Stimulating Supply and Demand Jude Wanniski July 10, 1997

Memo To: Steven Piraino, Website Fan
From: Jude Wanniski
Re: Mundell 1974 Interview

A question from Steven Piraino about my interview of Robert Mundell in 1974, which we ran in our Supply-Side University: In Mundell’s article, he states that a tax cut will stimulate supply and demand simultaneously. In The Way the World Works, you assert that Keynesianism is an effective model for managing contractions. Both of these statements seem to assume that overproduction/underconsumption can occur. Doesn’t the supply-side economic model assume that supply is demand? To what extent do you believe in Say’s Law and under what conditions, if any, can a shortfall in demand occur?

1 A tax cut stimulates supply and demand. What Mundell means is that in the broad marketplace there is a carpenter and a plumber who would love to find each other and build two houses, one for each. The financial intermediary will not finance the construction of the two houses because the tax rate on the incomes of carpenters and plumbers is so high that it is not likely they can build two houses that will be competitive in the housing market. In this case, a tax cut on incomes makes the construction of the houses financially realistic. The carpenter’s demand for a house becomes effective as soon as he is able to supply his work to the plumber. Two houses are supplied and two are demanded, simply by reducing the tax rate on the incomes of both.

2. When contractions occur, carpenters and plumbers suddenly find themselves unemployed. If the government does not know how to get out of recession via supply-side solutions, they can try demand-side solutions. Keynes would advise cutting taxes to put more money into people’s pockets so they can consume more. The policy is the same as the supply-side solution as long as the tax cut makes it possible for the private sector to finance the building of the two houses. It can also work if the government borrows funds from the plumber and the carpenter at market rates of interest and then asks them to build public housing units for unemployed carpenters and plumbers.

3. Supply is demand. A carpenter demands that part of a house built by a plumber and supplies the part built by a carpenter. The plumber does the same. Supply equals demand, minus what the government takes from the transaction in the form of taxes. The tax on both plumber and carpenter means they must each supply more than they demand in order to satisfy the government. As the tax wedge between the two workers increase, it becomes impossible for the intermediary to finance the dual construction.

4. Jean-Baptiste Say’s Law of Markets asserts that supply will create its own demand. When the carpenter supplies his part of the house and the plumber his part of the house, and the government suddenly decides to extract a higher tax from each, the financier withdraws. The carpenter’s part of the house sits unfinished on one side of the transaction and the plumber’s part sits on the other. It is easier to visualize when you think of the Smoot-Hawley Tariff Act of 1930, which increased the size of the tariff wall on 20,000 commodities coming into the United States. The wall blocked the imports, which meant that foreigners did not have the money to buy the exports of the US. Goods piled up on both sides of the tariff wall. The US had an oversupply of goods that had to be liquidated at prices low enough to make up for the higher tariff wall. The same was true for the foreigners offering goods to the US. You can call it an excess of supply or a shortfall in demand. In any case, it was caused by the government, making a terrible error in response to greedy businessmen who want to sell goods without buying goods in exchange, i.e, protectionism.