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Keynesian (Demand Side) Economic theory Supply Side Economic theory (“Reaganomics”) Each Congress and Presidential administration has its own perception of the proper relationship between the government and the economy. Named after John Maynard Keynes, a British By the 1980s, the policy of deficit spending economist whose most important and influential seemed to be out of control—deficits were work, The General Theory of Employment, Interest, mounting. and Money (1936) presented reasons behind and prescription for the terribly high unemployment Uncontrolled spending by the government on rates that accompanied the Great Depression. entitlement programs like Social Security payments at all levels without accompanying At the center of his theory was the message that increases in government revenues (i.e. higher government had to become involved in economic taxes) resulted in a massive, growing, and affairs and could no longer trust any invisible burdensome national debt. force to right the economy. In short, the U.S. government did not let prudence Keynes said there was no natural method of dictate by reigning in uncontrolled spending. correction that would easily and quickly force the economy back into full employment (rather, an As the national debt continues to rise, the U.S. artificial stimulus was needed). federal government will eventually run out of credit—since the value of the dollar rests on Keynes claimed the level of employment peoples’ confidence in the government, there is a depended on the total demand for goods and great deal at stake in bringing the debt under services in the market place. control. Since aggregate demand (consumer spending) diminishes during a depression, producers are forced to cut back on production and lay off employees. This causes a decline in demand and downward spiral begins. In order to increase the aggregate demand for goods and services in the marketplace, Keynes proposed that the government must provide the means to stimulate consumer spending. Increased government spending would ignite a need for increased production, and people would have to be re-hired. Through the use of fiscal policy, the government can use its taxing and spending powers to get more money in the pockets of consumers (e.g. reduce taxes and/or increase government spending on public works projects and welfare programs or by buying up market surpluses so as to keep the productions lines open and jobs available). In 1980, with the election of Ronald Reagan to the presidency, the approach to fiscal policy changed (resulting in yet another episode/battle in the raging debate over the liberal (loose) v. conservative (strict) construction of the Constitutional powers and responsibilities of government. Reagan’s conservative supporters denounced most liberal demand-side policy as inefficient, shortterm manipulation of demand. Conservative programs sought to generate a balanced budget and end deficit spending. Whereas they cut taxes, they never managed to reduce spending (largely because of defense spending and the Cold War). To replace Keynesian (demand side) economics, President Reagan’s advisors saw a solution in the writings of Jean-Baptiste Say. Say was a French economist (1767-1832). In his This action/policy would then trigger a chain reaction of buying and producing, thus providing jobs and reducing unemployment . Treatise on Political Economy (1803), Say reorganized and popularized Smith’s market theories in Europe. This is known as discretionary (intentional) fiscal policies; When the economy suffers from recession or depression (high rates of unemployment and economic stagnation), Congress can reduce taxes and/or increase spending by providing jobs and increasing government contracts for public works. The objective is to “prime the pump” (i.e. pump more $ into society to stimulate consumer spending (aggregate demand). Say believed that most government intervention with the economy is harmful—he claimed that economic stability can be assured not by stimulating aggregate demand, but by increasing aggregate supply. When people are earning an income or get a tax break (i.e. they keep more of their income), hopefully, they take that money and spend it in the marketplace. This increases spending (aggregate demand) which further triggers increases in supply because as people spend more, more goods and services are needed and factories and private businesses (prodded by an increase in aggregate demand) begin to increase production (would necessitate rehiring people who were hitherto unemployed to produce the increased amount of goods that consumers are demanding). Once factory workers are back in the factories earning wages (i.e. the unemployment rate drops), they would further add to aggregate demand. In turn, factories would have to hire more people, and so on. During the New Deal, leaders avoided fiscal policies related to taxes (taxes were already low and raising them for revenue would have been disastrous because it would have taken purchasing power away from consumers and any further drops in aggregate demand would result in more factory closings/cutbacks and an even higher rate of unemployment/underemployment). FDR stated in his 04-14-1938 Fireside chat on economic conditions that the cause(s) of the recessions in the 1930s was under-consumption and overproduction. Say’s interpretation of Smith’s ideas, he argued that supply creates its own demand. Producers not encumbered by government rules (laissez-faire) act in their own self-interest to realize profits, and in doing so, they stimulate growth (Say’s law). According to Say’s law, producers create demand by paying for all of the factors of production necessary to put a good or service on the market—meaning every payment made by a producer is income for someone else. Once that income is obtained, it is spent, essentially becoming new demand. In this way, Say maintains the production of one good stimulates the creation and consumption of others. To supply-side economists, this means that growth is defined by an economy’s ability to produce. The more the economy produces, the wealthier it is. Say’s economic theory also embraced and endorsed Smith’s doctrine of laissez faire. According to Say, any economic depression that existed was caused by trade barriers (tariffs) that government put up to prevent the free exchange of goods and services with other nations. Output must have markets in which to be sold. When government prevents producers from accessing these markets, it causes the Instead, New Deal programs centered on spending actions. In order for the government to “prime the pump” (stimulate the economy by triggering an increase in aggregate demand), it must have the financial resources to use. To spend more while keeping taxes low, the government