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2012-03-19 12:03:25
May 14 2010 | Filed Under Economics , Entrepreneur
Supply-side economics is better known to some as "Reaganomics", or the
"trickle-down" policy espoused by former U.S. president Ronald Reagan. He
popularized the controversial idea that greater tax cuts for investors and
entrepreneurs provide incentives to save and invest and produce economic
benefits that trickle down into the overall economy. In this article, we
summarize the basic theory behind supply-side economics.
Like most economic theories, supply-side economics tries to explain both
macroeconomic phenomena and - based on these explanations - to offer policy
prescriptions for stable economic growth. In general, supply-side theory has
three pillars: tax policy, regulatory policy and monetary policy.
However, the single idea behind all three pillars is that production (i.e. the
"supply" of goods and services) is the most important determinant of economic
growth. The supply-side theory is typically held in stark contrast to Keynesian
theory, which, among other facets, includes the idea that demand can falter, so
if lagging consumer demand drags the economy into recession, the government
should intervene with fiscal and monetary stimuli.
This is the single big distinction: a pure Keynesian believes that consumers
and their demand for goods and services are key economic drivers, while a
supply-sider believes that producers and their willingness to create goods and
services set the pace of economic growth.
The Argument That Supply Creates Its Own Demand
In economics we review the supply and demand curves. The left-hand chart below
illustrates a simplified macroeconomic equilibrium: aggregate demand and
aggregate supply intersect to determine overall output and price levels. (In
this example, output may be gross domestic product and the price level may be
the Consumer Price Index.) The right-hand chart illustrates the supply-side
premise: an increase in supply (i.e. production of goods and services) will
increase output and lower prices.
Starting Point Increase in Supply
(Production)
Supply-side actually goes further and claims that demand is largely irrelevant.
It says that over-production and under-production are not really sustainable
phenomena. Supply-siders argue that when companies temporarily "over-produce",
excess inventory will be created, prices will subsequently fall and consumers
will increase their purchases to offset the excess supply. As put by the
Fountainhead Capital Group, "After all, what would cause consumers and
businesses to stop demanding goods and services and force the economy into a
recession or a depression? Keynes had no idea, and said as much ."
This essentially amounts to the belief in a vertical (or almost vertical)
supply curve, as shown below on the left-hand chart below. On the right-hand
chart, we illustrate the impact of an increase in demand: prices rise but
output doesn't change much.
Vertical Supply Curve
An Increase in Demand
→ Prices Go Up
Under such a dynamic - where the supply is vertical - the only thing that
increases output (and therefore economic growth) is an increase in the
production of the supply of goods and services. As illustrated below:
Supply-Side Theory
Only an Increase in Supply (Production) Raises Output
Three Pillars
The three supply-side pillars follow from this premise. On the question of tax
policy, supply-siders argue for lower marginal tax rates. In regard to a lower
marginal income tax, supply-siders believe that lower rates will induce workers
to prefer work over leisure (at the margin). In regard to lower capital-gains
tax rates, they believe that lower rates induce investors to deploy capital
productively. At certain rates, a supply-sider would even argue that the
government would not lose total tax revenue because lower rates would be more
than offset by a higher tax revenue base - due to greater employment and
productivity.
On the question of regulatory policy, supply-siders tend to ally with
traditional political conservatives - those who would prefer a smaller
government and less intervention in the free market. This is logical because
supply-siders, although they may acknowledge that government can temporarily
help by making purchases, they do not think this induced demand can either
rescue a recession or have a sustainable impact on growth.
The third pillar, monetary policy, is especially controversial. By monetary
policy, we are referring to the Federal Reserve's ability to increase or
decrease the quantity of dollars in circulation (i.e. where more dollars means
more purchases by consumers, thus creating liquidity). A Keynesian tends to
think that monetary policy is an important tool for tweaking the economy and
dealing with business cycles, whereas a supply-sider does not think that
monetary policy can create economic value.
While both agree that the government has a printing press, the Keynesian
believes this printing press can help solve economic problems. But the
supply-sider thinks that the government (or the Fed) is likely to create only
problems with its printing press by either (a) creating too much inflationary
liquidity, or (b) not sufficiently "greasing the wheels" of commerce with
enough liquidity. A strict supply-sider is therefore concerned that the Fed may
inadvertently stifle growth by contributing to deflation and encouraging
investors to horde dollars.
What s Gold Got To Do with It?
Since supply-siders view monetary policy not as a tool that can create economic
value, but rather a variable to be controlled, they advocate a stable monetary
policy or a policy of gentle inflation tied to economic growth - for example,
3% to 4% growth in the money supply per year. This principle is the key to
understanding why a supply-sider often advocates a return to the gold standard
- which may seem strange at first glance. (And most economists probably do view
this aspect as dubious.) The idea is not that gold is particularly special but
rather that gold is the most obvious candidate as a stable "store of value".
The supply-sider argues that if the U.S. were to peg the dollar to gold, the
currency would be more stable, and fewer disruptive outcomes would result from
currency fluctuations.
As an investment theme, supply-side theorists say that the price of gold -
since it is a relatively stable store of value - provides investors with a
"leading indicator", or signal for the direction of the dollar. Indeed, gold is
typically viewed as an inflation hedge. And, although the historical record is
hardly perfect, gold has often given early signals about the dollar. In the
chart below, we compare the annual inflation rate in the United States (the
year-to-year increase in the Consumer Price Index) with the high-low-average
price of gold. An interesting example is 1997-98: gold started to descend ahead
of deflationary pressures (lower CPI growth) in 1998.
Conclusion
Supply-side economics has a colorful history. Some economists view supply-side
as a half-baked economic theory - economist and New York Times columnist Paul
Krugman even called its founders "cranks" in a book dedicated to attacking the
theory ("Peddling Prosperity"). Other economics are so utterly disagree with
the theory that they dismiss it as offering nothing particularly new or
controversial to an updated view of classical economics. We have discussed the
three pillars, and, based on this, you can see how the supply side cannot be
separated from the political realms: if true, it implies a reduced role for
government and a less progressive tax policy.
by David Harper