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These two ideas are pertinent to the study of government and economy because it is these ideas that have guided this country's economic policy for the greater part of the former century. This paper is subjective in nature and any of the ideas may or may not have more validity than the other. The paper will, however try to show the validity of the Keynesian approach over the supply side doctrine. Keynes is perhaps one of the best known of all economists. This is hardly surprising for two main reasons. The first is that his work was perhaps the most important work in economic policy that had been done for decades and changed the whole face of post-war economic policy. The second, less important reason for his fame is that he is perhaps the only economist to have a whole branch of economics named after him. Keynes remains the only person to be honored in this way. His main contribution to the economics debate of the time was in putting together a coherent critique of the existing classical economic theory that dominated economic policy-making circles. Keynes' father was an economist and his mother was Mayor of Cambridge for some time. Keynes went to Eton (as a scholar) and then went on to King's College Cambridge to study Classics and Maths. He worked for a short time in the Civil Service but didn't like it much, and so left and went back to Cambridge as a Fellow. In 1911 he was made editor of the Economic Journal - Britain's foremost economics publication. He was a varied character - not at all the stereotypical economist of people's assumptions. He married a Russian ballerina and was for much of his time a member of the Bloomsbury Group - a group of intellectuals whose ranks included well-known names such as Virginia Woolf, E.M.Forster and Bertrand Russell. He speculated considerably and as Bursar of King's College made the college very rich! He also acted as an advisor to a number of companies. In the Second World War made his peace again with the Treasury. As a result he was instrumental in providing the framework for post-war economic recovery. By the early 1930s, Keynes was well aware of the impact that his writings would have in their attacks upon some of the foundations of neoclassical economics. In 1935, he wrote George Bernard Shaw: I believe myself to be writing a book on economic theory which will largely revolutionize -- not, I suppose, at once but in the course of the next ten years -- the way the world thinks about economic problems. Keynes' new theory was published in 1936 as The General Theory of Employment, Interest, and Money. In the preface Keynes warned the reader of the struggle between fundamentally different ways of understanding how an economy really works: This book is chiefly addressed to my fellow economists . . .. I myself held with conviction for many years the theories which I now attack, and I am not, I think, ignorant of their strong points. . . The matters at issue are of an importance, which cannot be exaggerated. But, if my explanations are right, it is my fellow economists, not the general public, whom I must first convince. At this stage of the argument the general public, though welcome at the debate, are only eavesdroppers at an attempt by an economist to bring to an issue the deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory, and will, until they are resolved, continue to do so. Keynes wrote this book as an effort to get away from conventional ideas of classical economics. He was able to see the inherent problems of the narrowness of the classical way of looking at economics. In the book he seems to struggle to escape from the habitual modes of thought and expression that were so deeply ingrained into the psyche of the economists of his day. The ideas that are expressed in his book so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which were so pervasive as to penetrate into all studies of economics as the time Keynes wrote the book. Keynes asked questions that in some sense had never been asked before; he was interested in the level of national income and the volume of employment rather than in the equilibrium of the firm or the allocation of resources. It was still a problem of supply and demand. But by "demand" Keynes meant the total level of effective demand in the economy, and by "supply" Keynes meant the nation's capacity to produce. Keynes said that when effective demand falls short of productive capacity, the result is unemployment and depression, and when it exceeds the capacity to produce, the result is inflation. The heart of Keynesian economics consists of an analysis of the what determines the level of effective demand. Keynes said that if one ignores foreign trade, then effective demand basically consists of three separate spending streams: consumption expenditures, investment expenditures, and government expenditures, each of which is independently determined. Keynes attempted to show that if you determined the level of effective demand this way one may well exceed or fall short of the physical capacity to produce goods and services: He discounted Say's Law of full employment in saying that there is no automatic tendency for an economy to produce at a level that results in the full employment of all available men and machines. This fundamental implication of the theory came as something of a shock to proponents of the traditional economics who had been inclined to take Say's Law at face value and depend upon the assumption that economic systems tend automatically to full employment. By keeping his attention focused on macroeconomic aggregates, like total consumption and total investment, and by deliberately simplifying the relations one saw between these economic variables, Keynes was able to devise a versatile yet powerful model that could be