Problems of Keynesian Economics, a COVID-19 Trend (Part 2 of 3)
Featuring Dr. Arthur Laffer, Father of Supply-Side Economics [Part 9]

Fiscal policies based on the Keynesian economic theory, as a theory of economic recovery, are underway during this Covid-19 crisis. Japan’s government debt is 285% of the GDP, which is by far the largest among developed countries. Following the previous story, Dr. Arthur B. Laffer continued to share problems of Keynesian Economics.

Interviewer: Hanako Cho


Cho: Previously, you taught us that there’s no stimulus in stimulus spending.

Dr. Laffer: Are you ready for the ugly chapter, the third chapter?

Last time, we spoke about the stimulus to the transfer recipient being offset by the de-stimulus to the transfer payer. The income effect of government spending equals zero due to the Slutsky equation, so there’s no net stimulus. While the income effect is always net out to zero, the substitution effect adds up to a negative (see explanation at the end of this article).


Testifying Before Three Keynesians at Congressional Hearing

Dr. Laffer: I was testifying before Senator Gaylord Nelson in 1974. Senator Nelson was from Wisconsin, and he was head of Senate Finance. I was on the witness stand with Otto Eckstein, Paul McCracken and Gardner Ackley, three very old and famous Keynesian economists. I was 33-years old at the time, and I was excited to be up there with them.

The discussion was on the effectiveness of President Gerald Ford’s tax rebate plan, which was a stimulus spending program.

The Senator from Wisconsin asked me, ‘What do you mean by the substitution effect?’ And, of course, I disagreed with the other three economists totally. I was frustrated and I didn’t know how to word it correctly so the senator would understand.

I said, ‘Senator, if giving people $600 stimulates the economy, why do you stop there? Why not $6,000? Why not $60,000? Why not $600,000? Why not 6 million dollars? Why not spend 100% of GDP? In fact, if government spending stimulates the economy, why not give everything to everyone who doesn’t work and take everything from everyone who does work?’

‘If everyone who works receives nothing, and all those who don’t work receive everything, Senator, what do you think will happen to output of the country?’

He looked at me and said, ‘Why, it would go to zero.’ And I said, ‘You got it. You understand supply-side economics.’

He then asked the other three economists standing on the podium with me, ‘What is wrong with Professor Laffer’s argument?’ The three economists said, ‘Nothing is wrong in the long run if you did it, but in the area we’re talking about it, it will stimulate,’ which is just wrong. They’re just garbage spouters.


Redistribution Will Only Create Equality of Poverty

Dr. Laffer: Let me use apples as an example.

If the price of apples rise, apple growers will have higher incomes and spend more. But what about apple consumers? If the price of apples rises, apple consumers will have lower incomes and be poorer. These income effects offset each other and net out to zero.

Now, the substitution effects here, are that if I raise the price of apples, everyone consumes less apples and produces more apples. It is true that apple growers will produce more apples, but the consumers will also produce apples. At the same time, everyone consumes less high-priced apples, including the apple growers themselves.

Looking at the economy as a whole, income effects always sum to zero, while the substitution effects add up to a negative because they move in the same direction.

The problems with redistributive policies are more pronounced in terms of substitution effects. Redistribution is when you take from someone who has a little bit more and give it to someone who has a little bit less. Whenever you take from someone who has a little bit more, you reduce that person’s incentive to produce, and that person will produce a little bit less. Whenever you give to someone who has a little bit less, you provide that person with an alternative source of income other than working, and that person, too, will produce a little bit less.

Whenever you redistribute income, whenever you stimulate the economy, you always reduce total income.

Sooner or later, the economy goes down to zero. Stimulus spending stimulates the transfer recipient. True. Stimulus spending destimulates the transfer payer. True. And stimulus spending also causes incentives for people not to work and incentives for people not to produce until the economy shrinks. Do you understand my economics?

The only way you can redistribute income and get equality of income is if everyone earns nothing. Then, we’re all equally poor.

Whenever you reverse that policy by cutting taxes and spending, the economy expands.

I believe the answer to the government, to the problem, is cutting taxes and creating economic growth. If you want more production, tax production less. If you want less production, tax production more. If you want people to work, do not pay them for not working. Pay them for working but not for not working. Is that so difficult?

Cho: I don’t think it’s too difficult.

