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Supply-Side Economics Can’t Fix a Demand-Side Problem
January 15, 2013

Typically, weak economies are characterized by high unemployment and low inflation, while strong economies are characterized by low unemployment and higher inflation. This makes intuitive sense – a strong economy creates more demand for goods and services causing price inflation. It also creates more demand for workers which can lead to a rise in wages.

The economy of the 1970′s was different. Throughout the 1970′s both inflation and the unemployment rate moved higher. The high inflation of the 1970′s implied that demand was strong – suggesting the problem was weak supply. This led to the supply-side economic policies of the Reagan administration.

The main tool of these supply-side (a.k.a. trickle-down) policies was tax cuts. The idea being that if you cut taxes for people at the top, there would be an increase in investment capital which would lead to more business investment and higher supply. The effects of these tax cuts would then trickle-down to everyone else through lower unemployment and a stronger economy.

Looking at the conditions which existed in 1981, this made a lot of sense. The stock market was significantly undervalued and interest rates on bonds were high. Both of these conditions suggest a shortage of investment capital.


In January 1981, the Shiller PE was 9.26 – about 38% below it’s historical average of 15. Today, it is 21.44 – about 43% above it’s long-term average.


In January 1981, long term treasury bond rates were over 11.5%.Today, they are at historic lows.

After the implementation of supply-side policies, both the stock and bond markets staged strong rallies. Those policies appear to have worked.

Today, however, we have the opposite problems – the stock and bond markets are both well above historical averages. This is clear evidence that there is plenty of investment capital, and no supply-side issue.

The current economy is experiencing an old fashioned demand-side problem. Implementing more supply-side policies now it will only make things worse.

A Primer on Supply-Side vs Demand-Side Economics

Let’s step back and examine how, in the U.S., Democrats and Republicans have become identified with two quite opposite economic theories.

We’ll start with the Republicans, who still clasp fealty to Supply Side Economics (SSE), a theory once labeled “voodoo” by the elder George Bush, but now mainstream conservative catechism for three decades.

Supply Side holds that you best stimulate economic activity by Increasing the net wealth possessed by society’s top echelons—people and groups who have no urgent material needs. Instead of spending it on direct “demand” purchases, these wealth-owners will invest any marginal wealth-gain (say from tax cuts) on things that increase “supply”—factories, new businesses, innovative goods and services. Thus the name Supply Side.

Interestingly, the most famous proponent of this approach was Karl Marx, who maintained that the owner-capitalist class propels industrial development by re-investing profits in plants and equipment, thus building up society’s capital stock and the means of production. SSE is, in that respect, an entirely Marxist theory.

Of course, Marx then looked farther ahead. He hypothesized an eventual “completion” of this capital-formation process, a final phase when all the factories are finished—an image we now find ludicrous, since productive capacity must be updated at an accelerating pace. (Hence there will always be a need for capitalists.) Still, it seems kind of sad that SSE supporters won’t ever acknowledge this fundamental root of their theory. They do not study their ideological forebear. Nor do they try, as Marx did, to extrapolate where their prescription may eventually lead.

But let’s examine the key SSE predictions. (All theories should make confident predictions that are clear-cut and testable.) For thirty years we have heard Supply Side zealots forecast that reducing taxes on the rich will:

1) result in direct investment of the released wealth into “supply” capacity for producing innovative goods and services.

2) stimulate so much new economic activity that even lower tax rates will rake in enough new revenue to erase any deficit caused by reducing taxes on the rich.

3) eliminate government debt, resolving any apparent conflict between reducing revenue and fiscal responsibility.

EFFECTS UPON POLICY

This lengthy definition is needed understand why a credibility deficit now burdens the Republican Coalition. All through the 1980s, 1990s and 2000s, the mantra was:

- if the federal budget is in deficit, cut taxes on the rich, in order to repair that deficit.

- if the federal budget is in surplus, cut taxes on the rich, because it’s their money, not the government’s, and there will henceforth be no rainy days.

- in times of peace, cut taxes on the rich, because government has lower priority in peacetime.

