Voodoo Economics, A Trojan Horse, and Trickle Down: Is it time to give the supply-side a try?

In Econ 101 we learn that economics is all about supply and demand. I was recently in South Korea where flooding caused by a typhoon virtually destroyed the cabbage crop. While Bugs Bunny would be quite upset about such an event it was even more important and upsetting for Koreans whose main dish, kimchi, is largely composed of cabbage. Kimchi is eaten at least once a day by many Koreans. Most Koreans have two refrigerators – one for all their other food and the other just for kimchi. I do not hide the fact that I love kimchi as much or more than most Koreans and I have several shirt stains to prove my devotion to the wonderful dish.

It was no surprise to anyone when the price of kimchi rose by 600% this summer. Why? Because of supply and demand. While the demand for kimchi had remained largely unchanged by the typhoon the supply had been reduced by the bucket-full.  As such grocery stores and restaurants bid up the price of this very scarce commodity as they tried to fulfill the usual wants of their customers. The market result was a much higher price. As kimchi came into Korea from abroad and the supply began to recover, the price of kimchi peaked and then started downward.

As the US Congress reconvenes as lame ducks and then for real in 2011, we should remember that government has policy tools that can be aimed directly at demand, supply, or both. But as the title of this message suggests, any member of the US government who recommends a supply-side policy will have to get over huge political obstacles. When George Bush Sr. was competing with Ronald Reagan to get the Republican presidential nomination in 1980, he labeled Reagan’s policy Voodoo Economics. The implication was that Reagan was trying to foist magic on the American public. Supply-side economics was also referred to as a Trojan Horse implying this policy was a trick on the American people. Finally, supply-side economics is alleged to be a tool to help the rich at the expense of the poor – meaning that the real benefits go to rich people and companies and all we can do is hope for some benefits to trickle down to the poor and middle class.

In short – supply-side policies are thought to be magic, a cheap trick, and a tool to steal from the poor and give to the rich. That’s hardly a resounding vote of confidence. It is no wonder politicians do not want to stand up and be counted for a supply-side approach. But I will argue below that the supply-side reputation is better than the title suggests and supply-side policy is just about perfect for our challenges today.

Let’s begin by quickly defining the supply-side. Economics concludes that while society will want and express a demand for food, autos, appliances and multi-colored condoms, it takes business firms to produce them. When we study demand we focus on the factors that determine what households want to purchase. But when we analyze supply, we emphasize the ability and motivations of business firms to produce those products. Supply does not get created magically. Firms must put together resources – like raw materials, intermediate assemblies, labor, machines, factories, and energy – if they are to bring the right goods to market at a competitive price.

If President Obama wants to improve the climate for production and employment, then he has choices. A demand-side approach focuses on the consuming household.  He can recommend tax reductions and subsidies to induce households to spend. He can use government legislation to direct the government’s awesome machinery to spend more. When we talk about a “stimulus package” we are usually thinking about how the government can create more demand in the economy. Despite all the controversy right now, it is true to say that sometimes these demand-side remedies work. The government stimulates demand and firms respond like Pavlov’s famous dog – demand increases and firms produce more. To produce more they often hire more workers.

But right now at the end of 2010, it isn’t perfectly clear if the demand stimulus choice is the best one. We saw what happened when cash for clunkers expired. In a previous post I explained that households are repaying debt or are otherwise saving. Given the remaining uncertainty about the economic recovery it seems wiser for them to be saving and not spending. Of course, business firms are watching all this and are not about to risk their capital to produce more until they are more certain that any demand increases are going to have some staying power.  That leaves the government’s direct spending on the economy. But even here we learned how disingenuous Congress can be. So called shovel-ready projects were about as ready as a Medicare patient at a high-jump competition. Government largess was aimed at a multitude of Democratic pet peeves. We learned that the political process can be very slow and unreliable when it comes to quickly generating more demand for goods and services. Yet it was perfect at increasing government debt.

The second choice available to President Obama is a supply-side policy. Supply-side economics was boosted when Jean-Baptiste Say ( Say’s Law) declared that “supply creates its own demand”.  The general meaning of this statement is that factors which cause permanent changes in society’s capacity to produce often lead to conditions (e.g. falling prices) which raise the level of demand to the higher amount of supply. Most economists today use Say’s Law to guide their analyses and forecasts of long-run economic growth. These forecasts have no role for demand and totally explain long-run changes in economic growth with two factors: labor supply and productivity growth.  The upshot of economic growth theory is that strong growth will occur only if and when labor supply and labor productivity growth permits it. Persistent economic growth is the only way to have persistent and permanent increases in employment.

Today our demographics indicate there is very little potential to increase economic growth and employment through faster labor supply growth. Our baby boomers (hurrah) are retiring and there is only so much that can be done through immigration or inducements to remain in the labor force.  So that leaves labor productivity as the only real route to stronger economic growth and employment.  How does a government formulate policy to achieve stronger labor productivity growth? First, the government needs to recognize that innovation and higher productivity are the keys to business success – firms with higher productivity compete better. So the firms are willing partners in any policy that improves labor productivity.  Second, the government must realize that productivity enhancements are expensive and often require firms raising large amounts of capital. Third, firms will not take these large risks without believing that they will pay off – and create excellent returns to the owners and stockholders. Fourth, these payoffs relate very much to two key factors in the business environment – expected future revenues and costs.

In a nutshell – supply-side policy needs to create optimism and clarity among business firms about future profits. This optimism is necessary for the capital investments that will lead to higher economic growth and employment. Any policies that promise restrained business costs and more certain long-run revenues and after-tax profits are what we need right now. These policies are what we call supply-side policies.

Is this magic? Ask China and the dozens of other countries that have implemented similar supply-side policies if they have worked.

Is this a trick? The above discussion explains why the supply-side approach should work.  While this approach might not work, it clearly has a strong rationale for why it should be effective. This is no Trojan Horse.

Is this trickle-down? It is no act of deception to recognize that supply-side policy generally aims its most immediate impacts on business firms and wealthier people.  How much of the benefits are absorbed by the poor or the middle class is definitely a legitimate question. My reading of economic history is that the only real way to permanently raise the standard of living in a country is through long-term economic growth.  Schemes to redistribute income or to equalize incomes can be effective only in an environment of growth. 

Demand-side policy is very risky right now. It might not work. Worse yet, it might create higher uncertainty about the long-run future of America as it raises US debt, worries our trading partners, and opens up concern about when and by how much the future stimulus will be withdrawn.  It is time to give supply-side policy another look.

There is a lot more to say about this issue. Hopefully this is a start to a good discussion. Let me know what you think.