Supply-Side Economics: An Effective Approach For Countering Stagflation?

Saturday, April 29th 2017

Article By: David McDonald

As consumers, we all fear the dreaded inflation, but we rarely hear economists discussing the even more damaging stagflation.

For those of you who have never heard the term, stagnation usually is felt to be synonymous with a recession. Inflation usually means prices rise (as measured by the Consumer Price Index) or the value of money falls, compared with the value of goods, by an amount considered excessive. Neither of these words has a rock-solid definition, and it is not unusual for the federal government to declare recessions, only to issue “corrections” months after the fact.

The Fed tries to keep what it defines as inflation in the 2% – 3% range. The fundamental belief is a “little” inflation is economically beneficial, while a lot of inflation, and any deflation, hurt the economy.

Clearly, determining when stagflation begins or ends is subjective and measured by arbitrary definitions. Nevertheless, stagflation is one of the most feared economic situations.

Why? Because the Federal Reserve Board’s primary inflation-fighting tool, raising interest rates, is believed to exacerbate stagnation. And what the Fed believes is it’s primary stagnation-fighting tool, lowering interest rates, will exacerbate inflation.

Thus, the Fed believes it is caught in a dilemma. It’s most important tool, cannot be used both ways. Imagine people caught on a burning ship, and their only life-saving tool is a fire hose. If they don’t use it, they burn. If they do use it, they drown.

I said the Fed believes it is caught in a dilemma. In fact, there is no dilemma. The reason can be found in history.

Contrary to popular wisdom, history shows there is no correlation between interest rates and GDP growth. High rates have not slowed GDP growth; low rates have not stimulated GDP growth. In short, interest rates can be raised to cure inflation, without hurting GDP growth.

But what about stagflation? How does the Fed go about fighting such a phenomenon?

With Supply-Side Economics

Supply-side economics is better known to some as “Reaganomics,” or the “trickle-down” policy espoused by 40th U.S. President Ronald Reagan. He popularized the controversial idea that greater tax cuts for investors and entrepreneurs provide incentives to save and invest, and produce economic benefits that trickle down into the overall economy. In this article, we summarize the basic theory behind supply-side economics.

The Argument That Supply Creates Its Own Demand
In economics, we review the supply and demand curves. The first chart below illustrates a simplified macroeconomic equilibrium: aggregate demand and aggregate supply intersect to determine overall output and price levels. (In this example, output may be gross domestic product and the price level may be the Consumer Price Index.) The second chart illustrates the supply-side premise: an increase in supply (i.e. production of goods and services) will increase output and lower prices.

Starting Point

Increase in Supply
(Production)

Supply-side actually goes further and claims that demand is largely irrelevant. It says that over-production and under-production are not sustainable phenomena. Supply-siders argue that when companies temporarily “over-produce,” excess inventory will be created, prices will subsequently fall and consumers will increase their purchases to offset the excess supply.

Was Supply-Side Economic Policy Effective In Ending The Stagflation Experienced In The 1970s?

Yes, of course, it was.

The most effective way to fix stagflation is to raise interest rates and increase the federal deficit.

As seen in 1971 and 1973, the federal budget deficit increased drastically when the US economy was faced with stagflation. When the government runs a budget deficit, it means they are spending more, which can lead to greater inflation but is not the sole reason as to what causes inflation.

We know that an increase in the money supply causes inflation.

However, History shows that this assumption is not correct. As you can see in the above chart, there is no relationship between changes in total debt (money) and inflation.

The value of money is determined by supply and demand. So, it is true that increasing the money supply without interest rate control would lead to inflation unless the demand also was increased. What increased demand? An increase in interest rates. In short, deficit spending does not cause inflation, because we have the power to prevent inflation at will.

This is precisely why supply-side economics works considerably well; in theory, if you can increase the aggregate supply of the economy by running a budget deficit, then you can hopefully increase aggregate demand, which should, in essence, lead to more inflation and less stagflation.

This is what happened in the 1970s which effectively led to more inflation and less stagflation.

The Future

When looking forward, we can conclude that supply-side economics (i.e. raising interest rates and increasing government expenditures) will be an effective means of exasberating recessionary periods.

For the world’s worst-performing economies, no good will come from New Year’s resolutions to do better. For many, 2016 will only bring more disappointment, say economists surveyed by Bloomberg.

Oil-rich Venezuela will contract by 3.3 percent this year, the worst forecast of any of the 93 countries in our analysis, followed by junk-rated Brazil, debt-laden Greece and commodities-ravaged Russia. 

According to Bloomberg, Brazil, Russia, Ukraine, Argentina, and Taiwan all have a 50-50 chance of facing a recession in the next year, and if this is the case, these countries’ governments should consider expansionary policies to alleviate any consequences a recession may cause. 

Supply-Side economics may be a promising solution for these nations because the practice increases the money supply in essence, and counteracts stagflation.