I. Keynesianism and the Development of Modern Macroeconomics
It is impossible to understand the promise of supply-side economics without understanding the environment it came from, which was an environment shaped by John Maynard Keynes and his findings.
The Great Depression was a truly horrible economic event in world history. Millions were thrown out of work, production shrank, and capital formation ground to a halt. The effects of the Great Depression, completely baffling to economists at the time, were so extreme that they swept in Franklin Roosevelt, who had a broad mandate that allowed him to do things that previous presidents could not have dreamed of; for example, FDR was allowed to declare a banking holiday, and managed to pull off most of his New Deal policies without a hitch.
In the midst of this environment, Keynes rose to fame. In 1936, he published the “General Theory of Employment, Interest, and Money,” which became his magnum opus. To simplify, we need not go into specifics of the argument here. It is sufficient to say that, over the next couple years, a new school known as Keynesianism was born, which argued that the Great Depression was caused by a fall in demand. Recessions caused by demand shortages could be dealt with by increasing government expenditures, which would move the economy back into equilibrium. Government intervention is especially important if the economy is slow-to-adjust, as recession could last quite a while. The Keynesians point to the Great Depression as a prime example of this, as GDP in the United States did not return to pre-depression levels until the outset of World War II.
Keynesianism gained ground rapidly, and become the leading economic theory held by Western officials after the war ended. This is best summarized in the statement “We are all Keynesians now” by Richard Nixon during his Presidency.
II. Disfavor of Keynesianism
A number of recessions occurred in the post-war period, and, in deference to Keynesian economics, the Federal Reserve pumped out more money and the government ran deficits to bring the economy back into equilibrium quickly. Growth was strong, especially in the 1960s (though US per capita growth actually grew more slowly than the recovering European states and Soviet Union), and political energy concentrated on new movements, such as the blossoming Civil Rights movement, or the Cold War.
However, the Keynesian consensus had a serious problem. This problem was exactly its strength in the 1930s: it had a heavy emphasis on demand-side shocks, and recommended government and Fed intervention to make recessions bearable. Inflation and real interest rates slowly crawled up as a result of these policies, and, in the United States, government deficits were created in the late 1960s that persist to this day.
Besides those problems, which were fully expected, the oil price shocks created unexpected problems. A recession caused by a productivity shock, such as what happened when oil prices rose dramatically, is different from a recession caused by a fall in demand. In the former, the recession is necessary to bring the economy back to equilibrium; the economy IS adjusting. In the latter, the economy is in recession because it is not adjusting to the new reality of lower demand by lowering prices.
The effects were astounding. Expansionary fiscal and monetary policies created even larger deficits all around the world, pushed interest rates even higher, and inflation ran rampant. The inflation was particularly troubling; periods of falling output and rising inflation, while quite possible under the classical framework, were impossible under the Keynesian framework of demand-side shocks. “Stagflation” became the death sentence of Keynesianism.
III. Supply-Side Economics and the New Hope
Supply-side economics, in my opinion, should belong to the wider political movement that I call “market backlash.” The underpinning of this movement was an intellectual rebellion against large government intervention domestically, and demands to confront the Soviet Union aggressively in the international arena. Both eventually achieved a big victory with the election of Ronald Reagan in the United States and Margaret Thatcher in Great Britain, which essentially made the two leading powers of the Western world committed to this ideology.
Before getting ahead of ourselves, we should examine the economic arguments of this movement.
The basic pillars of the supply-side movement are as follows: a strong emphasis on cutting marginal taxes so as to encourage productivity, an emphasis on monetary over fiscal policy, a policy of inflation targeting (especially trying to target the dollar to the price of gold), and an appreciation for the free market. Taxation will be the focus of this, although it does us well to look at the other pillars.
The emphasis on marginal taxation is a result of incentives. People, of course, will not work if there is no incentive to work. In regards to labor, the important incentive that government creates is taxation, specifically marginal taxation. The marginal tax is the amount of money government takes on each additional dollar of income that a person earns. If this becomes too high, people will stop working, and the economic wealth of the nation will be harmed. This is in contrast to AVERAGE taxation, which actually raises the amount that people work; higher average taxes make people feel poorer, and thus they will work more. The supply-siders differ from other economists of the time by stressing the importance of marginal taxes over the average tax level. Substantial cuts in the top income bracket will, according to the supply-siders, encourage them to work more, making society wealthier as a whole. Some refer to this as “trickle-down economics.”
The second pillar is the strong emphasis on monetary policy. This results in large part due to Milton Friedman’s work and his school of thought known as Monetarism (though monetarism is NOT directly related to supply-side economics). While all economists agree on the expansionary or contractionary effects of monetary policy, Friedman, and many supply-siders put a special emphasis on it. Friedman’s own magnum opus, a Monetary History of the United States, claims that monetary policy has been responsible for basically every boom and bust in American history. Especially important is the Great Depression; Friedman shows that the money supply shrunk rapidly in the early years, which caused (or at least made horribly worse) the entire ordeal. While many have taken this as an opportunity to blame the Federal Reserve for causing the Great Depression (which is incorrect, as the monetary base expanded; it was the money multiplier that fell as banks failed rapidly), it has been influential in the argument between fiscal and monetary policy.
The third policy is inflation-targeting. While monetary policy is influential, most supply-siders believe that monetary policy should be used primarily to keep inflation down. This is extremely important, as inflation distorts cost calculations and therefore reduces economic welfare. It also was an important political issue during the 70s, when double-digit inflation was a reality. As to the specific policy recommendation, supply-siders recommend using gold prices as an indicator; when they go up, it means that the dollar is getting too weak and monetary policy should strengthen it. When gold prices go down, it means the dollar is getting far too strong.
The fourth policy is a strong respect for free markets. Prior to this period, according to supply-siders, the Western economics were being burdened by extreme amounts of regulation. These regulations had strong effects on everyone; environmental regulations, for instance, made it much tougher to start and grow a business, airline regulation kept prices high, and gas price regulation created shortages and long lines for gasoline. No branch of the economic pyramid was untouched. The supply-siders favored extensive deregulation, believing that the government simply couldn’t help the economy and was preventing economically good transactions.
The overall effect of this would be to promise price stability, a smoother business cycle, and greater long-run economic growth.