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Thursday, July 7, 2011

Supply Side / Demand Side Rivalry

            Imagine for a moment that you are the leader of nation whose economy is struggling to grow.  After months and months of GDP stagnating, two different economists present to you two different plans for stimulating the economy and hopefully sparking some growth.

            Economist A: “Let’s try to kick-start industry, since they are the employers and the producers of goods and services in our economy.  We will take less from them in taxes, and maybe scale-back some of the financial regulations on them as well.  Then it will be more cost-effective for them to hire large workforces, and less cost-prohibitive for them to make larger quantities.  Employment will go up, and with more goods in the market, the prices of goods will fall, thus spurning the economy.”

            Economist B: “How about we try to kick-start purchasing, since that would incentivize more production.  The government could hire a lot of people, and they’ll spend the wages they earn.  That will encouraging other producers to step it up a bit and produce more goods to sell.  Heck, us here in the government will even start buying up goods!  All this spending will drive up prices, encourage more and more industrialists to invest and start new companies, thus spurning the economy.”

            Economist A is a supply-side economist.  They propose that the supply of goods and services - bank loans, computers, economics classes, Barbie dolls, WHATEVER - is the key driver of economic growth.

            B is a demand-side economist (typically referred to as Keynesian economists, for John Maynard Keynes, who popularized the concept in the 1930s).  Their angle is that it’s the demand for goods and services - energy, medicine, business consultants, books, WHAT HAVE YOU - is the key driver of economic growth.   

            Either one of these ideas have plenty of merit.  Prod on the economy by either helping those who sell, or helping those who buy.  Intuitively, either method should produce some sort of growth.  

Unfortunately, neither plan is perfect.  In A’s plan, there is no control over how industry will spend the money.  They might be timid to expand in this slow economy, and sit on the money and wait for a brighter day, even though they are supposed to be the one bringing that day about.  They might all spend their newly freed up cash in so many disparate ways that it has no singular significant effect on the economy at large.

            In B’s plan there’s no guarantee that the government will figure out the “right” things to spend on – the one key industry that is interconnected enough to other ones that its stimulation will pull other industries up along with it.  They will just have to guess as to what is the most productive way to spend, throw money at it, and hope for the best.

            In the US, like in most nations, our liberal politicians always seem to come up with a Keynesian solution to any economic hardship we encounter.  And the conservatives seem to consistently come up with supply-side solutions whenever the going gets tough.
            Now, why would that be…?

            I’m sure if you were to ask them, they would all tell you that each one of them objectively and rationally studied all available data and literature, and each independently arrived at the particular conclusions that they did.  And these conclusions, by pure coincidence, fell so precisely and uniformly along party lines, with Democrats in favor of stimulating demand and Republicans for stimulating supply.

            In reality, of course, the two parties support the particular economic strategies that they do for a different reason: because they are politically convenient.

            Republican politicians like to be seen as supporters of commerce and business.  They also are constant proponents of less intrusive government.  These attitudes typically mesh well with the policy implications of supply-side economics.
            Democrats, who like to be seen as the "people's party," or the "worker’s party," and who typically advocate for more proactive government, find that Keynesian economists happen to be the ones who are preaching what they want to hear.

            And strangely enough, the two parties consistently conclude the “most promising way to move ahead” just so happens to be the one that fits best with their particular rhetoric repertoire. 

            Their economics has nothing to do with economics, and everything to do with politics.  They make their conclusions first, than scour literature for academic material that already exists that supports the convictions that they’ve had all along.

            It should be noted that amongst economists, these two schools aren’t necessarily viewed as ideologies but rather as techniques.  Sometimes a single economist might recommend a supply-side policy, sometimes demand-side.  

Many economists view them just as two different tools for one's tool chest, both useful in achieving the goal of growth.  Sometimes they might even recommend policies that stimulate both supply and demand simultaneously.  

          Now, why would that be…?

Well, simply put, because an economy can slow down for any number of reasons, so there is no solution that will be applicable in every circumstance.  The prescription you need is dependent on the disease that you have.

There's an entire host of issues that could cause an economic slow down.  Maybe the public has lost some of its disposable income, causing the demand for services to slip.  Or maybe industries find themselves unable to produce and sell goods at their target levels, and so they scale back the supply.  Both scenarios would result in a poor performing economy, but neither could be best addressed using the same strategy.

You’ve probably been hearing a lot lately about Congress’ squabble over the national budget and the debt ceiling.  If you want to know more about the legal procedure of federal budgets and borrowing, you can check out this Planet Money podcast, (that was brought to my attention by Economystified reader Brenton S.), but suffice it to say the mechanics of the situation are quite involved.  Yet at its core, the current hub-bub goes back to this eternal debate.  

Both parties feel something needs to be done to help along our economy.  But they disagree as to what should be done.  The Democrats have a pretty Keynesian set of recommendations, the Republicans, their standard supply-side fare.  Neither want to move on with the budget unless their plan is the one enacted.

The annual negations over the federal budget plan have ground down to a complete stand still now, as the two parties bicker over how the government should move the recovery along in the upcoming year.  