- in times of war, cut taxes on the rich, because… well, this one never made sense even by conservative logic. Indeed, this was the first time in US history that the clade of uber-wealth demanded ever-increasing state largesse even while the nation was under deadly threat.

In any event, we must admit that the core demand of SSE believers has been utterly consistent. Reducing taxes on the uber-wealthy is good for America, across all circumstances, under all conditions and without limit.



TESTING SUPPLY SIDE THEORY

For three decades, SSE proponents told skeptics “just watch and see what will happen!” (Whenever top tax rates were cut.) Okay, we’ve watched. And absolutely every large-scale forecast made by promoters of Supply Side Economics failed—diametrically—without major exception.

The uber-rich did not take their tax-break largesse and invest it in innovative/productive equipment. They poured it into either passive investments—what Adam Smith derided as “rent-seeking”—or else risky financial instruments and asset bubbles. Above all, the direct forecast that reduced revenues would erase federal deficits went directly opposite to observed fact.

TESTING THE OPPOSING THEORY

The one period over which deficits decisively vanished came right after Bill Clinton got moderate increases in taxation on the rich, in 1991, followed by stringent pay-as-you-go budgetary management. What we saw then was a combination of budget balancing, strong economic activity and revenue-based debt reduction.

So now let’s examine the competing theory: Demand Side Economics (DSE)... also called modified-Keynesianism.

Named for long-ago FDR advisor John Maynard Keynes, this theory holds that economic activity is driven by demand for goods and services. Moreover, money in the hands of the middle and lower classes has greater inherent VELOCITY—meaning that a given dollar will be spent and then re-spent more often, if the middle class is passing it around with sequential purchases, than if it is stockpiled in a rich person’s portfolio.

(Mind you, by this theory, tax cuts for the rich might actually make sense when rapid inflation in an overheated economy calls for decreased monetary velocity! I never said that such cuts are NEVER called for. Indeed, JFK’s tax cuts did achieve all of its intended goals.)

Under Keynesian or Demand Side theory, the government should spend heavily, even deep into debt, when the nation is in recession, in order to get high-velocity economic activity going again. Hence the recent surge in stimulus activity, in the first year of the Obama administration… in sharp contrast to the equal-scale “stimulus” measures taken in the last year of George W. Bush’s term, most of which went to shoring up the positions of those at the top of the social-economic order.

Now, to a person who genuinely despises all deficit spending, both SSE and DSE methods may seem horrific. Both claim to use deficits and state-largesse to stimulate the economy, under a notion that economic activity will thereupon surge ahead and resulting revenues will later erase the incurred debt. Only there are some truly major differences.

1) Demand Side (Keynesian) deficit spending goes to where each dollar will have high velocity impact, as their theory predicts. In contrast, Supply Side largesse for the rich definitely did NOT go into predicted capital formation. (Marx was wrong.) It simply made the rich richer.

2) Completely aside from macro-economic effects, the beneficiaries of Demand Side largesse—the poor and middle class—may have some actual direct need. Fulfilling that need (if done well) may result in creation of either more-skilled workers or more small businesses. In contrast, it is hard to see how Supply Side sends the money to a place (the rich) where a direct need merits government intervention.

3) Supply Side is a monotone. “Give money to the rich under ALL circumstances, at all times and conditions, no matter what.

In contrast, Keynesians have proved that their policy is adaptable and variable, un-dogmatic and contingent upon circumstance. They spend lavishly in order to get out of recession, because that is what Keynesians do. (Right-wing rants and rails against the current governing party acting consistently with its own economic theory is simply hypocritical. You had your turn, now it is theirs.)

But the 1990s prove that Democrats have credibility for being situationally flexible. When a recession ends, they spend more cautiously, remove the largesse, and start building up savings. In fact, had Bush continued the Clintonian policy of debt buy-down in good times, a considerable reserve fund would have been available to help us ride out the present crisis.

4) The experts—professionals who have actually spent their lives studying this difficult field—generally despise Supply Side Economics. That may seem a good thing from the perspective of those who increasingly call expertise a disqualifying trait. From contempt for the Civil Service and the US Officer Corps to distrust of universities and the climate experts who have achieved miracles in weather forecasting, it’s become clear that one side in our tragic, debilitating “culture war” does not want to hear the professionals on any matter, least of all economics.

