Freeman

ARTICLE

A Walk on the Supply Side

Products Ultimately Are Purchased with Products

JUNE 01, 1995 by RAYMOND J. KEATING

In the movie Ferris Bueller’s Day Off, Ben Stein portrayed a high school teacher droning on about supply-side economics while students fell asleep and even drooled in their seats. Critics of supply-side economics must relish this and other pop-culture references, believing them to buttress their own view of supply-side as a kind of “pop economics.”

However, supply-side economics is not just a recent fad popularized by The Wall Street Journal‘s editorial page and a small band of late-twentieth-century conservative economists. The historical roots of supply-side theory run deep. In fact, the seeds of supply-side thought were firmly planted by such classical economists as Adam Smith and Jean-Baptiste Say, with strands of supply-side ideas dating back literally thousands of years. As nations debate and embark on economic changes taking us into the next century, it is crucial to understand what “supply-side economics” actually means.

Supply-side economics has been defined and ill-defined many times over the past two decades. Often, it seems that supply-siders themselves fail to agree on a definition. Economist Norman Ture cut through much of the morass surrounding supply-side economics, compactly summarizing the subject as follows: “Supply-side economics is merely the application of price theory—so-called ‘microeconomics’—in the analysis of problems concerning economic aggregates—so-called ‘macroeconomics.’”[1] Though brief, Ture’s statement captured the essence of supply-side economics.

I would expand the definition of supply-side economics a bit to the following: Supply-side economics places supply over demand in the hierarchy of economics, and therefore deals with enhancing economic production, efficiency, and growth within the context of the marketplace; largely—but not exclusivelyfocusing on relative prices, such as incentives for working, saving, investing, and risk-taking. While supply-side tax policy has been highlighted for the past two decades, the supply-side school’s purview is much wider.

The Pre-Eminence of Supply Over Demand

The phrase “supply creates its own demand” is known as Say’s Law, after the nineteenth-century French economist Jean-Baptiste Say, and constitutes a central tenet of supply-side economics. The idea undergirding Say’s Law is that supply comes before demand in the economic pecking order, if you will. The fundamental point remains that nothing can be demanded before it is first offered, created, or inventedthat is, before it has been supplied by someone. In addition, no one can legitimately demand something before first supplying a product or service of value to others.

Say, however, never actually wrote in his Treatise on Political Economy that “supply creates its own demand.” He observed that “Products are always bought ultimately with products.”[2]

Understanding that products are bought with products, that one must produce before one can demand, any economy that emphasizes demand over supply is destined to be confronted with stagnation and relative decline, as the size of government inevitably increases, the scope of wealth distribution efforts expand, and the economy slows as creativity, innovation, and risk-taking diminish. Say himself asserted that “the encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.”[3]

Say’s Law not only provides a foundation for the “equilibrium in most economic models and a source of the stability of capitalism,” as supply-sider George Gilder has noted, but also explains how economic growth occurs.[4] Gilder observed: “As the driving force of economic growth, Say’s law exalts the creativity of suppliers over the wants and needs of demanders or consumers. As entrepreneurs invent new things and learn how to make them more efficiently, unit costs and prices drop and goods become more attractive. As goods become more affordable to a wider public, more people work to acquire them by creating goods to exchange. These new suppliers both provide and acquire new wealth at ever lower expense.”[5] That is, supply—work, investment, entrepreneurship, and risk-taking—drives economic growth.

