Evaluating Effectiveness of Supply Side Economics on Macroeconomic Objectives

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Table of Contents

Introduction
What is supply side economics
Alternative approaches
Methods and benefits of supply side economics
Effectiveness of supply side economics
Conclusion
Sources

Introduction

This paper is about evaluating the effectiveness of supply side economics in tackling the macroeconomic objectives. This paper starts off by defining what supply side economics is and the alternatives to it. The relative merits and demerits of supply side economics as opposed to the monetarists and fiscal policy theorists are discussed. Supply side economics has been the primary driver of growth during the last two decades of the 20^th century and was responsible for the high rates of growth that the US economy witnessed in these years.

However, there has been widespread criticism of the theory that focuses exclusively on the supply side of the equation as opposed to that of the demand side. The essential difference in the approaches is that supply side economics concentrates on producing more whereas Keynesian approaches concentrate on stimulating demand by massive government spending.

This paper takes the position that supply side economics has had its day and the deregulation aspect of the theory has gone too far with the result that the US economy as well as the world economy is more prone to recessionary tendencies due to the profligate practices of the financial sector. The contention of this author is also that supply side economics has widened the gap between the rich and the poor.

What is supply side economics

Supply side economics is that branch of economics that deals with production of goods and services by providing incentives to the producers to produce more and hence ensure a steady stream of goods to the marketplace. This paradigm of economic growth assumes that lowering the tax rates provides incentives for the producers to produce more, leading to a situation where there is an increase in incomes and hence the increase in tax revenues to the point where the shortfall due to the lower tax rates is more than made up due to the increase in the tax collections.

Supply side economics is defined as “An economic theory which holds that reducing tax rates, especially for businesses and wealthy individuals, stimulates savings and investment for the benefit of everyone. It is also called trickle-down economics” (Investor Words, 2009). By definition, it implies that the best way to stimulate demand is by increasing production and consumption by cutting taxes. This is the route that is favored by economists who deal in the supply side equation of the AS curve.

Supply side economics came into prominence with the Reagan administration in the US and the Thatcher stint in the UK. This lead to an unprecedented boom in the economies of these countries that was touted as the example of “trickle down” economics that posited that wealth generated at the top of the pyramid trickles down to the members at the bottom.

Alternative approaches

The alternative approach to supply side economics is the one that has been espoused in the US after Ronald Reagan demitted office. This is the method of stimulating demand by cutting interest rates. The other method that are often touted as alternatives is the Keynesian method that holds that only increased governmental spending can stimulate demand make the economy grow. According to the Investopedia website, “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” (Investopedia, 2009).

This dichotomy between encouraging the producers as opposed to encouraging the consumers lies at the heart of the debate between supply side economics and other approaches. While proponents of supply side economics argue that increasing government spending leads to higher inflation, the Keynesians point to the growing income disparities between the rich and the poor as a sign of failure of supply side economics.

Methods and benefits of supply side economics

In this section, we look at the ways in which supply side economics work and the perceived benefits of the same. The pillars on which supply side economics rests are privatization, deregulation and reduction of taxes. As we shall discuss later, some of these foundations of supply side economics have been called into question in the wake of the current economic crisis. In the succeeding paragraphs, we look at each of the components of the supply side policies and the ways in which they bring about the desired benefits to the economy.

If we take each of the methods by which supply side economics works, According to the Economics Help website, “Privatization involves selling state owned assets to the private sector. It is argued that the private sector is more efficient in running business because they have a profit motive to reduce costs and develop better services. Deregulation involves reducing barriers to entry in order to make the market more competitive. For example BT used to be a Monopoly but now telecommunications is quite competitive, this has led to lower prices and better service and lowering taxes involves cutting corporate and other taxes on income to levels where they have the desired effect of increasing the disposable income” (Economics Help, 2009).

“The benefits of supply side economics are lower Inflation that is achieved shifting AS to the right will cause a lower price level.

