The concurrent high unemployment and inflation of the 1970s was a painful period in American economic history. Stagflation came as a shock to many politicians and economists alike. By the 1970s, Keynesian economic thought was embedded in the minds of most policymakers. Although Milton Friedman and Edmund Phelps had publicly refuted the idea that there is stable trade-off between inflation and unemployment, policymakers were not quite willing to let go of the belief.
Arthur Okun developed a simple index of economic hardship called the misery index. The misery index is the sum of the unemployment rate and the inflation rate. Given normal conditions, the misery index is usually around 7. During the Carter administration, the misery index steadily increased because of stagflation and reached an all-time high of 20.76.
The Keynesian economic framework so permeated policy decisions by the 1970s that data challenging the effectiveness of Keynesian economics created cognitive dissonance for many. When unemployment is high, government should spend more, and when inflation becomes a problem, the Fed should tighten. What stagflation presented was an intractable problem for many in positions of power. Spending to alleviate unemployment would only make inflation worse. Fed tightening would reduce employment. The policy options of those influenced by Keynes focused on either increasing or decreasing aggregate demand. What to do? The answer offered by some was to focus on the supply side of the aggregate supply and aggregate demand model.
Although it might appear that all things Keynes are associated with Democrats and supply side with Republicans, this is not the case. Much of the criticism of supply-side economic theory came in the 1980 Republican primary from Reagan’s chief opponent, George H.W. Bush, who referred to Reagan’s economic plan as “voodoo economics.”
Stagflation was fundamentally a supply problem, which is why a demand-side solution would not work. Classical economics’ laissez-faire approach enjoyed something of a renaissance after Ronald Reagan’s election. In the classical view of the economy, flexible and efficient markets ensure that the economy will maintain full employment. When recessions or periods of inflation set in, flexible input prices cause aggregate supply to increase or decrease and bring the economy back to full employment without government intervention. In the years from the 1930s to the 1970s, there was a decrease in the flexibility and efficiency of the labor market. The supply-side argument was that government had gummed up the works and the markets needed to be de-Keynesed.
Deregulation, which began under President Carter, picked up steam under Ronald Reagan. The airlines, which in the past had been heavily regulated by government, were set free and forced to compete with each other. This resulted in far more flights at cheaper prices. It also meant that the least efficient airlines were driven out of business.
Labor unions saw a decline in power under the Reagan administration. Foreign competition in the steel and car industry weakened the position of the unions. Probably the most powerful symbol of the loss in union power came at the hands of the newly elected president. The air traffic controllers union had lobbied for better pay and working conditions. In 1981, the union went on strike in violation of federal law. After being warned to return to work or be fired, over 11,000 air traffic controllers refused to return and were summarily fired by President Ronald Reagan. The message was clear.
While running for office, Reagan promoted the idea that tax cuts on high-income earners would enrich all Americans, as people had more incentive to spend and save. The spending and saving would lead not only to more consumption, but also more capital investment. As investment increases, businesses expand their productive capacity, and this leads to higher employment. The resulting increase in capital also leads to greater productivity, and eventually, lower prices.
The power of tax cuts to stimulate aggregate demand was well known to Keynesian economists. But the supply-side spin was that tax cuts would not only stimulate aggregate demand, but supply as well. At the same time that Reagan was proposing tax cuts, he also called for an increase in defense spending to counter the Soviet threat. Economists, politicians, and average people questioned the idea of simultaneously cutting taxes and increasing government spending. It appeared obvious that such a combination of policies would result in the federal government running large deficits as it spent more and taxed less.
Sometimes reality has a way of ruining a great idea. Reagan got his tax cuts and he got his increases in defense spending, but he also got huge deficits. Increased tax revenues failed to materialize. Instead, tax revenues drastically fell, and government budget deficits increased steadily during Reagan’s administration.
A criticism of supply-side economics is that it effectively redistributes income to the rich. Because the mantra of supply-side economics is “tax-cuts on income and capital gains,” it stands to reason that the immediate beneficiary is going to be those with significant income.
Although supply-side economics is not mentioned much anymore, its arguments and logic are still part of the Republican and Libertarian political platforms. Cutting taxes, creating incentives for people to save and invest, and a general distrust of government involvement in the economy are supply-side ideas that still resonate with many voters. Democrats tend to promote a more populist agenda. Tax cuts for the middle class with tax increases on the wealthy, increased regulation of business, and the use of transfer payments to redistribute income are all ideas advanced by the Democrats and associated for good or bad with the Keynesians.
Although supply-side economics as a field of study is derided by most mainstream economists, it has served to remind people that incentives matter. Policymakers must consider not only what voters want, but also how their policies shape the incentives of consumers and producers. Whenever government creates a new mandate that seeks to regulate economic behavior, it must also be prepared to deal with the unintended consequences that occur as the new mandate alters the incentives of individuals and institutions.
Ignoring the supply side of the economy leads to a unilateral approach to policymaking that ultimately boxes government into two choices: increase aggregate demand or decrease aggregate demand. By recognizing the role of aggregate supply, policymakers can promote more policy solutions to achieve their ultimate economic goals. For example, recognizing that a tax cut on personal income has demand-side and supply-side effects allows policymakers to sell the option to their diverse constituencies.