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Supply-side economics

While all macroeconomics involves both supply and demand, supply-side economics is a school of macroeconomic thought popularised in the 1970s by the ideas of Robert Mundell, Arthur Laffer and Jude Wanniski. The term was coined by Wanniski in 1975.

In 1978 Wanniski published "The Way the World Works" in which he laid out the central thesis of supply-side economics and detailed the supposed merits of low taxation and a gold standard.

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.


Historical Origins

Supply-side economics was principally a response to perceived failings of Keynesian ideas that had steadily risen to dominance following the Great Depression. In particular, the point of disagreement was the question of the stagflation of the 1970s, and the failure of Keynesian policies to produce growth without inflation, and the failure to provide a clear solution for the series of recessions which occurred in the wake of the oil crisis in 1973. As with the crash of 1929, whether particular policies could have avoided the negative outcomes of history is a matter of intense debate.

Specifically, supply-side economics grew out of monetarists' critiques of Keynesian economics, and instead focused on encouraging investment, which they asserted was the basis of classical economics. In particular the notion 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 summarised in Say's Law of economics, which had been refuted by Keynes in the 1930s. This led the supply-siders to advocate large reductions in marginal capital gains tax rates in response to inflation, to encourage allocation of assets to investment, which would produce more capital, and therefore more supply. The increased supply would then lower prices because of competition, hence the term "Supply-Side Economics". This policy was generalized to call for lower marginal tax rates in general, especially at higher incomes.

Like many conservative versions of economics, many supply-side advocates claim that they are merely reinstating classical economics. (See Keynesianism for a discussion on Keynes and the classical critiques of his theory) However, to most economists they are practicing Keynesian economics, with the lateration of promoting demand side for investment and upper income consumption, that there is nothing to distinguish "Supply Side Economics" from ordinary borrowing to finance present budget deficits.

Supply siders maintain that they offer a production-centred world view, and that this was behind the writing of classical economists such as Adam Smith and Karl Marx. In contrast to the modern Keynesian world view these authors are thought, by supply siders, to focus exclusively on production, as opposed to the effects of demand. Despite both these economists being frequently characterised as polar opposites in economic thinking, Jude Wanniski says that their production centred world view puts them closer together than either is to Keynsian economic thinking. By appealing to Say's Law supply-side economists such as Jude Wanniski seek to return the emphasis of macro-economic analysis to these classical traditions.

Critics of supply-side economics, such as Paul Krugman, quote one-time Reagan aide, David Stockman, to argue that this rhetoric is merely "a trojan horse for upper bracket tax cuts without economic justification." They point out that demand is crucial to both Marx and Smith, and that Keynes formulated demand side ideas because there had been a demand side failure in the late 1920s and early 1930s.

Supply-side supporters broke with Friedman and Lucas in that they argued that cutting tax rates alone would be sufficient to grow GDP, lift tax revenues and balance the budget. Supported by the powerful editorial pages of the Wall Street Journal and the Washington Times, supply-side economics became a force in public policy starting in the early 1980s.

In the United States commentators frequently equate supply-side economics with Reaganomics. The fiscal policies of Ronald Reagan were largely based on supply-side economics. However the monetary policies that prevailed at the time under Federal Reserve chair Paul Volcker were based on standard Keynesian and monetarist theory: he pursued a policy of using high interest rates and low money supply growth to squeeze inflationary expectations out of the economic system. Hence supply side supporters argue that Reaganomics was only partially based on supply-side economics. Nonetheless, Jude Wanniski cited Reagan, along with Jack Kemp, as a great advocate for supply-side economics in politics and to repeatedly praise his leadership.

Supply-side theorists also point to the success of the Kennedy tax-cuts to defend their case (even though they were justified at the time by Keynesian theory). More generally, supply-side rhetoric is often used to justify tax cuts for high income earners and other policies based on trickle-down theory. However an examination of the actual policies proposed and their motivations shows that Kennedy was attempting to end, not exacerbate trade deficits, and his intention was focused on the macro-economic effects of an inflation-employment trade off. (See Kennedy's 1963 speech on the balance of payments deficit and his address proposing the tax cut for his own balancing of supply and demand side forces which motivated the tax reduction, and the awareness that too large a tax cut would be inflationary.)

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 specialisation and lower economic efficiency. The idea is illustrated by the Laffer curve.

