Guest Blogger Buck Klemkosky Slow and Steady Job Growth Not Enough

The U.S. Labor Department announced job growth of 215,000 for March in line with expectations. Given a working-age population of over 200 million, it doesn’t seem to be a significant number of jobs. But 215,000 new jobs are the net increase of many moving parts.

Annually, the U.S. creates a little less than 13 million jobs, but also destroys about 10 million jobs. If there was a net increase of 215,000, it means that approximately 1.05 million jobs were created and 833,000 destroyed for the net increase of 215,000 in March. Even during the Great Recession, 10 million jobs were created annually but unfortunately 16 million jobs were destroyed. In the U.S., job creation peaked out at 16 million in 2000 and hit 14 million in 2006, so the economy has not recovered in terms of job creation. Fortunately job destruction of 10 million is a three-decade low.

Since the labor market hit bottom in February 2010, a net of 14.4 million jobs have been created over the 73 months, a record for the longest period of sustainable job growth. The unemployment rate rose to 5.0% in March from 4.9% in February. As perverse as it may sound, the rise in the unemployment rate was considered good news because the civilian labor force participation rate increased to 63% from a 39-year low of 62.4% in September, meaning more people are entering the work force. The labor participation rate of workers ages 25-54 was 81.2% in the first quarter, a three-year high, but still down from 83.3% in 2007. There still is some slack in the labor market.

The mood of many Americans doesn’t reflect the lowest unemployment rate in nearly a decade. While a net 14.4 million jobs have been created, only 5.6 million new jobs have been created since January 2008, which was the job peak before the Great Recession of 2008-2009. Job growth relative to population growth makes the 14.4 million look less impressive. The U.S. working-age population grew by 15.8 million since 2010 and 20 million since 2008. Job creation has not kept up with population growth. The Labor Department also reported that average hourly earnings increased 2.25% in March, relative to a year ago. This is below the last 6-month average of 2.5% but better than the 2.0% annual average over the prior four years.

Wages are subdued primarily because labor productivity remains close to zero. Productivity is weak because corporations have not invested in efficiency-enhancing equipment and may be substituting labor for capital because of low wages. Also the cause of the productivity problem may be structural; the service sector of the economy has become more dominant relative to the goods sector, and it is more difficult to increase productivity in the service sector. Also, less experienced millennials are replacing more experienced baby boomers in the work force.

Regardless of stimulative monetary and fiscal policies, the key to enhancing economic growth lies in the labor market. Economic output is a function of the number of workers times the productivity of each worker. The civilian labor participation rate needs to continue on its upward trajectory and labor productivity must improve. Increases in both are needed to get U.S. economic growth out of its lethargic 2.1% pace. Labor-force growth of 2% and productivity increases of 1% would produce a more desired 3% economic growth.

Lesson 8 Macroeonomic Policy: Out Of Bullets?

Yesterday: General Sir – the enemy keeps coming should we keep firing at them? Yes, Private keep firing. But Sir, I am running low on ammo and most of the enemy intruders are the weak ones carrying no weapons. Private – I said keep firing. You never know when one those weaklings might hit you on the head with a broom stick.

Today: General Sir, I am now out of ammo and a whole new army is coming at me. What should I do? General? Are you there General? What should I do General? Click. Buzz.

When the market fell last week, it became more and more obvious that our policy makers are out of bullets. Which brings up the topic of what we mean by Macroeconomic Policy. So this is another lesson on macro for all you folks who tell me that you only understand one out of seven words in my posts. It is also an opportunity to crow about what  I have been calling jeopardy for years.

My parents never tired of warning me about jeopardy – meaning that today’s decisions can put you in a vulnerable place. My mother would shout, Larry quit playing Party Doll on your Victrola over and over and over. Do your math homework. If you don’t do your math homework you will someday be a horrible guitar player with no source of financial stability.

So I learned the concept of jeopardy at a young age. And that explains why I have been writing for at least five years about how the US Government and the Fed have put the nation at jeopardy. And this also explains why we are now in a very risky economic state because we may be facing tough times ahead and our policy makers are out of policy bullets.

Liberal or conservative, there is room to believe in the efficacy of national macroeconomic policy. But let’s start at the beginning using some questions.

What is macro policy? Macro policy is aimed at making national policy variables approach desired ends. It is not about specific industries or specific companies or specific regions. National policy ends are economic growth, low inflation and unemployment, and so on.

What are the options for macro policy? In most macro courses we teach that there are these four policy areas: Monetary Policy, Demand-side Fiscal Policy, Supply-side Fiscal Policy, and International Trade Policy.

Monetary Policy consists of the Fed managing interest rates and money. Demand-side Fiscal Policy involves the government (Congress and President) implementing policies designed to impact spending in the economy. Supply-side Fiscal Policy is about the government legislating policies that improve incentives to produce goods and services – more efficiently and in greater volumes. International trade policies are not popular in the US but generally involve countries trying to improve their competitiveness so they can sell more goods abroad. These policies include exchange rate manipulation as well as policies like Free Trade Agreements that would make US goods more desired by the rest of the world.

So are we out of policy bullets? If not out of bullets we are getting close to zero balance.

Fed policy is easy to start with. As you know the Fed has spewed a lot of money into the system and lowered interest rates to zero. None of that inspired a strong recovery. The Fed admits to economic weakness every time they explain the economy is too anemic to return to normal policies. So if a future shock weakens the US economy the Fed has little left that it can do. Any new monetary policy that would lead to negative interest rates or new rounds of quantitative easing would signal weakness and would worry world investors. You saw a little bit of that in the stock market last week.

How about Demand-side Fiscal Policy? The story is similar. The US government reacted to the past world economic crisis with huge increases in spending accompanied by policies to reduce tax rates. This was meant to prevent the economy from tanking. 

This activity took us into new territory when it comes to national debt. Without throwing around big numbers let’s just say that the relative size of our nation’s debt more than doubled and so far the debt burden is planned to get even higher in the future. When times improve we are supposed to reduce debt. But that never happened. Now as we approach a possible new economic contraction the government has no room to increase spending and/or reduce taxes. Do we want the national debt to double again? If we do try to use Demand-side Fiscal policy, then this will be taken as a sign of extreme alarm by world investors. We do not want that. I won’t even bring up Greece here. But I think you get my drift. Greece is clearly out of bullets. They don’t even have a slingshot.

How about International Trade Policy? I think we are out of bullets there since problems abroad mean that other countries are not buying much from the rest of the world and definitely are not buying from us. The value of the dollar is rising – not falling. Free trade agreements won’t do much to solve a crisis since the fundamentals mean that foreigners will not be buying more goods from us. They can barely buy goods from themselves.

