Supply-side economics explained

I wrote this post four years ago on kuro5hin. The picture has just gotten worse since then. I sure am glad I’m learning to grow food in the backyard.

George W. Bush’s economic policy is based on trickle-down economics, also known as supply-side stimulus. Reagan was a big fan of this idea also. Simply described, supply siders argue that the best way to stimulate the economy to grow is to cut taxes on the wealthy. When their tax rates fall, the rich will increase their investments. For example, a restaurant owner might decide to build a larger kitchen if she gets a big refund check. Then, she’ll have to hire more workers to staff that kitchen, and so employment goes up, indirectly because of that original tax cut.

It’s an appealing idea. Reagan argued that it even makes sense for the government to cut taxes to below current spending and take on debt because in the long run, the economy would grow back so that eventually the tax cut would pay for itself. This approach is called “supply-side” because the stimulus (the tax cut) are applied to the suppliers of goods and services (the business sector).

The common objection to supply-side economics is that there’s absolutely no guarantee that if you cut taxes on the wealthy, then they will use that money to invest in new business. In fact, since these tax cuts happen in bad economic times, investors might decide that their money is safer if they save it rather than invest it. Going back to the restaurant example, if the restaurant owner decides to just stuff that tax refund into a savings account, or just keep it in her mattress, then no job growth occurs.

Also, if the government did what Reagan (and George W. Bush) recommended and went into deficits to finance one of these tax cuts, and no economic growth occurs, then the government is in a really bad spot. They have to raise taxes back to sustainable levels, and then raise taxes again in order to get the money to pay for the debt, and then raise taxes even higher to pay for the interest on the debt. Or, they can do what Reagan did, and just roll the debt over by issuing more debt. This is sort of like paying off the Master Card bill with the Visa. It works great as long as you can always get another credit card to lend you more money. When the last credit card company decides not to give you a card, then you are in trouble.

George Herbert Walker Bush called supply-side economics “voodoo economics” because all of supply-side theory was based on a hope that the rich would invest those tax cuts and not just stick them in the bank. George W. Bush ignores his father’s opinions about the wisdom of his economic policy, however, and is a big supporter of supply-side economics.

Third-world countries do the Visa-Master Card swap trick all the time. They run up huge debts by spending more than they tax, and keep borrowing money from private investors in their country and abroad. When it becomes obvious that the country is so far in debt that they will never be able to pay it back, investors start selling off their debt, even if they sell them at steeply-discounted amounts. This is really, really bad for the country still trying to pay its bills by borrowing more. When investors start dumping your IOUs on the market, then your country’s currency quickly loses value. This is called hyper-inflation.

In 1997, investors all around the world had lots of money invested in east Asia. Then, people lost confidence in certain countries, and so investors all started selling off like mad. The investors sold debt denominated in Asian currency to buy dollars. This pushed down the value of Asian currencies relative to $US. In short, families in these countries found out that their life savings (which were stored in their home-country currency, like the Thai baht, or the Indonesian rupiah, not in $US) lost all of its value because of inflation. It was as if these people woke up, went to the store, and discovered that all the prices had doubled, and were probably going to double every day after that. That’s when the riots broke out, which scared away more investors, and the downward spiral continued.

The same thing happened recently in Argentina. Investors all started selling off Argentinian debt, so the value of the Argentinian currency plummeted, and people were wiped out. Also, when you have high, high inflation, goods imported from other countries become much more expensive.

What happened in the 1980s is like a big Rorschach test. Some economists see all the signs that supply-side economics worked, and others see the same period as the beginning of severe fiscal irresponsibility (“fiscal” means how the government manages spending). There’s no doubt the economy grew after the Reagan tax cuts, but it never grew enough to pay back the debt Reagan racked up. We’re stilling paying interest today on that debt. We’re also now adding to it because each year that the government spends more than it taxes, it creates a deficit, so that gets added to the debt, and we’ve been in a deficit ever since the George W. Bush tax cuts. Also, in some other recessions, the government has chosen to just wait it out, and most recessions end in about 11 months. Based on previous experience, the recession probably would have taken care of itself eventually, and we wouldn’t have all this debt hanging over us today from twenty years ago that we still haven’t paid off.

In 1991, part of the reason why George H. W. Bush had to break his “read my lips: no new taxes” pledge was because he was forced with the choice of either raising taxes, or putting the country further in debt. He made the politically painful move in order to protect the long-term interests of the country, even though he knew he was just about guaranteeing he would lose the 1992 election.

