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Saturday, December 13, 2008

Demand Side Vs. Supply Side Economics

A couple weeks back I put my hat into one of the most sophisticated economic arguments, monetary vs. fiscal policy. An argument that is even more sophisticated is one on supply vs. demand side economics. A demand sider, or often called a Keynesian, believes that getting an economy out of a rut requires stimulating demand. By this I mean that a demand sider would want to do things to stimulate consumer spending. A supply sider believes that the best way to stimulate an economy is to stimulate business investment. Now President Elect Obama is CLEARLY a demand sider. Since the beginning, he has staked out a position in which the middle class get more tax cuts, rebate, and spending so that the middle class spends more. His package includes only breaks for those in the middle. He has nothing for those on the supply side, the wealthy and businesses.

One of my problems with demand siders is I can never tell where politics end and where policy starts. It's easy to be a demand sider since it is also a very populist position. After all, you are giving to the class of people that has the bulk of the population, the middle class.

My main problem with demand siders is there is no solid evidence in history of demand side economics ever working. Supply side economic policy, on the other hand, has a fairly rich history of working. For instance, Ronald Reagan was a supply sider. He cut the top rate from 70% to 28% and within a couple years our economy was humming in what amounted to a near 25 year roll of economy prosperity. Ireland cut their corporate tax rates dramatically and it lead to a massive growth in that country's GDP. President Bush, 2001-2003, cut all taxes across the board and staved the economy from a serious depression and ultimately lead to a period of growth that lasted five years, until recently of course. JFK made similar tax cuts with similar results as well.

Demand siders often point to FDR, but as I analyzed, his economic record is rather complicated. Others point to the Clinton years, though it's still unclear to me what Clinton did to stimulate the economy. Besides these two examples, one is hard pressed to show any historical examples of demand side economics working.

One of the reasons that demand side economics has such popularity is the media's total distortion of the two policies. Because Republicans are most commonly associated with supply side economics, its effectiveness is downplayed. Whereas it is Democrats that are more commonly associated with demand side economics, and thus, the media plays up its effectiveness. For instance, George Bush rarely gets credit in the media for the effectiveness of his tax cuts. Clinton's economic policies are played up. FDR has been so lionized that his economic policies have been played up way beyond their actual effectiveness in my opinion.

As such, we are about to enter a period of serious economic malaise with an economic policy that is totally unproven. Rather than cutting taxes that have worked in the past. Rather than going with a strategy that has a history of effectiveness we are going with one that has scant evidence it works. This incarnation of demand side economics may in fact work but if it does, it will be the first time, from my view.

26 comments:

peterholthoffman said...

It seems incorrect to me that people refer to the policies of Reagan, Bush I, and Bush II as 'supply side'. Although they did cut taxes per the philosophy of 'supply side' they also increased government spending per the philosophy of 'demand side'. It seems to me that they silently created and introduced a new economic policy which I propose be called 'stupid'.

mike volpe said...

Reagan's case is very complicated. He, for the most part, cut government spending. He raised spending on defense. He also raised some spending but that was to appease the Dems in order to get his tax cuts passed. For the most part though, Reagan believed in lower spending and smaller government and he governed that way.

Bush believed in more government spending because of social philosophy and I don't know how much of his increased spending helped the economy.

RASTAMAN said...

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.

Robert Freeman writes on history, economics, and education. He can be reached at robertfreeman10@yahoo.com.

bill greene said...

It is curious how the posts above never mention Congress. The Constitution gives sole authority to Congress to set spending levels, pass tax legislation, and the annual budget and all appropriations are determined by their vote. The President attempts to direct those measures, but Congress has the vote!

What has happened the last few decades is that some of the Presidents have fought and won tax cuts, and the Congress has fought for and won big spending budgets. Both branches won, but the economy lost. You can't have one without the other.

Unfortunately Americans have become so accustomed to Hollywood celebrities and the media's soundbites that they focus attention on the President and hold him accountable for everything that happens in the World. The recent activities of the House Banking Committee for example are ignored and yet they were the primary movers behind the government encouraging, guaranteeing, subsidizing, and paying for bad mortgages given to bad credits. Those disatrous policies were implemented through Fannie Mae and other governmental agncies and had a huge and harmful impact on the economy. They may have been demand side policies, to help homeowners who couldn't afford a house get one, but whatever, they were disastrous, and yet flew beneath the radar of most economists debating their varied theories.

You can debate supply side and demand side but it has never been proven that governmental programs can direct the economy for the better. The economy arises from the energies of the millions of citizens working, saving, and investing. Most governmnetal actions get in the way of that process; many have unintended consequences, and all are based on rather complex unproven theories relying on faulty data.