Norman Ture identified the sheer absurdity of a contrary economic theory purporting that government fine tuning or enhancement of aggregate demand fosters economic growth. Ture laid out a devastating supply-side criticism of Keynesian demand management: “The prevailing view that government actions do directly affect aggregate income derives from perceiving these actions as impacting initially and directly on aggregate demand, via effects on disposable income, the changes in which are deemed to result directly in changes in total production. The supply-side analysis, on the other hand, holds that government actions have no direct initial impact on real aggregate demand and, indeed, affect nominal aggregate demand only as a consequence of changes in the stock of money. Changes in real aggregate demand, to be sure, would elicit increases in total output. The pertinent question is how changes in real aggregate demand can occur without a preceding change in total output. By definition, aggregate demand is the sum of purchases of all types by all economic entities—governments, businesses, households, etc. Also, by definition, these outlays must exactly equal aggregate income which in turn, at every moment in time, must just equal the value of aggregate output. Changes in real income, therefore, occur only as changes in output occur. And changes in output occur only as a result of changes in the amount of production inputs or in the intensity or efficiency of their use. To have a first-order effect on income, therefore, government actions would have to alter directly the amount or effectiveness of production inputs committed to production. But government actions, in and of themselves, do not change the aggregate amount of production resources available in the economy or their productivity. Changes in the amount of production inputs committed to production will result only if the real rewards for their use, i.e., the real price received per unit of input, is changed.”[6]

That is, as Say noted, products ultimately are purchased with products. Growth occurs when supply-oriented incentives are enhanced.

Entrepreneurship

Supply-side economics returns the entrepreneur’s role to the center of economic theory. After all, if, as Ture asserts, “changes in output occur only as a result of changes in the amount of production inputs or in the intensity or efficiency of their use,” then the entrepreneur must take center stage as he is the agent of innovation and creativity that increases inputs and/or efficiency.

The modern-day Keynesian school’s focus on government-attempted adjustments in aggregate demand naturally ignores the critical aspect of entrepreneurship in the economy. In addition, the increasing mathematical nature of economics as an academic discipline has left little room for the entrepreneur’s roles as innovator and bearer of risk.

This focus on entrepreneurship perhaps best illustrates the difference between supply-side economists and industrial policy economists. A free-market economy leaves most economic decisions to individuals operating in the private sector, rather than government bureaucrats and/or elected officials, as is the case with industrial policy and its more extreme cousin, socialism. While both supply-side and industrial policy economists largely concern themselves with supply-related issues (e.g., investment, production, etc.), the supply-side school of economic thought operates within the wider intellectual framework of free-market economics, knowing that production for the sake of production is fruitless. Production must meet current or create new demands. Value must be created. And supply-side economists recognize that the government lacks the requisite experience, knowledge, and incentives to make resource allocation decisions or to create value.

The critical role of the entrepreneur in the economy is to see added value where others have failed to do so—to enhance production and/or efficiency. That is, to fulfill the essence of Say’s Law–that supply creates demand. In turn, one can identify numerous types of entrepreneurship. The Schumpeterian entrepreneur, named for economist Joseph Schumpeter and his notion of “creative destruction,” offers innovations or inventions that can transform entire industries and economies. Other entrepreneurs offer improvements in the way particular firms perform through, perhaps, different management or production structures; while still others simply see better ways of doing things and start their own businesses. Additional entrepreneurs are at work in the investment community. For example, an investment banker or corporate raider might see added value through a proposed corporate merger or takeover. Then there are the venture capitalists willing to risk their own investment dollars supporting an idea, invention, innovation, or new business.

George Gilder articulated the importance of returning the entrepreneur to the economist’s center stage: “Economic recovery depends on the resurrection of entrepreneurs. This resurrection cannot fully and durably occur until the ultimate arbiters of economic policy—the economists—resurrect entrepreneurship in their own influential theories. The contrary vision of capitalism without capitalists springs in part from a fundamental error of economic thought, drastically overrating the importance of physical capital formation and other quantitative measures of economic activity and drastically underestimating the decisive and controlling importance of entrepreneurial creativity.”[7]

Relative Prices and Incentives

As Norman Ture noted, supply-side economic analysis is largely microeconomic in nature, i.e., supply side in many ways equates to price theory. Price theory deals with the allocation of resources among different uses, the price of one item relative to another.[8] In particular, supply-side economists focus on the relative prices of work versus leisure, saving and/or investment vs. consumption, risk-taking versus risk avoidance, and productive, market-based activities versus activities based on tax avoidance or government fiat. As a result, we see the great supply-side emphasis on marginal tax rates–or the tax on the next dollar earned–more so than on average tax rates.

