There is no central focus to SSU summer classes. We will bounce around as the spirit moves us, taking as much direction as we can from those of you who made it through the fall and spring semesters and have questions about the theory or its application in the real world. The supply "model" is one that has its foundation in classical theory (which concentrates on production or supply rather than consumption or "demand"). The version of the model you learn at SSU is one that has evolved at Polyconomics, as we have tried to understand the workings of the domestic and world economies in order to help our clients "see the future." A "model" is an artificial device, just as a mannequin is an artificial human that helps us visualize how clothes that hang on a rack will look when they hang on us. An economic "model," enables policy makers to take pieces of theory off the rack and attempt to improve the looks of the economy.
The most basic economic models are "supply" models or "demand models," but within each of these two basic classes there are a great many narrower models. In the demand school, there is a monetarist model, a Keynesian model, a neo-Keynesian model, a Phillips Curve model and several others. Within each of these there are subsets. Within the monetarist demand model, there are several definitions of "money" and several definitions of "credit" that become variables that distinguish one monetarist school from another, or even one monetarist from another. Fed Chairman Alan Greenspan's personal model of the U.S. and world economy is not only distinctive and unique. It also changes from year-to-year as his opinion changes of what works and what does not. There have been periods when my personal model and Greenspan's were almost totally congruent. Now they have diverged to points of major disagreement, as he has devalued the signal the price of gold represents and has elevated the unemployment rate and even the rate at which people are quitting their jobs to look for better ones as an early sign of "wage inflation."
In the basic supply model, consumers do not even exist. There are only producers who exchange goods and services with each other, with the financial market between them arranging the exchanges (trade). Supply-siders speak of the "exchange economy." In the demand model, producers do not exist, only consumers. If consumers have sufficient "money in their pockets" and feel confident about spending it on goods and services, they will do so and contribute to "aggregate demand." If they have more money than they wish to spend, they will save it or invest it. Saving it means they will make it "illiquid" by exchanging it for an interest-bearing security -- a passbook savings account or a public or private note or bond. Investing it means they will exchange it for part ownership in an asset that pays no interest, but may pay dividends if successful, or a capital gain if the value of ownership rises in value because of success.
In a supply model, "supply creates its own demand." In this model, a baker bakes bread and takes what he does not use himself to the marketplace. There he finds a vintner who has brought wine over and above his needs. They strike upon an exchange after fixing the terms of trade. Our model loses interest in them at this point, as they become consumers -- the baker of bread, the vintner of wine. In a modern economy, finance replaces barter in the exchange economy. The baker must dispose of his bread every day, the vintner can only sell his wine when it is ready, once a year. A financial intermediary -- a "bank" -- arranges for the purchase of the bread on a daily basis and the wine on an annual basis, enabling baker and vintner to dispense with the complexities. The "bank" does the work in exchange for a percentage of the bread and wine.
In a perfectly functioning supply model, the only limits to growth are the willingness of the bakers and vintners and other producers of goods and services to spend more time and energy making what they make best and offering it for exchange of other goods. The biggest factor inhibiting growth is that of an inefficient Government. The Government polices the economy to keep out abusers or thieves or polluters. It must take a cut of the bread and the wine -- a tax -- in order to pay and equip its workers. Government also borrows bread and wine from the exchange economy, providing interest-bearing bonds that will be redeemed out of future taxation. It also provides the "money" which is used by the exchange economy in the form of debt that does not pay interest. The dollar is a "measure" of the value of government debt. The government maintains all important "measures." A gallon is a measure of liquid volume, whether a gallon of milk or of gasoline. A yard is a measure of length, whether of land or of fabric. A dollar is a measure of government debt, which permits it to also become a measure of private debt.
The exchange economy is most often disrupted by government errors. Private producers can contribute to distress in the market, by failing to live up to contracts. But because there are myriad producers, none can have an appreciable effect on the economy if they fail by their own incompetence. There is only one central government, though, which means that a government error can cause distress in the ability of producers to produce and exchange through financial intermediaries. The supply model was thought to have failed in 1929 with the Wall Street Crash, which economists came to believe was caused by unwarranted speculation in the value of ownership assets -- stocks of enterprises. In 1977, I discovered the true cause of the Crash, the Smoot-Hawley Tariff Act of 1930, which the market learned in the last week of October 1929 would almost certainly become law. This meant that producers of goods in the United States who were planning on exchanging them for goods being produced in the rest of the world would have to pay a surprise "tax" or tariff to the government. The exchange of goods no longer made financial sense, which meant the value of the assets underpinning the producers had to fall in value. Goods produced here were in surplus and goods produced abroad for sale here were in surplus -- each piled up against one side or the other of the tariff wall.
In the classical model, producers need a constant and reliable unit of account by which to measure the value of bread and wine, domestic and foreign, in a common reference point. Among all supply-side classical economists, it was always agreed that gold would serve that function, because it is the most monetary of all commodities. Government can get the tax rates and the tariff rates correct, which permits producers to produce and exchange at optimum levels. If the government constantly changes the value of the unit of account, the exchange economy has to take the fluctuations into account. Some bakers and some vintners now have to become insurers of trade in bread and wine, which means there is less bread and wine that can be produced. The economy becomes inefficient when more of the people who work in it must facilitate trade instead of producing for trade.