5) In fact the situation is not entirely black and white! Keyensianism has had its failures. Economics is a dismal “science” and Demand-Side has many problems dealing with a complex economy. Furthermore, pre-Clintonian Democrats sometimes acted as if the law of gravity did not apply. That potential always lurks on the left (witness Greece, today.) Moreover, Democrats did play some (lesser) role in the unleashing of our recent Asset Bubble.

Nevertheless, Keynesianism has a long, eighty-year record of being right in the most general sense.

Government should outspend its revenues in recession, directing high-velocity stimulus toward the middle class. Then, in good times, it should use adequate revenues to build up reserves. The Pharoahs knew this. It is even in the Biblical story of Joseph. It is common sense.

What does not make sense is to hold fast to an alternative “voodoo” theory—Supply Side Economics—that has always and universally failed in every major prediction, after being tried repeatedly for three decades.

A theory that is quasi-Marxist, in that it openly aims to propel the rise of an all-powerful aristocracy of wealth in exactly the manner that Marx prophesied, taking us toward the sort of class divisions that had old Karl chortling and rubbing his hands, murmuring “Yessss!”

Published on Sunday, May 14, 2006

A Tale of Two Theories: Supply Side and Demand Side Economics
by Robert Freeman

It was the best of times. It was the worst of times. It was the era of low taxes. It was the age of high deficits. Prices were up. Wages were down. Oil and gold soared. Housing and big cars cratered. Foreign powers threatened. Foreign currencies beckoned. Some saw a new Jerusalem in the nation's future. Others saw only the glaucoma of gluttonous greed. It was the summer of economic hope. It was the winter of economic despair.

In short, the early eighties were an economic time not unlike our own, a time that scared the Dickens out of most sober observers.

The common thread that unites the two times is Supply Side Economics. In the eighties it was new and promising. In the aughts it is recycled and damaging. In both eras, it stood against Demand Side Economics in its prescription for how to manage the economy. But it is in their outcomes that the two theories present such stark and measurable differences.

In the late seventies, the U.S. economy was falling to pieces. Johnson's Great Society programs and the Vietnam War had produced enormous inflationary pressures. But these were only the beginning. In 1973, Arab oil sheikdoms tripled the price of oil and in 1978, they tripled it again. Inflation soared, interest rates skyrocketed, and the economy tanked.

Higher prices cut into corporate profits, forcing employers to cut back production. The higher prices also reduced the purchasing power of workers, causing a slowdown in the economy. It was the worst of both worlds: a stagnant economy with rampant inflation. Economists called it "stagflation." They were at a loss for a cure.

Traditionally, to fight inflation, governments raise interest rates and cut spending, tampening down demand. To fight unemployment, they do the opposite: cut interest rates and raise spending, increasing demand. But now they had both problems at the same time. The cure for stagnant growth (lower interest rates and higher spending) would only aggravate the inflation. And the cure for inflation (higher interest rates and lower spending) would only aggravate the stagnation. The problem seemed insoluble. Enter Supply Side Economics.

Supply Side Economics claimed that if the government cut taxes on the wealthy, it would jump-start the economy as the wealthy plowed their tax savings back into investments. New factories fitted with new technologies would produce goods at lower cost, taming inflation. And the newly hired workers would tame unemployment. It would, in effect, square the economic circle, fixing both inflation and unemployment at the same time.

Even better, more output meant government tax receipts would grow. The government could continue to spend money without having to raise taxes, it would simply materialize as a byproduct of higher levels of production! The economy would bootstrap itself in an ever-expanding, virtuous circle of tax cuts, investment, productivity, employment, and rising tax revenues. It was the proverbial something for nothing story. It seemed too good to be true.

It was.

In 1980, Ronald Reagan promised that, if elected, he would cut taxes, raise military spending AND balance the budget, all at the same time. His opponent, George H.W. Bush called it voodoo economics. But Reagan won the election and kept his promise. He cut the marginal tax rate on the highest income earners from 75% to 38%. What happened?

