1961 and published in March, 1962) showed that none of the three approaches would work. Instead, he recommended cuts in marginal tax rates to spur growth and employment, with tighter monetary policy to improve the balance of payments problem. Before the end of 1962, President Kennedy announced a reversal of existing policies, adopting Mundell’s recommendations. The tax cuts were enacted into law in 1964, after President Kennedy’s death. The result was rapid economic growth, higher employment, and improved stability in the international balance of trade.
Closing The Gold Window
During that time the dollar was still tied to gold at $35 per ounce. Under the international monetary exchange arrangement signed at the Bretton Woods conference in 1944, the U.S. dollar was the only currency with a value tied directly to gold. Other currencies were valued in terms of the dollar. Thus, fixed exchange rates existed among the currencies.
In 1964, Mundell had participated in a prestigious study group on international monetary reform that examined the concept of flexible exchange rates among currencies. Flexible exchange rates would become necessary if the ties between the dollar’s value and gold were severed. In 1966, Mundell split with other leading economists in the study group by concluding that flexible exchange rates would be a step backward for the international monetary system.
In the late ‘60s and early ‘70s, gold became undervalued at that rate due to inflationary monetary actions by the Fed. The Fed was helping the Nixon administration to finance the costs of the Viet Nam war without raising taxes. U. S. citizens could not convert their dollars to gold, but European nations could do so by bringing their dollars received in international trade to the U.S. “gold window.”
By August, 1971, the gold outflow from the reserves of the U.S. became so worrisome that President Nixon’s economic advisors were strongly urging him to close the gold window. Mundell understood, however, that cutting the ties between the dollar and gold would make the international system of fixed exchange rates impossible. Each currency would be floating under the management of an independent central bank.
Arthur Laffer, then working in the Office of Management & Budget, and Assistant Secretary of the Treasury Paul Volcker argued against closing the gold window. But Treasury Secretary John Connolly and other economic advisors overruled them. In August, 1971, President Nixon signed an executive order closing the gold window, thus ending dollar convertibility for European nations under the Bretton Woods agreement.
When the dollar’s convertibility to gold was ended in 1971, the value of the dollar was effectively floated. The values of all currencies of the world were floated at the same time by the same act. This required a mechanism of flexible exchange rates among the currencies.
Supply-Side Economics in the ‘70s
By January, 1972, Mundell was predicting severe inflation for the dollar and great instability in the international monetary system. Indeed, Mundell forecast that the flexible exchange rates among floating currencies would prove to be so volatile and unsatisfactory by 1980 that a return to a gold-based system would be unavoidable.
Once again, Mundell’s forecast proved to be on the mark, at least in terms of the inflation and instability. The price of gold doubled by the end of 1971 and quadrupled by 1973. The prices of other commodities soon followed, including first and foremost the price of oil. Oil producers of the world accepted payment in dollars, but they mentally measured the value received in terms of the amount of gold per barrel. OPEC was formed, and the price of oil was raised from $3 to $12 per barrel.
When the gold window was closed in 1971, the Nixon administration had indicated an intent to return to dollar convertibility at $43 per ounce “when stability had returned” to the gold price, as his economic advisors assured him would occur. Instead, with gold at $140 per ounce, Nixon abandoned all ties between the dollar and gold in early 1973.
Another important contribution of Robert Mundell was his early recognition and announcement that the worldwide inflation unleashed in 1971 was historic because, for the first time in world history, such inflation would be coupled with progressive income tax systems in all of the developed economies. With virulent inflation and progressive tax rates operating in tandem, tax burdens would increase annually and automatically across the board without public debate or need for legislative action. The continuously increasing tax burdens placed on world economies in this manner had significant anti-growth effects throughout the ‘70s and into the ‘80s.
The Tutoring of Jude Wanniski
Mundell and Arthur Laffer had begun collaborating in the ‘60s while both were on the faculty at the University of Chicago. Jude Wanniski became acquainted with Laffer in 1970, and Laffer began tutoring Wanniski, introducing him to Mundell in May, 1974.
Wanniski had eventually returned to New York after completing his UCLA degrees, working first on newspapers in Anchorage, Los Angeles and Las Vegas, then as a political columnist for the Dow Jones weekly National Observer. In January 1972, he moved within the Dow Jones media empire to the Wall Street Journal, working as an editorial writer. Wanniski became the ardent student, first of Laffer in 1970, and then of Mundell himself. Mundell and Laffer were voices in the wilderness, educating Wanniski in their theories and forecasts in order to obtain public exposure for their views.