What a pessimistic picture. Or is it? I left out one type of macro policy – Supply-side Fiscal Policy. Talk about tainted meat! Supply-side policy is an interesting alternative but it is saddled with cuss words like Reaganomics, Trojan Horse, Trickle-Down, and more. Liberals light up and glow when they use these terms. Sort of like when you got mad at your friend in third grade and called him a poopy-head. 

But SSFP -- let's call it that since it is less provocative -- is simple and straight-forward economics. Like bitters -- SSFP is not perfect for every situation but bitters is a necessary ingredient to make an awesome JD Old Fashioned. SSFP does wonders when suppliers of goods and services are reluctant to produce. SSFP attacks disincentives to produce. SSFP looks at things that unnecessarily add to business costs. SSFP is NOT about getting consumers to buy more. But it ends up increasing demand if it promotes firms to compete better and harder. 

SSFP tools are many. The best tool for today comes from examining what is constraining businesses right now. Why aren't firms hiring more workers? Why are firms reluctant to purchase new capital equipment and software? Why are some firms moving their assets abroad? Answer those questions and then use SSFP to remove the impediments. I won't prioritize the answers but clearly there are many areas of policy we can examine including minimum wage increases, environmental regulation, Dodd-Frank banking regulation, Obama-Care impacts on employment, and corporate taxation. 

My liberal friends will scream that we need all those taxes and regulations. Don't interpret me as saying we need to get rid of them. But just acknowledge that if we are truly out of policy bullets, then some small backtracking on these priorities could be very useful in getting this train wreck of any economy back on its rails. As J. Cash would sing -- Look Yonder Coming -- Coming down that railroad track.  It's the SSFP Special bringing my baby back! Humming is permitted. 

Lesson 3 Productivity: Not Such a Mystery

Alan S. Blinder wrote an article a couple of weeks ago in the Wall Street Journal called “The Mystery of Declining Productivity Growth ” (May 15). Who doesn’t like a good mystery? So I picked up the article and started looking for who killed Cock Productivity.  And then it hit me. This could be Lesson 3. All of you HomeEc majors are going to love this one.

Now that you have GDP under your garter belt it is now time to master another macro indicator, productivity. And it is a good one to master. Productivity is important, misunderstood, and controversial. And because productivity is the result of dividing two numbers, it is arithmetically challenging.

Productivity is important because it is a key driver of a nation’s output growth. We all have t-shirts that say Go Growth because we have fallen prey to this macro mantra. Recall that GDP is like a mountain of stuff. We like the mountain to get bigger each year. Macro says it gets bigger each year if we have one or more of the following:

            More labor producing stuff

            More capital (plant, equipment, software, etc) producing stuff

            More Productivity (Better ways of producing so that using a given amount of labor and capital gives you even more stuff)

Productivity is misunderstood. First, it is defined as output per unit of labor input. (Note: for those of you who know the difference between a two-factor and a one-factor production function please ignore my using labor productivity rather than total factor productivity. It seems easier to discuss this topic using labor productivity. I realize that technically it is not correct. But it does no harm for my purposes here).

To calculate productivity you therefore have to divide output by the number of labor inputs. People love rising productivity as much as a grilled cheese sandwich on white bread. Suppose Lila goes to a yoga camp and comes back to the factory all stretchy and happy. Her experience at that yoga camp means that Lila can now produce 10 Nehru jackets each day instead of her former best output of 7. She is still just 1 worker – but now her productivity is 10 instead of 7.  Her boss, Mohammed, is quite happy with this result. Getting more work out of Lila and paying her the same means Mohammed can afford more chicken wings and wheat beer at the Upland Brewery on Friday night. Of course, since Lila can produce so much more in a given day, Mohammed has other choices – he can reduce the price of his Nehru Jackets and/or give Lila a pay raise.

Do you see why we like productivity to increase? Workers who become more productive lead to higher output, higher profits, higher wages, and lower prices. Slower growth or lower growth of productivity is not good and leads to the opposite. So companies and countries try very hard to improve worker productivity.

Rising productivity is good but it is pretty complicated. A second reason for misunderstanding is that if Lila can produce so much, maybe old Mohammed can fire Adore, her co-worker who has been known to read Herman Hesse novels on the production line. That doesn’t sound so good. Higher productivity can lead to a reduction in employment. Some of you are old enough to recall when the tractor replaced the horse.  A lot of horses and agricultural workers got replaced when tractors increased the productivity of Ag workers – the ones who could master those new-fangled tractors.

Like Hillary Clinton therefore, productivity has a checkered past. This leads to controversy. One controversy has to do with the question of employment. Some productivity gains are very bad for some workers who get displaced by the new technology. But recall – stronger productivity also means more output, increased competitiveness, higher wages and so on.  The higher output can lead to more employment. A new technology causes an initial employment decline and it may take years before the output effects generate more employment. So it is a tough call for politicians to actively promote increased productivity – even though it is the key way to increase GDP for the future.

Okay we are almost done and it is getting close to 5 PM and I can hear JD screaming for me. Here is where we get to the mystery, whodunit, and then the solution. Alan Blinder notes that productivity growth slowed in the USA since 2005. It is barely crawling at 1.3% per year compared to a rate of 2.9% before that. You used to be able to dunk the basketball. Now you can barely touch the bottom of the net using a trampoline. This is a serious decline.

Blinder in his Alan Blinder sort of way says this is both a problem and a mystery. We should solve this mystery. But in my humble opinion Prof Blinder may have been spending a little too much time lately in Colorado and Washington State. He lays off this mystery to things like getting free services off the Internet and how much of the current tech boom (Facebook, Twitter, Snapchat) creates employment but not much output. He also says that businesses are churning less and that means less output from entrepreneurs.

There might be some truth to Blinder’s story but being one of the liberal persuasion it seems that Blinder simply does not want to admit to a whole other set of factors that might be important enough to have cut productivity growth by more than half. These items are not a mystery. Two recent articles offer a totally different view from Blinder– and suggest that the mystery is not very mysterious.

Martin Feldstein writes “US Underestimates Growth” (WSJ 5/19/15) and concludes that measurement problems during a time of rapid technological change underestimate GDP. The output and productivity are there – it is just that the government’s methods to measure them are not flexible enough. Feldstein goes on to say that approaching the productivity problem needs to address why firms are not buying more capital, why workers are not joining the labor force, and why smaller firms are not innovating. His advice is to focus on reducing tax disincentives and reforming taxes so firms want to invest and workers want to work. This,of course, is basic supply-side economics.

