Keynesian economics is considered to be a ‘demand-side’ theory that focuses on changes in the economy over the short run. A pure Keynesian believes that consumers and their demand for goods and services are key economic drivers. The ‘supply-side’ theory is typically held in stark contrast to Keynesianism, which includes the idea that demand can falter, so if lagging consumer demand drags the economy into recession, the government should intervene with deregulation and lower capital and income taxes. While both agree that the government has a printing press, the Keynesian believes this printing press can help solve economic problems. But the supply-sider thinks that the government (or the Fed) is likely to create only problems with its printing press by either creating too much inflationary liquidity, or not sufficiently ‘greasing the wheels’ of commerce with enough liquidity. As a corollary, they advocate a stable monetary policy or a policy of gentle inflation tied to economic growth.
Stagflation is a situation where inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high. It raises a dilemma for economic policy as actions designed to lower inflation may exacerbate unemployment, and vice versa. As per Keynesian macroeconomic theory dominant between the end of WWII and the late-1970s, inflation and recession were regarded as mutually exclusive (relationship between the two being described by the Phillips curve). However, this relationship refused to hold during the double-digit inflation experienced in the 1970s and 1980s by the US (‘the great inflation’). This was due to misguided pro-Keynesian attempts by earlier regimes to keep artificially high levels of employment, and to keep the economy from falling into recession. Lyndon Johnson’s Great Society programs were instrumental in creating a wage-price spiral that didn’t end until 1980 when Ronald Reagan was elected. Even Richard Nixon could not stop the spiral with the imposition of a wage-price freeze. Nixon too was guilty of tampering with the system by urging the Fed chairman to keep the economy out of recession. During Jimmy Carter‘s presidency inflation was running at 14 percent and there was indeed an economic malaise.
To combat this, Reagan aggressively cut income taxes from 70% to 28% for the top income tax rate, and from 48% to 34% for the corporate tax rate while concurrently reducing the money supply. Reagan’s pro-‘supply-side’ policies sought to encourage economic expansion enough to eventually broaden the tax base and increase revenue from a stronger economy offsets the initial revenue loss from the tax cuts. Reagan’s tax cuts worked because tax rates were so high in the early ’80s they were at the ‘prohibitive range’ on the Laffer curve. In tandem, he adopted a pro-Keynesian stance of increase in per capita spending which saw the economy grow as inflation fell from 13.3% to 4%. GDP per working-age adult, which had increased at only a 0.8% annual rate during the Carter administration, increased at a 1.8% rate during the Reagan administration. The increase in productivity growth was even higher: output per hour in the business sector, which had been roughly constant in the Carter years, increased at a 1.4% rate in the Reagan years.
Britain plagued with stagflation symptoms can take a leaf off Reagan’s astute handling of ‘the great inflation’ that plagued the US for two decades. Admittedly, though British inflation figures aren’t audaciously comparable to the Reagan era, yet their persistence is; July 2013 being the 44th consecutive month of above-target inflation (2.80% versus target 2.00%) since the end of 2009, unemployment rate sticky at a higher range of 7.80%-8.50%, PMI numbers hovering around the 50 benchmark from early 2012 onwards until recent June 2013.
Domitrovic, B., 2011. Volcker and the Reagan Legacy, Forbes, [online] Available at: < http://www.forbes.com/sites/briandomitrovic/2011/02/07/volcker-and-the-reagan-legacy/> [Accessed 15 August 2013]
Jones, C., 2013. Stagflation menaces economic horizon. The Financial Times, [online] 16 April. Available at: <http://www.ft.com/intl/cms/s/0/904ffe84-a6ad-11e2-885b-00144feabdc0.html#axzz2cNlROxZT> %5BAccessed 15 August 2013].
Krugman, P., 2012. Reagan Was a Keynesian. The New York Times, [online] 7 June. Available at: <http://www.nytimes.com/2012/06/08/opinion/krugman-reagan-was-a-keynesian.html?_r=0> [Accessed 15 August 2013].
Krugman, P., 2009. The Stagflation Myth. The Conscience of a Liberal, [blog] 3 June. Available at: < http://krugman.blogs.nytimes.com/2009/06/03/the-stagflation-myth/ > [Accessed 15 August 2013].
Samuelson, R.J., 2008. The Great Inflation and Its Aftermath: The Past and Future of American Affluence. Random House Trade Paperbacks.
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