Review of Supply-Side Economics

Common-Sense: Review of Supply-Side Economics.
First: History

The oil crisis on the 70's created huge profits for oil producing nations.
The huge profits attracted capital to the oil industry.
Many new jobs were created in the oil industry, many new wells were drilled, many new oil fields were discovered. The result was A. dramatic growth in investment, employment and income of the oil industry, followed by B. a dramatic fall in oil prices.
Second: Review

The oil companies generated an above a normal rate of profit.
The profits attracted capital.
The capital created jobs.
The jobs and capital created products, i.e., increase supply.
The increased supply decreased prices.
Third: Heller and Laffer

Review: GDP = C + I + G + (X-M)
GDP = Gross domestic product
C = Personal consumption. Biggie.
I = investment, both autonomous and induced.
G= Government spending, i.e. fiscal policy.
(X-M) = net exports.

Now, remember

Keynesian economics increased GDP by increasing G.
Heller, a Neo-Keynesian under Kennedy argued for TAX CUTS to increase the incomes of people with a large marginal propensity to consume. This means that they spend a large percentage of every dollar that you give them. Kennedy\Johnson decreased taxes to battle a recession by cutting taxes. It targeted increasing C, as opposed to increasing G as with Keynesian economics.
Now, what is the problem? Well, in the 60's and 70's we had "stagflation" and "cost push" inflation. The government following Keynesian economics tried decreasing inflation by raising taxes under Johnson. Well it did not work, inflation "expectations" had set in, i.e., "rational expectations" was born. The stagflation of the 70's demonstrated that an increase in demand (C or G) in a cost push inflationary environment only lead to higher inflation, w/o decreasing unemployment. Keynesian economics did not seem to be working. Notice that Keynesian economics addresses demand only, it does nothing to increase supply. This is why it works best during recessions where there is excess capacity. Otherwise it only leads to inflation; more dollars chasing the same number of goods.
Now the 80's. Laffer looked at the success of the supply-side approach to the oil industry, and decided to take it nationwide. Where Keynes and Neo-Keynesians increase G and C, Supply-Siders increase "I." Same mechanism, just different aggregate targets. Under Supply-Side Economics, tax cuts are given to those with a high marginal propensity to SAVE, as opposed to a high marginal propensity to CONSUME. Yes, the rich man does get a break, as did the oil companies. But, it requires a plant to be built before a worker can be hired. There is no chicken or the egg theory here. The plant must FIRST be built.
Now, the benefit of supply side.

Demand is increased for investment goods, i.e., capital. This has a lower inflationary effect than increasing C, which is consumption goods.
You expand the production possibility curve, i.e., productive capacity of the nation. Keynes and neo-Keynesian's only expanded production to capacity, they did not expand capacity. Biggie.
Supply is increased lowering prices, and employing more workers to produce the increased supply.
As more firms enter the market the demand for labor rises, increasing wages.
Now, as you can see, saying that Supply-Side Economics does not work is like saying Keynesian or Neo-Keynesian will not work. They all work by increasing one of the aggregate components of GDP.

Keynes increases (Government demand-side) G
Neo-Keynesian increases (consumer demand-side) C
A weak dollar or a successful tariff increases (X-M)
Supply-Side increases I

They are all versions of the same mechanism.
Both Neo-Keynesian and Supply-Siders use a carrot, i.e., spending incentives.
Keynesians use a stick, i.e., direct fiscal spending.

Now a brief IS/LM approach. We will combine monetary policy, i.e., shifting LM, with Keynesian, Neo-Keynesian, and Supply-Side, i.e., shifting IS.

r=interest rates
y=GDP
.*....................xLM
!......*............x.........
!...........*..x ............
r !.........x......* ............
!.....x..............*.........
!x.......................*.....
--------------------------- *IS
y
IS shifts right with an increase in C, I, G, (X-M) LM shifts right with an increase in the money supply (controlled by the Federal Reserve).