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 government spending. Jude Wanniski is to some extent almost indifferent to the effects of government debt. Of course under a floating fiat monetary system interest rates are typically regulated through open market operations so there is no unfettered market pricing to transparently signal crediters views on the nature or level of government debt.

According to Mundell "Fiscal discipline is a learned behavior." Or 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 and other advocates of "starve the beast" politics.

The central issue at stake is the point of diminishing returns on liquidity in the investment sector: is there a point where additional money is "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 out run 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 siders advocate that monetary policy should be based on a price rule. The aim of monetary policy should be to target a specific value of money irrespective of the quantity of money than must be created or withdrawn by the central bank to achieve this target. This contrasts with monetarism's focus on the quantity of money, and Keynesian theory's emphasis on real aggregate demand. The important difference is that to a monetarist the quantity of money, specifically represented by the Money Supply is the crucial determining variable for the relationship between the supply and demand for money, while to a Keynesian adequeate demand to support the available money supply is important. Keynes famously remarked "money doesn't matter".

This is an area where supply side theory has been particularly influential. Under macro-economic theory, the general level of price was based on the strict increase in price of a basket of goods. Under supply-side theory, the rate of inflation should be based on the substitutions that individuals make in the market place, and should take into account the improved quality of goods. In the late 1980s and through the 1990s, under Presidents of both American political parties, shifts were made in the calculation of the broadly followed measure of inflation the "Consumer Price Index for Urban Consumers", or CPI-W, which reflected supply side ideas on substitution. The argument for factoring in goods quality was not accepted, which has lead supply side economicists to claim that the real CPI is actually between .5% and 1% lower than the stated rate.

This area represents one of the points of contention between conservative economic theorists who argue for a quantity of money theory of inflation, including Austrian economics, many strict gold standard economists and traditional monetarists, and supply-side theorists. According to the increases in money supply during the 1990s, the real rate of inflation must be higher than is currently stated. These economists argue that the cost of housing is understated in the CPI-W, and that the inflation rate should be between .5% and 1% higher. It is for this reason that many central bankers, investment analysts and economists follow the "GDP deflator" which measures the total output of the society and the prices paid for all goods, not merely consumer goods.

Typically Supply Siders view gold as the best unit of account with which to measure the price of "fiat" money, which is defined as a money supply not directly limited by specie or hard assets. 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.

Supply Side economists assert that the value of money is purely dictated by the supply and demand for money. In their view, a monetary system without a hard basis is a fiat money system, which means that money has value only because 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.

According to critics of supply side theory, this is a "sky-hook" which allows supply side economists to "blame the fed" every time supply side theory fails to deliver on its promises of unending growth at lower tax rates.

USA Monetary and Fiscal Experience

Supply-side economists seek a cause and effect relationship between lowering marginal rates on capital formation and economic expansion. The supply-side history of economics since the 1960s hinges on the following key turning points:

The Kennedy Tax cuts which reduced marginal rates are believed by supply side economists to be responsible for the 1960s prosperity. The more generally accepted view among economists is that the tax program of 1963, by reducing the incentives to shelter income, reduced economic distortion. For example, while the theoretical top bracket rate was originally 90%, in practice, no one paid this rate, using various loopholes and deductions to avoid paying.

In 1971 Richard Nixon ended the Bretton Woods gold standard. After a few short years the price of gold rose rapidly followed in quick succession by the price of oil. The supply side explaination of this event is that the real value of gold and oil was mostly unchanged but the US dollar was in rapid decline due to monetary mistakes and policy drift. This cycle of money losing its value manifest itself as an wage/price inflation spiral.

At the same time the Flemming-Mundell model of currency flows gained greater credence when it was codified into a single set of equations, and became increasingly influential in Neo-liberal economics. The argument for a floating currency regime had first been adopted by Friedman, but supply side economics such as Wanniski typically argued that exchange rates should be fixed relative to gold. Mundell was the author of the influential view that it was Johnson's budget deficits that were the cause of inflationary pressure. However, as Lester Thurow pointed out, the standard model of inflationary pressure shows that Johnson's peak year of deficits would have created only a small upward pressure, that instead it was persistent American trade deficits through the 1960s which had a greater effect on the imbalance between the value of the US dollar and the gold that it was in theory convertible to.

