Which actions should government take to spur economic activity during economic recessions?

Liberals tend to believe in Demand Side Economics, that is, demand drives the economy. So during recessions, government should stimulate demand through spending. Conservatives, on the other hand, tend to believe in Supply Side Economics, that is, supply drives the economy. In that case, during recessions, government should stimulate supply by promoting new production.

Who’s right?

Figure 1

There are two tautologies economists use to explain the basic functioning of the economy. The first tautology says that Total Output in the economy, Y, must equal Total Consumption. Total Consumption is the sum of Consumer Consumption, C, Investment, I, Government Spending, G, and Net Exports, (Ex – Im):

(1)                   Y = C + I + G + (Ex – Im)

The second tautology says that the value of money must equal the value of output. The Total Value of Money is equal to the product of the Supply of Money, M, and the Velocity or turn rate of Money, V. The Value of Output – total value of goods produced – is the product of the Price Level, P, and the Quantity of Output Produced, Q:

(2)                   M V = P Q

Brief Description of Demand Side Economics

Demand Side economists claim that demand drives supply. So to stimulate economic activity during downturns, the government should foster demand for products and services. More specifically, government should decrease taxes or increase subsidies for the middle and lower classes. Middle and lower class consumers are likely to immediately spend any income they generate, which will create economic activity. The government should also make up for lack of consumer demand by engaging in either fiscal spending or monetary stimulus. Ideally, fiscal spending by government should focus on infrastructure projects. This will create immediate demand for labor and supplies, while providing long-term economic benefits to the population. Monetary policy, on the other hand, involves increasing the supply of money. When consumers have more money in their pockets, they will spend more, thereby promoting economic activity.

Graphically, Demand Side economists believe that if the economy is sitting at (P₀, Q₀) in Figure 1, then tax decreases for low and middle class consumers and/or increases in government spending will cause the demand curve to shift from D to D’ and equilibrium output to increase from Q₀ to Q₁.

Regarding equation (1), Demand Side Economists say that when Y is too low, we should increase C or G, which, in turn, will increase Y. Regard equation (2), Demand Side Economists say we should increase M and V. M is increased through increases in the money supply. And giving money to middle and lower class people, i.e., through tax breaks or subsidies, will lead them to immediately spend the money, thereby increasing V.

Here’s how others describe the theory of Demand-Side Economics:

Robert Freeman, “A Tale of Two Theories: Supply Side and Demand Side Economics”:

Demand Side Economics, says that if taxes are to be cut, they should go to those who earn the least amount of money. The reason is that low-income workers spend virtually all of their incomes. Money given to them goes right back into circulation, fueling a boom in consumer spending.

David Brin, “A Primer on Supply-Side vs Demand-Side Economics”:

Under Keynsian or Demand-Side theory, the government should spend heavily, even deep into debt, when the nation is in recession, in order to get high-velocity economic activity going again.

…the beneficiaries of Demand Side largesse - the poor and middle class - may have some actual direct need. Fulfilling that need (if done well) may result in creation of either more-skilled workers or more small businesses.

Nick Robinson, “Supply-Side vs. Demand-Side Economics”:

Demand-side economists like Paul Krugman argue that the best way to avert recessions and depressions is to stimulate demand by investing in large-scale infrastructure projects, such as building highways. These projects, they argue, directly increase demand for products like asphalt but also put money in workers' pockets. Workers then spend their wages, further increasing demand and encouraging businesses to increase production and hire more employees.

Brief Description of Supply Side Economics

Supply Side economists, on the other hand, claim that supply drives demand. So to stimulate economic activity during downturns, the government should foster supply of products and services. More specifically, government should decrease tax rates and regulations to encourage investors to invest in new capital projects. Increases in the supply of capital will increase the marginal productivity of labor. This, in turn, will increase the demand for labor and eventually increase wage rates, as suppliers bid up the price of labor.

Graphically, Demand Side economists believe that if the economy is sitting at (P₀, Q₀) in Figure 1, then tax decreases for upper class consumers will lead them to invest in the supply of new products and services, which will shift the supply curve from S to S’, and it will lead equilibrium output to increase from Q₀ to Q₁.