applied to a wide range of practical problems concerning the economy and public policy concerning it.. His system was not perfect, however, and subsequently underwent considerable refinement and this refinement worked so well that Keynes ideas became so thoroughly assimilated into the body of received doctrine that the statement was made, "we are all Keynesians now." Still, it is not too much to say that Keynes is perhaps the only economist to have added something really new to economics since the classical economists. He declared existing explanations of unemployment to be nonsense. Keynes wrote that neither high prices nor high wages could explain the persistent depression and mass unemployment that was being experienced in his day. Instead, he proposed an alternative explanation for these happenings phenomena. His explanation focused on what he termed aggregate demand—that is, the total spending of consumers, business investors, and governmental bodies. When aggregate demand is low, he theorized, sales and jobs suffer; when it is high, all is well and prosperous. Keynes ideas on the theories of ownership of resources and property are discussed in the following paragraph. Keynes specifically rejected the need for public or government ownership of the means of production. What did concern Keynes was the aggregate outcomes in the economy. He therefore did not direct his attention in The General Theory to the issues of what should be produced and how. He believed that this was not necessary to his theories or that it would matter that much anyway. When speaking of equality or fairness of the distribution of income Keynes was quite clear. Keynes was critical of the inequalities in income and wealth but argued that some inequality is necessary to provide incentive to entrepreneurs to undertake investment. Keynes was of the mindset that there are valuable human activities, which require the motive of moneymaking and the environment of private wealth-ownership for their full development to fruition. The most important aspect of Keynes work in respect to this paper was his expositions and ideas upon the role of government in the economy. Keynes rejected the Adam Smith/classical economics belief, which held out the promise of material progress in a laissez-faire environment. Laissez-faire is a French term meaning "hands off" that De Tocqueville used when describing the American governmental paradigm concerning economics and markets. Keynes was convinced that market-based economies do not produce full employment automatically. He argued that there would be unemployment and depression from time to time in the absence of corrective government policies. In his view, government action was essential to stabilize an unstable economy. It was necessary for the government to intervene, to 'fine-tune' the economy by running demand-management polices; these were to counter current trends in the trade cycle - to speed up economic activity when there is too little, to slow it down when there is an excess. From these general ideas flowed a powerful and comprehensive view of economic behavior—the basis of contemporary macroeconomics. Because consumers were limited in the amounts that they could spend by the size of their incomes, they could not be the source of the extreme ups and downs of the business cycle. It followed that the most dynamic forces were business investors and governments. It was Keynes idea that in a recession or depression, the proper thing to do was either to enlarge private investment or create public substitutes for the shortfalls in private investment. In mild economic contractions, easy credit and low interest rates, which would involve monetary policy, might stimulate business investments and restore aggregate demand to a figure consistent with full employment. More severe contractions required the sterner remedy of deliberate budget deficits either in the form of spending on public works or subsidies to afflicted groups. The following section will speak of the economic theory that Keynes was contradicting. Neoclassical economics was the new economics of the 1870's, and one of the things that was new about it was the wide role it assigned to the principles of supply and demand and market equilibrium. Keynes would say that it was too dependent upon the natural progression of the market of supply and demand and that that natural progression did not always produce equilibrium. Economists had thought in terms of supply and demand from the first, but until the reformulation of the late 1800's, these were rough intuitive concepts and were not thoroughly suitable for any very precise and scientific economics. Neoclassical economists were able to make these intuitive ideas more precise and to give them more definition. The were even precise enough in their development to begin work on statistical economics. The Neoclassicists refined these ideas and made them the central ideas of their new economics. Many neoclassical economists envisioned a world in which supply and demand were in equilibrium in every market, and almost everything important was determined by the equilibrium of supply and demand: relative prices and production, but also total production, the employment of labor, saving, consumption, and growth of the national economy. After 1929, however, the real world didn't seem much like that. What happened in 1929, of course, was the crisis that led to "the Great Depression." One of the results was a great increase in unemployment, and the unemployment was understood to be an excess supply of labor. The trouble encountered in the neoclassicists approach was that one theory of the Neoclassicists was that one could not have excess supply and equilibrium at the same time, so this was a problem for the neoclassical understanding of the economy. In an economy with