Robert Mundell believes that Nixon's failure to cut taxes in the early 1970s to be the cause of "stagflation", his argument being that the incentive for individuals to invest was reduced to below zero. Measuring the S&P 500 in inflation adjusted terms, the stock market lost half of its value between the market peak of 1972 and its bottom in 1982, with money seeking better returns in real estate and commodities instead. The argument from the supply-side point of view then goes on to state that the cuts in capital gains tax rates that were part of the 1981 tax package returned incentives to invest. The Keynesian point of view is that after a long bear market, money had fled from stocks and was set to return, once the expectation of inflation had been reduced. Neither of these two arguments fully account for the rise of equities over the course of the "long Bull Market" of 1982-2000.

The importance of this argument needs to be seen in light of the effects of the hyper-inflation of the late 1970s, where credit became constricted, as rates of interest rose rapidly, and the number of borrowers who could qualify for even standard mortgages fell. Inflation acted as a tax on wage increases, because the highly progressive income tax system of the time meant that more and more households suffered from "bracket creep" - were a wage increase would be reduced in value by the increased taxes collected. The effects of inflation produced, in 1980, a strong political consensus for a change in basic policy.

Ronald Reagan made supply side economics a household word, and promised an "across the board" reduction in income tax rates and an even larger reduction in capital gains tax rates. When vying for the Republican party presidential nominee for the 1980 election, George H.W. Bush derided Ronald Reagan's policy of supply-side economics as "voodoo economics". However, later he seemed to endorse these policies, and is speculated by some to have lost in his re-election bid for allowing tax increases.

Supply side economics was critiqued from the right as well, for example hard gold standard advocates, such as the Mises institute, have argued that there is no such thing as a dollar, merely a specific quantity of gold. Therefore, according to this view, the entire central bank mechanism which supply-side economics advocates is a needless fiction which creates anomalies in the price of commodities. In their view the central problem was that the United States needed to reassert a hard gold standard first, and this would force the necessary reductions in expenditures.

The centerpiece of the supply side argument is the economic rebound from the 1980-1982 double dip recession, combined with the continued fall in commodity prices. The "across the board" tax cuts of 1981 are seen as the great motivator for the "Seven Fat Years". Critics of this view point out that the "rebound" from the from the "Reagan Recession" of 1981-1982 is exactly in accordance with the "disinflation" scenario predicted by IS-LM models of the late 1970s: essentially that the increases in federal funds rates squeezed out inflation, and that federal budget deficits acted to "prime the pump". This model had been the basis of Volker's federal reserve policy.

In 1981 supply-side economist Robert Mundell told Ronald Reagan that by cutting upper bracket taxation rates, and by lowering tax rates on capital gains, national output would increase and as a result government tax revenues would also increase. The economic expansion would also mop up excess liquidity and bring inflation back within control. Revenues did not increase, and federal budget deficits exploded, however, the incentive to invest in equities worked: in 1982 the stock market began a rally which nearly tripled the dow between its low in 1982 and its pre-1987 crash high in August.

This failure of expected revenues to materialize caused a search for "reasons", and increased the level of criticisms from those who had stated before the 1981 tax package that reducing revenues and increasing spending would lead to deficits. It was in this atmosphere that David Stockman, the self-proclaimed supply side Budget Director under Reagan, admitted that the "Rosy Scenario" which he used to justify the predictions was "cooked" and "So the supply-side formula was the only way to get a tax policy that was really 'trickle down.' Supply-side is 'trickle-down' theory."

Critics of supply side economics, cited this as proof that the theory had failed. They also pointed to the lack of academic credentials by movement leaders such as Jude Wanniski and Robert Bartley to infer that the theories were bankrupt. Mundell in his Nobel prize lecture countered that the success of price stabilty was proof that the supply-side revolution had worked. The continuing debate over supply-side policies tends to focus on the massive federal and current account deficits that have accumulated in the US since 1980.

Proponents of supply-side economics, such as Canto, argue that the emergence of deficits was because of insufficient fiscal discipline - where as critics, such as Solow of MIT and Friedman of the University of Chicago, argue that supply-side economics is garden variety "vulgar Keynesianism", and that tax cuts unmatched by spending cuts and financed by borrowing is within the realm of standard theory. However, the results have eluded both sides of the debate: in supply side theory revenues should have shot up, and in classical monetarism, the price stability of the period beginning in 1982 should not have occurred given M1 growth. (For a fuller discussion of the uncoupling of money supply to inflation see Monetarism), where as classical Keynesian theory predicts higher long term interest rates based on standard models - instead, interest rates have continued to generational lows in the US and Europe.