In 1982, the first full year for Reagan's policies, the economy shrank by 2%, the worst performance since the Great Depression. Investment, the magic transmission belt through which all other Supply Side benefits were supposed to flow, actually declined as a percent of GDP over the 1980s. Worse, Reagan's Supply Side policies created the biggest budget deficits in history. The numbers tell the story.

Jimmy Carter's last budget produced a deficit of $77 billion. At the time, it seemed huge. But Reagan's first budget swelled the deficit to $128 billion. By the next year, 1983, it had exploded to $208 billion and was creating severe problems for the economy. By 1992, at the end of the Reagan Revolution, (under Reagan's Vice President and successor, Bush, Sr.) the deficit was approaching $300 billion a year.

Annual deficits, of course, accumulate to the national debt. In 1980, the national debt amounted to less than $1 trillion. By the end of 1992, it had reached $4.35 trillion. In other words, the debt, which had taken over 200 years to reach $1 trillion, quadrupled in the 12 years of Supply Side Economics. A more complete, definitive repudiation of Supply Side's claims could not be imagined. What went wrong?

According to Supply Side theory, tax cuts should go to the wealthy for only they can afford to use the extra income to invest in the economy to increase its capacity to supply goods. But there is nothing to make sure they actually invest, especially in the U.S. economy.

The new money might simply sit in the bank, or be spent on expensive foreign imports. It might be wasted in misdirected speculation, or invested in fast growing markets like southeast Asia. Without the ability to ensure that tax cuts are, in fact, invested in new productive assets, Supply Side Economics cannot ensure any real linkage between tax cuts and the hoped-for economic boom.

Revealingly, Supply-Siders strenuously resisted calls to tie tax cuts to actual productive investments, that is, give the tax cut only after the investment had been made. This led critics to suspect the real motives behind the theory. The only thing that was certain was that the rich would become richer and revenues to the government would be lower. Beyond that, it is all just wishful thinking.

Contrast this wishful thinking with Demand Side economics. Demand Side Economics, says that if taxes are to be cut, they should go to those who earn the least amount of money. The reason is that low-income workers spend virtually all of their incomes. Money given to them goes right back into circulation, fueling a boom in consumer spending. This is essentially the policy that rescued the U.S. economy from the Great Depression. This, say the Demand Side economists, is the real foundation for an expanding economy. How has this theory held up in practice?

Bill Clinton reversed Reagan's Supply Side policies, raising taxes on the wealthy and lowering them on the working and middle class. This Demand Side formula was fiercely resisted by Republican leaders in Congress who predicted a stock market crash and another Great Depression. Indeed, every single Republican member of Congress voted against it. It took a tie-breaking vote by Al Gore in the Senate to get the bill passed. What happened?

The economy produced the longest sustained expansion in U.S. history. It created more than 22 million new jobs, the highest level of job creation ever recorded. Unemployment fell to its lowest level in over 30 years. Inflation fell to 2.5% per year compared to the 4.7% average over the prior 12 years. And overall economic growth averaged 4.0% per year compared to 2.8% average growth over the 12 years of the Reagan/Bush administrations.

It wasn't even close. The economy performed dramatically better in almost every way once Supply Side policies were replaced with Demand Side policies.

The most dramatic outcome was the reversal of the Reagan-era Supply Side deficits. Clinton's Demand Side policies not only paid down the Reagan/Bush deficits, they produced the first budgetary surpluses since 1969. By the time Clinton left office, the government was running surpluses of almost $140 billion per year. This is what he turned over to George W. Bush in January of 2001.

Bush, of course, returned to the Supply Side policies of Reagan and his father. He lowered taxes on the very rich, his base, as he calls them. His $1.6 trillion in tax cuts give 45% of the benefits to the top 1% of the population. It is classic Supply Side economics. What happened?

According to the Economic Policy Institute, "By virtually every measure, the economy has performed worse in this business cycle than was typical of past ones." GDP growth since the bottom of the 2001 recession has averaged 2.8%. But it grew at an average rate of 3.5% over the prior six recoveries dating back to World War II. Or consider jobs: 1.3% more jobs under Bush versus 8.8% more during earlier upswings.