The only reason supply side economics might be beneficial is that it sometimes removes some of the burden of government from the backs of the participants. It would be better to argue for clearer objectives: encourage saving, reward investment, and limit the burden of taxation, regulation, reporting, and compliance. And never establish programs that reward bad behavior! Those are simple common sense rules and trump most all "economic theories."

Instead of trying to manipulate the people, and engineer abstract goals, the best economics would be to empower and liberate the people--enhance their opportunity to pursue their own prosperity and happiness.

mike volpe said...

With all due respect, Congress directing Fannie/Freddie to set limits on how may poor folks should get mortgages as the start of the crisis is a myth created by conservatives. I am conservative but that's just not how it happened. That had little to do with the crisis. That may have happened but its role in creating the crisis is limited.

As for Congress, I agree though it is the President with the bully pulpit and the one that ultimately sets the agenda.

Sometimes, economies need to be manipulated, like now, and the question is what is the best way to manipulate them.

david said...

This article is decimated by the following much more reliable essay
which shows that everything stated in this blog post are opinions based on ignorance and not on historic fact, which show that demand side economics is much more effective than the supply side.

see article:

http://www.commondreams.org/views06/0514-20.htm

mike volpe said...

Yeah, David, that very same article has already been posted by its author on my site in a previous comment.

Demand vs. Supply side economics is an ongoing debate. That article wasn't a response to mine but rather a defense of Demand side economics. That you didn't realize that its author wrote it in full in my comments section speaks volumes. That you post it as though it is the authority without arguing specifics about the virtues of demand side economics speaks volumes about your own knowledge of the subject, or lack thereof.

marry said...

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Kevin30144 said...

I'm a supply side proponent, but I'm looking for information on Keynes demand side theories as it relates to our National debt. I've only read SS high level theory about government stimulating the economy when needed, but does this take into account using surplus or creating debt, and how much debt is acceptable? In business, debt is acceptable only because of tax deductions. What about cash flow, the current supply siders never address debt and cash flow and assume Government is more efficient than private industry, which based on example, is insane. Thanks, Kevin McQueen

Kevin30144 said...

Does SS Economics take into account where the money comes from that the Government uses to stimulate the economy? Isn't SS theory related to spending surplus? I've never heard or read anything about SS theory using debt and significant debt being ok. It seems to ignore cash flow and paying back the debt with interest to the Chinese for the t-bills.

Jerry said...

Demand drives supply. You don't add room to your hotel when half of the ones you have are empty.

Chris Q said...

that may be true jerry, however, increases in demand caused by fiscal stimulus are only temporary and cannot be held forever. it leads to an untrue level of demand and eventually leads to malinvestment on the part of the producer. however, if you lower taxes, things will become cheaper, i.e. the beds, sheets, vacuums, televisions, microwaves, etc which a hotel needs to purchase, and this leads to the hotel being able to lower its prices which will raise demand and will result in the hotel filling up rooms. supply-side effects are longer lasting

Anonymous said...

Here are the facts: I am a landlord and an eyewitness to what happens when you give tax breaks to the poor. The extra money you give them will be "gone in 60 minutes"!

Why? Where? My tenants are poor by your standards, and don't believe in bank accounts because all of there money is spent before the week is over. LOCALLY! AND THAT'S THE CRITICAL POINT. Locally spent stimulates the local economy and this happens because they don't believe in banks. How they will next spend their next money is all planned out way before they get it. They have wants and needs and are just scarcely able to wait to get their hands on it.

As soon as some extra money arrives, it's off they go to spend it as fast as they can. IF THEY DON'T SPEND IT FAST, OTHERS WILL HEAR ABOUT SO AND SO HAS SOME CASH! It's so hard for the poor to deny cash "loans" (gifts) to other poor, so the sooner it's spent, the better.

Do you get it yet? When it's gone, nobody can weasel it out of them.

BUT, if you give the rich tax breaks, where does the extra money go to? I'll bet you can guess... The extra money gets invested wherever it will likely give the best return on investment. If it's in the US, then great, the economy might grow. Chances are, it will go overseas. So not a darn thing good for America has been accomplished.

Mike said...

you have no idea what you're talking about...

Anonymous said...

I think the best example of demand-side economics is Cuba in the early 1960's and Buenos Aires in 2001. Both countries had very strong businesses, wealthy people, and a strong culture and sense of community. Then, "demand-side" economics pushed aside the capitalists in a "for the people" movement that left the poor only poorer (after a few, very brief years of milking the capitalists and destroying their economic system). Now, both countries are left with no economic activity, poor credit, and a population that has no opportunity to succeed financially. Buy hey, at least they're all still collecting a few pesos a month from those leftists radicals that revolutionized the country by introducing "demand-side" economics.

Anonymous said...

Cuba did not use demand side economics, demand side economics is still based on capitalism, cuba was communist which abolished private property and left little room for expansion, supply vs demand side are just 2 different ways to stimulate the economy, nothing is worse then someone who has no idea what they are talking about

Dean said...

