Tag Archives: Supply Side economics

A Dunce’s feast: Laffer, Herndon and the Austerity Hawks

Thomas Herndon

Thomas Herndon, a 28-year-old economics graduate student at the University of Massachusetts at Amherst, just used part of his spring semester to turn the Washington austerity consensus on its head. He’s getting tremendous press coverage for finding an Excel spreadsheet error in the root calculations that have driven the recent slash-the-budget mindset in DC. This ‘consensus’ promoted by, among others, congressman Paul Ryan and Secretary of the Treasury, Timothy Geithner, is actually not the first time economic data has been skewed to support prevailing ideological winds. In fact, if you want to track the beginning of the Reagan revolution that called for reducing taxation on the wealthy to encourage ‘growth’ (another fallacy at the heart of neoliberal economic group think), you can find the supporting concept on the back of a cocktail napkin. I am not making this up.

The architect of the Laffer curve, economist Arthur Laffer, drew the infamous Laffer Curve on a cocktail napkin during a small dinner meeting at a Washington hotel attended by Dick Cheney and Donald Rumsfeld. In truth, he drew many variations of the curve before then, but this particular meeting was propitious. Although at first skeptical, when Laffer explained the gist of the curve, that increases in taxes could conceivably lead to a reduction in overall revenue, Cheney became intrigued. If increases in tax could reduce revenue, surely the reverse was also true! Decreasing the tax rate could conceivably increase revenue!

With great excitement, the Republican establishment latched onto this idea, arguing counter intuitively that decreases in tax rates would actually increase revenue because so called ‘wealth producers’ would be willing to create “more wealth” if it was not taken from them with taxation. In short order, the notorious concept of ‘Supply Side’ economics was born, with Arthur Laffer’s curve serving as its foundational principle.

But many economists have questioned the utility of the Laffer Curve in public discourse. According to Nobel prize laureate James Tobin, “the ‘Laffer Curve’ idea that tax cuts would actually increase revenues turned out to deserve the ridicule with which sober economists had greeted it in 1981.” It would only ‘increase wealth’ to a very limited degree and based on a fairly precise understanding of what level of taxation would actually deter economic growth, a fairly high rate, as it turned out.

It’s also a theory which has been widely discredited, both on a theoretical level and in practice. Because with the Laffer curve – perhaps unusually for economics – we have a historical instance of it being implemented by a direct proponent. Arthur Laffer, thanks to his cocktail napkin meeting with Dick Cheney and Donald Rumsfeld, became an instant persona grata of the Reagan administration. On the conceptual promise of the Laffer curve, Reagan cut the marginal higher rate of personal income tax from 70% to 28%. A dramatic slash. The effect on the budget deficit was also striking. Reagan doubled it to $155 billion and tripled government debt to more than $2 trillion. His successor, Bush senior, was forced to raise taxes as the deficit doubled again.

Not all taxes were treated the same. Payroll taxes were increased. So taxes were cut for higher earners while workers paid more. Corporate and capital gains tax rates were also cut in an earlier outing for current “austerity” policies, the transfer of incomes from labor and the poor to capital and the rich.
The Laffer curve relies on the twin assumptions that the rich create the output in an economy and that they need incentives to choose idleness over work. But there is little evidence to support these hypotheses. On the contrary, economists from Adam Smith to Karl Marx have known that all value in an economy is created by labor. Those who labor are obliged to work in order to purchase the necessities of life.

Kenneth Rogoff and Carmen Reinhart
Which brings us to that little big error Thomas Herndon recently revealed. According to the New York Times magazine Herndon first started looking into Reinhart and Rogoff’s work as part of an assignment for an econometrics course that involved replicating the data work behind a well-known study. Herndon chose Reinhart and Rogoff’s 2010 paper, “Growth in a Time of Debt,” in part, because it has been one of the most politically influential economic papers of the last decade. It claims, among other things, that countries whose debt exceeds 90 percent of their annual GDP experience slower growth than countries with lower debt loads — a figure that has been cited by people like Paul Ryan and Tim Geithner to justify slashing government spending and implementing other austerity measures on struggling economies.

Herndon pulled up an Excel spreadsheet containing Reinhart’s data and quickly spotted something that looked odd.
“I clicked on cell L51, and saw that they had only averaged rows 30 through 44, instead of rows 30 through 49.”

What Herndon had discovered was that by making a sloppy computing error, Reinhart and Rogoff had forgotten to include a critical piece of data about countries with high debt-to-GDP ratios that would have affected their overall calculations. More importantly, they had consciously excluded data from Canada, New Zealand, and Australia — all countries that experienced solid growth during periods of high debt and would thus undercut their thesis that high debt forestalls growth.
The mistakes Herndon found were so big, in fact, that even Herndon’s professors didn’t believe him at first. As Reuters reported earlier:

“At first, I didn’t believe him. I thought, ‘OK he’s a student, he’s got to be wrong. These are eminent economists and he’s a graduate student,'” [UMass Amherst professor Robert] Pollin said. “So we pushed him and pushed him and pushed him, and after about a month of pushing him I said, ‘Goddamn it, he’s right.'”

According to the New York Times, “After consulting his professors, Herndon signed two of them — Pollin and department chair Michael Ash — on as co-authors, and the three of them quickly put together a paper outlining their findings. The paper cut to the core of a debate that has been dividing economists and politicians for decades. Fans of austerity believe that governments should cut spending in order to grow their economies, while anti-austerians believe that government spending in times of economic duress can create growth and reduce unemployment, even if it increases debt in the short term. What Herndon et al. were claiming, in essence, was that the pro-austerity movement was relying on bogus information.”

Source: Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff Thomas Herndon | Michael Ash | Robert Pollin | 4/15/2013

Now that the Laffer curve is pretty much a laughing matter, and whatever economic basis there was for an austerity push in the middle of a recession has been flushed down the toilet, surely Washington will see the light, rebuke the self-inflicted sequester, and start working to save the economy by funding real jobs programs rather than killing them, right?

Um, not so fast:

“With Reinhart and Rogoff’s once-authoritative work now under serious question, there’s no question that the austerity movement has been dealt a major blow. But Herndon’s finding won’t likely stop politicians from trying to reduce the deficit. The global march for austerity began before Reinhart and Rogoff’s work was published, and will continue as long as there are people who believe that governments can shrink their way to prosperity.”

Still, Herndon holds out hope. He calls austerity policies in the United Kingdom and elsewhere “counterproductive.”

“I have social motivations,” he told the New York Times magazine. “I care deeply about how policy affects people.”

So do we.

*Quick follow-up. Looks like the Harvard Professors who authored the buggy study that ended up supporting the worldwide austerity consensus–that is killing economies from Spain to the US– have direct social and financial ties to….(wait for it)….Pete Peterson. That same Pete Peterson who desperately wants to privatize Social Security, and who lionized the Simpson Bowles ‘Cat Food’ Commission. Small world.
Pete Peterson Linked Economists Caught in Austerity Error