After the emergence of supply-side economics, economists using Supply Side Theory began advocating a flat-tax system, most prominently Arthur Laffer developer of the Laffer Curve, and Jude Wanniski who coined the term "supply side economics". While generally associated with conservative politics, such as former Presidential candidate Steve Forbes, flat tax systems based on Value Add Taxes have been proposed by liberal economists and by at least one Democratic Presidential Candidate.

The paradigm of a tax system which rewards investment over consumption was accepted across the political spectrum, and no plan not rooted in supply-side economic theories has been advanced since 1982 which had any serious chance of passage into law. In 1986, a tax overhaul, described by Mundell as "the completion of the supply-side revolution" was drafted, largely by Democrats in congress. It included increases in payroll taxes, decreases in top marginal rates, and increases in capital gains taxes. Combined with the mortgage interest deduction and the regressive effects of state taxation - which has increased dramatically, it produces closer to a flat tax effect. Proponents, such as Mundell and Laffer, point to the dramatic rise in the stock market as being a sign that this tax overhaul was effective, although they note that the hike in capgains may be more trouble than it was worth. Critics, such as economist Bradford J. DeLong point to the dramatic increase in disparity of wealth as being proof that the result was merely to create "bad productivity".

Supply-siders blame the 1991 recession on the Federal Reserve, and argue that Clinton's tax increases, since they did not change marginal capital gains tax rates, left the supply side nature of the 1986 tax bill in place. Similarly, supply side economists blame the Federal Reserve for the collapse of the economic bubble, and have argued that since the early phases of the massive tax breaks of George W. Bush's first two years were based on credits and not cuts in marginal rates, they did not act to stimulate the economy. Critics of Supply Side economics note that the "blame the Fed" excuse of supply siders seems to be a "one size fits all" cover, that when anything good happens, supply siders credit tax cuts, and when anything bad happens, it is the fault of the Federal Reserve.

More generally traditional economists point to the "overhang" of deficits from the Reagan era, the S&L bailout, the effects of a ballooning federal budget deficit, the defense budget cuts which began in earnest in 1989, and the expectation of lack of continued fiscal discipline as being the source of the recession. These arguments focus on the Reagan Deficits, which supply siders vehemently denied would occur, and in some cases pretend did not even happen. Critics of supply side economics take these "head in the sand" positions to be indications that supply side economics is a religion, not a school of economic thought, and that it has a "one size fits all" approach to policy, namely cutting upper income taxes.

More vehement critiques of supply side economics dismiss the entire project as a complete failure which is "out of touch with reality" and a mere trojan horse for reducing marginal tax rates on upper income brackets. These critiques are found in Samuel Bowles work, which argues that real productivity fell under supply-side taxation regimes on a unit-worker basis. Paul Krugman, of MIT, called supply-side economics "Peddling Prosperity" and dismissed it as being unworthy of serious economists in a 1994 book written for the general audience.

These criticisms point to the explosion in deficits, the failure of the "Laffer Curve" to materialize and the conversion of price volatility to currency volatility as proofs that supply side economics does not work.

The long jobs drought after the recession which began in 2001 has provided further ammunition for critics of supply side theory. After a string of massive tax reductions, which added over a trillion dollars to the deficit, and managed to produce only tepid growth after three years, both liberal and conservative economists have attacked the paradigm of "deficits don't matter" promulgated by the avowedly supply side Executive Branch of George W Bush. The supply-siders have difficulty blaming the Federal Reserve, whose chairman backed the tax packages and has kept the federal funds rate in an "easy" monetary stance - and at the same time the lack of results has been extremely visible. Supply siders procede to blame Clinton and Osama bin Laden, despite the lack of any rigorous model which explains the long drought in hiring that can be attributed either to the bubble bursting of 2000, or the September 11th attacks of 2001.

See also

External links

  • Supply Side Proponents:
    • Mundell's Nobel Prize Lecture claiming that Supply Side Economics was responsible for growth, price stability and the collapse of the Soviet Union.
    • Karl Marx as a supply side economist.
    • Another version of this article
  • Supply Side Critiques:
    • Supply-side Economics Explained for k5ers

Macroeconomic schools of thought

Keynesian economics | Monetarism | New classical economics
New Keynesian economics | Austrian School | Supply-side economics
Post-Keynesian economics

Last updated: 10-24-2004 05:10:45