To be ideologically (I like to use the term “pathologically”) Keynesian or supply-side, to advocate one particular method in all instances - no matter what is actually causing the poor economic performance - would be to deny how complex an economy truly is.  If your going to try to juggle something as awkward and complicated as a nation’s economy, you’ll probably want two hands at least!

PS - I wrote this post a few days ago, but by luck, while I was driving to work this morning, I heard this news story that I though tied in nicely.  Some members of Congress' policy choices seem to be influenced by how they think those choices will be perceived by the public or spun by their rivals later on, not on what the actual effect of the choice will be.  It can come right down to what words we use to refer to a measure that makes or breaks political support!

[*Side Note – Just as taxes are taken out of your wages, there are taxes taken out of income made from investing - money from made off of stocks or bonds, for example.
Taxes on any “non-wage income” are called “capital gains taxes.”  Supply-siders almost always campaign for reductions on capital gains taxes when the economy slows down, arguing that if people stand to make more money from investing in industries, more of them will be willing to try their luck lending their money out, which would in turn spurn economic growth.  

Those who have income available for investing presumably are those with above average incomes.  You literally have “more money than you can spend” to become an investor.  That’s why supply-side detractors often refer to the policy of cutting capital gains taxes with the buzzphrase “tax cuts for the wealthy.”  You hear it in press conferences and on CSPAN all the time.

I think the usage of that phase is often misleading, and deliberately so.  If the goal of these tax cuts was actually to give the rich a break just because they are rich, it would be better accomplished by lowering income tax rates in high brackets, or widing existing brackets.  That would be a benefit accessible only to people who reach those income echelons, and would leave the rest of us paying our usual amount. 

The only rich people who’d feel the benefits of a reduction in “capital gains taxes” are the ones willing to risk their money own money by investing in our economy. 

And honestly, some of them might not really be “wealthy” at all in the popular sense of the term.  If your parents sells their house, they’d probably have to pay a “capital gains tax” on the sale, for example.  I think the phase is often used just a ploy to make the supply-siders sound like the bad-guys.  

Don’t misunderstand me, sometimes the “tax cuts for the wealthy” are actually just that.  But many times the situation is just not so cut and dry (the now iconic "Bush Tax cuts," - the EGTRRA and the JGTRRA - contained both capital gains and income tax cuts).  

So when you hear TV pundits throw around the term "tax cuts for the wealthy" (and it does get thrown around a lot) you need to cognizant of what it truly means.]


  1. Is there any consensus among the academic economist community about whether a mostly supply-side or mostly Keynesian approach (or exactly down-the-middle approach) would be ideal to deal with the current economic difficulties? Or any specific Keynesian/supply-side strategies that need to be implemented?

  2. Dave, THAT is the million dollar question!

    One of the biggest problems we have on settling on a plan for addressing the recession is that its still not 100% clear precisely what happened that caused it!

    Sure, sure, we know what happened conceptually. But at a real nuts and bolts, practical level - as in if such and such had gone up 5% instead of 4%, if so and so had depreciated this cost for 8 quarters instead of 9 – heck, we may never know. Even today, people are still coming up with really good insights about the Great Depression, I’m sure generations from now, academics will still be adding new details to our understanding to this economic disaster.

    I’ll give you the best answer I can, but I want to give it a caveat first. There’s been a lot of talk about new economic policies over the last 3 or 4 years. Although it’s typically all been discussed under that umbrella term “economic policy,” these actions are actually addressing two very different issues: the financial crisis and the recession that was caused by it.

    Recession solutions are short-term, stimulus packages, focusing on what can be done to spurn on the slow economy RIGHT NOW. New financial regulations are being batted around as long-term, permanent solutions for preventing a financial crisis like the one we saw in 2008 from happening again.

    So there’s no really honed in consensus on what caused the issue, nor is everyone right now worrying about same issues (some are espousing ideas about short term recession issues, some talking ideas about long term financial system overhauls). For these reason, you’ll hear the TV talking head economists talking about a pretty varied set of recommendations.

    THAT BEING SAID, in general, I will say I think there has been a shift toward Keynesian solutions to address the current recession (the debate about how the financial system needs to be restructured is still up in the air, but I feel like that one is leaning toward more government involvement and regulation, the Keynesian reaction). Most of the government actions over the last few years are pretty Keynesian oriented.

    I feel like that happened mostly because the crisis originated in the industrial sector - the finance industry. Government realized the issue wasn’t just little “gum ups” in finance and banking "production," but rather a systemic, global failure across many firms at once. In 2007, there was no short supply of capital funds. And by late 2008 financial institutions were largely unable to move capital. So presumably, something was going wrong with the structure and regulation of the firms, making governments wary of just turning over cash to them.

    What’s interesting too is that the US wasn’t the only nation to go all Keynesian in the wake of the financial disaster. The UK government, for example, also got really involved in the response to the crisis.

    Some examples:

    Current Keynes (In Concept)
    The “Keynesian Resurgence”

    Current Keynes (In Practice)

    The Obama stimulus package from 2009