By making the economy more efficient, supply side policies will help reduce cost push inflation. Lower Unemployment is also possible because supply side policies can help reduce structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment. Finally, Improved Economic Growth results because supply side policies will increase economic growth by increasing AS” (Economics Help.org, 2009).

Effectiveness of supply side economics

There has been much speculation on the role of supply side economics in stimulating demand and causing overall economic activity to pick up. The main criticism against supply side economics is that merely cutting taxes alone would not do the trick and other measures like controlling the money supply and lowering interest rates are the necessary conditions for economic growth.

The point about lowering interest rates and stimulating demand became more relevant in the 1990’s when the manufacturing base of the US had shrunk and what the US economy was being driven was by growth in services. Thus, as opposed to growth in real manufacturing and production of goods and services, the economy was clocking impressive growth due to the rise in the growth of services. This growth in services was brought upon by the other pillar of supply side economics i.e. monetary policy.

In the aftermath of the current economic meltdown, there are many who are questioning the viability of supply side economics and the lower interest rates paradigm as an alternative for the Keynesian paradigm. Considering the fact that the economy now had to be revived using massive stimulus packages in a throwback to the years of the great depression, it is worthwhile to note the return of classical economic paradigm in the US.

As pointed out in a previous section, the method of reducing taxes would lead to a situation where the people who benefit from this would be in a minority as opposed to the people who have lost out. This is the main criticism against supply side economics, namely that of the widening income gap between the rich and the poor. This approach has been criticized by many as contributing to increased alienation of the poor who have not benefited from the trickle down theory propounded by the proponents of supply side economics.

As Ackerman puts it in his book, “Ask yourself whether you are better or worse off than you were four years ago, said Ronald Reagan. It was the most memorable, and most successful, question of the 1980 campaign. Millions of people answered when they voted, not so much for the new as against the old. The 1970s had been a decade of quite dramatic failure for traditional economic policies — more than enough reason; it seemed, to try a new belief about how the world works” (Ackerman, 1984). Hence the overriding belief that supply side economics would make the economy grow and make everyone better off.

Supply side economics grew in response to the Oil crises and shocks of the 1970’s when it was apparent that higher oil prices would have deflationary effects on the US economy. Hence, the government resorted to cutting down taxes and making products more affordable to the people by practicing the supply side equation of the curve. However, this did not lead to an overall increase in prosperity and has been called by many as “making magic” and “peddling prosperity”. It is to the credit of the paradigm that many developing countries hitched themselves to this model of economic growth as well.

Conclusion

The inescapable conclusion that stems from the current global economic meltdown is that supply side economics has outlived its purpose and it is now time to go in for a new paradigm of growth that revolves around making everyone wealthy instead of a select few. Though business is tending to be fearful of the Obama administration in the assumption it would raise taxes, it is by no means clear that they intend to do so (Business Week, 2009). On the contrary, President Obama is trying to stick to his campaign promise of not raising taxes on the middle classes.

In conclusion, it is apparent that massive government spending is the only way out of the current crisis. Contrary to the claims of the supply side economists, a small government may not be the best possible solution particularly when deregulation breeds excesses of profit taking and speculation way beyond the acceptable levels and results in a systemic failure that threatens the entire global economy. Hence, the position of this author is that it is time for us to find a new paradigm where capitalism is conscious of its responsibilities and duties apart from its rights. I end the paper with the hope that the “green shoots” in the economy would turn into plants and that there is real recovery not only on Wall Street but on Main Street as well.

Sources

Ackerman, Frank. (1984) Hazardous to our Wealth: Economic policies in the 1980’s. New York, South End Press.
Business Week. (2009) Obama and Business: What business thinks s: Business Week Website. [Online].
Definitions. (2007) Supply-Side Policies: Economics Help Website. [Online]. Web.
Definitions. (2007) Supply-Side Economics: Investor Words Website Website. [Online].
Harper, David. (2005) Understanding Supply-Side Economics: Investopedia Website. [Online]. Web.

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