Now, all three shift the IS curve right by increasing C, I, or G.
A right shift in the IS curve above leads to HIGHER interest rates, r, and a higher GDP, y. Now, in order to maintain a stabile, r, the Federal Reserve increases the money supply, i.e., "accommodates" the fiscal policy. This leads to an even higher y, with stabile r. This did not happen however in the 80's. Volker did not accommodate the Supply-Siders, and maintained relatively high interest rates. The money that would have gone to investment and expanding the productive capacity of the nation, instead went to buy T-bills, pay for entitlements, ending the cold war, and an S&L bailout.

So basically one can say that Supply-Side Economics has not yet been adequately tried. You can point to the oil industry for a micro example/case-study of its possible success. Suppy-Side Economics is not much different that Keynesian\Neo-Keynesian Economics, relying on identical mechanisms targeting different aggregate targets, i.e., C&G vs.. I. No one would argue that a weak dollar did not increase exports and increase GDP. No one would argue that Keynesian economics worked great pulling us out of the depression. No one would argue Neo-Keynesian tax cuts increased GDP by raising consumption. Why then, do we have such passions attached to Supply-Side Economics? The only reason I can see is that it first rewards the savers, I.e., the "rich man." This is a political argument, not an economic argument. If I was asked, I would say give a man a fish, feed him for a day, teach a man to fish, feed him for a life. Keynesian and Neo-Keynesian's give the man a fish. They provide temporary spending fixes, without expanding capacity.

Supply-Side Economics, takes longer, but once those factories are built, they provide jobs way down the road. When is the last time you heard about a layoff in the oil industry? Software? Computers? Net job creation in telecommunications, i.e., MCI, LCI, Sprint hired far more than the AT&T layoff. Note, all these industries are micro examples of Supply-Side Economics implemented by the private sector. Other examples are our auto industry, Internet companies, memory chips mgf(Micron), disk storage mgf(Iomega), Iced Tea(Snapple), Coffee(Starbucks), etc., etc.. All these industries turned a profit, attracted capital, created jobs, increased supply, and decreased price. Supply-Side Economics at work. The government does not have to even encourage it through tax incentives, the market often does it on its own.

Below is part of an Internet News group debate on Supply-Side Economics:

>Once again (and for the hundredth time), there is a vast ideological gulf
>between conservative and supply-side economists. Apparently some conservatives
>are confused on this score. But there should be no mystery about what a
>supply-side economist is. I've printed the following description of
>supply-side beliefs many times before:

>1. A belief in Say's Law ("Supply creates its own demand"). Consequently, gluts on
>the market are impossible, and the economy cannot be controlled from the
>demand side (i.e., monetary policy).

Steve, where do you get this stuff. Say's law is one of the oldest/earliest economic laws. This is one law that I think we can easily say has been discredited. In fact you won't even find it mentioned after the depression. I am curious to know where you read that Say's law is a basis of supply side economics. No wonder you hate supply side economics so much, you obviously do not understand it.

>2. Tax cuts increase tax collections. (At least at the point where the U.S.
>is supposed to be on the Laffer Curve.)

OK, what is hard to believe about this? Walmart sells its products for less than Saks 5th ave, and yet has a greater profit. Stores sell more products by putting them on sale, what is the problem? 50% of 100 is less that 10% of 1000. Look at the Reagan years, tax cuts DID bring in more tax revenues. Only problem, spending cuts did not correspond with the increase in revenues. That is a fact, I know you have the numbers. If not, look it up in the economic report of the President 1996.

>3. Tax cuts increase investment and therefore GDP.

Yes, also it can increase consumption. No one will argue this.

>4. And the caveman supply-side belief: we should return to the Gold Standard,
>and peg the dollar in international trade.

This is not a supply side belief. Some people may support it, but it is not a foundation of supply side economics. I agree, the gold std is a dumb idea.

>I can already tell you that not a single Nobel-prize winner alive believes in
>this rot. But apparently no one has told the supply-siders.

Steve, did you not read my last posting? Every Nobel prize winner believes in Supply side economics, they just do not believe it is the best approach. In physics light can be described as either a wave or a particle, no one knows which one it is for sure. Physicists do not disbelieve it is one or the other, they just debate the merits of each theory. Both are valid, some just feel one theory is more valid than the other. I will re-post the explanation of supply side economics again, be sure to read it this time, it might help you understand where you are wrong. Your posting makes you sound like that annoying spouse at a cocktail party. They have read a Time magazine article, and suddenly are an expert on the subject. They would argue physics with Einstein, thinking they are correct, and Einstein wrong. Your arguments are a mish mash of misunderstandings and misrepresentations. Oh, notice in the explanation below there is no mention of the gold std, or Say's law.