Private sector jobs, an especially telling measure of economic health, are up only 1% since 2001 versus an average of 8.6% for past recoveries. Investment? That Holy Grail of Supply Side orthodoxy? Up 3.6% compared to the 8.2% average for the six earlier rebounds. Pick your measure: growth, jobs, income, spending, investment. The recovery based on the Bush II Supply Side tax cuts is one of the weakest ever recorded.

The one thing the Supply Side revival did excel at, not surprisingly, is debt. Bush turned a $136 billion surplus from Bill Clinton into a $158 billion deficit in his first year. When he took office, the national debt stood at $5.8 trillion. It now stands at $8.1 trillion and is projected to hit $10 trillion by 2008 when Bush's second term is over. The ten-year cumulative deficit forecast by the non-partisan Congressional Budget Office has changed from a $5.6 trillion surplus in January 2001 to a $3.4 trillion deficit in March of this year an almost inconceivable swing of $9 trillion to the worse in only six years.

After more than 17 years of experience with Supply Side economics, we now know beyond doubt that this is not an accident.

These mammoth debts are a huge boon to that rich base that Bush loves to coddle. It is they, the very rich, who loan the money to the government to fund its debts. And since more borrowing drives up interest rates, they get to do so at higher and higher rates of return. This is simple supply and demand. By increasing the demand for borrowed money in the economy as a whole, Supply Side deficits drive up the cost, not just of government borrowing, but of ALL borrowing everything from credit cards and mortgages to car loans and municipal bonds.

In other words, Supply Side economics rewards the rich both coming and going. Higher government debt leads to higher interest rates for all borrowing or in their case, lending. And then, they get to pay lower and lower taxes on their higher and higher earnings. It is a magical two-fer worth hundreds of billions of dollars a year.

This is the real reason Bill Clinton was so relentlessly hounded while in office. It wasn't that he was being serviced by an intern or that he was a particularly radical president. Indeed, Clinton himself described himself as an Eisenhower Republican. His big faux pas was that by paying down the Republican debts, he lowered interest rates, the basis of Republican earnings. In fact, real interest rates declined 40% while Clinton was in office. You can see why he simply had to go.

This is the real magic of Supply Side economics: greater-debts-leading-to-higher-returns-but-lower-taxes for the rich. It is one of the reasons the top 20% of income earners has raised its share of national income from 44% in 1980 when Supply Side policies began, to 50.1% last year. They now earn more than all of the rest of the people in the economy combined.

But it only works for the rich. If you're not rich, it is you who are paying those higher and higher interest rates and it will be you or perhaps, more precisely, your children who will be stuck with the bill for the higher government debts. Paying off those debts can only come at the expense of future economic growth for income spent paying off inflated debts is money that is not available for college tuitions, job retraining, repairing infrastructure, etc.

Rarely in matters of public policy do we have the luxury of such starkly clear, repeatedly proven, empirically founded contrasts. Demand Side economics, as we saw in the 1990s, while far from perfect, produces robust growth, budgetary surpluses, and broad based prosperity. Supply Side economics produces middling growth, soaring deficits, and broad based debt. Mountains of debt. And the mountains are growing.

If we are to salvage any kind of economic sanity and prevent the bankruptcy of the nation, the next Congress must reverse the Supply Side agenda and return the country to a responsible fiscal course.

How Awesome the Bush Tax Cuts Were Supposed to Be (but Weren't)

Hilarious predictions by the false prophets at Heritage Foundation, back when they were assuring the country that tax cuts would produce high revenues, contrary to what is actually known about the relationship between revenues and taxation.