Always been against supply side. I am a 54 year old independent businessman with no formal training in economics. Free capital today is moving into land, metals and commodities. These investments, while protecting investors from devaluation of the dollar and paying high returns, create no new jobs for the economy and push the cost of living ever higher for the middle class. So much for depending on the wealthy to rebuild the economy.

Dean said...

I've always been against supply side since going broke and losing a farm during Reagan years. Just read Robert Reich's "Aftershock" and I'm more convinced than ever it's bad economic policy. The reason we're not creating jobs at this time is people and corporations with excess capital are pouring it into investments they see as a hedge against falling dollar. Check out the price of oil, corn, gold, cotton etc. Not only is this not creating jobs, but it's increasing the cost of living at a time when most Americans can least afford it.

mike volpe said...

It's interesting that you'd say corps are hedging against inflation. What do you think is causing all this inflation? Could it be out of control demand side spending that's weakening the dollar? I think your comment makes the argument against demand side policies.

Anonymous said...

My hat is out of fashion by the time it hits the ring. Reagan went on a spending spree which stimulated business growth. I can assert and substantiate my claims with CBO data. Reagan's man was Milton Friedman (you probably know that) and his man David Stockman. Supply side accompanied by tax cuts while simultaneously spending huge amounts on the military was coined "voodoo economics" by George Bush . Maybe it was Bush who knew little about economics but I venture Reagan knew significantly less of the mechanics of Supply. It all begins with spending . Either way to the top or bottom of the food chain fiscal relaxation allows the flow of money . Given to the top it merely waters a little below the first tier . Given to the bottom it moves through the entire root system and benefits the entire structure. The grief is caused through distribution when only reasonable profits accomodate the rich. The investment multiplier works much better when widely distributed as shown through various levels of revenue and spending as observed in CBO data.

Anonymous said...

My hat is out of fashion by the time it hits the ring. Reagan went on a spending spree which stimulated business growth. I can assert and substantiate my claims with CBO data. Reagan's man was Milton Friedman (you probably know that) and his man David Stockman. Supply side accompanied by tax cuts while simultaneously spending huge amounts on the military was coined "voodoo economics" by George Bush . Maybe it was Bush who knew little about economics but I venture Reagan knew significantly less of the mechanics of Supply. It all begins with spending . Either way to the top or bottom of the food chain fiscal relaxation allows the flow of money . Given to the top it merely waters a little below the first tier . Given to the bottom it moves through the entire root system and benefits the entire structure. The grief is caused through distribution when only reasonable profits accomodate the rich. The investment multiplier works much better when widely distributed as shown through various levels of revenue and spending as observed in CBO data.

Anonymous said...

anonymous never forgets. anonymous never forgives.

Anonymous said...

Your just a moron is all I can say...Keynesian Economics has been successfully used during the Great Depression, World War 2, etc. Each time leading to years of economic prosperity. In 2003, the Wall Street Journal did a piece on a report put out by the Congressional Budget Office basically putting an end to the debate of which theory works better. There report concluded lowering taxes does not increase revenues like the Supply Side folks believe. Try turning off Fox News and do a little research before you speak....

Anonymous said...

Take some time and read the definition of "Supply Side Economics", also known as "Trickle Down" or "Voodoo Economics". We're currently experiencing the "success" of the Trickle Down Theory. It will take years to fix the mess that your Republican friends help create

mike volpe said...

Did you claim that the Great Depression and WW2 were examples of successful Keynesian policies? That's about twelve straight years. How successful could they be iftgey were still in placetwelve years after starting. Isn't success inherent in policies that lead ASAP to the economy growing on its own. Yet, you've chosen a twelve year uninterrupted period as success. If this was successful why was it still in effect twelve years after it started.

Besides I don't believe WW2 wasKeynesian but a command economy designed to win the war.

You didn't name any other examples.

I don't know what this report said and it's not properly cited so there's no reply necessary.

As for trickledown economics, I've analyzed the financial crisis ad nauseum and there's no credible evidence it had anything to do with tax policy.

Nic Thorson said...

pointing out there there was sustained growth of GDP for a WHOLE 5 YEARS (whoopie!) under Bush II is short sighted... because there has been sustained GDP growth for 50 years, with the exception of the later years of Bush's term. Here's a chart to show the whole picture.

http://www.google.com/publicdata/explore?ds=d5bncppjof8f9_&met_y=ny_gdp_mktp_cd&idim=country:USA&dl=en&hl=en&q=gdp+chart#!ctype=l&strail=false&bcs=d&nselm=h&met_y=ny_gdp_mktp_cd&scale_y=lin&ind_y=false&rdim=region&idim=country:USA&ifdim=region&tstart=-311961600000&tend=1265961600000&hl=en&dl=en