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David Brin

David Brin
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http://www.davidbrin.com David Brin’s novels have been translated into more than twenty languages, including New York Times Best-sellers that won Hugo and Nebula awards. His 1989 ecological thriller, Earth, foreshadowed cyberwarfare, the World Wide Web, global warming and Gulf Coast flooding. A 1998 Kevin Costner film was loosely adapted from his post-apocalyptic novel, The Postman. ............................................ Brin is a noted scientist, futurist and speaker who appears frequently on television (Life After People, The Universe), discussing trends in the near and far future, on subjects such as surveillance, technology, astronomy, and SETI. His non-fiction book, The Transparent Society, deals with issues of openness and security in the wired-age. ............................................. David Brin web site: http://www.davidbrin.com http://davidbrin.blogspot.com/ Twitter: http://twitter.com/DavidBrin Facbook: http://www.facebook.com/pages/David-Brin/22358129265

FEBRUARY 19, 2010 7:28PM

A Primer on Supply-Side vs Demand-Side Economics

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Russ Daggatt's latest missive discusses whether the Stimulus Bill has had good effects.  His analysis is well worth perusing... and spreading the link.

My own take on things is more abstract. So let's step back and examine how Democrats and Republicans have become identified with two quite opposite economic theories. We'll start with the Republicans, who still clasp fealty to Supply Side Economics (SSE), a theory once labeled "voodoo" by the elder George Bush, but now mainstream conservative catechism for three decades.


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. 

Interestingly, the most famous proponent of this approach was Karl Marx, who maintained that the owner-capitalist class propels industrial development by re-investing profits in plants and equipment, thus building up society's capital stock and the means of production. SSE is, in that respect, an entirely Marxist theory.

Of course, Marx then looked farther ahead.  He hypothesized an eventual "completion" of this capital-formation process, a final phase when all the factories are finished - an image we now find ludicrous, since productive capacity must be updated at an accelerating pace. (Hence there will always be a need for capitalists.)  Still, it seems kind of sad that SSE supporters won't ever acknowledge this fundamental root of their theory. They do not study their ideological forebear. Nor do they try, as Marx did, to extrapolate where their prescription may eventually lead.

But let's examine the key SSE predictions. (All theories should make confident predictions that are clearcut and testable.) For thirty years we have heard 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.



EFFECTS UPON POLICY

This lengthy definition is needed understand why a credibility deficit now burdens the Republican Coalition.  All through the 1980s, 1990s and 2000s, the mantra was:

- if the federal budget is in deficit, cut taxes on the rich, in order to repair that deficit.

- if the federal budget is in surplus, cut taxes on the rich, because it's their money, not the government's, and there will henceforth be no rainy days.

- in times of peace, cut taxes on the rich, because government has lower priority in peacetime.

- in times of war, cut taxes on the rich, because...
well, this one never made sense even by conservative logic. Indeed, this was the first time in US history that the clade of uber-wealth demanded ever-increasing state largesse even while the nation was under deadly threat.  

In any event, we must admit that the core demand of SSE believers has been utterly consistent. Reducing taxes on the uber-wealthy is good for America, across all circumstances, under all conditions and without limit.  

TESTING SUPPLY SIDE THEORY

For three decades, SSE proponents told skeptics "just watch and see what will happen!"  (Whenever top tax rates were cut.)  Okay, we've watched. And absolutely every large-scale forecast made by promoters of Supply Side Economics failed -- diametrically -- without major exception.

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.  


TESTING THE OPPOSING THEORY

The one period over which deficits decisively vanished came right after Bill Clinton got moderate increases in taxation on the rich, in 1991, followed by stringent pay-as-you-go budgetary management. What we saw then was a combination of budget balancing, strong economic activity and revenue-based debt reduction.

So now let's examine the competitive theory - Demand Side Economics (DSE)... also called modified-Keynsianism.

Named for long-ago FDR advisor John Maynard Keynes, this theory holds that economic activity is driven by demand for goods and services. Moreover, money in the hands of the middle and lower classes has greater inherent VELOCITY -- meaning that a given dollar will be spent and then re-spent more often, if the middle class is passing it around with sequential purchases, than if it is stockpiled in a rich person's portfolio.  

(Mind you, by this theory, tax cuts for the rich might actually make sense when rapid inflation in an overheated economy calls for decreased monetary velocity!  I never said that such cuts are NEVER called for. Indeed, JFK's tax cuts did achieve all of its intended goals.)

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-velocvity economic activity going again.  Hence the recent surge in stimulus activity, in the first year of the Obama administration (see Daggatt's article)... in sharp contrast to the equal-scale "stimulus" measures taken in the last year of George W. Bush's term, most of which went to shoring up the positions of those at the top of the social-economic order.

Now, to a person who genuinely despises all deficit spending, both SSE and DSE methods may seem horrific.  Both claim to use deficits and state-largesse to stimulate the economy, under a notion that economic activity will thereupon surge ahead and resulting revenues will later erase the incurred debt.  Only there are some truly major differences.