During the five and a half years of the Nixon administration, literally every Keynesian economic remedy (both monetary and fiscal) that could be devised had been tried, including wage and price controls, without success. In May, 1974, Mundell forecast that unemployment would increase to 8% by January, 1975, unless an immediate tax cut of at least $10 billion was enacted. The necessary amount of the tax cut would increase with every month of delay.
By December, 1974, Mundell was recommending a tax cut of $30 billion. Yet, after Nixon’s resignation, President Gerald Ford (in Wanniski’s words) “followed the advice of all the big-time Nobel prize winners and other stars of the profession, liberal and conservative, asking Congress for a tax increase to reduce pressure on prices.”
The Enlistment of Kemp and Reagan
If Mundell and Laffer failed to convert President Ford, they found a devout disciple in Jack Kemp, at the time an obscure congressman from Buffalo, New York. By the time of the 1976 Republican Convention, Kemp had proposed tax cutting legislation called the “Jobs Creation Act” based on the Mundell and Laffer Curve principles.
The two major Republican presidential candidates, Gerald Ford and Ronald Reagan, were both still mired in economic strictures of Keynesian and monetarist advisors. Ronald Reagan needed a few more delegates to take the nomination from Ford in ‘76, and Kemp offered (through Wanniski) to help him get them if Reagan would endorse the Jobs Creation Act. John Sears, Reagan’s campaign manager was ready and willing, but Reagan’s economic advisor Martin Anderson adamantly insisted “no.”
Wanniski Authors The Way The World Works
Ford kept the nomination from Reagan in a squeaker, but Mundell’s economic views had gained a better foothold in the political arena. With that encouragement and responding to his own burning commitment to the power and importance of the economic understanding he had gained from Mundell and Laffer, Jude Wanniski set himself to the task of writing a book expounding what he had already named in 1976 “supply-side economics.”
Wanniski’s book is entitled THE WAY THE WORLD WORKS, and was first published in 1978. Irving Kristol of Columbia University, by consensus an important American intellectual of the 20th Century, called Wanniski’s book “The best economic primer since Adam Smith.” Arthur Laffer remarked “In all honesty, I believe it is the best book on economics ever written.” Now in its 4th Edition, THE WAY THE WORLD WORKS is described by columnist Robert Novak as one of two books he has read in his life that changed his world view. (The other book was WITNESS by Whitaker Chambers.) In the year 2000, the editors of NATIONAL REVIEW listed TWTWW as one of the 100 most important non-fiction books of the 20th century.
Carter’s Keynesian and Monetarist Failures
Jimmy Carter defeated Gerald Ford in 1976 and brought his own Keynesian, and then monetarist, economic advisors into authority. Economic “stag-flation” and “malaise” continued unabated and even worsened. The price of gold doubled again to $280 per ounce by 1979. Fed Chairman Volcker abided by the monetarists’ call for slow, steady growth in the money supply. But by February 1, 1980, gold climbed to $840 per ounce, government bond interest rates climbed above 10%, and the prime rate rose above 20%.
Ronald Reagan’s 1980 Election
Fortunately, Ronald Reagan read Wanniski’s TWTWW and found that supply-side economics fit very comfortably with his own education in classical economics. By 1980, Reagan and John Sears had their campaign ducks in a row, and Ronald Reagan signed on to Mundell’s economic advice centering upon major cuts in marginal income tax rates. You will recall that Reagan’s eventual vice president, George H. W. Bush, anointed Reagan’s economic proposals with the epithet “voodoo economics” during the Republican primary. No matter. Reagan swept to victory in the ’80 presidential election.
As an aside, Bush’s campaign manager in 1980 and later Reagan’s Secretary of the Treasury, James Baker III, published his opinion on the WSJournal editorial page, April 20, 2003, good-humoredly calling himself a “reformed drunk.” He is now a true believer in the 1981 marginal tax rate cuts that keyed the Reagan economic recovery, and calls the results of the 1981 tax cuts “nothing short of miraculous.
Unfortunately, not many of Reagan’s economics appointees understood or shared his enthusiasm for Mundell’s views. In fact, many Reagan appointees were monetarists loyal to the views of Milton Friedman. The monetarists retained effective influence over the operation of the Federal Reserve Board. Their control was short-lived, however, because their theory that monetary growth should be strictly governed by a pre-set percentage soon had to be abandoned. Wanniski terms this monetarist theory as akin to keeping your car’s accelerator depressed to the same degree regardless of whether you are going uphill, downhill, through curves or around a corner; the outcome can be disaster.
