Do We Need a Bigger Pot?

You planted your lovely Japanese Maple in a nice pot and it flourished – at least for a while. So you added some fertilizer and moved the plant to a sunnier location. That helped but only for a while. Your neighbor suggested JD but you didn’t agree. Other friends suggested you try moving it to a bigger pot.

The economy is not so different from the Japanese Maple. When growth slows, we want to do something to restore healthy growth. It is not always obvious which is the best remedial path to follow. So we will always have some difference of opinion as to how to proceed. History helps us think about these competing policy ideas.  

Macro has a history of policy preferences. Before the 1940s arrived, we had no strong preferences for active policy and we preferred to let the markets work. Adam Smith’s invisible hand would heal the economy. As policy makers stood by, it was believed that prices and wages would fall enough to restore weak demand to stronger levels. Competition and markets would ensure growth in the longer term.

The Great Depression shook that theory. Despite large reductions in wages and prices, the economy did not return quickly to its former strength. John M. Keynes was among a number of economists whose theories supported a stronger role for government in rehabbing a sick economy. While Keynes was not a big fan of monetary policy, he did believe that fiscal policy could be used to kickstart a weak economy. If people were too pessimistic about the future to spend, then the government could spend or perhaps induce people and companies to spend through tax breaks.

This was the start of Keynesian aggregate demand policy. It was notable for three reasons. First, it gave a stronger role and perhaps an obligation for government to intervene when an economy was in recession or headed for one. Second, it was very specific that the intervention had something to do with reviving flagged demand for goods and services. Third, other followers of Keynes were less negative about monetary policy and added monetary policy to fiscal policies as acceptable government macroeconomic tools.

This approach to macroeconomic policy became the status quo until the late 1960s and 1970s when we experienced a series of supply shocks and a run of stagflation. Increasing AD was not the remedy for this disease, since a policy to get people to buy more would worsen inflation. And worse yet, with inflationary expectations high and rising, any increase in spending would cause even more supply shocks and stagflation.

What to do? Nixon threw up his hands in frustration and landed on wage and price controls as the solution. Even Spiro Agnew knew that wouldn’t work. The controls were stopped in 1974 after three frustrating years of failure. We were eventually treated to a remedy in the early 1980s when the Fed stopped AD and inflationary expectations in their tracks with 20%+ interest rates. We had two recessions as a result. Lesson: don’t let AD get out of the corral. Getting it back in is too painful.

Reagan and Thatcher wondered if there was an easier way to combat stagflation. And they hit upon aggregate supply policy. The idea is that sometimes a weak economy is not primarily caused by reluctant consumer spending, but rather by uncertain business firms who don’t want to take risks involved with producing more. It’s not easy to tell what is causing an economy to slow. But clearly there are times when uncertainty of business firms is what is mostly responsible for low levels of employment and output.

Depending on which famous economist you bribe, he will tell you that AS policy is either the best thing since sliced bread or worse than a Syrian Bar Mitzvah. But the sad truth is that the concept has been thoroughly trashed by people who refer to AS policy as a Trojan Horse, Voodoo, or Trickle-Down Economics. You would never give your kid any of those names. The challenge is that AS policy is aimed to increase the incentives of business firms to produce. So instead of AS policy directly impacting your ability to spend, it starts by stimulating firms with the idea that they will then produce more and probably hire more workers and then they will spend like the Tuna after winning the lottery.

So what about now? The situation now is that AD policy was tried, and it is out of bullets. The Fed has kept interest rates at zero so long that interest no longer impacts spending decisions. Of course, old fools like me are constrained from spending because the interest earnings of our retirement accounts are producing very little spending power. And if monetary policy is out of bullets, fiscal policy did about all it could to give us cash for clunkers and now the government is in debt with all projections showing the nation’s debt situation getting worse and worse. Don’t count of the usual fiscal policy to get spending roaring again.  

So if AD policy won’t work, what are we left with? Yup, we are pretty much left with the Voodoo. I think AS policy is worth the risk. Maybe it won’t directly and immediately improve the distribution of income. But most of us would be more than happy to have growing job opportunities and rising incomes. Okay, maybe all those rich business executives will gain more than I will from an AS Policy – but right now many people would be pretty happy to just get a job and/or a fat raise.

AS policy is like making the pot bigger. The plant already has too much fertilizer on it. The roots need some room to grow. This might not lead to a miracle but tax reform, deregulation, and a number of other AS policies can lead to more economic capacity and growth. AD will follow. So will our incomes.