A Review of Brian Domitrovic's 'Econoclasts'
As Americans contemplate slow economic growth and a spiraling dollar, Brian Domitrovic's new book, "Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity," should serve as a roadmap to revitalizing the private sector. This sharply written, thoroughly-researched narrative weaves together financial history, economic doctrine, and character study so skillfully that recent decades' policy debates become not only comprehensible, but at times, downright exciting.
Domitrovic, an assistant history professor at Sam Houston University with degrees from Harvard and Columbia, argues supply-side economics, far from being an unserious program dreamed up by ideologues, had both deep roots in classical theory and serious intellectual backing from one of our era's true economic heavyweights, Robert Mundell. Professor Mundell, the father of not only supply-side economics but the euro (and one day, possibly an Asian bloc currency), is so respected in the world that in addition to his Nobel Prize and numerous European accolades, he is the first Westerner ever granted full residence rights in Beijing. China has profited so handsomely from Mundell's advice that it named a university for him. Clearly, Mundell's ideas deserve serious consideration.
Yet, Domitrovic says, despite such recognition, plus a two-decade bull market and global boom, historians have pointedly ignored the supply-side revolution, at least as an academic matter. Domitrovic explains that while numerous historians have written negative tertiary analyses of "Reaganomics" as monographs or textbook entries, none have bothered to research the primary sources on the topic, preferring opinion to scholarship. "It is high time for history to be true to its responsibilities and to consider in a methodologically serious way the momentous phenomenon that was supply-side economics," he says.
Domitrovic recounts that early in his career, Mundell realized that major periods of U.S. growth and prosperity such as the Gilded Age and Roaring Twenties coincided with the "policy mix" of sound money and tax cuts. Moreover, Mundell understood this was historically true, noting the rise of great nations, even empires, corresponded with these policies.
Mundell argued monetary policy was an arrow only able to hit one target, and it was best aimed solely at currency stability. Fiscal policy, specifically tax rates, should target employment.
Mundell's analysis ran counter to the economic establishment's consensus in the 1960s and '70s. Keynesians Paul Samuelson and James Tobin argued employment should be targeted with loose money, while taxes should be raised to check inflation. On the right, monetarists led by Milton Friedman argued steady money supply growth would stimulate demand.
The Mundellian policy mix was different from its Keynesian and monetarist competitors because it put the producer, supply, rather than the consumer, demand, at the framework's center. Supply-siders believed if investors, entrepreneurs, and business owners were incentivized to work, save, and invest at the margin - i.e. to take new risks - expansion would result. In this view, production led to consumption and was therefore paramount.
Domitrovic argues a central supply-side insight came from Mundell-protégé Arthur Laffer, but it wasn't his famous curve. Rather, Domitrovic places Laffer's Wedge Model at the heart of supply-side economics. The wedge is "that additional product which government compels persons to make if they want to make some other product in the first place." In other words, if two workers want to trade 16 hours each of their labor with one another, and the government requires four additional hours from each, the pair may conclude that working 40 hours to transact 32 is not worth it. The eight hours "tax" is the wedge between them. Reduce the wedge, and more transactions will occur.
Like the classical economists of the 18th and 19th centuries, Mundell argued sound money was essential because inflation punished creditors, forcing them to increase interest rates. Currency weakness undermined long-term economic planning, diminished wages, and destabilized trading relationships. Devaluations destroyed savings and incentivized investors to prefer safe havens over entrepreneurial ventures.
Mundell also drew a causal line from poor economic policy to global tragedies. He saw that American failures in the 1920s - in monetary policy (deflation) and fiscal policy (the Smoot-Hawley Tariff Act, tax increases) - collapsed the world economy, leading directly to the Depression, the Nazi Revolution, and World War II.
Ironically, as Mundell's ideas faced opposition from the 1960s academic establishment, the Kennedy Administration effectively enacted them, cutting taxes and recommitting to a dollar as good as gold. The result was, from 1961-68 the economy boomed at more than 5 percent annually.
The expansion faltered in the late ‘60s when the Lyndon Johnson Administration moved in favor of the Samuelson/Tobin policy mix, expanding the money supply while raising taxes. President Nixon followed Johnson's lead, raising taxes and further inflating the currency.
As U.S. monetary authorities oversupplied dollars, the gold standard - first established by Alexander Hamilton in 1791 - became untenable. In successive steps, President Johnson closed the London gold pool in 1968; President Nixon closed Treasury's gold window in 1971; and in 1973, Nixon permanently floated the dollar. The post-war Bretton-Woods currency system, which provided the U.S. would maintain the dollar value of gold at $35 while foreign governments would maintain the dollar value of their currencies, was dead.
Witnessing these events, Mundell said, "The forces of history are determined to engage in one of their periodic experiments with a managed currency." He predicted a major currency devaluation and inflation. As the gold price shot up, quadrupling from 1971-73 and then quadrupling again by 1980, Mundell warned oil prices would follow, and was proven right.