As Congress attempts to negotiate a way to cut the budget deficit and avoid a fiscal cliff, it's worth remembering that one sticking point of the negotiations was supposed to eliminate the deficit problem entirely: the Bush tax cuts. On April 27, 2001, the conservative Heritage Foundation published the above chart, forecasting the effects of then-President George W. Bush's then-proposed tax cuts — a chart that is, in retrospect, pretty hilarious. Pass the Bush tax cuts, the conservative non-profit predicted, and the future would be awesome. The tax cuts would so stimulate the economy that the government would start bringing in extra money starting in 2008. Alas, in real life, the Bush tax cuts led to huge budget deficits, and 2008 was, as you may also remember, the year of the financial crisis. Republicans continue to say they are open to raising revenue, but they want to do it without raising tax rates. "I’m willing to generate revenue," Sen. Lindsey Graham said Sunday. "It’s fair to ask my party to put revenue on the table. We’re below historic averages... I will not raise tax rates to do it." Whatever the reason for holding onto this technicality — that limiting deductions and closing loopholes is not the same thing as raising taxes — it is not based on recent evidence of what effect the Bush tax rates have on the economy.

Here's another Heritage chart from the same 2001 analysis, showing the totally crazy revenue the Bush tax cuts would bring in for the government:



They were supposed to create jobs, too:



Via the Associated Press, here's what actually happened:



Heritage predicted a lower unemployment rate if the Bush tax cuts passed: "Moreover, the unemployment rate would average just 4.7 percent instead of 4.9 percent from FY 2002 to FY 2011." Alas, despite the extension of the Bush tax cuts in 2010, the unemployment rate has remained a bit higher than predicted:

I still don't know where the "supply-side" comes from. I have this ancient econ 101 text, no idea where I got it as I'm positive wasn't for a class, but there it was gathering dust. It was printed in the 80's so holds some value as to what thinking was like on this topic before the internet. Though the normal text is very helpful, the little "focus" blue box that dumbs down "current" issues explains Reaganomics in the same confusing terms I see everywhere else. The biggest problem with Reaganomics as a "test hypothesis" for any "supply side" is the huge deficit spending for the military. This is noted in this text, but not discussed. Thomas Sargent (Krugman's brain multiplied by 150) has a quote I stumbled upon online from the 80's lambasting the disconnect (I'll dig it up sometime).

Where the back of my mind has processed this so far:

In classical, you have a "supply side" in vague terms until Keynes draws the lines of division with his polemic, "Supply creates its own demand." Keynes advocates make it sound like in classical, people just build a bunch of crap nobody may want and expect markets to clear, how lame is that? But to me, it's like, people can demand whisky, butter, yachts, mansions, sex with celebrities and a lot of things. How lame is that -- what, the market is going to magically supply this crap for them because they demand it? The classical view has a concrete guage for demand in the theory of supply. Suppose in a barter economy I get off my ass and build a raft with a plan to sell it. Well, that must mean, I demand a couple chickens and a few smokes, what the raft will trade for. Not really all that irrational, I'd say.

But how does S vs. D side factor into who to tax, the rich or the poor? cuz' that's what it boils down to in the media today.

It doesn't. Or if it does, I can't figure it out for the life of me. The most radical updated view of the classical model is the Efficient Market Hypothesis, which I swallow hook, line, and sinker, and there is zero intution that I can find in EMH on who to tax first. Personally, I'd tax the rich first, just to be nice.

but.....

then there's the Keynesian model. And Milton Friedman, though a libertarian with strong intuition into market efficiency, was techinically working within the Keynesian model. And I can't say for sure for Milton, I really never studied his macro beyond the basic textbook stuff, but with the GOP internet stuff I run across, there is this idea that the economy can be "stimulated" from the supply side. This requires the Keynesian investment multiplier to be invoked, and so when one of Kev's sources says,

Kev's source wrote:Now, to a person who genuinely despises all deficit spending, both SSE and DSE methods may seem horrific. Both claim to use deficits and state-largesse to stimulate the economy, under a notion that economic activity will thereupon surge ahead and resulting revenues will later erase the incurred debt. Only there are some truly major differences.

Yes. That's me. that person. The idea of stimulating the economy is in spirit contrary to market efficiency. And believing tax cuts on the supply-side can take advantage of the Keynesian investment multiplier to make the economy better than it can be is a sacrelige to market efficiency, which is what the spirit of free-market economics is supposed to be about, so the right wing is in apostasy here.

From a classical perspective, I'm sympathetic to tax cut arguments but there is no intuition that suggests business should have their taxes cut before employees or vice versa.