NEW ECONOMIC EXPERIMENT: THANK YOU MR. TRUMP - AND MR. KUDLOW / SEEKING ALPHA

New Economic Experiment: Thank You Mr. Trump - And Mr. Kudlow

by: John M. Mason

 

Summary

 

- Larry Kudlow is now expected to step into the position in Mr. Trump's administration just vacated by Gary Cohn.

- Larry Kudlow is a supply-side economist and was part of the supply-siders in the Reagan administration.  He is very vocal in his support of the supply-sider Donald Trump.

- If Larry Kudlow becomes Trump's National Economic Council, we are sure to hear of the outcome of the economic experiment now being conducted between supply-side economics and demand-side economics.

 

Yes, Larry Kudlow is interested in stepping into the position of Director of the National Economic Council reporting to President Donald Trump just vacated by Gary Cohn.

According to the New York Times, Mr. Kudlow is now the favorite to take on this responsibility.

 

Funny thing, Mr. Kudlow just happened to have the lead opinion piece, co-authored with Heritage Foundation senior fellow Stephen Moore, supporting Trump economic policies, published in The Wall Street Journal on the very day that all the news was being released about his taking on this new role.

 

In this article, Mr. Kudlow and Mr. Moore attempt to make it clear that there are two concepts of how macroeconomic policies work and that the efforts of Mr. Trump and his administration create an environment where the difference between the two can be tested.

 

The two concepts are the demand-side approach the construction of macroeconomic policy and the supply-side approach.

 

Mr. Kudlow is from the supply-side approach and he first gained recognition in his support for supply-side policies when he was a member of the Reagan administration in the 1980s.

 

But, Mr. Kudlow and Mr. Moore have written their article with one particular focus in mind and this focus has to do with the possible impact the Trump economic policies will have on inflation. And, it is this focus that is, to me, the foundation of the economic experiment that is now underway and that Mr. Kudlow, especially, wants to fight for.

 

The concern has arisen that with the US economy so near to full employment after over eight and one-half years of economic recovery along with the tax cuts just passed in December and the budget provisions just passed in the last month leading to a rapidly increasing governmental budget deficit, that higher rates of inflation are just around the corner.

For one thing, the bond markets have shown a substantial increase in inflationary expectations in the past six months or so. I have already written about the rise in inflationary expectations several times this year.

 

And, this is the key point in the economic experiment that Mr. Kudlow and Mr. Moore discuss.

 

The authors argue that if an analyst just works from a demand-side perspective they will expect that the policies of the Trump administration will produce greater amounts of inflation as unemployment goes lower and lower.

 

The “myth” supporting this belief they argue comes from work of New Zealand economist A. W. Phillips, the father of the Phillips Curve that purports to show that a trade-off persists between wages and unemployment:

“He (Phillips) was right that wages tend to rise as unemployment falls.”

However, Kudlow and Moore argue, “it wasn’t until the 1960s that economists Paul Samuelson and Robert Solow wrongly extended this theory by suggesting a linkage between unemployment and general inflation.”

 

They add, “That theory doesn’t comport with the facts, then and now.”

 

The important conclusion for the current argument, however, is that the Phillips Curve is assumed to show that unemployment can be reduced if policymakers can increase aggregate demand sufficiently to generate a little more inflation. This is what the popular presentations of the Phillips Curve are used for. And, an “empirical” construction of the Phillips Curve has been a major component of most econometric models of the economy used in the policy making of the federal government and the Federal Reserve System. This is demand-side economics.

 

Supply-side economics claims that economic policies should stimulate more production - more economic growth - so that more goods and services will be produced, leading to greater hiring of labor, and higher wages. Higher wages are possible because labor productivity increases in this model. And, inflation? Well, inflation might even decline should the supply of goods and services be large enough.

Kudlow and Moore claim: “In the Reagan tax-cut boom, which lasted through the 1990s, unemployment and inflation fell together as the dollar stabilized under treasury secretaries Donald Regan, James Baker and Robert Rubin.”

 

Where does inflation come from? It comes from excess money creation, Milton Friedman taught us that.

 

Mr. Kudlow and Mr. Moore conclude that there is no reason to expect inflationary pressures to rise within the current policy environment. The consumer tax cuts won’t produce inflation: “unlike stimulus spending, tax cuts don’t distort the economy with artificial demand.”

 

Furthermore, "Except for some of the child credits and a few fattened deductions, the $1.5 trillion cuts…was almost completely geared to reducing taxes on small and large businesses to boost incentives to invest and produce.”

 

Thus, we see the economic experiment right before our eyes. If inflation picks up and becomes a real problem, then the demand-siders win the argument. If inflation remains stagnant and economic growth picks up, then Mr. Kudlow and the supply-siders take home the prize.

 

The outcome of this “experiment” is very important for the Federal Reserve. Currently, Fed officials are signaling that they will raise their policy rate of interest at least three times this year, possibly four. One of the arguments being used to justify this path is that inflation seems to be rising and such increases are needed to keep the economy from getting overheated.

 

So, Fed policy is going to be dependent upon whether or not the supply-siders win.

 

But, there are two other issues that I think are important to keep in mind. First, are the tax cuts and other economic efforts of the Trump administration really supply-side cuts? A lot of the analysis that has been put out indicate that the Trump policies are not really that supply-side orientated. In addition, many analysts are arguing that the policies are skewed to help wealthier individuals, a group that might not be so interested in creating supply-side improvements.

The second issue has to do with financial engineering. Over the past fifty years or so, government policies have created an atmosphere where the benefits of governmental programs become incentives for businesses to use financial engineering to reap “unintended” benefits from programs meant to stimulate the economy.

 

Morgan Stanley analysts have already produced results that indicate that businesses will overwhelmingly put their policy benefits to use in the following three categories: stock buybacks and dividend increases, mergers and acquisitions, and bonuses and raises.

 

Well, we’ll see where things come out. Mr. Kudlow and Mr. Moore claim that the results of the Reagan tax-cuts created a boom where “unemployment and inflation fell.” Mr. Kudlow may be in a position to highlight such a result achieved during the Trump years - if such the supply-siders win the argument. Stay tuned!