A Primer on Supply-Side vs Demand-Side Economics
Russ Daggatt’s latest missive discusses whether the Stimulus Bill has had good effects. His analysis is well worth perusing… and spreading the link.
My own take on things is more abstract. So let’s step back and examine how Democrats and Republicans have become identified with two quite opposite economic theories. We’ll start with the Republicans, who still clasp fealty to Supply Side Economics (SSE), a theory once labeled “voodoo” by the elder George Bush, but now mainstream conservative catechism for three decades.
A PRIMER ON SUPPLY SIDE VS DEMAND SIDE ECONOMICS
Supply Side holds that you best stimulate economic activity by Increasing the net wealth possessed by society’s top echelons — people and groups who have no urgent material needs. Instead of spending it on direct “demand” purchases, these wealth-owners will invest any marginal wealth-gain (say from tax cuts) on things that increase “supply” — factories, new businesses, innovative goods and services. Thus the name Supply-Side.
Interestingly, the most famous proponent of this approach was Karl Marx, who maintained that the owner-capitalist class propels industrial development by re-investing profits in plants and equipment, thus building up society’s capital stock and the means of production. SSE is, in that respect, an entirely Marxist theory.
Of course, Marx then looked farther ahead. He hypothesized an eventual “completion” of this capital-formation process, a final phase when all the factories are finished – an image we now find ludicrous, since productive capacity must be updated at an accelerating pace. (Hence there will always be a need for capitalists.) Still, it seems kind of sad that SSE supporters won’t ever acknowledge this fundamental root of their theory. They do not study their ideological forebear. Nor do they try, as Marx did, to extrapolate where their prescription may eventually lead.
But let’s examine the key SSE predictions. (All theories should make confident predictions that are clearcut and testable.) For thirty years we have heard Supply Side zealots forecast that reducing taxes on the rich will:
1) result in direct investment of the released wealth into “supply” capacity for producing innovative goods and services.
2) stimulate so much new economic activity that even lower tax rates will rake in enough new revenue to erase any deficit caused by reducing taxes on the rich.
3) eliminate government debt, resolving any apparent conflict between reducing revenue and fiscal responsibility.
EFFECTS UPON POLICY
This lengthy definition is needed understand why a credibility deficit now burdens the Republican Coalition. All through the 1980s, 1990s and 2000s, the mantra was:
- If the federal budget is in deficit, cut taxes on the rich, in order to repair that deficit.
- If the federal budget is in surplus, cut taxes on the rich, because it’s their money, not the government’s, and there will henceforth be no rainy days.
- In times of peace, cut taxes on the rich,because government has lower priority in peacetime.
- In times of war, cut taxes on the rich, because… well, this one never made sense even by conservative logic. Indeed, this was the first time in US history that the clade of uber-wealth demanded ever-increasing state largesse even while the nation was under deadly threat.
- In any event, we must admit that the core demand of SSE believers has been utterly consistent. Reducing taxes on the uber-wealthy is good for America, across all circumstances, under all conditions and without limit.
TESTING SUPPLY SIDE THEORY
For three decades, SSE proponents told skeptics “just watch and see what will happen!” (Whenever top tax rates were cut.) Okay, we’ve watched. And absolutely every large-scale forecast made by promoters of Supply Side Economics failed – diametrically – without major exception.
The uber-rich did not take their tax-break largesse and invest it in innovative/productive equipment. They poured it into either passive investments — what Adam Smith derided as “rent-seeking” — or else risky financial instruments and asset bubbles. Above all, the direct forecast that reduced revenues would erase federal deficits went directly opposite to observed fact.
TESTING THE OPPOSING THEORY
The one period over which deficits decisively vanished came right after Bill Clinton got moderate increases in taxation on the rich, in 1993, followed by stringent pay-as-you-go budgetary management. What we saw then was a combination of budget balancing, strong economic activity and revenue-based debt reduction.
So now let’s examine the competitive theory – Demand Side Economics (DSE)… also called modified-Keynsianism.
Named for long-ago FDR advisor John Maynard Keynes, this theory holds that economic activity is driven by demand for goods and services. Moreover, money in the hands of the middle and lower classes has greater inherent VELOCITY — meaning that a given dollar will be spent and then re-spent more often, if the middle class is passing it around with sequential purchases, than if it is stockpiled in a rich person’s portfolio.