Clinton saw an opportunity to steal an issue from the Republicans in 1992. Since they were no longer the party of being fiscally responsible, Clinton made that his mantra. He balanced the budget early, by cutting spending and raising taxes. Then of course, the public didn’t like that, so in 1994, the Democrats lost control of Congress. Still, thanks to Clinton, we got out of deficits by the end of 1990s and in 2000 Gore wanted to start paying down the debt, but then George W. Bush won the election, and instead of paying down the $7 trillion that we owe (about $24,000 per US citizen, and growing every day), he pushed through his tax cuts instead.

The US debt is at an all-time high, and the financial world is starting to worry about the long-term stability of the US economy. The International Monetary Fund, in a release a few weeks ago, recently warned that the US debt was increasing to the size where it could threaten the world economy. The Bush administration almost entirely ignored the report and the mainstream US media didn’t make the report into a big story.

Meanwhile, the US dollar has lost about 30% of its value versus the EU Euro in the last 12 months. A weak currency in the short run may help our exports, but in the long run, it pushes up interest rates and frightens foreign investors. Since most of our debt is held by non-US investors, the US government’s ability to borrow depends on maintaining confidence that our currency will maintain value in the long-term.

One economist described debt as more like termites in the walls, rather than a tornado outside. Both will eventually destroy the house, but it is a lot easier to pretend that the termite problem isn’t so bad.

The Brookings Institute, a think tank in Washington, DC, just finished a paper that describes some long-term consequences of ignoring the budget deficits. Alice Rivlin, former vice-Chair of the Federal Reserve Board of Governors co-authored the paper. It is written for the interested outsider, rather than the professional economist. In short, allowing the government to run deficits indefinitely raise interest rates for all of us, risks inflation of US currency, and limits long-term economic growth.

Total employment (the number of people with jobs) has fallen by about 3 million jobs since the economy peaked in March of 2001. George W. Bush promoted the tax cut as a tool to create jobs, and by that standard, it hasn’t worked at all.

  • Ed

    Matt, a good long review of economic policy. A few things you skipped over/ may want to look at.
    1) Why would the people throw out a Congress when they had just done such an excellent job balancing the budget and fixing the economy? Its hard to find an answer to that when working from the limited views of the notions here, but there are some really, really good policy reasons dealing with the poor in this country, whom the Congress (40 years the same party and very incumbent-heavy) had ignored.
    (Interesting side–I'm reading War in a Time of Peace, and David Halberstam, that icon of a writer, just totally glosses over the issues of that election, and ascribes it to some right wing fad! How a writer so gifted could completely ignore the domestic mess of those years just stuns me!)

    What was wrong in 1994 was that our cities had collapsed into mires of crime and decay. Murders in DC had risen to 400-450 a year (they're now half that). Welfare had created a situation where three generations were still making no upward movement to get off. Homeless/mentally ill people lay on the corners of every street–and the park, libraries, etc. Schools went into lockdowns daily, and little to no learning was taking place. Drug gangs rules the streets. In the best of areas, normal people were afraid at night, and often during the day.

    Its hard now to remember just how bad our cites had gotten, but that was the issue in 1994.

    Another skipped item is the budgets of the Reagan years. There is an image of Reagan standing at the podium in Congress with the spending bill they had sent him. It was as tall as he was. He spoke with disgust of it, of all the junk that Congress had added. Unfortunately, he didn't veto the whole thing. When we talk of deficit spending in those days, its wise to remember Congress' part.

    Also, what price did Clinton pay when he and Congress “balanced” the budget? Well, in some ways, none. All of the biggest defense programs of the 80's were ramping down. So, for example, Clinton was handed stealth bombers and fighters, and submarines, and a complete navy, and a GPS satellite fleet, and military communications systems– he got all the benefits of those, with the cost already sunk on Reagan's political tab. (By the way, if you buy a plane that lasts 30 years, is debt a bad way to go? You'd think nothing bad of taking out a car loan for a car you know will serve you into the future. On the other hand, if you take out a loan for groceries—which was Congress sin–not so good!). Everyone in that time called this the “Peace Dividend”. Since the cold war was over, we could save on defense.

    Ahh, but one could go to far on cutting defense costs, and did we? Well, when GWB took over and needed an Army, we had a few problems. One, training was inadequate–not enough had been allotted to supplies. Similarly, maintenance was a terrible problem, as no one had allotted enough funds to keep all the fielded equipment running. And, of course, as you know, we had skipped on things like enough armor for the troops who would be deployed. All that lean spending had a cost in lives.

