Great Depression And Supply-Side Economics

Q. (1)

The Great Depression can be viewed as a series of what seemed to be favorable conditions, but in truth, their hidden dynamics would impact the U.S. and other developed economies across the globe. It might be the first incidence where spillover effects and economy shocks propagate from the U.S. to Europe. While a number of theories exist on the causes of the Great Depression, none is more discussed than the role of the Federal Reserve in fueling, and then lacking the ability to end the economic downturn.

Before the Great Depression (GD), the Fed’s policy can be categorized as expansionary, following the First World War. The roaring 20s, modernization, and other factors prompted large spending by the U.S. government, and private-sector

contracting. From Howard Hughes’s ‘Hercules’ to the ad-hoc investments in the stock market, the Fed’s policies caused the economy to overheat.
Specifically, the access to credit allowed investors to pursue speculative activity in the stock market, thus fueling and inflating prices. Price stability, following the recovery, was exhibited from 1921 to 1929. GNP grew at an average rate of 4.7%, and real per capita income grew by a total of 28% across this period. In February 1928, stock prices began to climb, and average number of shares traded would reach seven or eight million on a daily basis. It was clear that the extra money left by the favorable recovery was causing an asset price bubble, but no one was paying attention; most importantly, the Fed’s policy did not react to an overheating economy.
As Herbert Hoover announced “We in America are nearer to the final triumph over poverty than ever before in the history of any land.” These policies created illiquid financial systems plagued by heavy borrowing for investments. Exposure to risks was becoming larger, and a number of economic indicators hinted at the catastrophe ahead. The U.S. economy was heavily dependent on foreign trade, especially with Europe, which may have contributed to the spill-over effect of the GD.
Not long before the stock price climb of 1928 – within 5 quarters – the U.S. experienced declines in auto sales of about 200,000 units within 2 quarters. In addition, Equity prices increased by 2.16 times the 1926 levels by mid-September. By October 21, the stock market declined sharply, and then recovered. It was too late to prevent the disaster.
Following the stock market crash, the Fed woke up and decided to pursue a contractionary monetary policy to rid the market of excess capital. However, this policy implementation was a few quarters late, and was not the proper course of action. Their decision placed additional strain on an already illiquid financial system, and turn led to the failure of many banks due to bank-runs fueled by a panicking public.
Simply put, the Fed’s policies were reversed. Instead of pursuing a contractionary monetary policy follow the recovery of the early 1920s i.e. 1927 – 1928, which would have cooled down the economy, the kept an expansionary policy. As such, this has fueled speculation and led to inflationary pressures on stock prices, large credit exposure of banks, and inefficient allocation of excess funds in the public’s hand.
The contractionary policy following the stock market crash should have been an expansionary monetary policy. Monetarists believe that this would have at least aided banks in recovery, and softened the severity and length of the GD into a mere recession. Keynesians believe that the government could have exercised an expansionary fiscal policy, creating a buffer for the falling economy, and would have stimulated aggregate demand and kept the GD at bay.

Q. (7)
Following the Fed’s policies had actually created deflation in the economy. Milton Friedman criticized the Fed’s response as “following a silly deflationary policy.” This is a byproduct of following a contractionary monetary policy, as money supply is being withdrawn from the economy, its purchasing power increases due to falling prices. The public, in an ill-advised decision, thought that markets were no longer safe. Following their bank runs, whatever money they had, they were hoarded and kept out of the economy. This has caused to a sharp decline in prices leading to deflation.
Fisher believed that the main factors of the GD were loose credit and over-indebtedness, which fueled speculation and asset bubbles. Under the condition of debt and deflation there was debt liquidation and distress selling. In addition, Fisher mentions additional events such as the contraction of the money supply as bank loans are paid off, falling asset prices, falling net worths of businesses leading to bankruptcies which led to a fall in profits. These events created a decline in output, trade and employment. As such, the public became less confident in the economy and the money hoarding began.
Since money was scarce in the economy, those that had money and were able to hide it prompted a drop in prices. Businesses who ventured on – those that did not fail or file for bankruptcy – faced increased costs of production and lower margins of profits as selling prices dropped. As such, they could not afford to hire workers, and unemployment was on the rise. Those that were already working observed low wages and temporary jobs, thus dampening aggregate demand and consumption. A drop in the aggregate demand coupled with a drop in supply, led to a stagnate economy that was stuck.
Therefore, based on this reasoning by Fisher, Friedman, Bernanke, and Hayek, deflation could be seen as one of the main causes of the prolonged state and severity of the GD. A more accurate depiction would be that deflation is a main byproduct of the conditions in the GD motivated by the poorly managed monetary policy of the Fed.

Q.

(8)

Supply-side economics is a school of thought in the macroeconomic field. It believes the economic growth can be most effectively created by lowering barriers for people to produce goods and services, as well as investment in capital. In essence, consumers will benefit from a greater supply of goods and services at lower prices, and investments leads to expansions in the businesses and increase the demand for employees. In essence, it advocates the need for competitive marketplaces to trigger increased production.

Supply side economics believes that taxes are a form of barrier that causes economic participants to revert to less efficient means of production. In addition, it views taxes as following a convex curve – the Laffer Curve – in which taxes at 100% and 0% have the same outcome. The optimal tax rate would be somewhere between these two extremes. Reduction in taxes, alongside free trade and the idea of comparative advantage, allows for economic expansion and increasing production. As such, governments are able to benefit from the rapid growth of the economy, which will offset the foregone revenues due to the short-run tax cuts. Implicitly, supply-side economics is based on Say’s law in which supply creates its own

demand.
Interest in the supply-side economics was sparked in the early 1980s as Ronald Reagan was elected President of the U.S.

Reagan assumed office when the U.S. was facing double digit inflations following increased government spending in the 1960s (Vietnam War), and the economic turbulence caused by the 1973 energy crisis due to the Arab Oil Embargo, as well as the detachment from the Gold Standard and following a floating exchange rate for the U.S. dollar.

Reagan believed the supply economics – later became known as Reaganomics – was the painless and easy way to get rid of inflation. He asserted that there were limited ways to fight off inflation such as tightening the monetary supply (contractionary monetary policy), which would create a recession and lead to layoffs. Rather, supply-side economics presented a planned approach to gradually cut taxes across a number of years. This would lead to a boost in revenues due to increased production. While revenues did increase, economists argue that revenues as a percentage of GDP declined during Reagan’s term.

However, while there are number of critiques of Reaganomics, the economy was in recovery which aided the election of George Bush in 1988 as he coasted on the benefits of supply-side economics from Reagan’s term. It may have caused Bush to lose the second election in 1992 recalling that his administration went back on the promise of cutting

taxes.
Economists such as Krugman, and Samuelson believed that Reaganomics was a smokescreen to starve the government revenues. Even Bush, before being elected or serving as Vice President, called it Voodoo economics. Krugman noted that when Ronald was elected supply-siders got a chance to try out their ideas but failed. Krugman and others point to increased budget deficits during Reagan administration as proof that the Laffer curve is wrong. In addition, they note that while income was taxes were cut, payroll taxes were increased. Samuelson called supply economics as the tape-worm theory that was not based on sound economic reasoning. He noted that to get rid of a tape warm (inflation and economic downturn in the U.S.) you would have to stab the patient in the stomach (the U.S. economy).
Reagan believed that supply economics was a way to avoid problems of contractionary monetary policy, and wanted to alleviate inflationary pressures from the economy through a painless procedure. While some believe that it did achieve some success, most economists assert that it was nothing a cracked pot theory led by individuals that lacked academic economic credentials such as Wanniski and Robert Bartley.