Supply-side economists argue, for example, that high marginal income tax rates raise the cost of additional work or work effort as compared to leisure. Higher tax rates also make it cheaper for an individual to undertake non-taxable, do-it-yourself work, like painting one’s own house, rather than performing income-generating, taxable work while hiring a house painter. Under these circumstances, the benefits of division of labor are lost to the economy. The returns of tax avoidance are enhanced as well.

A high marginal income tax rate regime also creates a clear bias in favor of consumption over saving and investment. Real and human capital investments become relatively more expensive versus consumption. Particularly worrisome, high tax rates, as well as onerous regulations, raise the relative price of such critical yet high-risk endeavors as entrepreneurship and venture capital investment. According to supply-side theory, the implications under such a regime can be severe. High-risk ventures require at least the opportunity for high returns. When such opportunities are diminished by governmental policies, a stultified economy results, with the relative security of, for example, employment in government or in a large corporation, and investment in government securities, being enhanced versus the potential returns on more risky, but more productive, entrepreneurial endeavors. Risk-taking, so crucial to economic growth, is discouraged by onerous taxes and regulations.

The full impact of relative prices on employment is captured in what supply-side economists refer to as the tax wedge. In essence, the tax wedge is the difference between the total cost to an employer for an employee, and the actual take-home pay of that employee. Taxes, regulations, and government mandates constitute the tax wedge. A large tax wedge significantly raises the price of labor relative to capital. Concurrently, the tax wedge can diminish incentives for employees to accept overtime; boost employee compensation demands; and/or narrow the gap between take-home pay and government benefits (e.g., welfare or unemployment compensation) for some workers.

These relative price/incentive arguments fall under the economists’ label of “substitution effects.” That is, as the costs of productive endeavors–such as working, investment, and risk-taking—decline as marginal tax rates are reduced, for example, the incentives to substitute these activities for leisure, consumption, and tax avoidance are enhanced. Under such a scenario, the opportunity costs of not working, investing, or risk-taking increase.

Other economists have claimed that just the opposite occurs under a tax-cut scenario, that individuals will choose to paradoxically work or invest less. These economists essentially claim that the income effect takes precedence over the substitution effect. The income effect argument states that individuals have a targeted level of income, and a tax cut allows them to reach that target by working less. Substantive problems arise with such an argument: (1) It not only nullifies supply-side, relative-price arguments, but Keynesian demand-management policies as well. Keynesian arguments that more government spending increases aggregate demand and therefore economic growth fall prey to the same income effect argument. Individuals would work less, and GDP and income would fall; (2) If the income effect were to hold in general, that would mean that ever-higher marginal income tax rates should induce ever-increasing levels of work and investment. Or, under the contrary scenario of tax reductions, as the price of work, saving, or investing falls, individuals choose to work, save, and invest less. In essence, as supply-side economist Paul Craig Roberts has noted, income becomes an inferior good.

Roberts identified the full implication of the income effect argument: “In economics, any time the ‘income effect’ works counter to the ‘substitution effect,’ we have the relatively rare case of what is called an ‘inferior good’ (i.e., people purchase less of it as their income rises). Since income is command over all goods, [the income effect] argument implies that all goods are inferior goods: A tax cut will cause people to purchase only more leisure, not more income (i.e., goods).”[9] It is difficult to muster a more devastating counter-argument to the income-effect criticism of supply-side economics than this inferior goods point made by Roberts.

