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Supply-Side Economics Can’t Fix a Demand-Side Problem

January 15, 2013

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.

Shiller 10 Year P/E Ratio

In January 1981, the Shiller PE was 9.26 – about 38% below it’s historical average of 15. Today, it is 21.44 – about 43% above it’s long-term average.

In January 1981, long term treasury bond rates were over 11.5%.

In January 1981, long term treasury bond rates were over 11.5%.Today, they are at historic lows.

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.

One Comment
  1. Rob11156 permalink

    It seems that supply side economics only works for 2% of the population. I’m no economist but tax cuts for the wealthy have spiked unemployment over the past nine years. The unemployment rate was at 4% at the end of the Clinton administration and at the end of the Bush reign it was 9%. So cutting taxes for the job creators didn’t work.

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