Cooking the books

Since the 1970s, US governments have been in thrall to an absurd, yet devastating economic theory. N

In the mid-1970s, a group of men who were untrained in economics - and, as it happens, borderline-insane - emerged in Washington DC and invented a whole new approach to economics. In the past, it had been thought that if you wanted to cut taxes, you had to ploddingly pay for it by either cutting spending or increasing borrowing. No more. This new group preached something called "supply-side economics", which claimed that you could cut taxes, increase public spending, and hold down borrowing and inflation, all at the same time. It's easy, they said: if you cut taxes, the economy will grow even faster - and make up the difference.

The story of the supply-siders' strange rise begins when three grey-suited men met in a swish Washington hotel in the gloomy aftermath of Watergate to turn this untested idea into a governing philosophy. They were the economic consultant Arthur Laffer, the journalist Jude Wanniski and Gerald Ford's chief of staff - a man called Dick Cheney. At the time, Laffer was merely a disgraced former adviser to the Nixon administration. He had lost his job after he made a series of wild and incorrect predictions that the economy would boom, and an investigation showed that he had been using only four variables - compared to the thousands used by other economists. But getting his predictions hideously wrong did not put Laffer off. No - he decided he had uncovered the secret key to economic growth, one that had eluded all economists since the dawn of capitalism.

Trying to explain this idea to an eager Cheney, "Laffer pulled out a cocktail napkin and drew a parabola-shaped curve on it," writes the liberal New Republic journalist Jonathan Chait. "The premise of the curve was simple. If the government sets a tax rate of zero, it will receive no revenue. And if the government sets a tax rate of 100 per cent, the government will also receive zero tax revenue, since nobody will have any reason to earn any income. Between these two, Laffer's curve drew an arc. The arc suggested that at higher levels of taxation, reducing the tax rate would produce more revenue for the government."

The Laffer Curve became the supply-siders' Sermon on the Mount, the core of their faith. For Cheney, it was "a revelation, for it presented in a simple, easily digestible form the messianic power of tax cuts", Chait notes. "In that sloping parabola was the magical promise of that elusive politician's nirvana, a cost-free path to prosperity: lower taxes, higher revenues." He had discovered his "totalistic ideology. The core principle is that economic performance hinges almost entirely on how much incentive investors and entrepreneurs have to attain more wealth, and this incentive in turn hinges almost entirely on their tax rate." It was an economic recipe for tax cuts for the rich.

Almost everyone else saw the idea as preposterous. George Bush Snr dismissed it as "voodoo economics". But a string of eccentrics, with no serious knowledge of economics, began to preach the gospel - and they were swiftly employed by Ronald Reagan's burgeoning presidential campaign. Most of these men were, it turned out, mad. The writer George Gilder - known only for a string of vehemently anti-feminist polemics - wrote a book called Wealth and Poverty, that was handed out by Reagan to staffers and friends. Nobody seemed to notice that at the same time that Gilder was co-inventing supply-side economics, he was also bragging about being a master of extrasensory perception. He explained that he could receive messages from strangers without using any of his senses, bragging that he had "hundreds of experiences" with psychics. "The trick," he explained, "is that you have to have faith." He applied the same evidence-free approach to his economic writing.

Similarly, the journalist Wanniski was hired as an economic adviser to Reagan, despite having no economic training or credibility. He was also fond of defending Saddam Hussein (who never gassed anyone, he insists to this day), Slobodan Milosevic, and the conspiracist Lyndon LaRouche, who says the Fabian Society is a secret drug-and-arms-smuggling gang. Nobody on Reagan's team seemed to notice that supply-side economics was just as fevered a fantasy.

All academic economists warned them their vision was absurd. They pointed out that a passing glance at the evidence showed the falsity of claims that marginal tax rates are the sole or primary determinant of economic growth. From 1947 to 1973, the US economy grew by 4 per cent a year - while the richest Americans paid a 91 per cent top rate of tax.

