Supply-Side Economics Can’t Fix a Demand-Side Problem
Typically, weak economies are characterized by high unemployment and low inflation, while strong economies are characterized by low unemployment and higher inflation. This makes intuitive sense – a strong economy creates more demand for goods and services causing price inflation. It also creates more demand for workers which can lead to a rise in wages.
The economy of the 1970′s was different. Throughout the 1970′s both inflation and the unemployment rate moved higher. The high inflation of the 1970′s implied that demand was strong – suggesting the problem was weak supply. This led to the supply-side economic policies of the Reagan administration.
The main tool of these supply-side (aka trickle-down) policies was tax cuts. The idea being that if you cut taxes for people at the top, there would be an increase in investment capital which would lead to more business investment and higher supply. The effects of these tax cuts would then trickle-down to everyone else through lower unemployment and a stronger economy.
Looking at the conditions which existed in 1981, this made a lot of sense. The stock market was significantly undervalued and interest rates on bonds were high. Both of these conditions suggest a shortage of investment capital.
After the implementation of supply-side policies, both the stock and bond markets staged strong rallies. Those policies appear to have worked.
Today, however, we have the opposite problems – the stock and bond markets are both well above historical averages. This is clear evidence that there is plenty of investment capital, and no supply-side issue.
The current economy is experiencing an old fashioned demand-side problem. Implementing more supply-side policies now it will only make things worse.