Supply-side economics

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Supply-side economics is a school of macroeconomic thought which emphasizes the "supply" part of "supply and demand." The central concept of supply-side economics is Say's Law: "supply creates its own demand," or the idea that one must produce before one has the means to buy. In evaluating public policy, supply-side economics is more concerned with the extent to which a reform will change producer incentives or capabilities, rather than how it may stimulate demand. This emphasis represents a fundamental difference between classical, supply-side economics and Keynesian or demand side economics.

Supply-side economics was popularized in the 1970s by Robert Mundell, Arthur Laffer, and Jude Wanniski. The term was coined by Wanniski in 1975. In 1978 Jude Wanniski published The Way the World Works in which he laid out the central thesis of supply-side economics and detailed the failure of high tax-rate, "progressive" income tax systems and U.S. monetary policy under Keynesians in the 1970s. Wanninski advocated lower tax rates and a return to some kind of gold standard, à la the 1944-1971 Bretton Woods System. The "horse and sparrow theory," similar to supply-side economics, was prevalent in the 1890s United States. The theory stated that "if you feed the horse enough oats, some will pass through to the road for the sparrows." [link]

In 1983, economist Victor Canto, a disciple of Arthur Laffer, published The Foundations of Supply-Side Economics. This theory focuses on the effects of marginal tax rates on the incentive to work and save, which affect the growth of the "supply side" or what Keynesians call potential output. While the latter focus on changes in the rate of supply-side growth in the long run, the "new" supply-siders often promised short-term results.

Supply-side economics is often conflated with trickle down economics.

Contents

1 Fiscal policy theory
2 Monetary policy theory
3 Historical origins

3.1 Supply-side vs. Monetarism & New Classical Economics
3.2 Reaganomics

4 Supply-side economics in popular culture
5 See also
6 Notes and references
7 External links

Fiscal policy theory

Supply-side economics holds that increased taxation steadily reduces economic trade between economic participants within a nation and that it discourages investment. Taxes act as a type of trade barrier or tariff that causes economic participants to revert to less efficient means of satisfying their needs. As such, higher taxation leads to lower levels of specialization and lower economic efficiency. The idea is said to be illustrated by the Laffer curve. (Case & Fair, 1999: 780, 781).

Crucial to the operation of supply-side theory is the expansion of free trade and free movement of capital. It is argued that free capital movement, in addition to the classical reasoning of comparative advantage, frequently allows an economic expansion. Lowering tax barriers to trade provides to the domestic economy all the advantages that the international economy gets from lower tariff barriers.

Supply-side economists have less to say on the effects of deficits, and sometimes cite Robert Barro’s work which states that rational economic actors will buy bonds in sufficient quantities to reduce long-term interest rates. Critics argue that standard exchange rate theory would predict, instead, a devaluation of the currency of the nation running the high budget deficit, and eventual "crowding out" of private investment.

According to Mundell, "Fiscal discipline is a learned behavior." To put it another way, eventually the unfavorable effects of running persistent budget deficits will force governments to reduce spending in line with their levels of revenue. This view is also promoted by Victor Canto.

The central issue at stake is the point of diminishing returns on liquidity in the investment sector: Is there a point where additional money in the system amount to "pushing on a string"? To the supply-side economist, reallocation away from consumption to private investment, and most especially from public investment to private investment, will always yield superior economic results. In standard monetarist and Keynesian theory, however, there will be a point where increases in asset prices will produce no new supply, that is where investment demand will outrun potential investment supply, and produce instead, asset inflation, or in common terms a bubble. The existence of this point, and where it is should it exist, is the essential question of the efficacy of supply-side economics.

Monetary policy theory

Supply-side economists assert that the value of money is purely dictated by the supply and demand for money. In a fiat currency system the government has a legislated monopoly on the supply of base money. Hence it has complete control over the value of money. Any decline in the value of money (or appreciation) is hence viewed as the result of errant central bank policy.

Supply-side economics place more significance on the management of moneys role as a "unit of account" than as a "medium of exchange" or "store of value". Inflation and deflation are regarded as nothing more than a change in the value of a nations currency. The domestic demand for currency will increase as an economy grows and decline when an economy contracts, although in a dynamic and otherwise unpredictable manner. The role of monetary policy should be to manage the supply side of the currency equation so as to maintain a "unit of account" that is stable in value.