1) Demand-Side (Keynsian) deficit spending goes to where each dollar will have high velocity impact, as their theory predicts. In contrast, Supply Side largesse for the rich definitely did NOT go into predicted capital formation. (Marx was wrong.) It simply made the rich richer.

2) Completely aside from macro-economic effects, 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. In contrast, it is hard to see how Supply Side sends the money to a place (the rich) where a direct need merits government intervention.

3)  Supply Side is a monotone.  "Give money to the rich under ALL circumstances, at all times and conditions, no matter what.  

In contrast, Keynsians have proved that their policy is adaptable and variable, un-dogmatic and contingent upon circumstance.  They spend lavishly in order to get out of recession, because that is what Keynsians do. (Right-wing rants and rails against the current governing party acting consistently with its own economic theory is simply hypocritical.  You had your turn, now it is theirs.)

But the 1990s prove that Democrats have credibility for being situationally flexible.  When a recession ends, they spend more cautiously, remove the largesse, and start building up savings. In fact, had Bush continued the Clintonian policy of debt buy-down in good times, a considerable reserve fund would have been available to help us ride out the present crisis.  

4) The experts -  professionals who have actually spent their lives studying this difficult field - generally despise Supply Side Economics. That may seem a good thing from the perspective of those who increasingly call expertise a disqualifying trait. From contempt for the Civil Service and the US Officer Corps to distrust of universities and the climate experts who have achieved miracles in weather forecasting, it's become clear that one side in our tragic, debilitating "culture war" does not want to hear the professionals on any matter, least of all economics.

5) In fact the situation is not entirely black and white! Keynsianism has had its failures. Economics is a dismal "science" and Demand-Side has many problems dealing with a complex economy.  Furthermore, pre-Clintonian Democrats sometimes acted as if the law of gravity did not apply. That potential always lurks on the left (witness Greece, today.) Moreover, Democrats did play some (lesser) role in the unleashing of our recent Asset Bubble.

Nevertheless, Keynsianism has a long, eighty-year record of being right in the most general sense.  

Government should outspend its revenues in recession, directing high-velocity stimulus toward the middle class.  Then, in good times, it should use adequate revenues to build up reserves.  The Pharoahs knew this. It is even in the Biblical story of Joseph.  It is common sense.

What does not make sense is to hold fast to an alternative "voodoo" theory - Supply Side Economics - that has always and universally failed in every major prediction, after being tried repeatedly for three decades. 

A theory that is quasi-Marxist, in that it openly aims to propel the rise of an all-powerful aristocracy of wealth in exactly the manner that Marx prophesied, taking us toward the sort of class divisions that had old Karl chortling and rubbing his hands, murmuring "Yessss!"

 

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The actual "Supply Side" theory worked. However, it was a simple tweaking of the already monetarist-adjusted Keynesianism, not a refutation. It involved lowering, instead of raising marginal tax rates in response to stagflation.
At the time, the policies of pumping up demand while raising marginal rates to discourage inflation weren't working. Suppliers were raising prices, not increasing output. The marginal rates went down, supply went up and demand was satisfied sans problems with inflation.
That is "real" supply side economics. It worked.

The term was hijacked, and came to represent a simple lie - low taxes for rich people trickles down. That's not economics. That's an excuse to reward political patronage.
"Trickle-down" policies won't help us now. We've bastardized our consumer base. Growth will have to come from closer to the ground, as history instructs and logic demands.
I think you can take Supply Side differently, and some parts of it are incorporated in government modeling.
Now, the Laffer Curve is incorporated in modeling in terms of dynamics: tax cuts do not reduce revenue one for one, because of standard multiplier effects, which is the same for spending, although who spends more is a factor.
But, both types of activities have a dynamic budget constraint, in terms of how much debt the government can accumulate and maintain a positive value for its debt, and/or the currency in which it is denominated.
Also, you can properly treat supply side as more of an argument about the long run postition of the AS Curve in terms of private versus public allocation of resources, in which there are people on the right who make very common "exceptions" for R and D and collective goods provision in terms of long run economic growth, even if they tend to favor private over public investment.
And note, if the government runs into a budget problem, then the only way to get out of it is too increase the rate of growth of the private sector economy, of use the G part of the AD identity to get more resources from abroad or alter the terms of trade.
I vote for entrepreneurship, although I have a sneaking suspicion that the G part of the AD identity is going to be decisive.
apan sure proved the Keynsians fallible! Priving that Kensianism is also culturally-dependent. Stimulating the middles class helps drive economic activity IF the people actually spend the money, instead of simply socking it away. Americans did this, but the Japanese have been uncooperative with government stimulation measures for two decades, refusing to spend.

Which brings us to the biggest difference between (most) democrats and (most) republicans.

