FRONT PAGE CONTRIBUTOR
Revisiting the Supply-Side Thesis
Everyone’s attention has temporarily shifted away from the automaker bailout, to consideration of a vast Keynesian stimulus program, with some side-distractions relating to the personnel of the US Senate.
Don’t worry about the automaker situation: it’ll be back on the front-burner next month as both GM and Chrysler LLC will have burned through last month’s bailout money and will be back for more. A lot more.
Instead, let’s take a closer look at the New New Deal, which was hurriedly pulled out of a hat immediately after the Presidential election as Barack Obama’s answer to the musical question: “Omigosh, the economy is falling apart! WHAT ARE WE GOING TO DO???”
Exactly what is the New New Deal? More importantly, exactly what problems does it purport to solve? Not the ones you think.
But the first question to answer is, how did we get where we are?
Back in September, we were in the thirteenth month of sustained disturbances in capital markets and in the banking sector, all around the world. Through mechanisms which will be the subject of debate for many years to come, the financial crisis abruptly boiled over into the “real world” and touched off a full-fledged global recession.
As a result of heroic but highly-controversial measures by all of the world’s monetary authorities, led by our Federal Reserve, the financial crisis is now showing abundant signs of stabilization. The patient is still in very deep trouble, but the defibrillators worked and his heart is beating again.
But the global economy, the world of jobs, goods, services and trade, is just starting its cycle of trouble and disruption. Since I’ve been using the phrase “Great Depression II” in these pages for well over a year now, I’ll save for some other time an analysis of how this moment is like and unlike the early Thirties.
It’s the economic crisis, not the financial one, that got the attention of policymakers and the punditocracy. The big problem that everyone desperately wants to address is expressed in two numbers: the unemployment rate, and the economy’s rate of growth (or GDP).
Now if you’ve been reading my posts here for the last year and a half, you know that the problems are much deeper, more systemic, and less cyclical. The stock of US housing is still vastly overvalued, for example. But forget about all that. The focus of government’s policy this year will be on bringing down headline unemployment and increasing headline GDP.
And that’s the point of spending as much as one trillion dollars borrowed from global investors, on a wide range of projects chosen not for their value, but rather for their readiness to start right now.
Considered as a political response to a political problem, a vast pulse of deficit-spending indeed has the potential to goose this year’s GDP numbers. (It will have almost no impact on the politically-crucial unemployment rate, although headlines a year from now will tell you that unemployment is “better than it would have been otherwise.”)
But what about the impact of the New New Deal on the economic problems, as opposed to the political ones?
Here, the impact over the medium term will be negligible at best, and most likely negative. Just as it was in the 1930s, a Keynesian stimulus is the wrong way to address a reduction in consumer demand caused by deflation and balance-sheet destruction.
It’s evident that the people advising Barack Obama (and the pundits who try to tell the rest of us what to think) reached for a classic Keynesian demand-side response without even thinking this through.
As I’ve already hinted, the housing and mortgage problems remain to be solved. And the primary thing now affecting consumer behavior is a widespread sense that people have consumed too much on credit, and need to pull back and save some more money.
Demand by US consumers is what needs to come back, before our economy can stage a sustainable and healthy recovery, and pull the rest of the world out of its recession too.
But consumer demand won’t come back until people feel like they have enough money saved up to meet the demands of an uncertain future. This objective will be met only indirectly and partially, if the government builds one trillion dollars’ worth of roads and bridges to nowhere. We’re working on the wrong problem.
But there’s an even deeper problem with the demand-side approach: it’s not certain to actually stimulate greater production of goods and services in the first place, except at an exorbitant cost which will ultimately lengthen the recession and weaken the recovery.
Let’s remind ourselves of the other side of the coin. There’s a supply-side approach to policy as well as a demand-side.
Informally, the supply-side insight is that aggregate supply (the total production of goods and services in an economy) depends not on demand, but rather on the returns to the capital required to produce the output.
Demand-driven stimulus programs like the New New Deal are intended to increase output (and employment) by artificially supplementing the demand generated organically by the economy. But without increasing the returns on capital, fiscal stimulus masks the fact that the increased output is bought at an unsustainably high price. (This imbalance will eventually show up in higher costs for capital.)
Here’s what’s messed up about the whole way that Obama and his brain-trust (and Keynes-cheerleaders like economist Paul Krugman) are thinking about this:
Returns to capital today are at historically low rates for reasons having nothing to do with the business cycle. This is part of the aftermath of the financial crisis that everyone seems to have forgotten about. We’re experiencing a global deflation in financial assets, and a reduction in leverage by financial intermediaries like banks, that has resulted in a widespread reluctance to create private credit.
This extreme aversion to take risk in the private economy will be a feature of the financial landscape for many years to come, quite regardless of the fact that we’re now in a recession. And a big fiscal-stimulus program will only exacerbate the risk aversion, which was also a distinctive feature of the mid-Thirties. Among other things, fiscal stimulus will reduce the real, risk-adjusted rates of return on capital for a long time.
And if you accept the supply-side thesis, that means the economy will simply produce fewer goods and services, and more inflation, than it otherwise would have. This will happen whether the government wastes one trillion dollars on fiscal stimulus, or nothing at all.
That’s the incompressible truth, which isn’t amenable to political manipulation.
So am I arguing against the New New Deal? Yes, although to do so seems like a pretty pointless exercise. There are sound reasons why a fiscal stimulus could be beneficial, first of them being that it will create a lot of inflation. Ordinarily that’s a bad thing, but we’re in the grip of widespread deflation now (although the Fed has done a remarkable job of masking that fact). So to counteract it with a bit of fiscally-induced inflation isn’t all bad.
What about tax relief instead of spending? Well, President Bush tried that last year, with the tax-rebate checks. There’s pretty good evidence that most of that money got saved instead of spent.
It’s just bizarre to me that everyone from Paul Krugman to Barack Obama sees this as a bad thing. The New New Dealers are so wedded to the idea that you can create supply simply by dialing up demand, that they’re completely looking past the concept of consumer confidence.
Of course people are saving their money now. That’s what they feel like they need to do. It would be extremely healthy, but terribly counterintuitive, to address the current economic crisis by allowing people to save more. That’s because you wouldn’t see an immediate increase in GDP.
What consumers need is time, several years at least, to rebuild their balance sheets and return to higher levels of consumption. And the financial sector needs time, several years at least, to get through the effects of risk aversion and deleveraging in the wake of the housing bubble and the credit crisis.
But time is the one thing that a highly-sensitive and poll-driven political process doesn’t have.
And as I said, the whole problem, as the political class sees it, is not to sustainably fix the economy, but rather to increase reported GDP this year. The New New Deal is intended to manage the news headlines, not the economy.