As such supply-side economist typically advocate a monetary price rule. The objective of monetary policy should be to target a specific constant value of money irrespective of the quantity of currency that must be created or withdrawn by the central bank to achieve this target. This contrasts with monetarism's focus on the quantity of broad money, Austrian economists focus on the quantity of currency (narrow money) and Keynesian theory's emphasis on real aggregate demand. To a Keynesian managing the aggregate demand for goods and services (typically via interest rates) is regarded as appropriate, whilst for a supply-sider ensuring an appropriate supply of currency to meet the prevailing demand for goods and services is appropriate.

Typically, supply-siders view gold as the best unit of account with which to measure and target the price of fiat currency. Hence the purest supply-siders are in general advocates of a gold standard. However the reverse is not true; many gold standard advocates are harsh critics of supply-side economics.

In appreciating the supply-side view of inflation it is necessary to understand the price spiral process of inflation where monetary shifts in the value of a currency are first realised in the nominal prices of a narrow set of goods and services (such as gold and other commodities) before being transmitted down the supply chain to other goods and services. As such supply-siders will view inflation as occurring even before it is reflected in the price of finished consumer goods.

Historical origins

Supply-Side economics developed during the 1970s of the Keynesian dominance of economic policy, and in particular the failure of demand management to stabilize Western economies in the stagflation of the 1970s and in the wake of the oil crisis in 1973. Case, Karl E. & Fair, Ray C. (1999). Principles of Economics (5th ed.), p. 780. Prentice-Hall. ISBN 0-13-961905-4.

It drew on a range of non-Keynesian economic thought, particularly the Austrian school, e.g. Joseph Schumpeter and monetarism.

As in classical economics, monetarism proposed that production or supply is the key to economic prosperity and that consumption or demand is merely a secondary consequence. In classical times this idea had been summarized in Say's Law of economics, which states: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." John Maynard Keynes, the founder of Keynesianism, summarized Say's Law as "supply creates its own demand." He turned Say's Law on its head in the 1930s by declaring that demand creates its own supply. Malabre, Jr., Alfred L. (1994). Lost Prophets: An Insider's History of the Modern Economists, p. 182. Harvard Business School Press. ISBN 0-87584-441-3. However, Say's Law does not state that production creates a demand for the product itself, but rather a demand for "other products to the full extent of its own value." More simply, it is only after we "produce" and have income to spend that we can "demand."

The supply-siders were influenced strongly by the idea of the Laffer curve, which states that tax rates and tax revenues were distinct -- that tax rates too high or too low will not maximize tax revenues. Supply-siders felt that in a high tax rate environment, lowering taxes to the right level can raise revenue by causing faster economic growth. They pointed to the tax cuts of the Kennedy administration and the high rates of the Hoover and Nixon administrations in justification. [The President Reagan Information Page: Federal Income Tax Revenues.] Kottmann (1994-2005)

This led the supply-siders to advocate large reductions in marginal income and capital gains tax rates to encourage allocation of assets to investment, which would produce more supply (Jude Wanniski and many others advocate a zero capital gains rate). The increased aggregate supply would result in increased aggregate demand, hence the term "Supply-Side Economics."

Furthermore, in response to inflation, supply-siders called for lower marginal income tax rates, as monetary inflation had pushed wage earners into higher marginal income tax brackets that remained static; that is, as wages increased to maintain purchasing power with prices, income tax brackets were not adjusted accordingly and thus wage earners were pushed into higher income tax brackets than tax policy had intended.

Supply-side economics has been criticized as essentially politically conservative. Supply-side advocates claim that they are not following an ideology, but are reinstating classical economics.

However, some economists see similarities between supply-side proposals and Keynesian economics. If the result of changes to the tax structure is a fiscal deficit then the "supply-side" policy is effectively stimulating demand through the Keynesian multiplier effect. Supply-side proponents would point out, in response, that the level of taxation and spending is important for economic incentives, not just the size of the deficit.

Critics of supply-side economics such as Paul Krugman claim that "supply-side economics" was always a smokescreen for politically-motivated tax cuts. They point to Reagan-era Director of the Office of Management and Budget David Stockman's admission that supply-side doctrine of across-the-board tax cuts embodied in centerpiece legislation commonly known as the Kemp-Roth Tax Cut "was always a Trojan horse to bring down the top [marginal income tax] rate"[link]. The administration justified such changes in socioeconomic terms with the argument that benefits would "trickle down" to poorer Americans. This conservative political argument in favor of supply-side policy is not part of supply-side thought however. For example, Jude Wanniski argued for lower tax rates to increase tax revenues and increase production, something favored by political conservatives, but also argued that redistribution of income through taxation was essential to the health of the polity -- a view which is anathema to political conservatives.

