The U.S economy is hurting. Despite massive stimulus programs and historically low interest rates, the economy remains mired in a slow growth cycle characterized by low labor force participation, wage stagnation and a lack of adequate investment. To get the economy moving again, we may need to draw on lessons learned from past generations.
John Maynard Keynes was a British economist who departed from neoclassical theory to argue that government held the power through monetary and fiscal policies to mitigate boom and bust cycles and stimulate economic growth. In the U.S., Keynes theories were embraced by Franklin Roosevelt as a cornerstone of the “New Deal” that helped lead the U.S. out of the Great Depression and through World War II.
In the Post-War Period of the 1950’s to the 1970’s, the “Keynesian Revolution”, as it came to be known, underpinned one of the most robust periods of economic growth in the Nation’s history.
In the 1970’s and early 1980’s, however, double digit inflation helped give rise to “supply-side” economics which argued that excessive government taxation, spending and regulation were at the root of the problem. Supply-siders maintained that, contrary to Keynesian doctrine, lowering taxes and reducing government spending would help tame inflation, lead to an increased supply of good and services and stimulate a sustainable level of demand.
Meanwhile, wealthy individuals and corporate interests in the U.S enthusiastically embraced supply-side economics because it argued for lowering high marginal tax rates. To generate public support, supply-side economics was sold as a pro-small business, anti-government initiative to unleash the creative energy of the private sector to generate economic prosperity.
For a while it actually seemed to work. Inflation was brought under control when the Federal Reserve under Paul Volcker aggressively raised interest rates in the 1980’s. Republican and Democratic administrations lowered marginal tax rates. And the economy boomed during much of the 1990’s.
If anything, supply-side economics worked too well – until it didn’t. Not only were taxes lowered, but government regulation of the financial services industry, for example, was weakened to the point that credit become much too easy. An asset bubble ensued in the late 1990’s and 2000’s, led by the housing market. Bad loans were re-packaged into complex financial instruments, known as “Credit Default Swaps,” that few people, including rating agencies and government regulators, understood. And it all came crashing down in a wave of defaults leading to the Great Recession of 2008 and 2009.
The U.S. responded with a combination of monetary and fiscal stimului. It was labelled by some as a “Keynesian Resurgence.” On the monetary side, the Federal Reserve aggressively bought bonds under a “quantitative easing” program that pumped billions into the banking sector to help keep interest rates low and increase lending and investment. And the Administration and Congress did their part by adding about a trillion dollars to government spending programs over a several year period starting in 2009.
However, the stimulus programs were offset by cuts at other levels of government; by consumers ratcheting back their spending as housing values plummeted and unemployment increased, and by banks and businesses reluctant to take on additional financial risk in a slow growth environment.
As illustrated in the graph at left, government spending at all levels as a percent of Gross Domestic Product (17.7% in 2015) is now at the lowest level since 1950.
In hindsight, the so-called stimulus after the Great Recession seems a minor blip up on an otherwise persistent downward trend line.
A similar trend is evident when looking at economic growth rates (see graph below). Today the economy is struggling to maintain 2% growth in Gross Domestic Product (GDP) – the lowest average rate in generations.
So, as you listen to the Presidential candidates debate economic issues, bear in mind that, if you cut through the populist rhetoric, much of what you are hearing is a debate on how to fix the U.S. economy.
Bernie Sanders is effectively arguing for a Keynesian approach, similar to the New Deal, with relatively high marginal tax rates and government sponsored investment in people and infrastructure to stimulate growth.
Hillary Clinton may not identify as a “supply sider,” per se, but her approach to economics is much more traditional and conservative, looking to constrain government, keep marginal tax rate low, and rely more heavily on the private sector to stimulate growth.
It is a debate worth having, but at the end of the day the U.S economy is hurting badly, more so than many of our political leaders are willing to admit.
Realistically, it may take a “Second Keynesian Revolution” to restore the economy to sustained pre-Great Recession rates of growth.