The former are actually curious about when and how their theory has worked... or not.
Just remember Ricardian Equivalence, as it is about to make a big comeback. :)
SSE wasn't even good Marxism -- it was Trickled-On Economics in a new dress -- the proverbial lipstick on a pig. And sorry, Don, but the Laffer curve wins the Aptonym Award for ideas mercifully thrown on the ass-heap of history -- not I didn't mean ash.

You can always find a dingy professor who will back you up -- just ask the climate-deniers . Remember Murray's bell curve? And how about the "serious" ID scientists who explain that the Flintstones was Reality TV and reflects the time when dinosaurs and men co-habited this 6,ooo year old earth?

Nobody takes Laffer seriously anymore, and they shouldn't have in the first place -- the primary effect of his work was to provide cover for vermin like Phil Gramm -- John (Sound Fundamentals) McCain's idea of the perfect SoT and probably they only choice worse than Tim Geithner.

The high priest of SSE was poor Jack Kemp, the former Buffalo Bills QB who really got buffaloed with this rotting hunk of stink. Methinks Jack took a few too many sacks. Jack might have been ignorant about economics, but he was mighty convincing -- at least he was able to convince good old Uncle Ronnie that up was down and black was white.

Jack Kemp and Ronald Reagan -- what a team! Supply-Siders will tell you with a perfectly straight face they deserved a Nobel for Economics.
Don,
With as many reasons to not spend as exist...how will we be able to tell? I didn't see the Bush years debt building curtail spending.
David,
In their free market dogma regurgitation, the conservatives insist their Libertarian interpretation works, even in the face of overwhelming evidence it doesn't.
Libertarians are smarter - they don't care if it works.
interesting/valuable summary of a complex topic. I havent read marx in detail [only in summary], but you can see some reverberation of his theory in that the cost of production goes towards the lowest possible price and highest efficiency, but his mistake is that the factories persist and additional gains go into the pockets of the "factory owners".... also, realestate/rent is a very large part of the economy which your analysis does not focus on. there is a economist john hudson who talks about the FIRE elements of the economy-- finance, insurance, real estate-- the exact segment that blew up in the latest recession..... check him out
you might also look at statistics on wealth disparity & paretos law.. some links in my blog.. apparently [shocker] wealth disparity has not declined during the recession.. in contrast to prior recessions... also, unemployment rate is much different among the wealth classes, with the wealthy less unemployed. surprise!!
Some great observations, David. Good job. I think the remark about never cutting taxes on the rich was excellently made and quite important for people to highlight.

Regarding the item in your list of cases that you were unsure of, I think in times of war you must not cut taxes on the rich because that's a time that everyone (meaning even those low-life poor people who are always skirting taxes) need to ante up.

I think a related point is the desire to hold politicians to their tax pledges. It is always spun as an issue of promises made or broken. (Although I'm sure that if Obama had promised not to lower taxes on the rich and later decided he would lower taxes on them, the rich would be lining up their considerable spin machine to explain that sometimes breaking a promise is necessary, etc.) But if you're going to elect people, you should expect them to use their brains and react to circumstance.

If you notice the rhetoric about taxes, the contingent element is never economic circumstance but who is doing it. That is, “lowering taxes was good enough for Kennedy.” not “lowering taxes on the rich was a good thing to do to avoid inflation.” Because if it were worded in the former way, we'd be trying to analyze the market, which they don't want us to do.

Even if you were going to believe the supply-side idea that the money would trickle down, my feeling is to take this additional bit of advice from Reagan: “Trust, but verify.” A tax break for people who do create jobs is great, but a tax break for people just because some such people might create jobs is not great. If I asked for a welfare check just because I might do great things if I didn't have a job, they'd be the first to say that you can't just trust people to do what's good for others.

By the way, you might get a chuckle out of this wall poster about Reagomics.
1) O'Rourke has a very sound summarization. Supply side, like any theory, works in some cases and not in others. When marginal rates are high, cutting it can, and will, spur activity. JFK cutting top marginal rates that were either 90% or 75% (I cannot recall) down drastically, spurred activity. If you are cutting a top rate from 39.6% to 36.0% it will not have as dramatic an impact. So in short, depending on where you are on the curve will drive whether or not the theory will work on not work. It's a cone on its side, frankly.

2) The prime flaw in pre Keynesian thinking, frankly, happens to be what was loosely described as "expectations" to explain away the depression. In short, you can cut taxes all you want, but citizens will not spend money if they still fear an economic implosion. Expectations is the social science element that leads it to being "inexact." Math cannot accommodate emotion into the thought process. Hence why you need to have government as a purchaser in the economy buy things to create the job creation. That is what true stimulus should be rather than tax cuts and more pork with no rhyme or reason to it that just looks like business as usual. (Do NOT get me started.)

So, supply side works with some radical cuts with ridiculously high rates. Not so much for marginal hits of a couple of points when rates are reasonable.