Is Supply-side Economics Driving the US Economy?

By: Gerard Jackson | Tue, May 16, 2006
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In his article Wild on the Supply-Side R. Emmett Tyrrell Jr attempted to explain how the Bush tax cuts are an of example supply-side economics driving the economy, and declared that the only thing that can explains its critics' wilful refusal to acknowledge the fact is "bigotry". Although he is right about the bigotry, particularly in the Democratic Party, he missed the vital point that supply-side economics is just not understood by its critics. I think this is because they tend to think of it in terms incentives and tax revenues, as do many of its advocates.

Supply-side economics can be summed up as just another term for Say's law of markets. Economists have been taught that Keynes exposed the fallaciousness of this law. He did nothing of the kind. It was Keynes who defined Say's law as "supply creates its own demand". Say never said anything of the kind -- and neither did any other classical economist. (See Say's A Treatise on Political Economy, 2001 edition published by Transaction Publishers, New Brunswick, New Jersey).

Say's law boils down to what would be patently obvious in a barter economy: supplies constitute demands. Writing for Barron's John Oakwood got to the heart of the matter when he stated that a person's buying power is really "his ability to create goods or render services that have an exchange value for other goods or services". (Wage Cuts and Economic Realities, Barron's, 29 June 1931 and How High Wages Destroy Buying Power, Barron's, 29 February 1932).

In the words Benjamin M. Anderson:

Purchasing power grows out of production. The producing countries are the great consuming countries...Supply of wheat gives rise to the demand for automobiles, silks, shoes, cotton goods, and other things that the wheat producer wants. Supply of shoes gives rise to the demand for wheat, for silks, for automobiles and for other things that the shoe producer wants. Supply and demand in the aggregate are thus not merely equal, but they are identical, since every commodity may be looked upon either as supply of its own kind or as demand for other things. (Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, LibertyPress, 1979, first published 1949)

Anderson followed this with the caveat that "the doctrine is subject to the great qualification that the proportions must be right; that there must be equilibrium". So when it came to Say's Law every pre-Keynesian economist knew to think in terms of proportionality or equilibrium as we say today.

This is why depressions were interpreted as disproportionalities. It was noted that it was manufacturing that suffered first and the most during a depression. David Ricardo had a clue to what was really happening when he drew the link between depressions and credit expansion. Unfortunately his own aggregate approach prevented him from being able to explain the clusters of malinvestments that mark depressions. Nevertheless, his explanation was far superior to Keynes' own mercantilist account.

Supply-siders should emphasise that if you want more of something you have to reduce the cost of producing it. What every country needs is more capital -- and capital comes out of savings. By eliminating, for example, taxes on capital gains, which are really profits, more savings are made available which then expand the capital structure. It should never be forgotten that regardless of what Keynes said: savings fuel an economy and entrepreneurship drive it.

One only has to think about how long an agricultural society would survive if it consumed its seed corn, meaning its savings. The durability of capital and the complexity of our own economies conceal the obvious from the electorate and help give economic quacks the support they crave -- not to mention the tax-loving Democrats.

The irony is that Keynesians do not realise they are supply-siders of a peculiar sort. Supporters of Say's Law understand, as do supply-siders, that consumption springs from production. To get a better understanding of this proposition we should turn to the late William H. Hutt's The Keynesian Episode: A Reassessment (LibertyPress, 1979) in which he gives a comprehensive view of payrolls, withheld capacity and wage rates.

As Hayek and others observed Keynesianism works by reducing the cost of labour relative to the value of its product. In other words, it uses inflationary policies to price labour back into work and so expand output. But as Hutt pointed out, by overpricing labour withheld capacity is created. When this happened during a depression the classical economists argued that the situation required that costs and other prices should adjust themselves as quickly as possible to the new monetary situation.

The Keynesian solution is to print money. But by proposing this course of action they are inadvertently admitting that the problem is not one of deficient demand but of withheld capacity, the overpricing of factors, particularly of labour.

Like supply-siders Keynesians do not take into account the fact that money is not neutral. Thus both sides will argue against a falling price level in the belief that this is deflationary. But a deflationary price spiral is the result of a monetary contraction. A falling price level caused by rising productivity is an entirely different beast, one to welcome and not to feared and kept at bay.

As productivity rises -- due to an expanding capital structure -- prices will fall and real wages will rise. And so the fruits of the capital expansion will not be arbitrarily distributed by loose monetary policies. But supply-siders, like Keynesians, argue that falling prices will cause a profits squeeze followed by recession.

They completely miss the point. In this benign climate the prices of capital goods also fall even as their productivity rises. For some strange reason, those who argue against a falling price level induced by increased productivity always assume that the prices of capital goods do not fall either. But this must be the case once we take into account the process of imputation.

The policy of trying to maintain a stable price level requires the manipulation of interest rates and the money supply. This in turn creates distortions that will make recessions inevitable. And as always, capitalism gets the blame.

So there it is, Mr Tyrrell: You are close but not quite close enough.



Author: Gerard Jackson

Gerard Jackson

Gerard Jackson is Brookes economics editor.

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