Inflation as a Monetary Phenomenon

Price stability is a paramount concern of supply-side economists. After all, inflation creates numerous economic woes. It acts as a tax by whittling away at individuals’ earnings, savings, and investments. Inflation raises interest rates. If income tax rates are not indexed, inflation pushes people into higher tax brackets without any real increases in income. Also, inflation weakens the international value of a currency, resulting in capital flight and economic stagnation. In the end, inflation is a clandestine tax that damages economic growth and opportunity.

Supply-side economists agree with most other free-market economists on the fact that inflation is a monetary phenomenon, and not a result of too much employment and economic growth, as today’s Keynesian economists argue. For supply-siders, the classic definition of inflation holds firm: too much money chasing too few goods. So contrary to Keynesian thinking, supply-side economists will argue that expanded production and economic growth actually act as an inflation remedy.

International Trade, Investment, and Currency Devaluation

Supply-side economists are exclusively, but by no means uniquely, free traders. Like most other schools of economic thought, supply-side subscribes to the notion of Ricardian comparative advantage. From a supply-side view, the lowering of tariffs and other trade barriers expands markets and opportunities, promotes competition, and fosters economic growth.

Also, supply-side economists extol the benefits of exchange-rate stability. Why? Exchange rate volatility creates uncertainty in terms of international trade and investment decisions. Supply-siders would agree with Adam Smith’s observation that “a commodity which is itself continually varying in its own value, can never be an accurate measure of the value of other commodities.”[10] Such uncertainty discourages international investment. Supply-side economists argue that this international uncertainty exerts upward pressures on interest rates, as investors seek to compensate for added risks, most prominent being government devaluation.

Mexico’s recent devaluation provides a clear example of the woes of devaluation. Generally, nations will devalue their currencies versus other currencies in a misguided and futile effort to manipulate the terms and balance of trade. Hence exports are cheaper to their trading partners, and their own imports more expensive.

This neo-mercantilist fantasy suffers from two problems. First is that products are still purchased with other products, so any advantage derived from exchange-rate manipulation will be short-lived until individuals re-adjust their currency terms of trade–ensuring that if two bottles of wine traded for one pair of shoes before devaluation, the same trade could be made eventually after devaluation. The only way to really alter such a transaction is by increasing production, improving efficiency, or changing tastes. Second, this short-term “advantage” is obliterated by inflation, capital flight, and economic stagnation. Huge swings in the value of currencies make it difficult, if not impossible, for individuals to make any long-range decisions regarding international investment.

General View of Government

As already noted, supply-side economics falls under the broader category of freemarket economics. Therefore, supply-siders hold the same skepticism of government as do their free-market cousins, such as monetarists and Austrian economists.

However, various supply-siders have been criticized by some of these free-market cousins for not focusing enough attention on government spending. Such criticisms may apply to certain individuals, but cannot be applied to the general supply-side school of economic thought.

In fact, devoid of proper incentives, government is viewed by supply-side economists as inherently wasteful. In essence, supply-siders view government as generally unable to produce anything of value. Government can redistribute; it surely can destroy; and when functioning adequately, it can protect; but government remains unable to create.

Therefore, supply-side economists concern themselves with the overall size of government. In fact, in the supply-side view, the size of government generally takes precedence over concerns about, for example, the size of a nation’s budget deficit. Supply-side economics argues that what primarily matters is the total amount of resources being diverted away from productive private-sector ventures to generally unproductive government undertakings. Then supply-side economists evaluate the method for financing those government expenditures. The relative shares of borrowing versus taxing are evaluated according to the respective marginal costs to the economy.

In particular, supply-side economists view government social-welfare programs with a wary eye, not only due to the amount of waste associated with such programs, but more importantly, due to the perverse incentives such programs establish. Of concern is the fact that the welfare state breaks the key supply-side principle of supply preceding or creating demand. The welfare state allows an individual to demand without first supplying a marketable good or service—flying in the face of the basic requirement for a prosperous economy and society according to supply-side theory, that “products are bought ultimately with other products.” So, we have a situation where an individual being subsidized through government welfare is buying products with products produced by others. This system provides disincentives for the individual on welfare to undertake productive activities, while also establishing disincentives for those individuals providing the welfare subsidies, as they receive less return for their work, investment, or risk-taking. Also under such a system, not only are producers confronted with higher taxes, but the marginal tax rate—including the combined loss of government benefits plus the tax rate on income–confronted by welfare recipients thinking of moving off welfare can be considerable, even in excess of 100 percent.