Dan Mitchell’s conclusion is pretty obvious from his title. “Big Government Is an Anchor on America’s Economy, Undermining Investment and Wage Growth” (WSJ May 16, 2015). Mitchell focuses on the thousands of new regulations imposed on financial, banking, and other firms in the years since 2008. These regulations create additional costs and uncertainty that prevent firms from expanding more and from workers actively seeking employment. 

Feldstein and Mitchell emphasize productivity problems that seem pretty obvious. I am not sure why Blinder sees this slowdown as such a mystery. Maybe his ideology does not include supply-side solutions and this we are left with mystery. I wonder what Sherlock Holmes would say about all this. 

Income Inequality and Economic Growth

Dad, can I have some money? Why do you need it honey? Because my friend got hurt and it makes me sad and if I bought a chocolate bar I might feel better. In that case, honey, here’s a five dollar bill. I hope you feel better soon. Come on. That is the dumbest reason ever given for wanting money from Dad and no kid would ever try it. But alas, Alan Blinder is up to his old tricks again and his article amounts to asking for that chocolate bar, “The Supply-Side Case for Government Redistribution,”” Wall Street Journal, August 15, 2014, page A13.

On July 1 I wrote a post Blindly Following Alan Blinder Over a Poverty Cliff. In that case I reviewed Blinder’s desires to expand most social programs aimed at low income persons.  Blinder never bothers with evaluating these programs and just cavalierly advocates expansion. If one billion wasn’t enough then we should try 2 billion.  In this August article Blinder gets more brazen when he concludes that long-run economic growth can and should be expanded if we spend more money on social programs.

Those of you who are not familiar with economic literature or colonoscopies should know that there is nothing written much-less proved or demonstrated about poverty programs causing economic growth. There are reams of articles written about the reverse – the impact of economic growth on poverty – but alas as Alan Blinder was hitting his deadline for the WSJ, he came up with a new and earth-shattering economic truth. If you want to increase economic growth then you should spend more money on programs for the poor.

Many of you will say that it sounds intuitive that helping the poor will create more economic growth. Widely shared economic growth models explain changes in long-term economic growth with several key indicators – labor, capital, and productivity. If turning a poor under-educated and unskilled person into a new and productive worker in the labor force can be accomplished, then the growth model shows how and why poverty programs might lead to stronger economic growth. And the reverse would be true too – rising poverty leading to fewer good workers in the work force would be bad for a country’s economic growth.

But just like needing chocolate to make you happy because your friend fell off her bicycle makes sense at some level, poverty programs simply are not an explanation for economic growth. The proof is in the pudding. Blinder made this whole thing up last week. Please someone show me in a journal or a book or a classroom or on a bathroom wall at an Irish Pub in Itaewon where economists have some sort of evidence to support the relevance of this idea.

There are several ironies here beyond lack of scientific rigor and evidence. First, Blinder says he wants to talk about the Supply-side as a means to promote stronger economic growth. Please pass me more JD. Isn't he among a group of liberal economists who routinely decry and label supply-side policy in the most horrible terms like trickle-down, Trojan Horse, and more? Second, Blinder says in the article about the ethical issue of poor people, “Either side can talk until it’s blue in the face without convincing the other.” Blinder apparently believes that ethics is not going to solve the poverty problem. 

Third, Blinder then goes on to minimize the case for improving national spending.  He argues that most people spend the same. Thus if you take $100 away from a person making $200,000 per year and give it to someone with $20,000 income per year – it would have no net effect on national spending. Thus poverty and income redistribution programs get no support from Blinder for ethics and spending.

And so we are left, according to Blinder, with economic growth. Help the poor more and the economy will grow stronger and faster.  And we better do it fast because we are becoming more unequal all the time. An afterthought of his article is that this inequality is exploding in both economic and political terms. That means we are all going to suffer because this will hurt economic growth even more. This is nonsense. I personally feel better about helping the poor because it is the right thing to do. And as I said in the last post, we do that best by first evaluating the programs we already have. We have 50 years of experience with such programs. An honest evaluation would find strengths and weaknesses. Why can’t we do such an evaluation before adding more fuel to the fire? 

Crash Diets, Debt, and National Economic Growth

Last week I argued that the priority for economic growth had slipped and pointed out why this is a prescription for continued labor and economic problems. For a government that claims it wants to help the average guy, its opportunistic approach to labor market (and other) problems does nothing but slow the healing process. Today I want to take this discussion a little further and possibly irritate even more of my friends and relatives. I associate the government’s current shotgun approach with the popularity and (lack of) effectiveness of diet crazes.  

Some of you responded last week by admitting that economic growth is crucial for developing countries. When the average person in a country makes $1000 per year it seems pretty obvious that economic growth is the only sustainable way to lift people out of poverty and into lives that more closely approximate modern living. There is no serious debate about the negative side-effects of growth in such cases. The first priority is to improve the lives of very poor people. Of course there is always some debate. I have been lambasted more than once by questioners attending my speeches who pointed out how the serene and wonderful lives of people living in jungle huts were destroyed by the encroachment of economic development. I also remember the NAFTA debates that pointed out the deplorable conditions faced by inhabitants of northern Mexico as they traded rural lives for wealth aspirations associated with factory work in the Maquiladoras.

But while many growth critics will agree that economic growth is okay for poor countries, the party ends when we start talking about richer nations. Apparently it is okay for poor people to get richer but at some point self-appointed representatives of proper behavior draw a red line that means enough is enough. Earning one more dollar above that line is apparently not worth whatever side-effects might accompany the increase in income. This idea is not without economic foundation. Economists often cite “diminishing marginal utility of income (DMIU).” That fancy term means that as your income rises the satisfaction you get from each additional dollar gets smaller and smaller. So when a poor guy earns another $100, he is happy as a lark. But when a rich guy earns an extra $100 it means very little to him and he leaves it sitting on a park bench with his half-eaten croque-monsieur.

While DMUI sounds pretty intuitive a critical question asks when any of this actually kicks in enough to make a difference. Judging from park benches in the USA today, I see very few $100 bills sitting around. Does someone who makes $50,000 a year not value what another $100 will buy? Does someone who makes $250,000 not value the extra Benjamin? Where is the line? I will agree there is a line but I have never observed it in my family. If DMUI kicks in at a low income level then it follows that the negative side-effects of growth might dominate the good things generated by it. But if high income people value extra income sufficiently then it is not so clear that DMUI favors less emphasis on strong growth.