unemployment, there are at least some markets; labor markets for example, in which supply and demand are not in equilibrium. Recall, the neoclassical economists had assumed that the employment of labor would be determined by the supply and demand for labor, along with the wage in purchasing power terms. The employment of labor, together with the productivity of labor, would determine production. If there is unemployment, then employment is not determined by supply and demand, since supply and demand are not in equilibrium. Then what determines employment? How could employment drop in all industries at once? It seemed to many people and some economists that, after 1929, the time had come for a new "new economics" that could answer that question. This is where Keynes came in. The General Theory was hard to read in parts because of the rapid transitions between arguments for and against various concepts. The reasons for this is stated in an online textbook that generally follow the following reasoning for Keynes methods in writing the book. In order to anticipate, and minimize, the counterarguments that the neoclassicists were going to put forth based on money and interest, Keynes had to state the counterarguments himself. This is one of the things that made the book so hard to understand, as I said before Keynes sometimes seemed to be arguing against his own ideas, if only then to return to them. But confusing as that may be, it was Keynes way of dealing with his very committed critics in the economic world. That's why Keynes developed the Complete Keynesian Theory, with its allowances for monetary policy and the impact of interest on money. But having worked all that out, Keynes went on to argue that monetary policy and interest rate impacts would be very weak and ineffective in the conditions of the 1930's, because the economy was already in the liquidity trap. He concluded that the Simple Keynesian Model explained most of the changes in employment and production, and that the only policy that would really work to bring the depression economies back would be government deficit spending. Was Keynes right? Does the Simple Keynesian Model, with its multiplier effects, explain most of the changes in production and unemployment? To this day, there are economists who do not agree on that. My own opinion, for what it is worth, is that Keynes was pretty close to right -- that multipliers and income-expenditure interactions are among the most important factors in explaining fluctuations in employment and production. That is that poor business transactions and management account for much of the problems. That explains (to me) why government deficits kept rising in the 1970's and 1980's, even when conservatives who quite sincerely hated government deficits governed the country. The deficit spending was easy because of the popularity of pork barrel projects. In the short run, deficit spending works --and the short run is long enough to get them re-elected. In other words, the politicians were using deficit spending to buy votes to keep themselves in a job. Even with all of the supply-side fervor that was going around in the early 1980's the deficits continued to rise. But regardless of the effects of the multipliers and income-expenditure interactions, monetary policy is still important, indeed more important than ever. The conditions we have now are not those of the 1930's, or even of the 1980's. In almost all, perhaps all, of the developed countries, large government debts have become a fact of life, and these debts make the market for government bonds a key factor in the market for loans. Many people believe that increases in government debt will lead to still higher real interest rates and frustrate the hope of increased production. This has brought about an increasing consensus that fiscal policy is no longer possible. Right or wrong, that means monetary policy is the only game in town. One only has to look at the impact that the Federal Reserve Board can have upon the stock market both here in America and overseas to know how important that monetary policy is today. And, indeed, it is monetary policy that makes the headlines. The central banks, including the American Federal Reserve in particular, behave as though they believed in the Complete Keynesian Model -- and it seems certain that they really do believe in it. They manage the interest rates from day to day. It is always with held breath that the stock exchanges wait for a decision of the Fed. We can ask ourselves the question about why, in economics, bad news is good news. Why does every report of increased production lead to a drop in the stock market, for example? It was not always that way, only after the general acceptance of the Keynesian views that this kind of event became commonplace. The answer is that good news may cause the Federal Reserve governors to worry that inflation will increase, and to react to the worry by increasing interest rates. This, too, will pass. But monetary policy is the main tool of macroeconomic management today and for that reason Keynesian Theory is key to understanding the way our economy works and developments in our economy. The central concept of supply-side economics is that tax cuts cause economic growth. Tax cuts allow entrepreneurs to invest their tax savings, which creates higher productivity, jobs and profits. This, ironically, allows the entrepreneur and his new workers to pay even more taxes, even at lower rates. The supply-side idea is a simple one, and makes a popular political message. However, it is interesting to note that mainstream economists, even conservative ones, almost universally reject supply-side theory. In the early 80s, the influential and multi-partisan American Economics Association had 18,000 members. Only 12 called themselves supply-side economists. In