Newly elected British Prime Minister Liz Truss has asked Parliament to approve a package of tax cuts for all British taxpayers including a large cut for the wealthiest. She also wants to reduce business taxes and regulations making it easier for business to expand.
While the International Monetary Fund has issued a stunning rebuke of her policy, this supply-side action is just what is needed to solve the stagflation problem that Britain faces. But the tax cuts should be delayed.
Despite many economists strongly disagreeing with Truss, history indicates this is exactly the right policy — just not quite the right time. If the U.S. follows this policy, after inflation comes down, we could completely end the stagflation that we have experienced since January. For a historical example, we need to look back at the last time the U.S. experienced stagflation.
Stagflation simply means that economic growth has stalled so the economy is stagnant, and, at the same time, inflation is extremely high. Theoretically, those two conditions should not occur simultaneously. Inflation occurs when the economy is growing rapidly. When there is a no-growth economy, inflation is very low.
In the 1970s, the U.S. had a severe inflation problem. Policymakers, who mostly try to manage demand, were unsure of the proper action to take. If demand was increased, that would add growth, but inflation would rise. If demand was decreased, that would reduce inflation, but it would also slow growth.
By 1980, the inflation rate reached 14%. The Federal Reserve finally realized that the inflation rate could be reduced by controlling the rate of growth of the money supply and by setting interest rates at an appropriate level. The Fed then slowed money supply growth and pushed interest rates higher than the 14% inflation rate.
While this action severely reduced demand and brought the inflation rate down, it did bring on a very severe recession. The unemployment rate reached nearly 11% by 1982. Policymakers were unsure of the correct action. The goal was to bring both inflation and unemployment down. Traditional fiscal and monetary policy controlled demand, so that wouldn’t work to solve both problems.
In the early 1970s, some economists said that the only way to end stagflation would be to take action geared to increase total supply. Increased supply means more output, which adds to economic growth. Increased supply also puts downward pressure on prices.
To increase supply, business must be encouraged to produce more goods and services. For that to happen, business needs capital and labor. Business also needs a clear, unobstructed path forward.
With the unemployment rate nearly 11%, there was plenty of labor available. Businesses just needed more capital. Where does new capital come from?
It comes from two primary areas. First, it can come from business-retained earnings, which are company earnings after paying taxes and dividends. New capital also comes from households who pay their taxes, spend income to support their lifestyle and then save or invest what’s left over.
Higher income earners have the most to save and invest. So, cutting taxes for the highest income earners creates the most new capital. In 1981, Congress passed a supply-side tax cut. It worked perfectly.
In 1983 annual economic growth increased to 4.6%. In 1984, growth hit 7.3%. The inflation rate dropped below 4%, where it mostly stayed until 2021.
Regulations were also reduced, making it easier for business to expand. The result of this supply-side policy was that the U.S. economy went on a 25-year growth spurt, from 1982 until the recession of 2008/2009, with minor hiccups in 1991 and 2001.
Today the U.S., England and most of the industrialized world are facing high inflation and no-growth economies. After the shockingly irresponsible monetary policy by the Fed in 2021, which most of the central banks worldwide duplicated, the Fed now has set price stability as its primary policy goal.
That means fed funds interest rates will have to rise significantly, even though they have already risen to 3% since last March. While that will reduce inflation, it will further stagnate the economy. The only way out of it is to copy President Ronald Reagan and, hopefully, Truss by passing supply-side policies by the end of next year.
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