In 1981-82, the Fed followed monetarist advice to tighten monetary policy. The result was a severe deflation as the dollar rapidly gained value, characterized by a drop in the price of gold from $850 in 1980 to $290 per ounce in early 1982. The deflation put tremendous pressure on debtors, who were required to repay loans with dollars much more valuable than those they had borrowed. Business shriveled and bankruptcies burgeoned.
Wanniski and other supply-siders pleaded with Volcker to add liquidity to the money supply. Monetarists argued that if he did so, inflation would be re-ignited and the bond market would collapse.
Volcker finally added $3 billion of new liquidity in the Summer of ’82, and the bond market boomed. Volcker’s decision to add liquidity was taken to avoid the imminent collapse of the banking system due to Mexico’s narrowly avoided default on loan payments - not because the Fed suddenly decided to acknowledge the merit and dominance of Mundell’s supply-side economic views. In Wanniski’s words: “Monetarism … ended as a serious experiment in the Summer of 1982.”
Dollar Instability and the Crash of ’87
One more thing must be mentioned of the Reagan years. The closest we have come to renewing the tie between the dollar and gold occurred in 1987. With James Baker III as Secretary of the Treasury and increasing volatility in the flexible exchange rates among currencies, Baker and Fed Chairman Volcker negotiated an agreement with Japan and West Germany called the “Louvre Accord” by which the three major currencies would maintain stability with respect to each other. The flaw in the “accord” was that it included no reference point for the price of gold with respect to any of the three currencies.
As 1987 proceeded, the price of gold in dollars was rising as economic growth weakened because the Tax Reform Act of 1986 had increased the tax rate on capital gains from 20% to 28%, thus slowing productive investment. Chairman Volcker favored sopping up the excess liquidity, but the Fed board would not go along. Secretary Baker feared a possible increase in the Fed discount rate before the ’88 election, and Volcker was replaced as Fed Chairman by Alan Greenspan in early August of ’87.
In September, 1987, Greenspan did not drain excess dollar liquidity, the dollar price of gold continued to climb, and the dollar fell against the yen and the mark. That month, Secretary Baker in a speech to the IMF proposed adding a gold price “reference point” to the Louvre Accord, as had been recommended to his advisors by Wanniski. On the news, the dollar strengthened and the dollar price of gold declined. However, the Fed did not follow up by removing excess liquidity, and the dollar decline resumed.
Wanniski met with Secretary Baker in his Treasury Department office on October 13 for an hour and a half, carrying a “message from Robert Mundell.” The message was that the markets would test the dollar’s value soon, and that Baker’s efforts towards international monetary reform could be blown away if the dollar was not adequately supported. Wanniski recommended Fed intervention and even the sale of gold “to scald the speculators.”
But Chairman Greenspan had already given an interview to FORTUNE magazine that was going to press as Baker and Wanniski spoke. Fortune published Greenspan’s opinion that the dollar was overvalued and would have to be devalued in future years. Baker confirmed on Meet The Press the following Sunday that the dollar’s value would not be supported. The next day, Monday morning, the U. S. markets opened and stock prices stepped into an open elevator shaft.
The monetarist influence over the Fed had returned with a vengeance in a no-holds-barred fight to prevent any return to a tie between the dollar and gold. Professor Friedman had forecast recession and recommended sinking the dollar with a pumped up money supply. Both Baker and Greenspan appeared to be influenced by this monetarist perspective.
Greenspan is widely credited with easing the panic by offering banks unlimited liquidity in a memorandum circulated on Tuesday, October 20. But the banks already had plenty of liquidity, and the additional dollars simply piled up in the banks until they were later taken back by the Fed. The equity markets stabilized and recovered as investors were reassured that the Reagan administration would not try to expand the economy by pumping up monetary liquidity.
Requirements of brevity will not permit reviewing the Reagan experience in further detail. But in December, 1988, as President Reagan was leaving office, he said this: "Economic truth is a lever that can move governments, move history...the economic model that we've created truly has become what Jude Wanniski described as 'the way the world works.’"
* * * * *
Part II will be posted next Friday.
[If you'd like to receive these commentaries automatically and free of charge please register at the link on the left of this page. You need only provide your name and e-mail address and choose the items you would like to get. If you would like to comment on the memo, please do so in “TalkShop,” at the link at the top of the page.]