goes into financial markets to borrow money on a very large scale. In truth, the government spends what it does not have (called deficit spending). Continued deficit spending will invariably increase the national debt ((the total amount the federal government owes to creditors—it represents the accumulated unpaid balance of many past years’ deficits). FDR in his 04-14-1939 fireside chat: “Such an addition to the net debt of the United States need not give concern to any citizen, for it will return to the people of the United States many times over in increased buying power and eventually in much greater Government tax receipts because of the increase in the citizen income.” In short, higher employment rates (i.e. increases in private income) would result in increased tax revenues that, once collected, could be used to pay back the government for the borrowed money it had to spend (i.e. pay down the deficit). This role of economic stabilization raises questions of Constitutionality and it often results in heated debates surrounding the perpetual loose v. strict battle over the use of implied powers and what is actually considered “necessary and proper” functions of government in carrying out its expressed powers. New Dealers claimed the role was implied as an evolution of the function of taxation. In other words, the elastic clause (Article I Section 8) allowed it, just as it did a B.U.S. to stabilize finances. depressions. Say claimed overproduction cannot harm the economy if trade is free. Only government interference with trade keeps goods and services from reaching world markets. Say’s supply side ideas became the basis for Reagan’s conservative economic programs, popularly known as “Reaganomics”. Conservatives want a reduction of the economic roles of government—their program includes income tax cuts for citizens and corporations, government spending cuts on programs (exception: defense spending), and cuts in government regulation of the economy (deregulation). Conservative supply-siders claimed these changes would provide producers with incentives to increase investment and production—they reasoned that more production would mean more jobs, and more jobs would mean more income, and more income would mean more spending, and more spending would mean growth and prosperity. Thus, supply-siders believed that stimulating supply would trigger a growth of aggregate demand. During the twenty years between the end of WWII and the mid-1960s, the government’s taxation and spending grew, and the economy flourished (employment/growth in certain industries like defense and construction soared as a result of the Cold War, construction of the Interstate Highway System, and urban renewal initiatives). This sustained period of economic growth and prosperity convinced many authorities of Keynes’ wisdom—it was clear, at least to them, that this form of fiscal policy could be used to keep the economy growing and meeting the goals of economic stabilization policy: (1) zero unemployment; (2) no inflation (i.e. continued and sustainable economic growth and prosperity). Since the New Deal, most Presidents and Congresses have followed the liberal Keynesian style of fiscal policy. The Keynesian approach was institutionalized with the passage of The Employment Act of 1946 that: 1. required the President to make an annual report on the condition of the economy, 2. authorized a three person Council of Economic Advisors for the President to assist with this, 3. established a Joint Congressional Economic Committee. This act acknowledged a permanent role for government to use tax policies and spending programs to stabilize the economy. With this legislation, the government now had a legal obligation to use discretionary fiscal policy to influence aggregate demand and make other adjustments to the economy. From FDR’s New Deal through the Carter administration, John Maynard Keynes’ ideas were part of our government’s economic activities. To demand side economists, growth is defined by an economy’s ability to consume. Increasingly, Americans have become dependent on the government for economic help. The public’s desire to create smaller, less costly government has always been hindered by its dependence on government services. Amid their cries for lower taxes and budget deficit reduction in the 1990s, many Americans still wanted a national government health care program in spite of the cost. Since the Great Crash of 1929, local, state, and federal bureaucracies have been growing continually. In the 1930s Depression, the situation was desperate enough to alter the sacred doctrine of laissez-faire. In the New Deal, Congress frequently stretched the Elastic Clause to give the federal government more and more economic power, and the public accepted all the help it could get. From the Great Depression’s desperate experience, people came to expect help anytime they needed it (floods, earthquakes, hurricanes, unemployment, bad weather and freezing crops, etc.). People now expect government grants, subsidies, low interest loans, and emergency finances to rebuild, restore, replace, replenish, resurrect, repair, and recover. Today, people demand more from government and its economic roles have grown—more people and more problems means more spending and bigger government. Some people feel entitled to all the services and protections as if they were a birthright. Yet, when government turns to taxpayers for revenue (income), they balk. Although taxes are the obligatory fees citizens pay for government, nothing causes more reaction to government than the mere mention of taxes since they decrease personal income and thus purchasing power. Government is expected to provide goods, and services, protect consumers and workers from harm in the marketplace, furnish the needy with assistance through transfer payments, and keep jobs safe while keeping prices stable (fiscal and monetary policies). While they often denounce the cost, leaders feel people want a “great safety net” to protect them from life’s problems. When the government is unable to meet people’s expectations, they blame its activity (or lack of action) for everything that is wrong. Both supply side and demand side economic theories have the same objective—they simply offer different routes for getting to the same place. Supply side economic policies diminish the government’s role. There are limitations to these approaches, however: Whilst the supply side approach assumes business tax cuts will wisely go into investments in product research and development or plant expansion (as opposed to increasing corporate executive salaries, raising dividends for their stockholders, in overseas investments, or in buying out competitors through mergers and acquisitions), the demand side approach claims that putting more money in consumers’ hands will lead to more spending.