Lastly, supply-side economists naturally view the government’s role of protecting life, limb, and property as essential to a healthy economy and society. Devoid of such protections, absolutely no reason exists for individuals to move beyond mere subsistence levels of production.

The Supply-Side Difference

What is the fundamental difference between economists and schools of economic thought? The late economic journalist Warren Brookes wrote: “Since economic thought first became formalized over two centuries ago, there have been essentially two different views about wealth. One view, first defined by Adam Smith and Jean-Baptiste Say, is that wealth is primarily metaphysical, the result of ideas, imagination, innovation, and individual creativity, and is therefore, relatively speaking, unlimited, susceptible to great growth and development. The other, espoused by Thomas Malthus and Karl Marx, contends that wealth is essentially and primarily physical, and therefore ultimately finite.”[11]

Though I risk upsetting many economists who shun the “supply-side” label, broadly, I think the former can be categorized as supply-siders, the latter wear the blinders of demand-side economics. I do not make such an assertion lightly.

For example, it was the great Austrian economist Ludwig von Mises who observed in his Human Action: “Capital levies, inheritance and estate taxes, and income taxes are … self-defeating if carried to extremes.” Mises went on to explain:

 

It is one of the characteristic features of the market economy that the government does not interfere with the market phenomena and that its technical apparatus is so small that its maintenance absorbs only a modest fraction of the total sum of the individual citizens’ income. Then taxes are an appropriate vehicle for providing the funds needed by the government. They are appropriate because they are low and do not perceptibly disarrange production and consumption. If taxes grow beyond a moderate limit, they cease to be taxes and turn into devices for the destruction of the market economy….

[T]he true crux of the taxation issue is to be seen in the paradox that the more taxes increase, the more they undermine the market economy and concomitantly the system of taxation itself. Thus, the fact becomes manifest that ultimately the preservation of private property and confiscatory measures are incompatible: Every specific tax, as well as a nation’s whole tax system, becomes self-defeating above a certain height of the rates.[12]

No supply-side economist could have put the argument better. []


1.   Norman Ture, “Supply Side Analysis and Public Policy,” Essays in Supply-Side Economics, edited by David G. Raboy (Washington, D.C.: Institute for Research on the Economics of Taxation, n.d.), p. 11.

2.   Jean-Baptiste Say, A Treatise on Political Economy (New York: Augustus M. Kelley Publishers, 197 1), p. 161

3.   Ibid., p. 139.

4.   George Gilder, Microcosm (New York: Touchstone, 1989), pp. 61-62.

5.   Ibid.

6.   Norman Ture, “Supply Side Analysis and Public Policy”, Essays in Supply-Side Economics, p. 13.

7.   George Gilder, Recapturing the Spirit of Enterprise (San Francisco: ICS Press, 1992), p. 165.

8.   Milton Friedman, Price Theory (New York: Aldine Publishing Company, 1976), p. 7.

9.   Paul Craig Roberts, “The Breakdown of the Keynesian Model,” Keeping the Tablets: Modern American Conservative Thought edited by William F. Buckley Jr. and Charles R. Kesler (New York: Harper & Row, 1988), p. 229.

10.   Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Volume I (Chicago: University of Chicago Press, 1976), p. 37.

11.   Warren T. Brookes, The Economy in Mind (New York: Universe Books, 1982), p. 12.

12.   Ludwig von Mises (Chicago; Contemporary Books, 1966), pp. 740-741.


Filed Under : Inflation, Demand, Ludwig von Mises, Entrepreneurship, Supply and Demand

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