Dr. Laffer: Now you understand why I am not a Keynesian and why my colleagues here are Keynesians. After World War II, government spending went through the floor. We reduced government spending from almost 50% of GDP to 12% of GDP. As a result, the economy boomed. It did really well.

When we cut taxes under Reagan, what happened to the economy?

Cho: Huge boom.

Dr. Laffer: When we cut taxes under Kennedy, what happened to the economy? When we cut taxes in the 1920s, what happened to the economy? When we raised tax rates during the Great Depression and increased government spending, what happened to the economy? Well, you see the story. When we raised taxes and raised government spending under Obama, what happened? Look at Japan. Do you remember that little piece I gave you, Sayonara, Japan?

Cho: Yes, I’ve read it.

Dr. Laffer: What did Japan do in the immediate post-war period? Japan cut tax rates dramatically until they got Obuchi, who was going to do the greatest job, and then all of a sudden, they went to Mori because Obuchi died. Mori came in and increased government spending and taxes, and Japan turned into the worst-performing country in the world. Same thing with Germany. Auf Wiedersehen, Deutschland.

Now you want to guess what’s going to happen in the US? We’re going to get increased taxes and big increases in government spending. That’s going to happen right away. Now you tell me what you think will happen to the economy. I don’t think it’s going to be very good, Hanako. It’s much better under Trump.


Government Should Fulfill Its Proper Role

Cho: Could you expand on the government’s role?

Dr. Laffer: Government is like everything else. It has a function; it has a role and it has a
purpose in life. And it should do that purpose, that role and that function. Now there
are some things governments do better than the private sector, so the government should do those things and stop there.

Let me describe the proper way to collect taxes.

All taxes are bad, but some taxes are worse than others. So, you want the government to collect its tax revenues in the least damaging fashion. You also want the government to spend that money in the most beneficial fashion.

When the benefit done by the last dollar of money spent is a little bit more than the damage done by the last dollar of taxes, you stop already. Government has done what it’s supposed to do. Any government less than that is too small, and any government more than that is too large. There is no role for government stimulus spending, period.

Cho: What’s the standard to determine whether or not the government should intervene?

Dr. Laffer: Government produces highways, education and vaccines. These are things that they do really well. Government does not produce cars, corn, wheat, sake and whatever else. Government has a role, and when it gets outside of its role, it should be stopped. What they are doing is hurting the economy and hurting their people.

Government has traditionally appointed the role of education, at least for kids who can’t get private education. There are lots of others that the government does well such as driver’s licenses and pollution controls.

Government also has a right of eminent domain.

If you’re going to have a railroad across the country, you have to be able to buy the land for the railroad tracks. Who gives it that right? I might say, ‘I won’t sell my land,’ so there has to be a government role in there called eminent domain, which is for the greater good of the country and the efficiency of the transportation network. These people have to sell their land to the railroad.

I own a piece of land, and the railroad wants to come through that spot so they can have a train going from San Francisco to New York. I think there’s a role for the government and sacrificing freedom for benefits. I should lose my freedom to be able to hold on to that land for the better good of having the railroad.

Economist Milton Friedman loves freedom more than anything on Earth. And I like freedom, don’t get me wrong. But it’s not everything. There are things the government can do to take away my freedom to make all of us better off. I do believe that. Milton Friedman didn’t, really.

But there’s a limit, and they’ve got to stop when they hit the limit.




Redistribution Reduces Economic Pie

In economics, there’s a concept called the Slutsky equation, which breaks down the change in an individual’s economic behavior into an income effect and a substitution effect. The Slutsky equation shows the sum of these two effects. Dr. Laffer applies this equation to the entire economy.

With an income effect, in the case of an income transfer, the effect of the transfer payer and the transfer recipient is offset to zero.

But what happens to the substitution effect? Let’s imagine that an individual has $100 of daily income. If a tax rate of 90% is applied, their daily after-tax income will be $10.

A higher tax rate reduces after-tax income from labor, along with the individual’s incentive to work. More people will begin to spend their time with leisure activities instead of work.

Meanwhile, another individual who has received unemployment benefits will be less incentivized to work as well, resulting in less people working overall.

Both transfer payers and transfer recipients produce less, so the country-level economic pie will shrink in size. As Dr. Laffer says, an “equality” that redistributionists seek to achieve can only be achieved in equality of the poor.

Problems of Keynesian Economics, a COVID-19 Trend (Part 2 of 3)
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