Another relevant economic concept comes from a psychologist named Abraham Maslow, “hierarchy of needs”. Wikipedia has a lengthy technical discussion (http://en.wikipedia.org/wiki/Maslow's_hierarchy_of_needs ) but the simple and popular version is that human beings (that means you too Charlie) first must meet their biological needs for food, water, etc. Once they have enough income to meet those needs, then they move up the ladder to such things as JD, security, friendship, self-esteem, and morality.  This is important for a couple of reasons. First, it gives a foundation for valuing all human wants and needs. Who is to say that the “higher order” needs are not important? Surely you must eat and drink to survive, but some people could barely “survive” if they missed the latest showing of Survival. Clearly people are willing to die to protect freedoms to associate, speak, protest, etc. If higher incomes allow a country to reap some of these higher order benefits, I am not sure where we are supposed to draw the line and stop the income parade.

But a more important aspect of Maslow is how it affects our political aspirations. Once a country gets richer and once basic needs are met for most of the people, then Maslow’s hierarchy might suggest a political recognition of higher needs.  More equal incomes, cleaner environment, and more humane immigration policies surely seem more important once you are easily meeting basic needs for survival. But again, the argument is not about the theory. The debate centers on the values of the tradeoffs. What if economic growth is negatively impacted by a stronger focus on equal incomes, a cleaner environment, and more humane treatment of immigrants? What if weaker economic growth then makes these higher order objectives less attainable? Or put another way, an "obvious or direct" approach doesn't always succeed. How many crash diets ultimately succeed?  Just because you think a diet will make you look like Popeye’s girlfriend Olive Oyl or Dan Marino, we have plenty of evidence from millions of people who try extreme stupid diets that do nothing but create more income for shady businesses.

When smiling politicians tell you that they have wonderful ways to redistribute incomes or improve the quality of the environment ask them how they are going to accomplish those goals when the policies of the last 50 years have done little to create lasting remedies. More important, however, is to ask them what happens if such policies create more debt and/or rob the country of its higher economic growth.  If such direct approaches to a myriad of higher order needs have dubious chances of succeeding and very strong chances of creating more debt and less income, then one has to wonder if there is a better approach.

That better approach is twofold. First you reduce debt. The more we sustain historically high levels of debt, the less wiggle room we have. Look at this latest issue with Russia. A country with no debt can easily devote more resources to an urgent military conflict. The same goes for natural disasters. But if you have a large debt, the only way for the government to spend more on the emergency without having even more debt is to spend less on other government priorities. We hate that. So we need to have less debt now to give us more room to spend tomorrow on our highest national priorities. But reducing debt isn’t enough.  What we spend is limited by our incomes. When a nation grows it generates more tax revenues that support government spending. If you want to afford expensive policies for anything – environment, income distribution, defense, security, etc – then having a higher income and more tax revenue is the surest way.

Crash diets don’t work. Healthful living does. Every diet that takes you away from a sustained healthful life plan simply makes you worse off. Shotgun approaches to numerous national problems that threaten economic growth and/or create more debt are doomed as well. 

Japan: A Road Not to be Taken By Guest Blogger Buck Klemkosky

Japan experienced stock market, credit and real estate bubbles in the late 1980s, but with more intensity than the U.S. experienced later. Prior to 1990, the Japanese economy and financial system was considered to be superior to the U.S. as expressed in several books, such as Japan as Number One (1979). Japanese society was considered to be more thrifty and conservative than Western societies. By hindsight Japan was not immune to speculative euphoria and bubbles.

Japanese euphoria was reflected in both stock prices and real estate prices. By the end of 1989, the market value of publicly traded Japanese stocks exceeded those of the U.S. even though the size of their economy was of one-third that of the U.S. Stock valuations were astronomical even compared to the dot.com era in the U.S. While the stock market was soaring, the real action was in the property markets. By the end of 1989, Japanese property was valued four times more than that in the U.S. The grounds of the Imperial Palace in Tokyo were supposedly worth more than all of the real estate in California. Real estate prices in Japan had never declined in the post-WWII period, so investors, including households, corporations and banks, were convinced that property price increases were a certainty.

This increased stock market and real estate wealth eventually fed into the credit markets and the financial system. A massive credit bubble evolved based upon the stock market and real estate bubbles – a nasty combination of corporations, banks and individuals all on a speculative binge. It couldn’t end well and it didn’t.

The Nikkei index peaked at 38,900 in December 1989 and eventually declined more than 80 percent. Property values started to decline in early 1990 and also eventually fell 80 percent. Both have never recovered. The economic consequences of the bursting of the bubbles were catastrophic and long lasting. Banks were technically insolvent and became “zombie” banks. The corporate and household sectors suffered massive losses. Japan has never fully recovered from the collapse of the bubble economy even after two decades. Economic growth has been stagnant and deflation has been a problem. Japan has other issues, such as demographics, but there is no more talk of Japan Number One. In fact, Japan has recently become the third-largest economy in the world after China.

If this all sounds familiar, it should. The U.S. experienced the same phenomena with the stock market, real estate and credit bubbles that collapsed in 2007-2009, but with less intensity and magnitude and also without corporate sector involvement. Japan has been a role model for the U.S. as what not to do when bubbles burst and affect the financial system and real economy. Hopefully Japan’s experience is not a glimpse of the U.S. future after the financial crisis.

Japan has a long-term problem of a declining and aging population and virtually no immigration; the population peaked at about 130 million and is expected to decline to 87 million by 2060, and 40 percent will be over 65 years of age. Since economic growth is a function of population growth and productivity, Japan has to have higher productivity to overcome a declining population just to maintain the same growth as other developed countries. A difficult task. The other major problem has been political leadership; Japan has had 15 prime ministers in the last 20 years. Not a good recipe for making tough economic changes.

Many think, including quite a few Japanese, this may have changed when Shinzo Abe was elected prime minister last year and his political party has taken control of both houses of Parliament, resulting in political stability for several years. He has instituted economic reforms referred to as Abenomics. It may be the last chance Japan has to rid itself of its economic paralysis.

Abenomic economic policy has three main arrows as dubbed by the media. Arrow number one is monetary easing. Because of low or zero economic growth and deflation, Japan has the lowest interest rates in the world, so that tool of monetary policy is not operable. So the Bank of Japan (B of J), like the U.S. Fed, has instigated a massive quantitative easing program. Their goal is to double the monetary base (money supply) in two years. But there are risks associated with this first arrow. The balance sheet of the B of J is already large relative to Gross Domestic Product (GDP); it has doubled in size in 2013 and is the largest relative to GDP among developed countries. At some point, investors may lose confidence in the central bank and then the banking and financial system.

