Tuesday, April 06, 2010

Supply-Side Economics: What is it? (Econoclasts, Part IV)

#5 in an ongoing series on Brian Domitrovic's Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity. First post in the series: Econoclasts: The Rebels Who Sparked the Supply-Side Revolution, Intro. Previous post: The Terrible 1970s, Part II (Econoclasts, Part III)

The ruling orthodoxy amongst government economists worldwide, pretty much from the 1930s and, mostly, even until today, is what is known as Keynesianism (CANE-zee-en-izm; after John Maynard Keynes [CANES])). Keynes had taught that unemployment and inflation are inverse twins: when unemployment is high, you can expect little if any pressure toward higher prices, i.e., price inflation will be low to nonexistent. Indeed, you may experience deflation--in which prices fall. Conversely, when there is little unemployment (i.e., when most people are employed), you can expect a serious trend toward higher prices, i.e., price inflation.

With these observations in mind, Keynes proposed some policies for governments to pursue. Most particularly, when economic activity falls and unemployment rises, governments need to step in and increase demand for goods and services. They can do this by means of "fiscal stimulus"--primarily tax cuts and/or deficit spending--and/or through "monetary policy"--reducing interest rates and/or increasing money supply (i.e., inflating the currency). As Domitrovic puts it,
In the Keynesian teaching, inflation is tolerable because it means that people are out there spending money vigorously, demanding, pushing up prices in the name of growth. Taxes, in turn, take money from people who might save it rather than spend it, and then give that money to the one entity that will assuredly spend it: government.
Keynesian economics was de rigueur in the '60s and early '70s. Very few economists of any note were willing to question it.

By the mid-1970s, however, it was becoming obvious to all that Keynesian orthodoxy was unworkable. The United States was suffering ever higher unemployment together with ever increasing price inflation. Meanwhile, the government was spending at unprecedented levels beyond its income.

And, withal, there was widespread talk of doom, of permanent stagflation and “the necessity of adjusting to 'diminished expectations.'

It was in this context, then, that several key players--almost all relatively young--came forward to question the reigning orthodoxy.

And they were soon labeled “supply-siders”--a name originally attached to them with derision, but, ultimately, adopted by proponents as a badge of honor.

Why "supply-side"?

Catch the juxtaposition with (or against) Keynesianism. Keynes had taught that demand--not enough buyers--was the key economic problem.

The "supply-siders" said there was plenty of demand . . . if only the government would get out of the way and permit investors to supply what the economy needs: most particularly, investment capital.

I mentioned that Keynes had taught, at least at one point in his career, that the cause of economic recessions--or depressions--is a lack of demand, i.e., a lack of people willing to spend money. And so governments need to use fiscal (taxing and spending) and monetary (interest rates and money supply) policies to increase demand.

“Supply-side” economics also speaks of fiscal and monetary policies, but approaches them from almost the exact opposite direction. According to “supply-side” economics,
Inflation [i]s by its very nature an inducement not to work and produce, but to consume and demand, to spend one's dollars before they [devalue]. . . . If inflation [is] conquered, people [will] seek to gain income through work and investment, because in the context of stable prices, income holds its value. [However, note well!] work and investment [will] be for naught if new income [is] then confiscated by taxes. Hence, a monetary policy aimed at maintaining stable prices [must be] coupled with a tax policy aimed at stimulating personal initiative . . . in order to cure stagflation.

--p. 15

The two leading supply-side economists, Robert Mundell and Arthur Laffer,
said that the stagflation crisis . . . had originated with government. . . . First, the government had taken to destabilizing the means of exchange--the dollar--by printing it with abandon. This was the origin of inflation. Second, the government had jacked up tax rates, particularly on income that people earned as they got richer. This brought about disincentives to work and poisoned the well of capital formation. Unemployment was the necessary result.

The solution to the problem [they suggested] was clear: stabilize the dollar and cut taxes.

--p. 10

Okay. Stabilize the dollar and cut marginal [highest-end] tax rates. These, says Domitrovic, are the cornerstones of supply-side economics.

Next time: Tax cuts v. tax cuts
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