Simplifying Demand Side and Supply Side Economic Differences

by: Wisdom vs. Information

Supply side economics, which was a silly term to begin with, has become completely meaningless. It was a silly term because economics is economics is economics; there is no such thing as supply side economics, liberal economics, etc. The curves can move up and down and one can theorize how to cause that, but HOW they will move is not subject to partisan politics. Copper miners in Chile do not care why you are trying to move the demand curve; if you move it up, they will charge you more for copper, and that is as certain as death and taxes. The term is meaningless because it has become a political term instead of economic; it is associated with one party and damned by the other, even though both parties proudly exercise supply side stimulus.

Stimulus. Ah, now we approach the heart of the matter. Economics at its most basic is two intersecting curves. One represents the amount of widgets (ie, goods and services) sellers will supply at various prices; the higher the prices, the more widgets sellers will supply. The other curve represents the amount of widgets buyers will demand; the lower the prices, the more widgets buyers will demand. These lines can only intersect at one point. Different widgets have different curves; eg, gasoline demand changes very little. Supply stimulus has two goals: 1. To move the supply curve straight down so that it intersects the demand curve at a lower price/ more widgets; 2. To create completely new sellers with new widgets. Demand side stimulus has one simple goal, move the demand curve straight up so that quantity and price increase.

Thus, we see the first enormous problem with demand side stimulus: prices increase. Demand side advocates will claim this is in fact necessary during deflationary periods; to simplify grossly, the theory is that if prices are going down, sellers will not invest in capital (to build new widgets) during deflation because they fear that they will not be able to get a reasonable return on their investment once prices have reduced. There are two problems with that theory: 1. History. History shows us that when widgets become overpriced during bubble/inflationary periods, consumers will not buy widgets at their new prices, demand side stimulus be damned; and, on the other side, history shows us that capital will be purchased if its cost goes down, regardless of price direction. 2. If demand was too high then supply was too high; supply must be allowed to adjust to new real demand, or a new cycle of failure will follow the first one as soon as stimulus is withdrawn. See Japan the last twenty years for a simple example.

Politicians have an infinite number of stimulative options. Some examples of demand side stimulus: the Treasury can buy more US dollars in order strengthen buyers' demand for foreign consumer goods, one of the Clinton administration's primary stimulus tools; federal income tax rebates give money back to consumers thus increasing total demand and the green energy rebates, Bush administration tools; and, the Obama administration tax rebates for homes and cars and expanded green tax rebates. All of these actions have no effect on the supply curve, they are strictly demand side stimulus, or 'demand side economics' if you like. So you see, the Bush administration's tax rebates are not 'supply side economics.'

Supply side stimulus is less understood and less discussed. Most HUD programs subsidize building of low-income housing; those actions have no effect on the demand curve, they are strictly a supply side stimulus. Creating the federal highway system increased the demand for transportation, but that is a secondary effect because the demand for transportation already existed; subsidizing road construction is supply side stimulus. The Rural Broadband initiative has zero effect on the demand curve as well, as the money goes to suppliers who are able to provide services on a lower curve because the initial cost is lower; again, supply is created that was not there before, but the theoretical demand CURVE does not move. Finally, we get to "supply side economics", Reaganomics, trickle down, etc: lowering capital gains taxes.

Lowering capital gains taxes makes it cheaper to invest in new capital. New capital is the sine qua non of job and wealth creation: without capital, entrepreneurs CANNOT buy capital equipment that employees need to operate, or cash to pay employees to supply services. No capital, no employees, no returns, no income tax receipts, it is that simple. Because it is cheaper to invest in capital, the supply curve moves down: more widgets are supplied at a lower price. The higher capital gains taxes rise, the higher the supply curves rise, and the fewer widgets are sold at higher prices. Again, this is not subject to politics. If it is more expensive to invest in a copper mine in Chile, then your wire is going to be more expensive and you are going to buy less.

The Kennedy/Johnson administration lowered capital gains taxes after job growth stopped in the Sixties and they needed some real growth, and the Clinton administration did the same thing. After some real job growth, Congress always shuts those tax breaks since they are perceived to benefit the wealthy; reality is far simpler: small business and the middle class thrives when capital gains taxes are relatively low-- more small business supply means lower prices directly and more efficiency and lower prices from big business indirectly; secondary effects are that small businesses need more capital equipment from big businesses, so corporate profits of efficient companies increase. Again, this is not subject to politics, we have seen this cycle in the mid-1960s, the 1980s and again in the 1990s. Capital increases, jobs increase, then tax receipts increase; in the case of the Eighties, enough tax receipts were created to pay for the capital gains tax decreases within a few years.

The effect of demand side stimulus is quite different. Since it has no effect on the supply curve, there is no direct effect on capital investment; corporate profits increase a little, but how much capital does it take to increase the supply cars or airline seats or iPhones? Very little. Corporations simply hire a few more employees, run another shift, etc. Since all prices go up and the cost of investing in capital remain the same, demand for corporate equities go up instead of small business investment. Again, this is not subject to political manipulation, we have seen this cycle repeatedly over the last hundred years. Western European and Japanese anti-capital actions over the last twenty years have completely eliminated small business growth, and we have seen the same effect in the US during the 1970s and the 2000s.

A quick example: locally produced eggs. Supply side stimulus would include tax breaks on feed or land to egg ranchers; demand side stimulus would include lowering property taxes in general, "demand side economics," or giving tax payers a property tax refund in exchange for receipts for purchasing locally produced eggs; if the locality had a capital gains tax, it could lower that tax, encouraging all businesses and potential businesses to expand-- and that would be "supply side economics."

Before it was used as "Republican economic strategy," supply side economics referred to the strategy of encouraging new business via new capital investment. These economic tools have been dramatically successful over the last forty years, and with job growth negative over the last ten years, it is inevitable that supply side economics will come back into style, still misunderstood and misrepresented, in the near future.

Disclosure: No positions