New religion in economic policymaking? Some insights to Supply-side economics

There's a new religion in economic policymaking. It's a more modern view of supply-side economics with converts on both the right and the left. But what that means and how to achieve it is dividing policymakers. The different paths taken by the UK and Europe may shed some insight.

Prices and the amount of economic activity are determined by supply and demand. Supply is what the economy produces and the demand side is its appetite for goods and services. Both can be tinkered with by policymakers.

Supply-side economics used to have a bad name. In the 1980s it was the idea that if you cut taxes enough you would spur so much growth that the tax cuts would pay for themselves. This might be true if marginal taxes are very high — as in, more than 95% — but at more normal levels it was wishful thinking. Cutting taxes is no free lunch. While the move can increase growth, that growth is usually not enough to make up for lost tax revenue.

So supply-side economics became a punchline. Supply concerns such as what the economy can make through workers' skills and constraints on starting or building a business received less attention or outright mockery. The approach totally fell off the radar during the Great Recession, which decimated household balance sheets and caused people to spend less. Instead, policymakers thought they could grow the economy by boosting demand: giving people money to spend or by the government spending more money.

Consumption is a big part of the economy, so the idea was that if people or the government demand more stuff, that would create more growth. Some economists argued demand was deficient throughout the economy, even during booms, and required lots of government spending regardless. Boosting demand became the policy objective right up until the emergence of Covid, when the pandemic constrained supply. Attempts to boost demand in 2020 and 2021 were met with inflation, and so attention has swung back to working on the supply side.

And that brings a return of free-lunch thinking: that more stuff and productivity and cheaper housing and all that abundance will lower inflation. Certainly, worrying about supply is long overdue. Take housing: There are many building restrictions that limit supply, which is one reason why prices are so high (prices are also high because government subsidizes demand, but this is so politically popular no one wants to touch it).

But there is already disagreement on the best way to boost supply. Liberals are more inclined to industrial policy, which means the government picks desirable industries and gives them tax credits and subsidies to increase production. Traditional conservatives are taking a get-out-of-the-way approach: They want fewer regulations and lower taxes. The difference comes down to whether you believe growth comes better from individual initiative and from starting businesses and allowing markets to direct their own investment, or if you think it's better for the government to pick where resources go.

The government approach makes sense if you think markets send capital to the wrong places, or when the economy needs projects that require so much fixed investment the government needs to make the first move.

The Biden administration has mostly been pursuing this more-government approach, which describes many of the provisions in the Build Back Better bill (though much of the original plan didn't pass Congress). Odds are we'll see more of it. Even conservatives in America have become fans of industrial policy.

And now we have the makings of a real-world experiment overseas. The UK's new prime minister wants to try the get-out-of the way approach with tax cuts and clawing back regulations. The hope is that this would reduce disincentives to work, innovate and start new businesses. So far, markets have not been very receptive, to say the least. In part because the timing suggests the government is not making inflation a priority since it intends to finance the proposed tax cuts by running bigger deficits. There is also good reason to believe that any growth created would be counteracted by further rate increases from the Bank of England in its fight against inflation.

The execution and communication around Liz Truss's proposed cuts has also been atrocious, as Clive Crook points out. But some of the criticism and market reaction was overblown. The tax reductions were actually not that large, about £45 billion ($52 billion) out of her overall £160 billion plan — and only about £2 billion of that was reversed. A lot of money is going to energy subsidies. And the overall idea is sound to let growth happen from the ground up by removing economic obstacles and disincentives.

Meanwhile, Europe is getting far less attention for trying the government-led approach and spending a similar amount of money relative to its GDP. The EU, which never met a regulation it didn't love, has allocated €806 billion ($804 billion) for various forms of industrial policy including digital infrastructure and battery production, plus an additional €1.2 trillion for Europe's Green New Deal (the war in Ukraine might change these plans), with individual countries kicking in some extra spending to meet these objectives. France, for instance, has a bigger debt-to-GDP ratio than the UK but is planning on spending €100 billion (40% financed from the EU, the rest with debt) on the initiative. European governments are also spending big on energy subsidies.

So which approach will work best? It depends. The key to future growth from the supply side is the innovation it produces. This is the only free lunch because when you innovate you can make more stuff with fewer goods and improve living standards. But innovation is inherently a messy, risky and unpredictable process. Industrial policy does not have a great track record of picking winners — it's hard when there is so much uncertainty about which innovations will be the big game changers. When there is a clear need for a project and it is well-executed, such as Operation Warp Speed for Covid vaccines or the Manhattan Project to produce nuclear weapons, government investment can be effective. Infrastructure spending can also accelerate growth if it picks the right projects, though there have been some real clunkers and waste there too.

Tax cuts also largely depend on execution. Tax cuts financed with deficits are less effective, and the best tax reform removes loopholes and other distortions as well as lowering rates. Deregulation also has a good track record if well done.

I am a market-inclined person, so I tend to favor the get-out-of-the way approach. I have more faith in individuals and a market that rations risk than I do in government bureaucrats. But which approach works better really comes down to how well it's executed and the problem that it's trying to solve.

Both spending and tax cuts can be inflationary, at least in the short to medium term, because expanding supply can take years while the effect of the spending or tax cuts on demand is felt immediately. Yet, there is a strong political bias toward the spending approach. Deficit-financed government spending is often seen as taking a wise, albeit levered, investment in the future, while deficit-financed tax cuts are seen as wasteful giveaways to the rich. But really, they are two sides of the same coin.

The supply side may not get too much traction in the near future. With rising rates and inflation and scarce energy, most countries don't have the fiscal space to deploy deficit-financed tax cuts or spending. Liz Truss has already nixed rate cuts going to the highest earners. Deregulation is costless, and can even save money, but requires taking on special interests. Following the pandemic there is a bias toward more intervention. But with lower productivity and aging populations, all developed countries need a supply-side revolution.