>We're still waiting.

Well Steve, there you go again. Supply side economics works by encouraging an increase in investment. In economics terms, this is a right shift in the IS curve. A similar action occurs under Keynesian economics, but the increased demand, right shift, comes from the government. Under both theories a right shift in the IS curve occurs. Now, under both theories, it is usually best to have a coordinated right shift in the LM curve, increased money supply, in order to expand the economy with stabile interest rates. This did not happen under Reagan however. Volker was fighting inflation by keeping money tight. This essentially created a right shift in IS, with a left shift in LM. If you draw it out yourself, you will see that what you get is no/slow growth, and higher interest rates. Under Roosevelt, you had a unique situation of a depression. It is difficult to determine the real cause of the depression, but under depression conditions, the attempted monetary policies did not work. No one would borrow money or lend money because of the expected negative return on your money. Would you have put your money in a bank back then? Money was printed, and then put under mattresses. Monetary policy would not work, but anything else would have gone against conventional wisdom. Then in walks Keynes. He describes the economy as having the classical L-shaped supply curve, and labor and its "sticky wages" prevented the markets from reaching a "market clearing" price.

!..X......................!Supply
P !....X....................!
!.......X.................!
!_____X_______!
!______XDemand_
GDP
Note, X, demand, crosses before Supply turns up. Intersection is below full employment. Demand can increase up to bend in the curve before inflation becomes a problem.

Under these conditions of extreme excess capacity, and no possibility of market demand picking up, he correctly prescribed government intervention. There was little possibility of inflation.
If GDP = C + I + G + (X-M), Keynes pointed out to get to full employment, the Government should increase demand G, to reach full employment GDP. This would shift the demand curve right. Now, if you look at the formula, the Smoot-Hawley Tariff made (X-M) essentially = 0, I, investment dropped like a rock, and C, consumption was also way down. Now Steve, do you see how Keynesian economics acts by increasing G. Now why is it any different to increase I? You end up with the same result, an increase in GDP. That is supply side economics. Only difference is that Keynesian economics uses a stick, direct spending (demand) with fiscal policy, where supply side uses a carrot, investment incentives, to increase GDP, which later increases supply resulting in lower prices. Supply side provides a double whammy, increased GDP and increased supply, where Keynesian economics provides only and increase in GDP and a government deficit. Reagan also had a more mature economy. If you look at your own numbers, the 1929 GDP is almost exactly = 1939 GDP. Reagan actually grew the economy, Roosevelt just got us back to 1929. A baby can double its size every month, an adult can not. Roosevelt also had a huge amount of excess capacity. He literally had people in the streets looking for work.

>2. Previously, you claimed that there were "many" Nobel Prize winners who believed in
>supply-side economics. Can you name them?

Believe? They all believe in the fact that an increase in supply will decrease price, Ceteris Parabus. They all believe that an increase in investment will increase GDP. Now, they may not all believe it is the best method, but none disagree with its basis. You will always have monetarists, Keynesians, Neo-Keynesians, Classicalists, Neo-Classicalists argue its merits vs. their own preferred method, but none do not believe in it. They may not feel it is the best method, but none would say it is without merit. You would also have a tough time demonstrating that it was ever attempted in its intended form. Had Keynes attempted to make his name during the cost push inflation of the 70's, he to would have been discredited by those who do not understand the basis of the theory. Fact is, different economic policies work well under different economic conditions. Go read up on how the "stagflation" of the 70's supposedly "discredited" Keynes. Is that to say Keynesian economics did not pull us out of the depression? No. Keynesian economics works, just not under ALL circumstances. Same with Supply side economics. Water boils at 100 degrees C under 1 atmosphere. Just because it does not boil at 100 degrees in Denver, does not mean the theory is discredited.