As soon as it was put into practice, the predictions of supply-side economics were shown to be false. Its supporters insisted tax cuts for the rich would create more economic growth, and therefore pay for itself. But straight after Reagan began to try it, deficits started to shoot up, past $100bn, then $200bn, as a vast hole was left in the nation's balance sheet. Then, when Bill Clinton tentatively tried to reverse some of this horrifying damage by increasing the top income tax rate from 31 to 39 per cent, the supply-siders made another set of predictions. It would destroy the economy, bringing on a recession, they insisted. Instead, the economy boomed.

And so it continued. When George W Bush followed their advice and slashed taxes for the rich, the supply-siders insisted yet again that tax revenues would actually increase as the economy was super-charged by these new incentives, so there would be no need for spending cuts or increased borrowing. In fact, income-tax payments fell to their lowest level as a proportion of the US economy since 1942, and the deficit soared to unprecedented trillions - a legacy that will poison American politics for generations. "It is impossible to think of how events could have turned out worse for them," Chait notes, "short of God appearing on earth to denounce the Laffer Curve as an abomination."

But something strange happened. Despite being proven flat-out wrong, supply-side economics did not disappear. Instead, it became the received wisdom of the Republican Party. It is now preached by every major presidential candidate for the Grand Old Party. As Chait says: "The[se ideas] have moved from the right-wing fringe to the commanding heights of the national agenda."

How did the preachings of these economic illiterates become the "common sense" of Bush and his successors? Chait gives a simple, compelling reason: "The lesson for cranks everywhere is that your theory stands a stronger chance of success if it directly benefits a rich and powerful bloc, and there's no bloc richer and more powerful than the rich and powerful."

Supply-side economics provided the ideological icing - a sweet-sounding rationale - for a straightforwardly corrupt programme, whereby the super-rich bought the Republican Party and in turn were handed vast tax cuts and lavish subsidies by them. As Chait argues: "The supply-siders taught the rich that economic growth hinges above all else on satisfying the desire of the affluent to grow even more affluent." So the rich funded their think tanks and threw money at politicians who preached their message. The failure of all their predictions and policies didn't matter, because from the perspective of the super-rich, it did work - they got their tax cuts.

Of course, the supply-siders claimed publicly that everyone benefited from their programme, not just their paymasters. Yet a memo wielded by Chait perfectly captures the insincerity of this. In March 2001, a coalition of business lobbyists arranged a march in Washington to support Bush's massive supply-side tax cuts for the rich. They secretly circulated instructions explaining: "The theme involves working Americans. Visually, this will need a lot of hard-hats . . . the Speaker's office was very clear in saying we do not need people in suits. If people want to participate, they must be DRESSED DOWN, appear to be REAL WORKER types, etc." Hard hats were provided for the millionaire lobbyists to wear on the day, to give the impression they were ordinary Joes.

This shift to supply-side goodies for the super-rich has not been supported at any point by the ordinary Americans they were so carefully posing as. A Pew Research poll following Bush's election asked the American public what the budget surplus left behind by Clinton should be used for. The vast majority wanted to use it for social security or Medicare; only 17 per cent picked tax cuts. Crucially, the Republicans know this, too. In 2002, Bush's political team privately instructed the treasury secretary Paul O'Neill: "The public prefers spending on things like health care and education over cutting taxes. It's crucial that your remarks make clear there is no trade-off here." This is a pure statement of supply-side economics, pretending there are no hard choices - you can cut and spend and laugh all the way to the Magic Bank.

Chait has managed to do something extraordinary: he has written a book about economic theory that is both gut-bustingly funny and as compelling as a horror story. The Big Con has a dark relevance for British readers, too. John Redwood, the man appointed by David Cameron to run his business strategy, tosses hardline supply-side myths around like confetti, and shadow chancellor George Osborne has declared: "We have a lot to learn from George Bush's compassionate conservatism." There is a chance that the British people could yet be forced to surf the Laffer Curve to economic disaster.

This article first appeared in the 19 November 2007 issue of the New Statesman, New best friends?