This was the model I learned in the early 1970s from Professor Robert Mundell of Columbia University and his protégé, Arthur B. Laffer. Alone in the world, they had come together at the University of Chicago in the 1960s to revive the classical theory that had been discarded for its failure to plumb the reason for the 1929 Crash. Because I had never studied economics in school, where only demand-side economics is now taught, it was easy for me to learn a new system of thought. Because it is the most accurate and because I have refined it over the years, I've been more successful than economists with advanced degrees in forecasting. This is what economics is about, when all is said and done. If you do not have a model that permits you to view the future better than others in the marketplace, you will lose ground to competitors. Economists who must always explain why they were wrong, even if they have Ph.D.s and Nobel Prizes, are of no value. Those who gain the ears of Presidents or Prime Ministers have negative value, which is why so much poverty exists in the world. Almost all formal economists everywhere are trained in the demand model.
Here is a letter I wrote to the Washington Post in July 1981, six months after the onset of the Reagan administration. In reading it, you will see that my forecast of the direction of the economy was exactly correct, but that I misjudged the willingness of demand-side economists to give up and become supply-siders. Where I foresaw the supply model eventually producing great budget surpluses that Republicans and Democrats would fight over, as they are today, I was too bullish in predicting an early return to a gold dollar that would eliminate monetary risk from the exchange economy. As recommended reading, I suggest today's main op-ed in The Wall Street Journal, by Judy Shelton, who I introduced to the merits of gold a dozen years ago. Her essay "Global Markets Need Golden Rule" is among her very best, almost perfect in technical detail.
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The Washington Post
LETTERS TO THE EDITOR
July 27, 1981
We Will All Be Supply Siders
by Jude Wanniski
In their column "A Rare Democratic Tax Innovation" [op-ed, July 13], Rowland Evans and Robert Novak reported on Rep. William Brodhead's discovery that supply-side economics is not of Republican patent. The Democratic Party is in the process of making that discovery en masse, as evidenced by the "bidding war" between Democrats and Republicans for the support of their respective tax bills.
It was inevitable. Economic departments may be able to successfully market obsolete ideas for quite a while, but political parties have to utilize economic ideas that reflect the state of the art, or they themselves will become obsolete.
For almost 30 years, with the exception of John Kennedy's last year, Washington policy-makers have been dominated by the demand model, the notion that consumer purchasing power drives the economy. Democrats and Republicans struggled within that framework, the former devising policies to put more purchasing power into the pockets of lower-income consumers, the latter devising alternate strategies to preserve higher income wealth.
Keynesians deployed fiscal policy to manage this "demand." The monetarists pushed Federal Reserve and exchange-rate policies to manage demand. The Keynesians produced stagnation, as demand taxation destroyed productivity. The monetarists produced the great inflation: their prescriptions to float the dollar and try to control the quantity of money, instead of its price, greatly diminished the dollar's utility as a unit of account, a store of value.
President Kennedy was the last policy-maker to embrace supply-side prescriptions. His posthumous tax cuts were the most successful economic events of our time. He was the last president with a passionate belief in a monetary policy based on gold: "This nation will maintain the dollar as good as gold, freely interchangeable with gold at $35 an ounce, the foundation stone of the free world's trade and payments system," he stated in a July 1963 message to Congress.
In my conversations with Mr. Brodhead, he worried that he might never see a national health insurance program if he employed supply-side tax policies. I observed that liberals never came closer to realizing their dream of national health insurance than they did in 1965-66, when the Treasury brimmed with productivity-swollen revenues that flowed from the Kennedy tax cuts. They have never been further away from a national health plan than they are now, after 15 years of inflation-swollen tax rates.
The demand model is being shed, a tattered snake skin. Milton Friedman and his monetarist students, who occupy important ground in Reagan's Treasury, Stockman's OMB and Weidenbaums' Council of Economic Advisers, still believe that Austerity Is Just Around the Corner. And they may cripple Ronald Reagan with their high interest rates as they have Margaret Thatcher. But their days are numbered. The president may give Professor Friedman's ideas a few more months, for old times' sake, but monetarism will be buried too. And if it is not, the Democrats -- and the Keynesians -- have no theoretical or political grounds for opposing a return to a convertible gold-backed dollar. They would end the inflation.
Very soon, either before or immediately after the 1982 elections, we will all be supply-siders. Democrats and Republicans will struggle on the foundations of the supply-side idea, the idea that it is the individual producer, man or woman, who is at the center of the economy. As the idea fosters policies that result in a resumption of economic growth, an expanding tax base will permit Republicans to argue for a reduction in the national debt and an increase in the defense budget while the Democrats push national health insurance. On such political judgments, supply-side economics is neutral.