Stagflation was fundamentally a supply problem, which is why a demand-side solution would not work. Classical economics' laissez faire approach enjoyed something of a renaissance after Ronald Reagan's election. In the classical view of the economy, flexible and efficient markets ensure that the economy will maintain full employment. When recessions or periods of inflation set in, flexible input prices cause aggregate supply to increase or decrease and bring the economy back to full employment without government intervention. In the years from the 1930s to the 1970s, there was a decrease in the flexibility and efficiency of the labor market. The supply-side argument was that government had gummed up the works and the markets needed to be de-Keynesed.
Deregulation, which began under President Carter, picked up steam under Ronald Reagan. The airlines, which in the past had been heavily regulated by government, were set free and forced to compete with each other. This resulted in far more flights at cheaper prices. It also meant that the least efficient airlines were driven out of business.
Labor unions saw a decline in power under the Reagan administration. Foreign competition in the steel and car industry weakened the position of the unions. Probably the most powerful symbol of the loss in union power came at the hands of the newly elected president. The air traffic controllers union had lobbied for better pay and working conditions. In 1981, the union went on strike in violation of federal law. After being warned to return to work or be fired, over 11,000 air traffic controllers refused to return and were summarily fired by President Ronald Reagan. The message was clear.
A debate is raging today between the Right and Left over the role of government in the economy. Those on the left with a Keynesian perspective are derided as “socialists,” while those on the right who favor less government intervention in the markets are decried as “market fundamentalists.”
While running for office, Reagan promoted the idea that tax cuts on high-income earners would enrich all Americans, as people had more incentive to spend and save. The spending and saving would lead not only to more consumption but also more capital investment. As investment increases, businesses expand their productive capacity, and this leads to higher employment. The resulting increase in capital also leads to greater productivity and, eventually, lower prices.
The power of tax cuts to stimulate aggregate demand was well known to Keynesian economists. But the supply-side spin was that tax cuts would not only stimulate aggregate demand but supply as well. At the same time that Reagan was proposing tax cuts, he also called for an increase in defense spending to counter the Soviet threat. Economists, politicians, and average people questioned the idea of simultaneously cutting taxes and increasing government spending. It appeared obvious that such a combination of policies would result in the federal government running large deficits as it spent more and taxed less.