And regarding equations (1) and (2), Supply Side Economists believe that cuts in tax rates for the upper class will lead in equation (1) to increases in I, and thus increases in Y. And in equation (2), by encouraging investment in future supply, we increase Q.

At the heart of Supply Side Economics lays two assumptions. The first is Say’s Law of Economics, which says that supplying products that consumers value will create its own demand. Wikipedia describes Say’s Law as: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." The second assumption that Supply Side Economists base their reasoning on is the idea that the income tax rate in the economy sits at the right side of the Laffer Curve (see Figure 2). In this case, by decreasing the tax rate, say from t₀ to t₁, government will stimulate supply that will generate more revenues than those lost by setting taxes at a lower rate, that is tax revenues will increase from Taxes₀ to Taxes₁.

Figure 2

Here’s how the same sources as those cited above describe the theory of Supply-Side Economics:

Robert Freeman, “A Tale of Two Theories: Supply Side and Demand Side Economics”:

Supply Side Economics claimed that if the government cut taxes on the wealthy, it would jump-start the economy as the wealthy plowed their tax savings back into investments. New factories fitted with new technologies would produce goods at lower cost, taming inflation. And the newly hired workers would tame unemployment.

Even better, more output meant government tax receipts would grow...

David Brin, “A Primer on Supply-Side vs Demand-Side Economics”:

Supply Side holds that you best stimulate economic activity by Increasing the net wealth possessed by society's top echelons -- people and groups who have no urgent material needs. Instead of spending it on direct "demand" purchases, these wealth-owners will invest any marginal wealth-gain (say from tax cuts) on things that increase "supply" -- factories, new businesses, innovative goods and services. Thus the name Supply-Side.

Supply Side zealots forecast that reducing taxes on the rich will:

1) result in direct investment of the released wealth into "supply" capacity for producing innovative goods and services.

2) stimulate so much new economic activity that even lower tax rates will rake in enough new revenue to erase any deficit caused by reducing taxes on the rich.

3) eliminate government debt, resolving any apparent conflict between reducing revenue and fiscal responsibility.

Nick Robinson, “Supply-Side vs. Demand-Side Economics”:

… the term ["Supply-side economics"] refers to the view that the best way to stimulate economic growth is to lower barriers to production, especially taxes. Specifically, advocates of supply- side economics argue that lower taxes will result in larger supplies of goods and services, thus lowering prices and improving standards of living.

Figure 3

Points of Failure

Both theories, Supply Side and Demand Side Economics have points of failure.

Demand Side Economics

Government Picks Winners and Losers

When government decides who gets funding, rather than letting the free markets decide, government gives the funded projects an advantage over rivals. The government can make the “wrong” choice by funding inefficient companies, who displace more efficient companies and only survive in the market because of government support.

Government-Funded Programs May Not Be Effective

Many government-funded programs to help stimulate the economy don’t work. A case in point is Federal Jobs Training Programs. As Lolade Fadulu describes in “Why Is the U.S. So Bad at Worker Retraining?”

Reagan’s version of this was the Job Training Partnership Act (JTPA) of 1982, which spent nearly $3 billion yearly between 1984 and 1998 and made some adjustments to the previous job-training formula by removing provisions for subsidized jobs in local and state governments and giving more control to the private sector. Although JTPA accounted for a relatively small share of the president’s response to unemployment, it was arguably Reagan’s most direct response to workers. And it worked about as poorly as any other program has.

…

Its flaw wasn’t Reagan’s approach. Rather, studies suggest it suffered from the challenges typical of federal job-training programs even before Reagan’s time. Such programs have historically been unable to change an economy in which low-wage workers suffer from both low pay and a lack of autonomy. The initiatives have struggled to achieve their mission for several reasons. One, those who need the training typically don’t know about—or are excluded from—them. Two, course material tends to be disjointed from the needs of employers. Three, and perhaps most importantly, job-training programs don’t force employers to pay skilled people decent wages.

Another reason government-funded programs to help stimulate the economy don’t work is when funded projects are chosen based on political favors, not economic merit. Examples include Alaska’s Bridge to Nowhere and California’s High Speed Rail Project.

