Supply-Side Economics, Theory & Policy

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.

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.

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.

Supply-Side Economics vs Keynesian Economics

Keynesian economics is focused exclusively on demand management in an attempt to stabilize short-term fluctuations in the total output of the economy - it was initially developed as a response to the great depression of the 1930s.

In many ways it is quite mistaken to compare and contrast it with supply side economics, because the two approaches are not often recommended as alternatives i.e. the circumstances in which it may be necessary to stimulate aggregate demand are usually totally independent of the circumstances in which a supply side policy is appropriate. Monetarism is a more suitable alternative to Keynesian ideas, but I won't be discussing that here.

On the other hand, policies aimed at boosting aggregate supply often also have an impact on aggregate demand, e.g. a tax cut aimed at encouraging people to work more (i.e. increase labor supply) will also stimulate extra spending on goods and services since after-tax wages will be higher (thereby boosting aggregate demand).

You may discover that the divide between these two schools of thought is somewhat politicized in nature. This is because it was the conservative governments of Reagan and Thatcher that were first to adopt a supply side approach to the economy, and some of the particular economic policies chosen were  certainly contentious.

There was some misguided beliefs that tax revenue would actually rise with a lower tax rate - the famous Laffer Curve prediction. This was proposed by Arthur Laffer, a supply side economist held in high regard by the Reagan administration. The tax cut policies that resulted were heavily criticized as favoring the rich. Certainly, the gap between rich and poor widened during this period.

The left wing of the political divide has traditionally favored government ownership of the means of production, and because of that they were deeply opposed to one of the primary supply side policies i.e. privatization.

The left labelled the sell-off of nationalized industries as akin to selling off the family silver. In reality these industries were all crumbling after decades of under-investment. Selling them off was more akin to getting rid of the family money-pit!

In any case, no government since the privatizations went through has opted to reverse the policy.

Supply-Side Growth

It was the supply side contractions in the economy throughout the 1970s that brought the new approach into focus, and the theory was developed to see what, if anything, could be done to expand economic activity via promoting policies that would increase productivity growth.

You should note an important point here, the primary role of government economic policy is to manage the peaks and troughs of the business cycle, in order to smooth out the growth path. It is not to try and increase the long-term economic growth rate, not directly at least. That is the role of technological advancement as explained in my articles about:

• The Solow Growth Model
• Endogenous Growth Theory

It turns out that governments are not creators of income or wealth, that role is best performed by the private sector, and government policy aimed at permanently improving economic growth is best focused on simply getting out of the way of the private sector.

I am aware the some people will resist this simple truth, and to those people I would simply ask them to look at the modern marvel of the smartphone and ask themselves what that device would be like if it had been designed, manufactured and marketed by the government. The answer, as everyone knows, is that it would look like a brick, it would cost a fortune, there would be a 6-month waiting list to get it, and when it finally arrived it wouldn't work!

Governments have a big role to play in setting tax rate policies for redistributing income in a fair and equitable manner, but that always comes at the cost of reduced efficiency and lost output. Supply side economists understand this tradeoff far better than proponents of Keynesian demand side policies and programs.

Supply Side Economic Policies

By far the best and most effective types of economic growth and stability initiatives are the legislative & tax policy approaches i.e. those that result in less government interference in the market. Broadly speaking these policies can be divided into the following three categories:

• Deregulation - This involves cutting back on the mountain of bureaucracy that interferes with what sorts of businesses are allowed, which are prohibited, when licenses are required, which operating standards must be met, acceptable trading hours and so on. All of it is well-intended, much of it is useful, and lots of it is essential, but there is still a vast amount of counterproductive rules and regulations that serve no one whist hindering business productivity.
• Tax Restructuring - The best practices here are aimed at either increasing the incentives and opportunities to work, or at stabilization of the economy. For example, if businesses were given tax breaks for employing people and subsidized less for buying job-replacing machinery, then wages and employment levels could grow. Similarly, high marginal tax rates (rather than the lower personal income tax rates that the Reagan administration put in place) would help to smooth out booms and recessions.
• Privatization - This involves the selling off of state assets to the private sector. It was very popular with the Thatcher government which sold off many state-owned businesses such as National Rail, British Telecom, British Airways, British Steel, British Gas etc. Not all of these companies thrived after the sell off, but all of them were hopelessly inefficient beforehand, swallowing up large amounts of government revenue to stay afloat. The big question is whether or not privatization will ever come to the really big public sector operations i.e. state education and health.
• Competition & Trade - Not to be confused with deregulation, this one actually requires some government involvement in the economy rather than a withdrawal from it. The role of government here is to nurture competitive markets by preventing monopolies from forming, and either breaking up or regulating those that remain. Additionally, the government can promote international competition by negotiating free-trade deals with other countries.

Fiscal Policy Initiatives

The second set of actions relate less to legislative acts and more to government run projects to achieve specific aims. They may be issue-specific or geographically-specific, but all of them suffer from the inevitable incompetence that comes with the inefficient hand of government. In other words, they tend to cost exorbitant amounts of money for the little good that they do, examples of these fiscal projects include:

• Infrastructure - No one denies that an economy needs a modern road and rail infrastructure, or that bridges and airports are needed, but when the government is the body responsible for commissioning these projects you can guarantee two things - they will come in way over budget and they will take years longer to complete than originally planned!
• Occupational Health - Ask anyone who has ever worked in the UK construction industry what they think about government projects to enforce health and safety regulations and you will see a flash of anger cross his/her face! Abiding by the rules is often overly cumbersome and bureaucratic.
• Job Retraining - Projects that aim to improve the job prospects of workers who are either redundant or in immediate danger of being made redundant can help people to transition from one industry into another that faces skills shortages. In practice this is extremely difficult and expensive to coordinate because effective retraining can take years.
• Economic Regeneration - This entails geographically focused projects that aim to bring new investment and jobs to areas that have suffered decline in traditional industries like manufacturing. I have worked in this industry myself, and I can assure you that whilst some good work is done here, it comes under a general regime of incompetence, inefficiency, and even corruption.

Does it work?

There have been many highly successful initiatives, and plenty of spectacular failures too, and I would urge the reader to assess any given proposal under its own merits.

My own assessment is that the fiscal spending policies perform poorly, but the legislative policies described above are indeed extremely effective and desirable. However, they do need to be complemented with policies to nurture a fair and equitable distribution of income, because some policies of the past have done exactly the opposite e.g. those focused on marginal tax rate cuts.

As the quote above makes clear, it is important to note that this is not a standalone all-encompassing theory. The 'incompleteness' to which the quote refers is made with regard to the lack of a monetary policy. The Federal Reserve, and other central banks, needs to better manage monetary policy in order to maintain short-run stability and avoid the boom-bust cycle.

Personally I am unpersuaded by the Monetarist approach to short-term economic stability, and I am particularly unimpressed by the Keynesians on this topic. If you are interested you can read about my concerns on my page about The Money Multiplier, as well as my preferred solution.

Criticisms of the Macroeconomics

One of the most common criticisms of supply side economics is that the results of the 1980s proved that it led to a sharp increase in income inequality. I think that there is some legitimacy to this complaint, particularly with respect to the income top rate income tax cuts for the rich that were implemented, but there were a lot of other factors at play that caused the growth in inequality. For more details have a look at my article about the Gini-Coefficient & Inequality.

I would also remind you that different supply side policies have different effects, and one policy in particular would have the effect of reducing inequality in a big way. A negative income tax (or a universal basic income) would certainly have positive supply side effects in terms of removing the welfare-trap and encouraging the poorest people in society to enter employment in a way that actually makes them significantly better-off financially.

Data Sources:

• Reflections on Supply-Side Economics, Morgan O. Reynolds (pp. 855 & 877)

Related Pages:

• Aggregate Supply
• The Economics of Decline
• The Bullwhip Effect on Supply-Chain Output
• Fiscally Responsible Government

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