(Mind you, by this theory, tax cuts for the rich might actually make sense when rapid inflation in an overheated economy calls for decreased monetary velocity! I never said that such cuts are NEVER called for. Indeed, JFK’s tax cuts did achieve all of its intended goals.)
Under Keynsian or Demand-Side theory, the government should spend heavily, even deep into debt, when the nation is in recession, in order to get high-velocity economic activity going again. Hence the recent surge in stimulus activity, in the first year of the Obama administration (see Daggatt’s article)… in sharp contrast to the equal-scale “stimulus” measures taken in the last year of George W. Bush’s term, most of which went to shoring up the positions of those at the top of the social-economic order.
Now, to a person who genuinely despises all deficit spending, both SSE and DSE methods may seem horrific. Both claim to use deficits and state-largesse to stimulate the economy, under a notion that economic activity will thereupon surge ahead and resulting revenues will later erase the incurred debt. Only there are some truly major differences.
1) Demand-Side (Keynsian) deficit spending goes to where each dollar will have high velocity impact, as their theory predicts. In contrast, Supply Side largesse for the rich definitely did NOT go into predicted capital formation. (Marx was wrong.) It simply made the rich richer.
2) Completely aside from macro-economic effects, the beneficiaries of Demand Side largesse – the poor and middle class – may have some actual direct need. Fulfilling that need (if done well) may result in creation of either more-skilled workers or more small businesses. In contrast, it is hard to see how Supply Side sends the money to a place (the rich) where a direct need merits government intervention.
3) Supply Side is a monotone. “Give money to the rich under ALL circumstances, at all times and conditions, no matter what.”
In contrast, Keynsians have proved that their policy is adaptable and variable, un-dogmatic and contingent upon circumstance. They spend lavishly in order to get out of recession, because that is what Keynsians do. (Right-wing rants and rails against the current governing party acting consistently with its own economic theory is simply hypocritical. You had your turn, now it is theirs.)
But the 1990s prove that Democrats have credibility for being situationally flexible. When a recession ends, they spend more cautiously, remove the largesse, and start building up savings. In fact, had Bush continued the Clintonian policy of debt buy-down in good times, a considerable reserve fund would have been available to help us ride out the present crisis.
4) The experts – professionals who have actually spent their lives studying this difficult field – generally despise Supply Side Economics. That may seem a good thing from the perspective of those who increasingly call expertise a disqualifying trait. From contempt for the Civil Service and the US Officer Corps to distrust of universities and the climate experts who have achieved miracles in weather forecasting, it’s become clear that one side in our tragic, debilitating “culture war” does not want to hear the professionals on any matter, least of all economics.
5) In fact the situation is not entirely black and white! Keynsianism has had its failures. Economics is a dismal “science” and Demand-Side has many problems dealing with a complex economy. Furthermore, pre-Clintonian Democrats sometimes acted as if the law of gravity did not apply. That potential always lurks on the left (witness Greece, today.) Moreover, Democrats did play some (lesser) role in the unleashing of our recent Asset Bubble.
Nevertheless, Keynsianism has a long, eighty-year record of being right in the most general sense.
Government should outspend its revenues in recession, directing high-velocity stimulus toward the middle class. Then, in good times, it should use adequate revenues to build up reserves. The Pharoahs knew this. It is even in the Biblical story of Joseph. It is common sense.
What does not make sense is to hold fast to an alternative “voodoo” theory – Supply Side Economics – that has always and universally failed in every major prediction, after being tried repeatedly for three decades.
A theory that is quasi-Marxist, in that it openly aims to propel the rise of an all-powerful aristocracy of wealth in exactly the manner that Marx prophesied, taking us toward the sort of class divisions that had old Karl chortling and rubbing his hands, murmuring “Yessss!”
(David Brin is a scientist and best-selling author. His future-oriented novels include Earth and Hugo Award winners Startide Rising and The Uplift War. The Postman inspired a film by Kevin Costner. Brin is also a leading commentator on technological trends. His non-fiction book, The Transparent Society, explores issues of privacy and accountability. This column was originally posted at his blog, Contrary Brin.)
(Tom Toles brilliant illustration of GOP hypocricy ©2004 The Washington Post.)