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.