Supply-side vs. Monetarism & New Classical Economics

Supply-side supporters disagreed with monetarist Milton Friedman and neoclassicist Robert Lucas Jr. by arguing that cutting tax rates alone would be sufficient to grow GDP, lift tax revenues and balance the budget.

Friedman, however, retained a more conventional monetarist view, believing that while tax cuts were on the whole desirable, money supply was the crucial variable.

Supported by the Washington Times and the powerful editorial page of the Wall Street Journal, supply-side economics became a force in public policy starting in the early 1980s.

Reaganomics

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Please see the discussion on the [United States frequently equate supply-side economics with Reaganomics. The fiscal policies of Ronald Reagan were largely based on supply-side economics. During Reagan's 1980 presidential campaign, the key economic concern was double-digit inflation, which Reagan described as "Too many dollars chasing too few goods," but rather than the usual dose of tight money, recession and layoffs, with their consequent loss of production and wealth, he promised a gradual and painless way to fight inflation by "producing our way out of it." Case & Fair, p. 781, 782. Switching from an earlier monetarist policy that some claim led to the early eighties recession, Federal Reserve chair Paul Volcker, began a policy of tighter monetary policies such as lower money supply growth to break the inflationary psychology and squeeze inflationary expectations out of the economic system. Malabre, Jr., pp. 170–171. Therefore, supply-side supporters argue that "Reaganomics" was only partially based on supply-side economics. However, under Reagan, Congress passed a plan that would slash taxes by $749 billion over five years. As a result, Jude Wanniski cited Reagan — along with Jack Kemp — as great advocates for supply-side economics in politics and repeatedly praised their leadership. Malabre, Jr., p. 188.

Critics of "Reaganomics" claim it failed to produce much of the gains Laffer and other supply-siders had promised. Krugman later summarized the situation in this way: "When Ronald Reagan was elected, the supply-siders got a chance to try out their ideas. Unfortunately, they failed." Incresed government spending, combined with a restrictive monetary policy, increased the primary interest rate (the price of capital) as high as 20%, which severely curtailed economic growth (see crowding-out). The tight monetary policy was inhereted from he Carter administration (too many dollars chasing too few goods), but the increase in government spending was a Reganite policy. Although Krugman has credited supply-side economics for being more successful than monetarism — which he claimed "left the economy in ruins," he stated that supply-side economic theory produced results which fell "so far short of what it promised," describing the supply-side theory as "free lunches." Malabre, Jr., p. 195. .It was thought that tax cuts would result in increased savings; in theory, high marginal tax rates discourage savings. Reagan tax cuts did not result in an increase in savings, but a decrease in the savings rate throughout the 1980s, falling from a high of 12% in 1982 to under 7% in 1989. In spite of increased consumption, the increased government revenue from induced taxes could not compensate for the lost revenue of the tax cuts, nor keep up with government spending. Between 1980 and 1990, Federal tax receipts nearly doubled, from $517 billion to over $1 trillion. However, Federal spending during this time was far greater than the tax receipts, resulting in a ballooning national debt, as shown by the [Tax Policy Center]. Under Reagan, the national debt increased, counter to what had been promised by Laffer, who had claimed that under his proposed policies, the resulting growth in output would offset any losses from cutting tax rates. Malabre, Jr., pp. 196, 201. It has been contended that many supply-siders believed that the tax cuts would lead to a commensurate drop in government spending. However, this did not turn out to be the case; Paul Samuelson called this notion "the tape worm theory — the idea that the way to get rid of a tape worm is [to] stab your patient in the stomach." Malabre, Jr., pp. 197–198. Yet, this claim is countered by proponents of Reaganomics that this was due to entitlement spending, which Reagen attempted to control, but was ultimately unable to due to Congress. Had Reagan had his way in this matter, it is believed that the national debt would have significantly decreased by the end of his term. In other words, Reagan, in order to force a Democratic Congress to cut government spending decided to effectively starve the government. Increases in national debt were a direct cause of the efforts of the Democrats to undercut Reagan's policies. Tax increases by H. W. Bush in the early 1990s also significantly countered the efforts of Reagan and these two circumstances (Democratic Congress, Bush tax increases) undermine the actual impact of Reaganomics.