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Understanding Supply-Side Economics

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