KEYNESIAN VS SUPPLY SIDE ECONOMIC THEORY – WILL SUPPLY SIDE THEORY GAIN THE STATUS IT DESERVES
There is a lot of media chatter right now regarding the presence of political bias in the rate making decisions of the Federal Reserve. There is no question that economics and politics are inexorably intertwined, but the Fed is purported to be nonpolitical. (see “The Unfortunate Connection Between Economics and Politics” posted in Georgeeconomics.com). The regulatory mechanism known as the supposedly independent Federal Reserve, which was created to eliminate the boom-and-bust cycle, has been anything but successful. The present Fed led by chair Jerome Powell and the cadre of Keynesian economists, that deliver demand side solutions to correct fiscal issues created by irrational demand side agenda driven spending policies, saw fit to lower the target rate when it was clearly counter to their inflation mandate prior to the 2024 presidential election. Yet they have been intransigent in lowering the target rate during the Trump Administration when the present rate has been severely out of line with relevant bond market yields and clearly above the level that would be dictated by their claim to be data dependent. Their obsession with tariff issues will be addressed later in this paper.
The political left, the Democrat party, and Keynesian macroeconomics are inseparable. Even though there is no defense for aggressive deficit spending, Keynesian theory’s overall favorable analysis of government spending as one of the main drivers of GNP and in rate setting adjustments has afforded the political left sufficient theoretical cover to radically expand the size of government and to facilitate agenda driven deficit spending. The Fed and the Congressional Budget Office (CBO), maintain their blindly static interpretation of the Phillips Curve (which theorizes an inverse relationship between unemployment and inflation which means growth causes inflation). Their refusal to consider the dynamic relationship between supply side fiscal policy driven economic growth and tax revenue collection, continues to project deficits and inflation within Trump’s supply side fiscal policies and recent legislation.
The fact that such supply side (including classical and neoclassical) policies did not trigger such issues when undertaken by presidents JFK and Reagan during their administration as well as Trump during his first administration, is conveniently ignored by the Keynesian macro modelers at the Fed, the CBO and the rating agencies. For example, the historically accurate Laffer curve which stipulates that when tax rates are too high, as they have been for many decades, tax revenues will increase as tax rates are lowered until an optimum rate is reached, has been discareded. They persist on projecting massive deficits associated with legislation that include tax cuts, even though they have been consistently wrong in the past. Over 90 % of economists in the US identify as Keynesians, which makes sense given the liberal bias that dominates academia in this country. Keynesian theory has undergone revisions (neo-Keynesian) in response to critiques from monetary theorists like Milton Friedman and from Neoclassical/Supply Side economists, but its forecasts remain debated. The Fed and the CBO) still ignore the dynamic reality of supply side factors.
Despite decades of inaccurate economic forecasts, Keynesian theory remains influential in academia. Keynesian theory, however, will continue to lose the accuracy war with Supply Side economics unless a black swan event totally unravels the American economy. For the near future economic growth will support supply side theories, as growth is spurred by innovation and productivity increases, which are supply side factors. The expected rapid growth of artificial intelligence across the economy is likely to boost supply, further supported by the Trump Administration’s investment-friendly tax and regulatory policies.
Growth theory has been a major aspect of economic theory, primarily as a neoclassical construct (including Supply Side). Keynesian economics views economic growth as being driven by aggregate demand, particularly in the short to medium term. Investment through the multiplier effect and private investment drive long-term growth. The neoclassical models are far more robust, even though assumptions established to facilitate a balanced growth path effectively limit both the dynamic and stochastic aspects of their models (see the works of Harrod, Solow and Hicks in the 1940s, 1950s, etc. leading to Solow’s Nobel Prize in 1987). The neoclassical models, which have been modified further, specify that economic growth is a function of capital, labor and technology. Later work elevates the labor variable to be treated as human capital which is a subtle but critical consideration when growth is driven by rapidly changing technology, where skills must keep pace with capital advancements. Trump’s successful legislation will spur technology into a wave of innovative capital expansion. My key question is whether current human capital can optimize the potential growth from this expansion. In other words, will the labor force have the diversity of skill sets that match up with capital requirements? There is considerable work remaining in that area.
Barring an unusual event, Keynesian theory will take another hit regarding Trump’s legislation. The coming round of robust growth will be supply driven, and the success or failure of such will be determined by the execution of these policies (which also must include deregulation and a cost cutting move toward a balanced budget). Trump is responsible for the current economy, and if Supply Side economics proves effective, it will remain prominent. The Fed has become a bureaucratic monstrosity that cannot shake off its left leaning application and misapplication of Keynesian Theory. Serious suspicious blunders that have dominated Jerome Powell’s leadership have shined a bright light on his political bias and the inability of the cadre of Keynesian economists at the Fed to get it right. The first blunder was his following of the far left and Democrat party line in 2021 that inflation was transitory which led to record inflation. The second was lowering the target rate 0.5% (double the standard rate change) prior to the 2024 presidential election when even a 0.25% lowering would have been suspect. The most recent has been using the specter of tariff driven inflation as cover to keep the target rate blatantly higher than a data dependent decision would specify since the beginning of the Trump Administration.
This tariff maneuver is another example of the inability of the Fed to be politically neutral. The Fed and left-leaning politicians have overlooked Trump’s negotiating tactics, thereby creating widespread fear. See section 3 of the article “The unfortunate Connection Between Economics and Politics” (posted in www.georgeeconomics.com on April 6, 2005) for a realistic overview and short analysis of Trump’s tariff adventure. In that analysis of Trumps’s tariff endeavor I have not allowed my preference as an economist, for no tariffs of any nature, to cloud my ability to analyze the Trump Administration’s procedures and tactics relating to his initial establishment of a tariff map and the negotiations that have led to and will continue to lead to final tariff agreements. It was obvious that the result of the plan would be radically lower tariffs than initially presented. Surely the mathematical wizards at the Fed knew what was obvious to me. Either they are inadequately trained as analysts, or their political blinders have sufficiently bent their analysis to accommodate the radical overstatement of the risk of tariff driven inflation. I’m surprised Powell and the Fed haven’t cut the target rate by at least a quarter point to address concerns about it being too high. Unless inflation becomes a significant problem, the Fed will face the challenging task of justifying their rate making decisions, given the economic damage that keeping the rates high has and will continue to create (complete discussion warrants another paper).
Needless to say, there are more than adequate grounds for an effort to overhaul the Fed and truly make the Fed data dependent as they claim. From my viewpoint as an economist, the next two years are going to be fascinating to observe as the Supply Side policies of the Trump Administration unfold and innovative capital expansion alters the economic landscape. Can the Fed and the CBO be updated without a total overhaul to carefully consider Supply Side solutions when and where those policies can be expected to be most effective? Or are the droves of economists that generate the left leaning prescriptions at the Fed, the CBO and many of the rating agencies so theologically indoctrinated into Keynesian demand side theoretical domination that they suffer from terminal tunnel vision?