trying to figure out where this idea came from this information became available. In American universities, there is no major department that can be called "supply-side," and there is no supply-side economist at any major department. This is significant, because evidently economists who espoused a more conservative economic theory dominated academia in the 70s, and conservative economists normally welcome any ideas that make the case against government intervention. The fact that they scrutinized supply-side theory and rejected it wholesale gives eloquent testimony to the theory's bankruptcy. When candidate George Bush called it "voodoo economics" in the 1980 presidential campaign, he was doing so with the full backing of America's economic community. Many people are surprised to learn that "conservative" does not necessarily equate to "supply-side" economics. The difference in general conservative view of government and supply side lies in spending. Mainstream conservative economists generally believe that tax cuts should be accompanied by spending cuts, that is to say one should exercise fiscal responsibility in regards to spending and cutting. Supply-side economists believe that taxes should be cut without regard to the deficit or spending. Spending cuts and deficits, they believe, are not important considerations. The 1980 supply-siders claimed that the growth resulting from tax cuts would be so great, and the total tax collections increased so much, that America would simply outgrow its deficits. This is to say that the tax cuts would pay for themselves so to speak. This did not happen, of course. Growth in the 80s was no greater than growth in the 70s, as the statistics in every modern textbook or records show. But the national debt nearly tripled under Reagan. Who deserved blame for this is a controversy that continues to this day. One interesting thing I found about Supply-siders is that they delight in pointing out that their theories are not wrong simply because academia rejects them. This would be falling for the "argument from authority" fallacy. They argue that science has been wrong in the past and that it is indeed wrong about this point. After all, it was once a scientific consensus that the earth was flat. They claimed that most scientific revolutions started out as minority opinions, and that this would be no different. Although these are worthy points, they are not sufficient in my opinion to make conclusive arguments against the value of scientific consensus. It seems foolish to ignore our best and brightest scholars, whose day jobs are to analyze these issues. Their excellence should be reason enough to warrant that their theories should be among the first we consider. It does not mean that they are correct, of course, but the likelihood of their being correct is more than that of the individuals who espoused the theory at the time. More often than not their information is better, and their theories more coherent, than the average person's. The following will give a summary of what Paul Krugman, a top economist, wrote in his book Peddling Prosperity. Krugman gives an excellent account of the rise of this idea. Krugman made the case that the supply-siders were what many have called "cranks," or people who stand outside the scientific mainstream and hurl accusations of basic stupidity and corruption at the entire scientific community. They do not really care if the accusations are right or not but they generally have some other beef besides the issue at hand to complain about. Cranks are people who are cut off from their academic colleagues, who neither argue before scientific conferences nor write for peer-reviewed journals. Instead, they speak before groups they themselves organize, and write for publications they themselves edit. Their insular and constrictive way of thinking prevents them from seeing what the fallacies of supply side are. Krugman states that an unusually high percentage of supply-siders were not economists at all, but journalists with no formal training. Robert Bartley, who has run the editorial pages of The Wall Street Journal for nearly 25 years, was perhaps the movement's greatest spokesman. Other journalists included Jude Wanniski and Irving Kristol. Crusading in their national publications, they were able to reach a much wider and more popular audience than most economists could. Of course, journalists are normally reporters of stories, not creators of theories. Krugman is very critical of their approach to news reporting. He thinks that one would expect them to report the latest cure for cancer but not claim that they had discovered such a cure themselves. This is common sense in most fields like biology and physics. The movement did have a few intellectuals, but even here, its professors were far from the mainstream. Arthur Laffer has a Ph.D. in economics, but according to Krugman he has contributed little to scientific conferences or peer-reviewed journals, instead playing to crowds on the lecture circuit and writing for popular publications. He is famous for the Laffer Curve (see Figure 1), which purports to show that productivity declines as taxation increases. Most economists agree that the general principle behind the Laffer Curve is correct, but widely disagree on how much taxation is necessary before productivity starts declining. Laffer believed that the effects of taxation were so heavy that cutting them would significantly boost productivity, thereby outgrowing any deficits caused by the tax cuts. Again, this prediction proved false. Another supply-side economist was Paul Craig Roberts, a Congressional staffer for former quarterback-turned-Congressman Jack Kemp. Another was Martin Anderson, who was so stung and bitter by academia's refusal to hire supply-side economists, he would go on to write a bitter