The second arrow is a massive stimulus package. This is nothing new as Japan has had several in the past. They have resulted in recurring government deficits; Japan’s government debt to GDP is 245 percent, one of the highest in the world, especially for a developed country. Again, a risk is bond investors lose confidence in the Japanese economy. Most of the debt is held domestically and denominated in yen, so it will be Japanese investors who may eventually question the credit worthiness of Japanese government debt; some foreign investors already have. No one knows where the tipping point is for the ratio of debt to GDP, but there is one. To alleviate this problem, Japan plans to raise the consumption tax from 5 percent currently to 8 percent in 2014 and possibly 10 percent in 2015.

The third arrow is longer term and involves structural reform of the Japanese economy. This would include industrial revitalization, deregulation, lower trade barriers, new markets for industry and a more global outreach for society. This may be the most difficult of the three arrows to achieve. Japan has world-class multinational corporations and most are doing well, like the auto companies, but some, such as several consumer electronics firms, are faltering. But it is primarily the corporate structure below the large multinationals that needs to be revitalized.

The aim of the three arrows of Abenomics is economic growth. There are signs that it may be working in the short term. Japan has had three quarters of solid economic growth, and consumer confidence has picked up as well as stock and property prices. Like Bernanke and the Fed, the Japanese government and B of J are targeting 2 percent inflation by 2015. With deflation, it pays to delay consumption as goods and services will be cheaper. So a little inflation may help domestic consumption.

Another result of Abenomics is that the yen has depreciated from 78 yen per U.S. dollar to 98 per U.S. dollar. A weaker yen will not only make Japan’s exports more competitive, but imports more expensive, helping foster a little inflation. Recent inflation has been close to 1 percent annually, but most of this is due to higher energy costs due to the weaker yen.

Perhaps Abenomics is the last chance for Japan to reverse more than two decades of stagnant economic growth and deflationary pressures. It may take time and be painful to some in society, but change is needed. Monetary easing and the stimulus may help in the short term, but structural changes of the third arrow are prerequisite to long-term economic growth. Given a declining and aging population, growth in domestic consumption is problematic, especially if base salaries remain stagnant. Exports would help the Japanese economy but slow global economic growth weighs against that. All developed countries would like to export more, including the U.S. but exports and imports are a zero sum game in totality. So the global economy may not be the solution either.

Japan has painted itself into a corner economically. Even though Japan is playing a diminished role in the world economy, it is important to the U.S. to have a strong Japan, given the growth of China, both economically and militarily. If these arrows of economic reform don’t work, especially the third arrow, there may be none left in the quiver. Let’s hope three are enough.

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!

New Age of Supply-Side Economics Part II.

Last week I spent some time trying to convince you that the Age of KE (Keynesian Economics) was being replaced by a new Age of SSE (Supply-Side Economics). I had so much fun bonking KE on the head that I ran out of juice and could not get to the best part – convincing you that SSE and SSE Policy are not evil monsters born of Bill O’Reilly and Ayn Rand but are legitimate policy options already being considered and tried in many nations. In fact, polite people these days are stressing policies of restructuring and/or rebalancing and these are really buzz words for SSE Policy. To bring all this out of the closet, let’s make a big point here:

            SSE Policy =  Restructuring

            SSE Policy =  Rebalancing

I feel a lot better now. I hope you do too.

But let’s start from the beginning. In a recent post I emphasized that economics is generally a discussion about demand and supply. It hardly makes any sense to talk only about demand. If you want to discuss procreation you talk about males and females. It makes no sense to focus on just one sex. As they say – it takes two to Tango. So the first thing to note here is that macro can and should focus on both of these main parts of markets – demand and supply. This is exciting stuff, eh? But it shouldn’t be. Why did macroeconomics survive for about 60 years ignoring SSE and SSE Policy?

This reminds me of the Internet joke that is going around now about the mother whose tiny daughter asks her what a virgin is. After stammering around for quite a while saying embarrassing things about sex to a five year old the mother takes a breath and the daughter asks her a second question. Mom, if that is what virgin means, what is extra virgin? Apparently her first question was about olive oil. It was not about sex.

That joke actually has nothing to do with this post but I have learned from experience that my readership improves proportionally to the number of times I write the words sex or oil prices.

The supply curve represents the actions of business firms as they decide how much to produce. Firms tend to supply more (and hire more workers) whenever their leaders envision a future with product prices and worker productivity rising relative to business costs. This is the kind of time period when firms see better returns on their investment. This kind of sanguine future supports the risks of investing in more capital, labor, and technology. It works in reverse too. If the macroeconomic environment is expected to be typified by wages and other business costs rising faster than product prices and productivity, firms are not going to buy more equipment, hire more labor, or otherwise invest in output expansion. They might, in that case, plan to reduce output.

Consider where we find the US and much of the world’s economy in early 2012. Huge government debt creates worry about riskiness of finance and is retarding company investments. Huge overhangs of money create a worry of future inflation and the eventual proportional increases in wages and business costs. So long as monetary and fiscal stimulus remain stretched it is hard to persuade business firms to produce more. Add to that a number of new government regulatory bodies producing literally thousands of pages of new business regulations. 

It is not surprising to find that the supply curve is hiding in the corner. It might sound backward to Keynesians – but one way to juice up the nation’s output is to convince these firms that wage inflation or interest rate escalation is not around the corner. Or convince these firms that the government is going to take firm control over the nation’s debts and will quickly clarify the details of regulatory compliance. Such a prudent macroeconomic policy would – therefore – lead to more certainty and optimism on the part of business firms and should cause them to hire more workers and produce more. 

So there’s your first SSE Policy—focus attention on reversing stimulus from the Fed and from the Government. Focus policy on reducing the uncertainty of future regulations.  

Reversing stimulus and regulatory burdens, however, are just the tip of the iceberg when it comes to SSE Policy. SSE is a holistic attitude toward economic well-being. This attitude recognizes that economic well-being comes from companies that create more and better jobs. And those companies exist and thrive when they compete, manage, and innovate as they meet existing and new needs of the world’s citizens. We somehow delude ourselves into thinking that somehow government manufactures economic welfare. Blackberry and Nokia are two recent examples of many. Samsung and Hyundai also offer testimony to the importance of companies. I admit that at some point in the history of these firms a government might have had some influence over their development. But the reality today is that no government can save Blackberry and Nokia from the ferocious surge of competition unleashed by Apple products. And no global electronics or auto producers can safely laugh off the challenge from Samsung and Hyundai. Firms come and go. The best ones meet the demands of the public. The best ones create employment opportunities and income growth.  

