Supply Side Economics Revisited
By Steve Bain
Mainstream opinion of supply side economics is mired in unnecessary controversy, with many opponents of the theory spurred to illogical disgust as soon as it is mentioned. A good deal of the blame for that comes down to a general misunderstanding of what exactly is meant by it.
"Supply-side economics is like the proverbial elephant described
by various blind witnesses as a tree, a rope, and sundry objects.
Supply-side economics means different things to different people..."
(Morgan O. Reynolds)
On this site my definition of supply side economics would simply be that it regards a set of ideas and policies that concentrate either on increasing the long-run productive capacity of the economy or improving the distribution of income within the economy. You should take note that the second part of that definition is not often included in other people's ideas of what the theory is all about, and many critics incorrectly believe that it is somehow synonymous with the nonsensical 'trickle down economics' - it really isn't.
Friedrich Hayek is one of the foremost champions of Austrian economics, a school that favors free-markets over government intervention in almost all cases.
He authored many books that have gone on to be considered classics, his most famous of which is 'The Road to Serfdom', a book that warns of the dangers of ever expanding government, something that is becoming more and more relevant in modern times.
Margaret Thatcher was a big fan of Hayek's, and in one heated discussion is said to have slammed one of his books 'Constitution of Liberty' on a table and exclaimed "This is what we believe".
Hayek was a highly respected defender of classical liberalism, and a 1974 winner of the noble prize for economics.
A little background reading
The supply side approach to economic theory rose to prominence in the US and the UK at roughly the same time with the inauguration of Ronald Reagan to the US presidency in 1981, and the incoming 1979 conservative government led by Margaret Thatcher in the UK.
Both the United States and the United Kingdom at that time had experienced a decade of high inflation and soaring unemployment that had broken the mainstream macroeconomic models of the day. The term 'stagflation' had come to be coined, and a new approach to economic management was urgently needed.
The problem arose due to the breakdown of the Phillips curve prediction that inflation would only increase by a limited amount if unemployment is reduced. This tradeoff relationship has been shown to exist in the short-run of a few years or so, but ultimately it fails in the long-run when inflation inevitably starts to accelerate ever higher and higher if government policy to maintain unemployment below a sustainable level is not relaxed.
Successive governments of the 1960s and 1970s had always prioritized the reduction of unemployment to the lowest possible rate, and well below the 'Non-Accelerating Inflation Rate of Unemployment' without understanding that they were pushing too hard, and that they were fueling inflation beyond anything that the economic models of the day could predict.
The Great Inflation
The period known as the 'Great Inflation' occurred from the late 1960s through to the early 1980s, a period that saw the worst peacetime economic instability since the great depression of the 1930s.
The 1970s OPEC Oil Crisis
The already bleak economic outlook for most western economies in 1973 took a serious turn for the worse in October of that year when the Yom Kippur War broke out between Israel and a coalition of Arab countries led by Egypt. The middle-east based Organization of Petroleum Exporting Countries (OPEC) was outraged by western support for Israel in the war against their brothers in arms and, in retaliation, they put in place an oil embargo that lasted from October 1973 to March 1974.
The resulting shortages that arose in the west sparked huge oil price increases, which in turn fed through to significant increases in the costs of production for many western industries. The effects sent severe ripples throughout the world economy.
Not only did economies contract and shed workers, they did so with growing levels of inflation - something that was not supposed to happen according to the macroeconomic models of the day.
The problem was that the Keynesian economic models had always assumed that productive capacity in an economy was very stable and not prone to significant shifts in the short run.
Keynes argued that the factors of production i.e. land, labor, and capital, were fixed in the short run and so the total level of aggregate supply in the economy should also be fixed. Unforeseen by Keynes was the fact that raw material prices, and oil prices in particular, were certainly not fixed - the oil embargo illustrated this point with great clarity.
When the oil price shot up due to the embargo, the costs of production for a huge number of industries also increased significantly, and the aggregate supply curves of economies throughout the West shifted inwards causing economic recession, job losses, and rising inflation all at the same time.
By 1979 the economies of the west had recovered somewhat, but then a second wave of oil price rises initiated by OPEC ensured further recession, more inflation and more unemployment.
The UK in the 70s & 80s
The turbulent years of the 1970s were not met with passive acceptance by the trade unions, not in the UK at any rate. Their members were being made redundant in alarming numbers, and wage-freezes and price-controls were the typical responses from industry leaders and the weak, feeble governments of the day.
Strike action in the UK had started as early as 1972, recurring again in 1974, followed by the 'Winter of Discontent' in 1979. At least one government had succumbed to trade union pressure and collapsed, but by 1979 Margaret Thatcher had won power and with it she started a new chapter in UK economic history, and supply side economics was a crucial element of that new approach.
If the events of the 1970s had been turbulent, the early 1980s were much worse. Inflation and unemployment both rose to the highest levels in decades, peaking at 18.0% and 12.2% respectively. For the first time ever, governments across the developed world started to regard the control of inflation as being the primary responsibility of macroeconomic policy - unemployment reduction would no longer be the primary goal (or at least not directly).
In the UK the incoming Thatcher government took the reduction of inflation very seriously, but to gain full control over economic decision making it would first have to wrestle control of some key decisions away from the over-powered trade unions.
The decisive battle came in the form of the 1984-1985 miners' strike, and the result was total victory for the Thatcher government. This cleared the path for a raft of new policies in the form of monetarism (i.e. control of the money supply) and supply side economic policies aimed at increasing productivity and investment.
The USA in 60s & 70s
The US government had been steadily increasing spending throughout the 1960s and into the 1970s in part because of new and extended social programs aimed at helping the poor, but also because of the mounting costs of the Vietnam War.
Monetary policy throughout the period had been loose, and there was widespread agreement among economists that the money supply had been allowed to grow too much, with the consequence that growing inflationary pressure would soon follow.
The ever increasing government spending levels had already started to increase inflationary pressure as early as the mid-1960s, and whilst the first half of the 1960s had seen inflation rates in the rock bottom 1-2% range, by 1965 a clear upward trend had begun. By 1973 inflation was already running at over 6% and then the oil embargo hit.
In 1974 inflation peaked at over 11% and unemployment had started rising fast, peaking at 8.5% in 1975.
A period of economic recovery followed for a time but when in 1979 the second round of action by OPEC caused oil price rises, the result once again was a sharp growth of inflation and unemployment, this time spiking at even higher rates of 13.5% and 9.7% respectively.