tirade against academia in a book entitled Impostors in the Temple. The supply-siders have one card in their deck that they can claim to be proud of, Nobel laureate, Robert Mundell. They even go so far as to claim that he is the father of supply-side theory. Although Mundell has never discouraged this impression, there is little evidence that it is true. Indeed, he is purported to hold some beliefs, for example, on the causes of the Great Depression, that go against the very fundamentals of supply-side theory. So where did the supply-side ideas actually come from? From Laffer and Bartley, developed over a series of dinner conversations at Michael 1, a famous restaurant near Wall Street. It was there, scribbling on napkins, that Wanniski showed Bartley the magical effects of tax cuts. Krugman writes: "There it was that [Bartley] and Laffer discovered that Keynesian economics was logically inconsistent - an insight that had eluded [Nobel laureate] Paul Samuelson and a few thousand other people over the course of hundreds of academic conferences. They also discovered that Milton Friedman was wrong in believing that monetary policy could have important effects on the economy - an insight that had similarly eluded [Nobel laureates] Friedman, Lucas and the faculty of the University of Chicago over a generation of notoriously brutal conferences. And the results of these deep thoughts over dinner were for the most part published -- surprise -- on the editorial page of The Wall Street Journal, or in Kristol's Public Interest." It remains a mystery why Reagan by-passed thousands of qualified conservative economists for the council of a few supply-siders. Perhaps the most likely reason was practical: the supply-siders told Reagan what he wanted to hear. To try to explain why I will devote a paragraph to the economic and political problems that Reagan faced in 1980. Until the 60s, there had been a tradeoff between inflation and unemployment. Government could achieve low unemployment by accepting high inflation; or it could achieve low inflation by accepting high unemployment. Earlier presidents had opted for low unemployment, which the Federal Reserve accomplished by expanding the money supply, thus giving people more money to spend. Extra spending means extra jobs. However, Milton Friedman and others pointed out that business people would eventually come to expect these inflationary increases, and they would simply compensate for them by raising their prices by the anticipated amount. This would not only negate the job-creating effect that more money in circulation would bring, but also make inflation worse. Eventually, they predicted, inflation would shoot up and then so would unemployment, breaking the tradeoff between them, and forming a twin monster that Paul Samuelson dubbed "stagflation." And, true enough, this is precisely what happened in the 70s. It seemed as though Keynesian economics was not entirely working the way it was supposed to. All of this economic turmoil led to the acceptance of the supply side doctrine. Economists in the late 70s were at a loss for a cure to this seeming failure of Keynesian Economics. To fight high inflation, governments traditionally raise interest rates and cut government spending. To fight high unemployment, they do the opposite. Thus, they were damned if they did and damned if they did not. Then the supply siders came along. The supply-siders told Reagan they had a solution. The Laffer Curve purported to show that tax cuts would actually increase tax collections. This meant that government could spend generously in an effort to curb unemployment, without requiring the burdensome taxes to pay for it. That was the first selling point. The second selling point was Mundell's. Most economists believe that government spending and interest rates can only be used together, in tandem, to slay either one dragon or the other. But Mundell argued that they could be split up: government could spend generously to fight unemployment, and raise interest rates to fight inflation. This was the perfect strategy for Reagan. He could cut taxes on the wealthy while spending money to keep the masses happy and everything would run smoothly. Hedrick Smith writes: "...Mundell's argument was music to Reagan. A few advisors warned him that Mundell's approach would not work, could not work -- indeed, Reagan's own experience would prove that in 1982-83. But Reagan bought Mundell's theory anyway, for it told Reagan what he wanted to believe: that you could cut taxes, cut inflation, have economic growth, and balance the budget all at the same time." The man charged to make this all work was David Stockman, Reagan's budget director who would later come to ridicule the ideas he once espoused. Stockman's genius and mastery of numbers was matched only by his relatively young age, which earned him the title of "whiz kid." Stockman, Roberts and Anderson came up with a massively optimistic forecast for the economy, which today Stockman derisively refers to as the "Rosy Scenario." The Rosy Scenario predicted that the 1981 tax cuts would produce 5 percent growth in 1982. This proved to be horribly untrue as the economy actually shrank accounting for inflationary factors. Many budget-watchers pointed out that the tax cuts would only increase the deficit, but Stockman silenced all his critics with a blizzard of statistics and information. "Like a child prodigy chess champion playing fifty matches at once, Stockman answered every query, parried every countermove, checked every challenge," Smith writes. "Congress was mesmerized." Today, Stockman admits it was all a performance. "Even the appearance of being an expert is self-validating," he wrote five years later. "I didn't know much about bud Bibliography: Word Count: 4825
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