This holistic attitude has no room for KE. Instead it provides the kind of national atmosphere that strengthens competitive response. This agenda has at least the following components:

• •       Increasing national saving so that firms will find ample funds with low cost of capital
• •       A more flexible labor market that builds and motivates a skilled labor force and allows firms to flexibly hire and fire workers
• •       Laws and regulations that promote and facilitate innovation and entrepreneurship
• •       Low tax rates on income and removal of barriers that impede investment and the process of translating scientific advancement into new products and services
• •       State of the art infrastructure that supports all of the above with respect to communication, transportation, scientific research, education, training, etc.

My KE friends worry that the above list ignores one important thing – income distribution. The above looks like another party for the rich. Most of the ideas above seem to fit a trickle down story that the rich benefit directly greatly from a SSE Policy and only a few crumbs get dispersed to everyone else. Some of my KE friends would say that we have tried some of these things in the past and the poor get farther and farther behind. To my KE friends I would say that you are wrong for a couple of reasons. First the lives of most poor people in America today are infinitely better than what they were 100 years ago. The benefits of income and general living standards (including health, safety, etc) came because business firms have grown and provided millions of jobs and increases in real incomes.

Second, if the rich have benefited disproportionately in the last 10-20 years – it is not because we did too much of the above SSE Programs – but because we did too little. The US economy is in a global competitive dogfight that shows no signs of abating. Instead of unleashing our resources our corporate-government elite sat in private meetings off-microphone and restrained our companies. Corporatism reins in America as witnessed by the penchant for bailing out huge corporations. Meanwhile we become less and less able to unleash furious competition as we piss and moan and fight among ourselves about bailing out this group or that one. America is a great country with great people. A strong and clear SSE Policy is all we have to stay in the race.

The New Age of Supply-side Economics and Policy

Blame it on James and Fuzzy. In commenting on my post last week they both agreed I was not a nut-job. I am now emboldened by their trust and have focused my attention on Come and Go. Some of you remember the 50s song by the Dell-Vikings, Come and Go With Me. While the song has nothing to do with economics the words Come & Go suggest that things like Keynesian Economic Policy will come and go. And in this blog please underline the word GO. It is time for Keynesianism to go and I try to explain why here in less than half a million words. I am selling PUTS on Keynesianism. Please send your money directly to the IU Credit Union in my name.

Everything comes and goes. My baby boomer friends personally remember the Age of the Dinosaur. The smart brontosauri who saw the end coming transformed themselves into elephants and business school deans and survive until today. Look around and notice – no dinos. The Age of Dinosaurs is over. Similarly, the Age of Peyton Manning is over. Forward-looking Indianapolis Colts players and coaches jumped to other professional football teams or became lawyers. But look. No more Manning at the Colts. The age is over. Kaput. Adios. On Yong he ka sayo.

The above lucid examples and your local funeral parlor prove that nothing lasts forever (except for Nancy Pelosi and Jerry Lewis). And this truth applies to Keynesian Economics (KE). Just like horses were replaced by cars and my comb gave way to a nose and ear hair clipper, KE is giving way to something else. And even though you have sworn a pledge to never say these words – Supply-side economics (SSE) – I brazenly predict that SSE will soon replace KE. You readers who are still awake may have noticed I got tired of typing and have replaced the longer phrases for the abbreviations KE and SSE.

This is bad news for Larry Summers, Paul Krugman, Martin Wolf and a host of other sweet but misguided guys I have written about in this blog. I shouldn’t be so harsh. KE had its place in history. There were time periods when the harm done by KE Policy was possibly over ridden by the benefits. But give your kid a bath too many times in one day and he gets wrinkled and itchy. Baths are like lots of things – just the right amount at just the right time can be really good. But too many baths or a bath at the wrong time or a three day soak in the tub just causes problems down the road.

Sometimes it takes a while for people to discover the end of an Age. Think of all the diets you have been on. You don’t really know squat about nutrition. But you keep trying to lose weight. You probably keep trying similar diets only to discover that no matter how many pounds you lose you always gain back that many plus 10. The body is a very complicated and uncertain system. It takes a while before we finally figure out that some of us are born with a cookie monster inside of us. To rid yourself of this cookie monster you have to buy special cookie monster dust. That is the only thing that will work. But don’t tell anyone I told you.

The point is that the economy is pretty complicated and even after about 60 years of experience with KE we are just now seeing why it must come to an end. It had its time and it probably succeeded a few times. But it has hit its limit and the ball game is over.

How do I know the ball game is over? I can think of at least four good reasons why The Age of KE is over. First, the essence of KE Policy is managing spending. It involves finding ways to get people to spend more during a recession. Well, after a Whopper Super-Size government stimulus, people are still reluctant to take the bait and will not spend much more.

Second, KE Policy has backed itself into a corner. Whether the government does more demand stimulus or less, people are not going to spend more. With less stimulus (or what people are calling more austerity) the obvious result is not more spending. But doing even more stimulus won’t increase spending because most people will associate higher government stimulus with economic failure and increased uncertainty. They may also associate more stimulus with higher inflation and increased debt – equally worrisome and bad for confidence and spending.

Third, if one takes the time to read Keynes, he believed monetary policy could not revive spending in a severe recession because people have low confidence. If Keynes was alive today, he probably would abolish KE himself since he would apply his negativity abut monetary policy to fiscal policy too.

Finally, one reason KE is wrong today is that it has its eye on the wrong ball. The problem today is not a lack of spending. The problems today involve the adverse impacts of globalization, aging, sovereign debt, industrialization, excessive leverage, deer over-population, and male pattern baldness. These are problems that need myriad and targeted solutions. If you were experiencing fever and high temperature because of multiple breakdowns in your heart, liver, foot, brain and several other places – you might be a little skeptical of a doctor who advised you to take a larger dose of aspirin…or of any other single treatment.

So KE had its day and there is no hope for its continued influence. Betting on KE to solve today’s problems is a loser. The Put is in. It is time to buy SSE and SSE Policy. SSE Policy is the perfect way to directly attack US problems. But talking about SSE Policy is like talking about someone passing gas. It just isn’t done in polite company. SSE Policy has been called a lot of names: Trojan Horse, Voodoo Economics, and Trickle Down to name a few. Those are not nice things to call an economic policy. Each phrase, however, exhibits a real reservation people have about SSE and each term is worth addressing. But calling SSE Policy a bad name or referring to a president as a bad actor and or a cowboy does not automatically disqualify SSE Policy. So let me explain why. 

I see that I am coming close to using up my weekly allocation of JD. And I am at my word limit too. So let’s postpone the positive story about SSE and SSE Policy to next week.  So take a little time off – pet the wife and kiss the dog and otherwise enjoy the week. 

