Supply-side Economics Explained
Paul Craig Roberts
What is Supply-side economics? There are various ways, if speaking to economists, to introduce Supply-side economics.
One is that Supply-side economics introduces the second blade of the scissors into macroeconomics that the famous British economist Alfred Marshall introduced into microeconomics. In Marshall’s time, economists argued whether price was determined by the cost of production or by what people were willing to pay. That is, by supply or by demand. Marshall said the argument was like arguing which blade of the scissors cuts the paper. Price was determined by supply and demand.
In Keynesian macroeconomics, the demand management policy of the post World War II era, there was no second blade of the scissors. There was only the demand blade. The manipulation of aggregate demand was used to control inflation and unemployment. Aggregate demand consisted of consumer demand, government spending, and investment. Investment demand played no real role, because “the reason companies produce is that consumers buy.” Investment was a response to demand.
Fiscal policy was the means Keynesian policymakers used to control inflation and unemployment. If unemployment was the problem, government could cut taxes, thereby giving taxpayers more money to spend, or government could overspend its revenues by running a deficit which would raise government demand. Keynesian economists maintained that the government spending multiplier was larger than the tax cut multiplier. In keeping with their view, aggregate demand was increased by government running a larger deficit by which it overspent its revenues. In other words, Keynesian fiscal policy favored the growth of government.
If inflation was the problem, government could reduce consumer spending by increasing income taxation or by running a surplus in its budget which would take more money out of the economy in taxation than it put back in spending.
Overtime, it took a larger increase in demand (whether public or private) or more inflation to reduce unemployment, and a larger decrease in demand or rise in unemployment to reduce inflation. The “Phillips curve” appeared, illustrating the worsening trade-offs between inflation and unemployment. By the late 1970s, Milton Friedman was able to write: “More inflation, more unemployment.”
In other words, Keynesian demand management policy no longer worked.
At this time I happened to be in the US Congressional staff as economic counsel to Rep. Jack Kemp, then as chief economist, Republican staff, House Budget Committee, and then as a US Senate staff associate, Joint Economic Committee.
The “Phillips curve” had degenerated into “stagflation.” Congress did not know what to do. The Keynesian “solution” was an incomes policy, which required all prices to be fixed. Having just experienced the difficulty of controlling one price–oil–Congress wanted nothing to do with controlling all prices.
This gave me my opportunity.
I explained that stagflation was the result of encouraging demand with easy monetary policy while restricting supply with high tax rates. I explained that fiscal policy not only affected consumer or government demand, but also directly impacted the supply-side of the economy through two relative prices. One is the price of current consumption in terms of foregone future income by not saving and investing. The other is the price of leisure in terms of foregone current income by reducing working hours. Therefore, fiscal policy could directly affect the supply of labor and capital.
I pointed out that marginal tax rates affected both relative prices. The higher the marginal tax rate on income, the cheaper are current consumption and leisure in terms of foregone future and present income. The lower the marginal tax rates, the more expensive are current consumption and leisure in terms of foregone income. Therefore, a reduction in marginal tax rates would shift the aggregate supply curve, resulting in more supply at every price. Previously, economists believed that a change in tax rates only affected aggregate demand.
That is the essence of Supply-side economics. It supplied the missing blade of the scissors to macroeconomics.
When I was invited by the combined graduate students of MIT and Harvard to give the annual State of the Economy address, I met Paul Samuelson, the leading economist after John Maynard Keynes of the 20th century. He told me that I was theoretically correct and acknowledged the correctness of my point in his long-lived economics textbook. The question in his mind was how powerful the Supply-side effect would be.
Generally speaking, Keynesian economists had too much human capital invested in demand management to accept Supply-side economics. They dismissed it as “voodoo economics” and a claim that “tax cuts paid for themselves.”
In the 1980s after I had left the Reagan Administration, having successfully as Assistant Secretary of the US Treasury got President Reagan’s reduction in marginal tax rates out of the administration so that Congress could vote on it and pass it, I had a contract from Harvard University Press to write the peer-reviewed story of the Supply-side Revolution. Henry Rosovsky, the Dean of Arts & Sciences at Harvard at that time asked me to come to see him. Rosovsky had been my graduate professor at the University of California, Berkeley, at that time a rival to Harvard. My term paper for Rosovsky had been published in Classica et Medievalia, a prestigious journal. Rosovsky said he wanted me on the Harvard economics faculty. He wanted to know if I would accept the appointment if he could arrange it. I told him that he wouldn’t be able to get it through, and I was right. New ideas are seldom welcomed by those whose human capital in invested in existing explanations.
The theoretical point of Supply-side economics is universally valid. At the time, it was directed at the worsening “Phillips curve” tradeoffs, and it succeeded in stopping stagflation. Since the policy’s success, the offshoring of US manufacturing jobs, increased monopolization, and the rise of robotics and artificial intelligence are challenging the US economy in ways that what we know as economic policy cannot effectively address.