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Supply-side economics

Supply-side economics is a school of economic thought popularised in the 1970s by the ideas of Robert Mundell, Art Laffer and Jude Wanniski. The term was coined by Wanniski in 1975. In 1983 economist Victor Canto, a disciple of Arthur Laffer, published The Foundations of Supply-Side Economics.

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 Keynsian economics failed to explain the stagflation of the 1970s and failed to provide a clear solution for the series of recessions which occured in the wake of the oil crisis in 1973.

Supply-side economics grew out of monetarist's 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. Like many conservative versions of economics, many supply-side followers claim that they are merely reinstating classical economics. (See Keynesianism for a discussion on Keynes and the classical critiques of his theory)

A production-centred world view was behind the writing of both classical economists as disparate as Karl Marx and Adam Smith. Supply-side supporters broke with Friedman and Lucas in that they argued that tax cutting alone would be sufficient to grow GDP and balance the budget. Supported by the powerful editorial page of the Wall Street Journal, and the Washington Times, owned by Reverand Moon of the Unification Church, supply-side economics became a force in public policy making beginning in the early 1980's.

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 while his monetary policies were based on Monetarism. Hence, while Reaganomics was only partially based on supply-side economics, it was enough for Jude Wanniski to cite Kemp and Reagan as the great advocates for supply side economics in politics and to repeatedly praise their leadership.

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 that causes economic participants to revert to less efficient means of satisfying their needs. As such higher taxation leads to 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, forces a fiscal discipline because of the adverse effects of current account and fiscal deficits - which can be masked with protectionist policies. According to supply-side theory, tax cuts will produce, automatically, sufficient pressure for spending cuts, because deficits will penalize the central banks of nations which pursue fiscal deficits in the face of currency devaluation. According to Mundell "Fiscal discipline is a learned behavior."

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.

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.

Supply Side economists assert that the value of money is purely dictated by the supply and demand for money. In a fiat money 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.

By way of contrast Monetarism is typically focused on targeting the quantity of money in circulation rather than directly targeting the value of that money, whilst Keynesians are focused on the concept of aggregate demand and the targeting of interest rates.

USA Fiscal Experience

In 1981 supply-side economist Robert Mundell, in 1999 to win the Nobel prize for "for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas", told Ronald Reagan that theory predicted that by cutting upper bracket taxation rates, and by lowering rates on capital gains, it would be possible to raise government revenues while cutting taxes. Subsequent budget years did not bear out this prediction, and between 1986 and 1994 a series of tax restructurings and tax increases were passed which raised the percentage of GDP taken as federal taxes to the same level that it had been in 1980. David Stockman, the self-proclaimed supply side Budget Director under Reagan later 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, and that the lack of academic credentials by movement leaders such as Jude Wanniski and Robert Bartley show that the theories were bankrupt. Mundell in his Nobel prize lecture countered that the success fo 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 this is 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, which they did not, and in classical monetarism, the price stability of the period beginning in 1982 should not have occured 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 cuts in capital gains taxes. Combined with the mortgage interest deduction and the regressive effects of state taxation - which has increased dramatically, it produces close 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. 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".

Criticism of

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 George W. Bush Sr. as President continued the policies begun by Ronald Reagan, and lost in his re-election bid, to no small extent, because he was perceived by many in his own party of having allowed a tax increase.

Both Reagonomics and supply-side economics have been described with derision as "trickle down economics". The implication being that it represents a set of policies that merely benefits the rich and that the poor are left with the crumbs. These criticisms of date back to FDR's criticism of Herbert Hoover's economic policies.

Supply side economics has been 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.

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 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.

External links

Supply Side Proponents:

More at: Reaganomics

Supply Side Critiques:
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