When Aggregate Demand Policy Isn't Enough

Charlie’s motor scooter wouldn’t start. He checked the spark plug and it was okay. He checked the fuel line and it was in place. He even checked tire pressure. Exasperated he went inside to watch Baywatch reruns and drink a PBR. Peter asked him if there was any gas in the tank and sure enough there wasn’t. Problem solved. They filled the tank and rode off into the sunset. 

That’s a nice happy ending. It illustrates that sometimes the solution is right there in front of your face. Many of the usual suspects are not always culpable. So stop badgering them and move on. While this advice pertains to many things, it seems very obvious right now with respect to economic growth. Our predilection is to focus on aggregate demand (AD). Keeping the budget deficit and/or monetary expansion hot is a macro tool for stimulating AD.

This idea goes at least back to J.M. Keynes who thought that a modern economy, like your teenage child, has a natural tendency to stay below its potential. He concluded and became famous for his idea to prime the pump. Taken from an agricultural application, Keynes said that all the engine needs is a wee bit of fuel and it will start running. Once the engine starts running the gas will more easily flow from the tank through the carburetor. Problem fixed.

I am not sure how we got from a wee bit of temporary stimulus to massive and perpetual government deficits but let’s say that Keynesians expanded the master’s ideas. If a little stimulus is not enough then it seems logical to try more of it. But like Charlie’s dilemma above, when a lot of stimulus does not appear to work it does not mean we should move to a “whole lot more AD stimulus.”

There are two parts to this issue of what to do when stimulus seems to not be working. First, are you sure it isn’t working? Second, what else can you do to fix the problem?

Many of the articles I am reading are starting to concede that you can have too much of a good thing. I can show you too many graphs of monetary indicators – reserves, excess reserves, narrow money – that all pretty much show the same thing. There is a s-load of money out there. Doubling excess reserves won’t do a thing to solve the problems of today’s economy.  And measures of government fiscal deficits and debts are no different. As economists project the course of future debt it shows no signs of reversal despite being at least double what me might call normal. All that stimulus and virtually no one proudly boasts that it has or will cause the economy to return to stronger growth.

Worse yet from the AD side is that since money is so abundant, interest rates so low, the government debt so high – we have collectively backed ourselves into an AD corner. If AD does worsen, we have very little room to use AD policy to counter such possible downturns. Do we take national debt from 80% of GDP to 150%? Can you speak Greek?

Okay I have beaten up enough on AD. If AD is not going to save the day, then what will? The answer is in the economist’s usual toolbox. Economists explain everything from sex to sympathy with demand and supply. We think this is a balanced approach to many issues – so why not macro too?

AS completes a market analysis. While AD represents the buyers in a market, AS is identified with the suppliers. In a market system, what motivates and allows the suppliers to bring more or less to market for sale? To begin with suppliers need inputs. Depending on what is being produced they may need a building, energy, workers, police protection, raw materials, parts, equipment, trucks, and so on. That and their own labor costs money. A business usually has to assemble all this stuff before it brings the first item to market for sale. So businesses always take risk. They have to lay out money and then they have to hope that someone will want to buy the fruits of their labor.

How much should they produce? While many new businesses do not earn any profits for years the main idea is that the owner or owners get a return for taking this risk as well as for the time they put into this business. If demand and market price turn out to be very low for their product or service, then the return is not going to be very high. If the market price is low enough it might not cover costs and would warrant no production and a shutdown. But as market price rises, this satisfies the owner and makes him or her more willing to supply more output.

This shows that demand is critical to output and this idea works at the national level – more AD and a higher national price level tend to stimulate higher national output. But there is much, more to story. What matters too is the productivity and the costs associated with the productive inputs. Imagine that your workers went to a Prince/Michael Memorial Show last night and came to work today full of vim and vigor. Working at the same compensation package they manage to Moon Walk their way to much higher output per person. The consequence is that each unit of output costs less for you to produce. It makes your company more competitive. You can offer a better price to buyers. And thus your profits and your incentives to produce increase.

The upshot is that anything that increases productivity stimulates more output. The opposite is true of increased costs. Whether it is an increase in wages, compensation, energy, taxes, or the price of any productive input, it tends to raise your costs per unit and reduces your competitiveness. Thus a firm tends to reduce output when costs rise relative to productivity.

While it might sound wrong to some of you to support a policy centered on improving business profits, the possibilities are pretty attractive in the sense that policies designed to raise business productivity and to reduce unnecessary business burdens and costs could go a long way to returning profits to normal, to raising the optimism of managers, and to increasing output, employment and earnings. Given that the usual AD stuff is not succeeding it might not be a bad option. Or instead we could go back to shouting at each other.