Since the dawn of Reagan, the joys and woes of supply-side economics have rattled about American politics.  The economic concept itself is far older, but Reagan popularized it, and the post-Reagan conservatives have practically made a religion out of it.  But what is it?  And is it actually a good thing or a bad thing?

Also known as trickle-down economics, supply-side economics holds that low taxes, tax breaks, and other business friendly incentives are good for the economy and will eventually raise the standard of living for the middle and lower income classes by incentivizing the rich to grow their businesses.  Expanded business means more jobs, and also means more product in the market place which drives down prices—both of which are a boon to the less than rich.

This has been the dominant theory driving economic policy in the U.S. since 1980.  And it is of paramount importance right now as we debate how to get out of the economic stagnation we find ourselves in.  Are more supply-side policies the answer?  If only it were that simple.

Everyone is familiar with the basic relationship of supply and demand.  Supply-side economics essentially holds that growing the supply side of the relationship will drive total economic growth.  An excess of supply will drive prices lower, providing more money for people to buy other things, thereby growing overall demand… which then pushes up supply, and the economy spirals upward to everyone’s joy.

Except it doesn’t work like that for all businesses, at least not when individual businesses are making independent decisions.  If you are creating a fundamentally new product, let’s say a very high-efficiency low-cost solar cell, then investing to grow supply ahead of demand has a positive impact on your business.  Demand will rise to meet your supply as you have a hot new product.  This drives business growth.

However, if you produce commodity products such as cars, cameras, or peanut butter, a growth in supply only serves to drive down your profits.  One of two things will happen.  The lower cost of your goods will increase demand such that you can move your larger inventory, but at a lower profit margin.  Alternatively, you’re just stuck with a warehouse full of goods for which there is no demand.  Neither scenario makes good business sense.  It’s a far better strategy to sit on your cash and wait for the demand to improve.

It’s also important to note one other emerging factor in supply-side strategy that wasn’t really an issue back in 1980.  We now live in a global economy.  If increasing the supply is accomplished by building factories in China or Mexico, the cost of the goods will still go down, but there is no domestic job growth to lower the unemployment numbers or raise the standard of living for the working class such that they are in a position to purchase all those new goods.

So how does this play out when we’re talking about economic policies like federal stimulus or the Bush tax cuts?  The upshot is there is little middle class value to across the board tax cuts for the rich.  Giving the rich more money doesn’t necessarily mean they’ll invest it domestically to expand business.  On the other hand, targeted incentives requiring domestic investment in new technologies or markets can be very effective.  This is where supply-side excels.

The reality though, is new technologies and markets take a long time to develop.  They are the correct long term strategy for growth, but they don’t help us now.  The only remaining solution with immediate term impact is to fuel the other side.  Fuel the demand.  And the only lever we really have there is for the federal government to become the spender.  Whether directly, through things like unemployment insurance, or indirectly through hiring people to build roads and bridges, the federal government is the only hope for a short term economic recovery.

But won’t that bankrupt the country with debt?  This is a reasonable concern, but keep in mind that both sides agree that debt in the face of a deflationary crisis is the right path to recovery.  Further, both sides agree that once the economy grows at a reasonable rate again, the cost of the debt gets lowered to comfortable levels.  The conservatives are actively trying to keep the Bush tax cuts as a way to stimulate the economy, and they argue the cuts pay for themselves via the growth they create.  The liberals want to allow the tax break to expire for the rich and reinvest that money in the economy, also claiming the short term investment debt will be small beans once the overall economy is humming again.  So there is agreement on the benefits of taking on the debt.  The disagreement is over how to spend the money.

As with most things in life, the truth is somewhere in the middle.  Just giving across the board money to the rich doesn’t help, nor does just giving away cash to consumers.  Rather, the government needs to approach this as an economic investment.  Make reasoned decisions about businesses and opportunities to incent on the supply side. For example, the newly proposed R&D tax credit for businesses is a step in the right direction.

Similarly, make careful choices about what demand-side purchases are made by the government.  Invest in infrastructure with long term benefit, such as the newly proposed public works spending plan.  And resist the urge for feel-good programs like Cash for Clunkers.

As a nation, we can and will get through this economic crisis.  But the pain will pass much quicker if we can use the tools from the toolboxes of both the left and the right.  We need to stop hammering nails in with wrenches out of some misguided allegiance to a particular guild.