Understanding Supply-Side Economics

Supply-side economics is better known to some as "Reaganomics," or the "trickle-down" policy espoused by 40th U.S. President Ronald Reagan. He popularized the controversial idea that greater tax cuts for investors and entrepreneurs provide incentives to save and invest, and produce economic benefits that trickle down into the overall economy. In this article, we summarize the basic theory behind supply-side economics.

Like most economic theories, supply-side economics tries to explain both macroeconomic phenomena and - based on these explanations - offer policy prescriptions for stable economic growth. In general, supply-side theory has three pillars: tax policy, regulatory policy and monetary policy.

However, the single idea behind all three pillars is that production (i.e. the "supply" of goods and services) is most important in determining economic growth. The supply-side theory is typically held in stark contrast to Keynesian theory which, among other facets, includes the idea that demand can falter, so if lagging consumer demand drags the economy into recession, the government should intervene with fiscal and monetary stimuli.

This is the single big distinction: a pure Keynesian believes that consumers and their demand for goods and services are key economic drivers, while a supply-sider believes that producers and their willingness to create goods and services set the pace of economic growth.

The Argument That Supply Creates Its Own Demand
In economics we review the supply and demand curves. The left-hand chart below illustrates a simplified macroeconomic equilibrium: aggregate demand and aggregate supply intersect to determine overall output and price levels. (In this example, output may be gross domestic product and the price level may be the Consumer Price Index.) The right-hand chart illustrates the supply-side premise: an increase in supply (i.e. production of goods and services) will increase output and lower prices.

Starting Point

Increase in Supply (Production)

Supply-side actually goes further and claims that demand is largely irrelevant. It says that over-production and under-production are not sustainable phenomena. Supply-siders argue that when companies temporarily "over-produce," excess inventory will be created, prices will subsequently fall and consumers will increase their purchases to offset the excess supply.

This essentially amounts to the belief in a vertical (or almost vertical) supply curve, as shown in the left-hand chart below. In the right-hand chart, we illustrate the impact of an increase in demand: prices rise but output doesn't change much.

Vertical Supply Curve

An Increase in Demand → Prices Go Up

Under such a dynamic - where the supply is vertical - the only thing that increases output (and therefore economic growth) is increased production in the supply of goods and services as illustrated below:

Supply-Side Theory Only an Increase in Supply (Production) Raises Output

Three Pillars
The three supply-side pillars follow from this premise. On the question of tax policy, supply-siders argue for lower marginal tax rates. In regard to a lower marginal income tax, supply-siders believe that lower rates will induce workers to prefer work over leisure (at the margin). In regard to lower capital-gains tax rates, they believe that lower rates induce investors to deploy capital productively. At certain rates, a supply-sider would even argue that the government would not lose total tax revenue because lower rates would be more than offset by a higher tax revenue base - due to greater employment and productivity.

On the question of regulatory policy, supply-siders tend to ally with traditional political conservatives - those who would prefer a smaller government and less intervention in the free market. This is logical because supply-siders - although they may acknowledge that government can temporarily help by making purchases - do not think this induced demand can either rescue a recession or have a sustainable impact on growth.

The third pillar, monetary policy, is especially controversial. By monetary policy, we are referring to the Federal Reserve's ability to increase or decrease the quantity of dollars in circulation (i.e. where more dollars mean more purchases by consumers, thus creating liquidity). A Keynesian tends to think that monetary policy is an important tool for tweaking the economy and dealing with business cycles, whereas a supply-sider does not think that monetary policy can create economic value.

While both agree that the government has a printing press, the Keynesian believes this printing press can help solve economic problems. But the supply-sider thinks that the government (or the Fed) is likely to create only problems with its printing press by either (a) creating too much inflationary liquidity with expansionary monetary policy, or (b) not sufficiently "greasing the wheels" of commerce with enough liquidity due to a tight monetary policy. A strict supply-sider is therefore concerned that the Fed may inadvertently stifle growth.

What's Gold Got to Do with It?
Since supply-siders view monetary policy not as a tool that can create economic value, but rather a variable to be controlled, they advocate a stable monetary policy or a policy of gentle inflation tied to economic growth - for example, 3-4% growth in the money supply per year. This principle is the key to understanding why supply-siders often advocate a return to the gold standard, which may seem strange at first glance (and most economists probably do view this aspect as dubious). The idea is not that gold is particularly special, but rather that gold is the most obvious candidate as a stable "store of value." Supply-siders argue that if the U.S. were to peg the dollar to gold, the currency would be more stable, and fewer disruptive outcomes would result from currency fluctuations.

As an investment theme, supply-side theorists say that the price of gold - since it is a relatively stable store of value - provides investors with a "leading indicator" or signal for the dollar's direction. Indeed, gold is typically viewed as an inflation hedge. And, although the historical record is hardly perfect, gold has often given early signals about the dollar. In the chart below, we compare the annual inflation rate in the United States (the year-to-year increase in the Consumer Price Index) with the high-low-average price of gold. An interesting example is 1997-98, when gold started to descend ahead of deflationary pressures (lower CPI growth) in 1998.



The Bottom Line
Supply-side economics has a colorful history. Some economists view supply-side as a useful theory. Other economists so utterly disagree with the theory that they dismiss it as offering nothing particularly new or controversial as an updated view of classical economics. Based on the three pillars discussed above, you can see how the supply side cannot be separated from the political realms since it implies a reduced role for government and a less-progressive tax policy.