A third reason government programs may not be effective is if they generate consumption in the present at the expense of consumption in the future. In this case, there is a cost to implement the program, but no net benefits. An example of this type of failure is the Cash for Clunkers program, which subsidized consumer trade-ins of older, less-efficient vehicles in exchange for purchases of more efficient vehicles.

A September 2010 open access Social Science Research Network study concluded that the program simply pulled purchases from the future: it produced a short-lived effect (360,000 additional cars sold in two months), but that the effect was almost completely reversed in the seven following months due to fewer cars sold, and found no evidence of effect on employment, house prices, or household default rates in cities with higher exposure.

Consumer Stimulus May Be Ephemeral

If government subsidies or tax cuts for lower and middle-income consumers are temporary, then the effects may be temporary or self-limiting, as well. Generally speaking, effective programs need to last for long periods of time (e.g., years), or otherwise permanently change consumers’ expectations about the future, before they create sustainable effects.

Supply Side Economics

Tax Saving May Not Be Invested in New Supply

Supply Side policies grant tax cuts to high earners, with the expectation that those cuts will lead beneficiaries to invest their savings in creating new productive capacity. Rather than reinvesting their saving in new projects, however, beneficiaries of tax cuts might instead use their money for rent-seeking or other non-productive purposes. As Robert Freeman states:

Without the ability to ensure that tax cuts are, in fact, invested in new productive assets, Supply Side Economics cannot ensure any real linkage between tax cuts and the hoped-for economic boom.

And David Brin claims that the past 30 years of tax cuts intended to stimulate the economy were, in fact, diverted to non-productive uses:

The uber-rich did not take their tax-break largesse and invest it in innovative/productive equipment. They poured it into either passive investments -- what Adam Smith derided as "rent-seeking" -- or else risky financial instruments and asset bubbles. Above all, the direct forecast that reduced revenues would erase federal deficits went directly opposite to observed fact.

It’s Effective Tax Rates, Not Marginal Rates, That Matter

Supply Side Economics focuses on decreasing marginal tax rates. However, it’s not the marginal rate, but the effective rate, that matters. Marginal rates are like list prices. If no one pays list price, but rather, everyone gets some kind of discount, then focusing on the level of list prices is useless. As a case in point, for the periods during which marginal tax rates in the US were highest, the average effective rate on top earners was only about half the marginal rate (see Figure 4).

Figure 4

And, in fact, David Brin reports that studies show marginal tax rates have not been correlated with economic growth:

Changes over 65 years in the top marginal tax rate and the top capital gains rate do not correlate with economic growth. Reduction in top rates appears to be uncorrelated with saving, investment, and productivity growth.

 

Both Demand and Supply Side

Actions Increase Government Debt and Interest Rates

Actions taken under both Demand Side and Supply Side Economics increase the Federal deficit, which increases the rate of interest, that is, the borrowing cost of money. In Demand Side Economics, government spending initiated to stimulate the economy increases the debt. In Supply Side Economics, tax cuts intended to stimulate productive capacity increase government debt, at least in the short run. (Recall that proponents assert that higher productive activity will subsequently increase tax revenues by more than those lost during the initial tax cuts.) Increases in the debt, in turn, cause interest rates to rise.

Actions taken under Supply Side policies cause interest rates to rise through yet another avenue: As tax cuts lead high-income earners to invest in more productive capacity, the demand for money increases, and in response, interest rates rise. As Robert Freeman indicates,

By increasing the demand for borrowed money in the economy as a whole, Supply Side deficits drive up the cost, not just of government borrowing, but of ALL borrowing-

Theories Don’t Account for the State of the Environment

Neither Demand Side nor Supply Side Economics considers other factors in the environment that might decrease the effectiveness of their recommended policies.

For example, when trying to stimulate creation of new productive capacity, Supply Side Economics doesn’t consider the state of automation or the state of international supply chains. These factors affect the value of new supply creation that’s captured domestically. How many new domestic workers will end up being employed? How much value will be created domestically, as opposed to internationally?

As another example, if the economy is experiencing inflation, policies that increase the deficit will exacerbate already high interest rates.

As a third example, to the extent that regulations and other taxes deter investment in new productive capacity, decreases in marginal tax rates might not be enough to overcome the other burdens. In this case, decreases in marginal tax rates won’t be enough to induce investments in supply.