Voodoo Economics, Part 2

In my last post – Voodoo economics – I hit my page limit before I got to any real specifics. I laid out a rationale for why demand-side policy probably was largely spent and gave some background on supply-side policy. The main point is that supply-side policy has a checkered reputation that is mostly undeserved. It is pretty easy to dispense with the charges that it won’t work or that it is trickery. The more difficult aspect is that supply-side policy generally works BECAUSE IT STARTS by impacting rich folks and business firms.  But what matters most is where it ENDS – so let me get on with that point.

If you are imbued with equity and making sure that all people are always treated equally then you may find supply-side policy offensive. If you HATE capitalism and think that most capitalist policies are part of a great hoax that perpetuates current power and wealth, then you are probably not going to trust supply-side policy. If you are simply hoping to find a policy that will help us permanently exit this horrible recession and slow growth period, then you will want some assurance that any policy will do what it is supposed to do – create more economic prosperity and jobs. So where is the beef (or tofu for my vegetarian friends)?

Keep in mind that every policy is uncertain and risky. The Fed’s new quantitative easing policy is hotly debated. Another round of short-run government stimulus is no slam dunk and has its supporters and detractors. Supply-side policies are no different so let’s not read what I say here as blue-sky advocacy.  In my previous post I made the point that supply-side policy works because it directly impacts those who do the hiring and produce the output. The supply-side policy is directly aimed at business firms’ bottom lines. The basic intuition is that if policy can somehow make business executives more optimistic about their future revenues and costs, then they will be more willing to make capital investments and hire more workers.

Of course, like all policies, supply-side policy has its own moral hazards and unintended consequences. So we shouldn’t throw the baby out with the dirty bath water. Whatever advantages are given to companies and high income investors, attention must be paid to how they will translate into jobs and economic growth. I have said many times that I am neither a democrat nor a republican. Adam Smith was very clear that while he favored letting the invisible hand work, that firms are just as capable of corruption and waste as governments. While supply-side immediate impacts must be directed to firms and higher income investors – the true value of this approach is in its ultimate impacts in terms of higher output, more employment, and higher incomes.

What I didn’t do in the last post is to discuss the many ways this can be done. Notice that even among supply-siders there can be very different preferences for specific policies. Much depends on what you think is the biggest problem – what is making firms less willing to use their piles of cash today? What is making them less willing to make capital investments? Why don’t they hire more workers?

For starters, imagine one group of supply-siders who believe the economy is on the mend. They believe that we got hit by an economic firestorm that rocked our economic foundations but that the resilience of the economy provided the foundation for recovery and the policies of the last two years did not prevent some early healing. These supply-siders point to various green shoots or data that show promise of a continued recovery. Their supply-side recommendation might be – Don’t rock the boat! They might advise the government to create as little change as possible.  Just let the economy continue to heal. Firms will jump in as soon as they are surer that this recovery really has legs.

Of course, another group of supply-siders might believe that government policy was too aggressive and that we have created a very risky business environment typified by too much government debt. We all have seen some really worrisome estimates of future debt burdens. They bring up scenarios in which the US becomes the disdain of world investors causing a plummeting dollar, declining stock prices, and rapidly rising interest rates. It is not a pretty picture. These supply-siders believe that you can reduce the risky environment by paying attention to imbalances in the balance sheet of the Fed and the large liabilities of the government. Firms will not hire workers in sufficient numbers until they believe government debt and Fed policy are under control. Their supply-side policy means significant changes in the government budget and Fed policy.

Other supply-siders worry about international competitiveness. They worry about a government that seems to give lip service to free trade and a strong currency but whose real actions seem to put off the real decisions about trade or they lead to a declining value of the dollar. Whether it was the recent Asian Summit or the G20 meetings, the US was able to accomplish little. We have stalled so long on bilateral free trade agreements that our potential partners now seem to be the ones dragging their feet. The US harps on about China’s currency when most people agree that the US is equally culpable. Geithner blames the recent spectacular declines in the dollar on a reversal of safe monies. But what does he think caused the “new” view that the US is an unsafe place to invest? Keep in mind that while dollar declines might help exporters – they do very little to improve the competitiveness of US importers and they accelerate the desire of foreign investors to move their money out of the US. If you were a foreign investor, would you really want to receive your future return in dollars that are worth 15% less?  Real free trade and a real strong dollar are not easy to buy today. But they are an indispensible part of a strong and viable supply sector. 

Most discussions of trade end up with a story about saving. We all know by now that the US saves too little – and therefore our imports end up rising faster than our exports. This implies a need to borrow from the rest of the world – and we do. It is pretty clear that we in the US need to save more and our trading partners could save a little less. But who does saving in the US? Short answer – rich people and companies! The only real way to increase saving in amounts that matter is to increase the reward to saving. A Fed policy aimed at zero interest rates does nothing to help! A threatened increase in income tax rates and capital gains tax rates does nothing but reduce the incentive to save. Opponents of lowering these rates always point to the disproportionate benefits that would go to rich people. But notice that their focus is on the immediate impacts. Instead they should trust that a country with normal or strong saving more easily channels resources for innovation and labor productivity without having to borrow from abroad. Saving is the key to economic growth and rising incomes.  The ultimate effect is the one we should be focusing on today.  Thus some supply-siders advocate lower tax rates for companies and households regardless of income.

I am getting too wordy again and I have only discussed four examples of supply-side policies. I don’t want to promise a Voodoo 3. There are so many other great topics to be talking about!

So let me just summarize the rest briefly. Another approach to supply-side policy focuses on the reward to produce and the reward to work. While the US used to have a reputation of a country with a small government and low taxes, this is no longer the case.  Whether it is taxes on energy or regulations that require firms to guarantee health care or be greener it is no secret that firms feel increasingly burdened by government. Given the inertia of the government, firms are also increasingly uncertain as to how these new regulations and taxes will impact their future net revenues.  Add to that a worry that current unflattering attitudes toward the rich and corporations raise expectations about higher taxes on the incomes of companies and high income individuals. A supply-side approach recognizes how counterproductive this environment is to economic growth and employment.

Several leaders of the Democratic Party have very recently pointed out that postponing increased tax rates for the rich is the fair thing to do. They also are holding social security out of any discussions of how to solve long-term government debt challenges. Again, the issue is fairness. But what does fairness mean? I really doubt that dragging our feet on needed policies for economic growth is going to have an impact on the rich or the poor. The rich will take care of themselves at the country’s peril. The problem of poverty has little to do with marginal tax rate changes and everything to do with very long-term factors involving sociology, education, and training.  All government policies should not be held hostage to fairness. The fair thing to do is to take a very comprehensive and realistic view of poverty in the US – and then do something about it. 

Supply-side policies deserve a good look. There are many ways to skin this cat. But we won’t get to the first step if we can’t get beyond the Voodoo. 