The slow-growth/weak currency years of 1968-1982 were an economic catastrophe second only to the Great Depression. As the dollar fell, the progressive tax system pounded workers when inflation pushed them into higher tax brackets, even while the cost of living outpaced wages. Investors couldn't make a buck, so they fled stocks and bonds for hard assets such as commodities, real estate, and collectibles. The prime rate reached 21 percent. In real terms, the Dow fell 70 percent during this period. By the time the dust had settled in the mid-80s, the dollar had fallen 90 percent against gold, meaning the general price level had to adjust accordingly over the ensuing decades. No wonder Americans wondered if their best days were behind them.
By the late 1970s, the economics establishment was stymied. Academic economists, left and right, saw their ideas tried and discarded as the debacle unfolded. A succession of presidents over the decade tried and failed to improve the economy, leading to a series of failed presidencies and a rising sense of political impotence and dysfunction.
Soaring commodity prices convinced many the Earth could no longer support humanity and was on the verge of environmental collapse. Currency devaluation punished long-term planning, driving out the bourgeois virtues of community, thrift, and prudence in favor of the Disco Era and the Me Generation. The inner cities were decimated and the crime rate rose. The nation was impoverished, the culture coarsened, and everything got seedier.
It was in this mad environment, Domitrovic recounts, that a few young men on Wall Street and Washington began to turn away from establishment economics, toward Mundell and Laffer.
"[S]upply-side economics was by all accounts a renegade, maverick movement driven largely by figures removed from or hostile to the economic establishments in academia, Washington, journalism, and business. In the early 1970s, all of two academic economists could be counted in the movement. The rest of the first "supply-siders" comprised a subterranean crew of journalists, congressional staffers, and business forecasters, many of whom were unknown to the others, and virtually all of whom were under forty years of age."
The ideas gained a following through conservative journals such as Irving Kristol's Public Interest and Bill Buckley's National Review, and were broadcast to the wider world by The Wall Street Journal's Jude Wanniski and Robert Bartley. From there, politicians including Bill Steiger, Jack Kemp, and Ronald Reagan became converts, and by 1981 the Mundellian policy mix was on its way to enactment.
The supply-side revolution's early results were mixed, as the Federal Reserve under Paul Volcker aggressively choked back money supply at the moment deep income tax cuts were incentivizing new business activity. Supply-siders argued the tax cuts had raised dollar demand and tight money was stifling the recovery. As gold dropped from its 1980 high of $850/oz to $300 in 1982, Volcker would not relent and the economy crashed into a severe deflationary recession. Domitrovic's analysis should help dispel the Keynesian chestnut that a recession was needed to wring inflation from the economy.
Curiously, Domitrovic's otherwise comprehensive reporting doesn't include the reason Volcker changed policy in summer 1982. Thanks to the dollar's rise, Mexico's economy was squeezed by falling commodity prices on one side and rising real debt costs on the other. Mexico told its American creditors it would default, which Volcker believed would seriously damage the U.S. financial system. Desperate, he abandoned his monetary targets, directly monetizing $3 billion into the cash-starved economy. Gold leapt and the stock and bond markets rallied, and kept on rallying. The Reagan Boom had begun.
Starting in 1983, annual GDP growth averaged 4.3 percent for seven years; in 1984 it was 7.2 percent, ensuring Reagan's landslide reelection. The misery index, combining inflation and unemployment, dropped from a high of 21 in 1980 to 13 in 1983 and dropped below 10 by the late ‘80s. The Dow rose an average of more than 17 percent per annum for eight years starting in late 1982, putting the 1980s on par with the historic bull markets of the 1920s and 1960s. Perhaps most impressively, inflation dropped from double digits in the late 1970s to 3.2 percent in 1983, and stayed below four percent for the rest of the decade.
Once the complete policy mix was enacted, Domitrovic notes, "to virtually everyone's astonishment and pleasure, stagflation up and vanished from the scene." In the following 20-plus years, the gold price stabilized and the U.S. returned to its average post-war levels of GDP growth, GDP per capita, inflation, unemployment, and interest rates; the stagflation era's slow growth turned out to be an aberration rather than a new long-term trend. The era took its place among the great American booms.
"Econoclasts" ends with a summary of 1983-present, as the supply-side revolution extended throughout the ‘90s and 2000s. Looking back, it is clear President Clinton - once he was constrained by a Republican Congress - bowed to supply-side economics: he signed a 25 percent capital gains tax cut, expanded free trade, and, under Treasury Secretary Robert Rubin, maintained a strong dollar policy.
Surprisingly, Domitrovic misses the most significant departure from supply-side economics in recent years, gold's 200 percent rise against the dollar since 2003. For decades, Keynesians argued U.S. trade deficits required a weaker dollar to support exports. Supply-siders categorically rejected this view, arguing devaluations produced inflation, poverty, and global instability, and that current account deficits were a sign of prosperity, balancing in an open economy through capital account surpluses. Today, with numerous conservative Keynesians along with most of the liberal economics establishment calling for further dollar decline, who but supply-siders can save the greenback?
Quibbles side, "Econoclasts" provides a vivid and deeply researched look at the forces that unleash prosperity, move history, and enhance great nations. In our time of loose money and rising taxes, supply-side's second revolution may begin with this book.