The recovery is acting like a recession. Wall Street economists are racing to slash their estimates of fourth-quarter growth in gross domestic product, following a widening in November's trade deficit. The unexpected loss of 101,000 jobs in December shows that management is still handing out pink slips at a rapid rate. The geopolitics of war and weapons of mass destruction are gnawing away at business and consumer confidence.

To stave off another recession, the Federal Reserve has cut its benchmark interest rate to the lowest level in decades. The federal government is doing its part by running a $200 billion-plus budget deficit, and President Bush is proposing an additional fiscal stimulus by frontloading some tax cuts in his $674 billion, 10-year tax plan.

Considering the economy's parlous state, the timing seems strange for a Nobel laureate in economics to proclaim the triumph of macroeconomic policymaking in managing the business cycle. Yet that's exactly what University of Chicago economist Robert Lucas did in an address ("Macroeconomic Priorities") at the annual meeting of the American Economics Assn. in Washington, D.C. in early January. And Lucas, a pioneering theorist and intellectual leader of the classic school of economic thought, is always worth paying close attention to, especially when he concludes that the future of economic policymaking lies in focusing on the supply side of the economy.

SHORTER AND MILDER.  In a sense, it's a shame that "supply side" has become synonymous with the Washington-based polemicist mantra of the past two decades, "Tax cuts solve everything." A much older school of thought in economics -- one that includes Adam Smith, David Ricardo, John Stuart Mill, and Alfred Marshall -- paid close attention to the economy's supply side. Lucas begins by observing that macroeconomics -- the study of economic growth and the business cycle -- emerged as an intellectual response to the Great Depression. No one ever wanted to go through another such downturn, when the U.S. economy contracted by almost a third and nearly a quarter of the labor force was out of work.

The role economists have played in preventing another depression is perhaps the profession's greatest triumph over the past 60 years or so. Today, thanks to automatic stabilizers like unemployment insurance, as well as a more sophisticated understanding of the levers of monetary and fiscal policy, recessions in the U.S. have become shorter and milder, vs. the interwar period or the experience of many other economies in recent decades.

Put somewhat differently, the economy is less volatile, and consumption and production more stable, than before. The "central problem of depression-prevention has been solved, for all practical purposes, and in fact has been solved for many decades," says Lucas. Adds David Warsh, an online commentator for Economic Principals: "Lucas' sophisticated calculations confirm what common sense suggests -- that a shallow recession every 10 years is pretty satisfactory business-cycle management."

LIMITED GAINS.  Lucas, though, goes further. He argues that the benefits from further muting the business cycle with better stabilization policies would be minimal. Through a complex series of calculations and theoretical assumptions, he figures that American consumers would need to trade off only about one-twentieth of a percent of their consumption to be completely protected from the swings in the business cycle. (Lucas's work is dense and rarified thought. As he wrote in his 2001 professional memoir, "Economic theory is mathematical analysis. Everything else is just pictures and talk.")

Maybe that figure is too low, maybe it's too high -- I have no way to judge. But he's on the right track in arguing that the greater payoff going forward will come from boosting the supply side of the economy, creating incentives that increase savings, knowledge, innovation, and work effort -- key ingredients for faster long-term economic growth. "Taking U.S. performance over the past 50 years as a benchmark," says Lucas, "the potential for welfare gains from better long-run, supply-side policies exceeds by far the potential from further improvements in short-run demand management."

He doesn't spend much time on specific fiscal-policy proposals. But it's not hard to come up with a general supply-side wish list: A better-educated workforce. More open borders and freer markets. Privatize public schools and public housing with vouchers. Improve incentives for more savings and investment. Indeed, one reason many economists favor Bush's proposal to eliminate the double taxation of dividends is that lowering taxes on capital boosts investment and productivity growth over the long haul.

PROMISE AND CHALLENGE.  One way to look at the experience of the '90s is that the American economy witnessed an explosion in the supply of knowledge, information, labor, and capital -- a real supply-side revolution. The productive capacity of business rose. Immigrants flocked to the country in record numbers. The labor force was better educated than previous generations. Money poured into the capital markets. Knowledge and information were disseminated to the far corners of the globe over the Internet. Entrepreneurship reached record levels.

The business cycle is an integral part of a dynamic, technologically innovative capitalist system. It can't be eliminated. But policymakers, with the indispensable aid of economists, have done much to tame the viciousness of downturns over the past 50 years. Although more needs to be done to protect those who lose their jobs during the inevitable downturns, Lucas is right in emphasizing that the greater fiscal challenge is creating a set of policies that ensure a genuine supply-side revolution. Fast economic growth is the promise -- and the challenge -- of the New Economy.


Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online
Edited by Beth Belton