Voodoo Economics, A Trojan Horse, and Trickle Down: Is it time to give the supply-side a try?

In Econ 101 we learn that economics is all about supply and demand. I was recently in South Korea where flooding caused by a typhoon virtually destroyed the cabbage crop. While Bugs Bunny would be quite upset about such an event it was even more important and upsetting for Koreans whose main dish, kimchi, is largely composed of cabbage. Kimchi is eaten at least once a day by many Koreans. Most Koreans have two refrigerators – one for all their other food and the other just for kimchi. I do not hide the fact that I love kimchi as much or more than most Koreans and I have several shirt stains to prove my devotion to the wonderful dish.

It was no surprise to anyone when the price of kimchi rose by 600% this summer. Why? Because of supply and demand. While the demand for kimchi had remained largely unchanged by the typhoon the supply had been reduced by the bucket-full.  As such grocery stores and restaurants bid up the price of this very scarce commodity as they tried to fulfill the usual wants of their customers. The market result was a much higher price. As kimchi came into Korea from abroad and the supply began to recover, the price of kimchi peaked and then started downward.

As the US Congress reconvenes as lame ducks and then for real in 2011, we should remember that government has policy tools that can be aimed directly at demand, supply, or both. But as the title of this message suggests, any member of the US government who recommends a supply-side policy will have to get over huge political obstacles. When George Bush Sr. was competing with Ronald Reagan to get the Republican presidential nomination in 1980, he labeled Reagan’s policy Voodoo Economics. The implication was that Reagan was trying to foist magic on the American public. Supply-side economics was also referred to as a Trojan Horse implying this policy was a trick on the American people. Finally, supply-side economics is alleged to be a tool to help the rich at the expense of the poor – meaning that the real benefits go to rich people and companies and all we can do is hope for some benefits to trickle down to the poor and middle class.

In short – supply-side policies are thought to be magic, a cheap trick, and a tool to steal from the poor and give to the rich. That’s hardly a resounding vote of confidence. It is no wonder politicians do not want to stand up and be counted for a supply-side approach. But I will argue below that the supply-side reputation is better than the title suggests and supply-side policy is just about perfect for our challenges today.

Let’s begin by quickly defining the supply-side. Economics concludes that while society will want and express a demand for food, autos, appliances and multi-colored condoms, it takes business firms to produce them. When we study demand we focus on the factors that determine what households want to purchase. But when we analyze supply, we emphasize the ability and motivations of business firms to produce those products. Supply does not get created magically. Firms must put together resources – like raw materials, intermediate assemblies, labor, machines, factories, and energy – if they are to bring the right goods to market at a competitive price.

If President Obama wants to improve the climate for production and employment, then he has choices. A demand-side approach focuses on the consuming household.  He can recommend tax reductions and subsidies to induce households to spend. He can use government legislation to direct the government’s awesome machinery to spend more. When we talk about a “stimulus package” we are usually thinking about how the government can create more demand in the economy. Despite all the controversy right now, it is true to say that sometimes these demand-side remedies work. The government stimulates demand and firms respond like Pavlov’s famous dog – demand increases and firms produce more. To produce more they often hire more workers.

But right now at the end of 2010, it isn’t perfectly clear if the demand stimulus choice is the best one. We saw what happened when cash for clunkers expired. In a previous post I explained that households are repaying debt or are otherwise saving. Given the remaining uncertainty about the economic recovery it seems wiser for them to be saving and not spending. Of course, business firms are watching all this and are not about to risk their capital to produce more until they are more certain that any demand increases are going to have some staying power.  That leaves the government’s direct spending on the economy. But even here we learned how disingenuous Congress can be. So called shovel-ready projects were about as ready as a Medicare patient at a high-jump competition. Government largess was aimed at a multitude of Democratic pet peeves. We learned that the political process can be very slow and unreliable when it comes to quickly generating more demand for goods and services. Yet it was perfect at increasing government debt.

The second choice available to President Obama is a supply-side policy. Supply-side economics was boosted when Jean-Baptiste Say ( Say’s Law) declared that “supply creates its own demand”.  The general meaning of this statement is that factors which cause permanent changes in society’s capacity to produce often lead to conditions (e.g. falling prices) which raise the level of demand to the higher amount of supply. Most economists today use Say’s Law to guide their analyses and forecasts of long-run economic growth. These forecasts have no role for demand and totally explain long-run changes in economic growth with two factors: labor supply and productivity growth.  The upshot of economic growth theory is that strong growth will occur only if and when labor supply and labor productivity growth permits it. Persistent economic growth is the only way to have persistent and permanent increases in employment.

Today our demographics indicate there is very little potential to increase economic growth and employment through faster labor supply growth. Our baby boomers (hurrah) are retiring and there is only so much that can be done through immigration or inducements to remain in the labor force.  So that leaves labor productivity as the only real route to stronger economic growth and employment.  How does a government formulate policy to achieve stronger labor productivity growth? First, the government needs to recognize that innovation and higher productivity are the keys to business success – firms with higher productivity compete better. So the firms are willing partners in any policy that improves labor productivity.  Second, the government must realize that productivity enhancements are expensive and often require firms raising large amounts of capital. Third, firms will not take these large risks without believing that they will pay off – and create excellent returns to the owners and stockholders. Fourth, these payoffs relate very much to two key factors in the business environment – expected future revenues and costs.

In a nutshell – supply-side policy needs to create optimism and clarity among business firms about future profits. This optimism is necessary for the capital investments that will lead to higher economic growth and employment. Any policies that promise restrained business costs and more certain long-run revenues and after-tax profits are what we need right now. These policies are what we call supply-side policies.

Is this magic? Ask China and the dozens of other countries that have implemented similar supply-side policies if they have worked.

Is this a trick? The above discussion explains why the supply-side approach should work.  While this approach might not work, it clearly has a strong rationale for why it should be effective. This is no Trojan Horse.

Is this trickle-down? It is no act of deception to recognize that supply-side policy generally aims its most immediate impacts on business firms and wealthier people.  How much of the benefits are absorbed by the poor or the middle class is definitely a legitimate question. My reading of economic history is that the only real way to permanently raise the standard of living in a country is through long-term economic growth.  Schemes to redistribute income or to equalize incomes can be effective only in an environment of growth. 

Demand-side policy is very risky right now. It might not work. Worse yet, it might create higher uncertainty about the long-run future of America as it raises US debt, worries our trading partners, and opens up concern about when and by how much the future stimulus will be withdrawn.  It is time to give supply-side policy another look.

There is a lot more to say about this issue. Hopefully this is a start to a good discussion. Let me know what you think.