Supply-Side Voodoo

This blog post uses a four-letter word – Supply-side macro policy (SSMP). Many people upon hearing SSMP get that look that often occurs when fingernails accidently screech on a blackboard. Otherwise they shake their heads as if someone just admitted they didn’t pick up their dog’s poopie while doing the circle at Green Lake Park.

Because SSMP has such a checkered reputation (Trojan Horse, Voodoo Economics Trickle Down, Charlie Sheen) most economists make up other names when they advocate a SSMP approach – restructuring, growth policy, tax reform, etc. But even with all this cover provided by taxonomical innovations, there is very little thrust today in the advocacy of SSMP. And let me say in all-caps, that there have been very few times in the USA when we have needed SSMP more that we do today. Okay so I didn’t use all caps. I thought that would be rude and annoying and why diss you now when you are already deep into my second paragraph?

After writing the above this weekend, I saw on Monday, July 8 the article by Princeton’s Alan Blinder on the Opinion Page in the Wall Street Journal, “The Economy Needs More Spending Now.” It is interesting that Blinder admits that “long-run growth is supply determined” and recommends SSMP for the long-run. But this is a Keynesian trick because he strongly advocates only demand-side stimulus now and we all know what Keynesians think about policy for the long-run, ie Keynes’ famous line that we are all dead in the long-run!

The proof that we need SSMP now has several parts. First and foremost is that we have exhausted demand-side macro policy. Whether from the standpoints of monetary or fiscal policy, we have used all of our demand-side policy bullets. There is no more ammunition we can throw at stimulating the economy through the demand side. If anything, the markets are pushing interest rates back up to normal values and there is little more the Fed can do to keep them down. The government knows it has to start addressing deficit and debt problems and simply cannot maintain trillion dollar deficits into the future without severe negative ramifications. 

It is like the field soldier who is out of bullets but he has a couple of grenades next to him. He cries that he is out of bullets and must surrender. His friend says, “but you have a whole bunch of grenades.” He retorts that he heard that sometimes grenades don’t work well and he had better just surrender. Demand-side policies are exhausted now and we have a basket full of SSMPs yet no one is strongly advocating them.

The second and more important reason we should focus on SSMP is that they directly address a myriad of factors or trends that are the root cause of our current problems. Business firms are reluctant to hire workers and produce more output. SSMPs directly aim at improving conditions in labor and output markets. It is commonplace for analysts to list all these supply-side obstacles so I won’t go into much detail. But rising business costs and uncertainty stem from a slew of new regulations relating to coal, energy, capital adequacy, financial leverage, lending to new homeowners, college borrowing, healthcare, Medicaid, immigration, and so on. One SSMP approach would resolve the uncertainty by directly addressing these regulatory issues. Reduce the uncertainty by making the regulations clearer. Of course it is also possible to re-think and change some of these regulations so that they have less negative impacts on employment and output decisions. If we cannot speed or change these regulations, then we are left with them but we can enact SSMPs that offset some of their negative effects.

What are these magical SSMPs? One kind of SSMP goes directly at the labor pool and finds ways to improve the desirability of adding another worker. There are many ways to give firms more incentives to hire. Labor subsidies or reductions in labor taxes might lead to larger government deficits and therefore should be aligned with tax reforms. Broadening the tax base is one way to bring in revenues while you lower tax rates that are more closely aligned with decisions to hire and produce.

Since firms often borrow to expand output or productive capacity, using financial and banking reform to transform all those bank reserves into loans has great supply-side appeal. Foot dragging on such regulations keeps banks in a holding pattern. Rising interest rates might deter some companies from borrowing – but lack of funds makes it virtually impossible to borrow. The same reasoning applies to mortgage markets and school loans.

A third reason to focus on SSP today has to do with the risk of higher inflation. Anything that has the potential to rekindle rising inflation threatens our employment and output goals. When workers begin to expect higher inflation then they are more motivated to ask for pay increases. Suppliers in commodities markets behave the same way. When bankers see more inflation coming, they raise interest rates. The upshot is that expectations of rising inflation become embedded in today’s prices with resulting negative impacts on business costs and profits. In today’s monetary and fiscal environment, any policy moves that lead to larger deficits or looser money will be self-defeating. On the contrary, tighter monetary and fiscal policies can be viewed as SSMPs because of their downward impacts on inflationary expectations and an improved competitive environment.

US unemployment is too high and output is too low.  In a market equilibrium sense, that means both supply and demand for labor and output are too low. The question then is one of causality. Some analysts cling to the idea that demand is the culprit and they advocate more demand stimulus. We gave demand policies more than a fair chance. It is now time to turn to supply. Bring on the Trojan Voodoo Trickle Down!