>3. Your arguments are always based on actual productivity, an economic yardstick which
>no economist uses when comparing the economies of Presidents. They use potential productivity
>instead, which shows that growth under Reagan was the same as it was under Ford, Carter
>and Bush: about 2.5 percent. Why do you use statistics for actual growth instead of
>potential growth?

2.5% is assumed to represent capacity/full employment growth. Anything below that would signal idle/inefficient use of the nations resources. If a president has growth below that, as if the president has that much to do about it in the first place, the nation it is likely to be in a recession, or signaling that the nation was not doing as well as it could.

>4. Can you define Okun's Law? Do you believe in it -- and if not, why not?

Very similar to the Phillips curve. At about 6% unemployment, full employment unemployment, i.e. unemployed = frictional and seasonal workers, inflation should be stabile, i.e. P1/P0 = 1. Anything below that is likely to cause inflation. Do I believe in it? Well that depends. Under a situation where we have very low unemployment, a strong dollar, and free trade, the relationship may break down. Any demand over domestic production could be "mopped" up by imports. Lower priced imports would also put downward pressure on domestic goods. Now, if we do not have free trade, or we have a weak dollar, it is more likely to hold true. MV=PQ, V is fixed. Now if an increase in M is above an increase in Q, one would expect P to increase. Now, if Q can increase through imports, it keeps down the increase in P. M= monetary growth, P= price level, V= velocity of money, Q= quantity of goods.

>5. What are your objections to the following chart, which shows that individual income
>for non-supervisory workers -- about four-fifths of the civilian work force --
>has been falling in real terms since 1973?

>Average weekly earnings of non-supervisory workers, total private industry, 1982 dollars

>1965 $290
>1970 297
>1973 315 (Peak)
>1975 292
>1976 297
>1977 299
>1978 301
>1979 291
>1980 274
>1981 271
>1982 267
>1983 272
>1984 274
>1985 271
>1986 271
>1987 269
>1988 266
>1989 263
>1990 259
>1991 255
>1992 255 (Nadir)

>(Bureau of Labor Statistics)

1. A tremendous influx of workers into the work force starting in the early 70's, i.e. women entered the work force. This is an increase in supply of labor. An increase in anything is likely to drive down the price of it.
2. Rebuilt Japan and Germany entered into the world market. The US was facing competition for the first time since WWII, decreasing the ability of firms to raise prices.
3. A market shift away from the heavy industrial industries, structural unemployment. Workers were not all retrained for the new industries.
4. OPEC oil embargo and cost push inflation.
5. In a free market open economy, rewards will go to the owners of the abundant factor, yes ABUNDANT. The US is capital abundant. Labor is being substituted for with capital, and foreign labor in labor ABUNDANT countries. Labor will continue to have falling wages, as long as they stay in the fields where they face foreign competition in labor intensive industries. Labor should buy their capital as in employee ownership plans if they want to succeed in raising wages in the future. Capital will continue to out perform labor in the US.

>6. According to supply side theory, the 80s tax cuts "worked" because they rerouted
>tax dollars to savings and investment. Yet savings and investment of all types fell
>in the 80s:

Yep. Proof that supply side economics was never tried. Consumption, notably government consumption, continued to outpace earnings. The only one who saved in the 80's were the Japanese. Now, under true supply side economics, a tax cut would have been accompanied by investment incentives, not increased government spending/borrowing. Reagan had little to do with the entitlements and S&L bailout, so most of the cause for the economic conditions that were unfavorable to supply siders was not Reagan's fault.

> Disposable personal savings:

> 1980 7.9%
> 1989 4.0

> National Savings, public plus private:

> 1970 - 1979 7.7%
> 1988 - 1990 3.0

> Private investment:

> 1970 - 1979 18.6%
> 1980 - 1992 17.4

> Public investment:

> 1950s and 60s 3%
> 1980s 1% and dropping

>What, therefore, was responsible for increased productivity in the 80s?

We still invested. Don't make it sound like we just let our factories and plants disappear. In addition, we may not have saved that much, but those dollars we sent to Japan for their cars, came back into our capital markets. Increased training also helped. What you should be saying is how wonderful our economy is that it can still grow in that poor of a saving environment. BTW, don't you think the government providing social security puts a damper on people saving. Why save when your pension is already taken care of?

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