    There's more going on, of course, but this gives a flavor of some of the many factors left out by the pundits. Good writing, though!!!

  • Hi Ed,

    If I understand you right, you're saying the 1994 election was about more than “the dems raised my taxes, so out they go!”. I agree with that. It can't be overstated though how unpopular those tax hikes were. Sure there was other issues in 1994; the old war on poverty ideas were showing their failure, and it was time for an overhaul of the welfare state.

    Thinking back to the 2000 election, there was a clear difference between Gore's “lockbox” mantra and Bush's arguments about giving the surplus back by cutting taxes. I think that's the mentality I want to highlight.

    Thanks for the comments!

  • Ed

    Yeah, Halberstam reiterates the old idea that Bush Sr. was “doing the right thing” and taking the political hit for the good of the country. Well, it may work that way with the Akron budget, but not necessarily so with the Feds.

    One thing you mentioned above is that money which is not confiscated by the government may well be put into savings. True, but they probably won't stuff it under the mattress. They'll invest it in stocks, bonds, money market accounts, whatever. That money in turn becomes available to companies, or to individuals to borrow and buy and grow the economy.

    The good of more taxes or less taxes depends where we're at on the tax curve. If individuals are at 90%, its probably not an incentive to work. If at 5%, they can probably be safely raised. You've seen the Laffer curve, right?

    Its been a long time since the Bush tax cuts, and the economy along the way was pretty good. This current mess, though, wow! One thing I see is that the NASDAQ has never properly recovered from 2000. If you look at a lifetime chart, you can see how rediculous the pre-2000 run-up was. However, if you follow the 50 year trendline to today, you can see that the stock market has never properly regained all its value. So, where is that money? Propping up ridiculous commodity prices!

    The fed doesn't help of course. Why would someone want to put cash in US accounts when the market interest rates are so low? Might as well put it in a European bank. Which, I guess people do.

    But the tax issue–well, the thing with that is, who can better make us of the money right now. In the 30's, government could somehow spend “better”. They slowly got people back to work. And of course in '42-25, govt was spending half the GDP! Under Reagan, we gave lots and lots of money to electrical engineers, computer scientists, rocket developers, and aerospace designers, and that certainly boosted the high end of the economy, propelling us immensely forward in the technical arena. The processors you and I are communicating with, and the vast network in between, all sprung from the huge govt spending on tech in those days.

    Once launched, then, all that technology is probably better in the hands of entrepreneurs and the public. Which is what Clinton did. (Though a huge portion of his defense budget was still high tech).

    The other question about taxes is, should government ALWAYS grow? For example, in the past 20 years, huge investments have been made in automating all kinds of processes throughout the governments. Shouldn't that tech pay off sooner or later in reduced payroll?

    Speaking of not laying off workers, the unemployment rate still seems to be historically pretty good. Not quite as low as '98-2000, but then the economy was a bit overheated in those last couple years before the market crash.

  • With the gambles taken by the government on automating processes, the huge investments that they have poorly decided on will backfire not only on their faces but back to us as well. They're brewing a bigger problem that may be too big for us to handle because of impulsive acts.

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  • it is so very nice way to stimulate the economy to grow and to cut taxes on the wealthy and it is so good policy to us.,.

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  • virginiachall17

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  • Also, if the government did what Reagan (and George W. Bush) recommended and went into deficits to finance one of these tax cuts, and no economic growth occurs, then the government is in a really bad spot. They have to raise taxes back to sustainable levels, and then raise taxes again in order to get the money to pay for the debt, and then raise taxes even higher to pay for the interest on the debt. Or, they can do what Reagan did, and just roll the debt over by issuing more debt. This is sort of like paying off the Master Card bill with the Visa. It works great as long as you can always get another credit card to lend you more money. When the last credit card company decides not to give you a card, then you are in trouble.

  • aryanmehta

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  • Hey, great post, very well written. You should blog more about this. I’ll definitely be subscribing.

    Financial Expert

  • One thing you mentioned above is that money which is not confiscated by the government may well be put into savings. True, but they probably won't stuff it under the mattress.

  • One thing you mentioned above is that money which is not confiscated by the government may well be put into savings. True, but they probably won't stuff it under the mattress.

  • I agree that many potential investors nowadays wants to save their money rather than investing it because they have a big doubts of no return due to the effects of recession.

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