On the Demand Side and the Supply Side: The Stimulus Debate

The flaming debate on how to steer the economy forward and avoid America’s “Japanification” has been dominated by two seemingly irreconcilable camps:

On one hand we’ve got the demand-side guys, who claim that Japan’s “lost decade” of the 1990s was the result of a spineless government policy reaction to the post-bubble reality… ergo the US can avoid becoming Japan by keep on stimulating itself with fiscal and monetary measures until private demand recovers.

On the other hand, we’ve got a bunch of supply-siders, who attribute Japan’s quagmire to the drop in Japan’s total factor productivity (TFP) 1/—a shock in the face of which demand-side policies are impotent.

The two schools of thought are irreconcilable only insofar as they are driven by the blind ideology of those expressing them; in economic terms, they are not.

Here, I’ll start form Japan and notably with the observation that TFP growth did in fact decline during the 1990s. (See here and here).

Now, while a TFP analysis may be useful in providing the breakdown of output growth into the contributions from labor, capital and TFP (ex post facto); it is not very useful in explaining why TFP may have fallen at any given period, let alone in forecasting how TFP might move in the future. The “why” has to rest on a comprehensive structural analysis of the Japanese economy over the past three decades, which is certainly beside the scope of this piece.

The key point here is that the observed drop in Japan’s TFP during the 1990s does not have to be exogenous (to policy). Indeed, plausible explanations as to why, allow for both the supply- and demand-side frameworks to have been at work simultaneously.

One such explanation has to do with the weak state of the financial sector after the bubble burst, and the concomitant misallocation of credit to inefficient, loss-making industries The link from bank weakness to credit misallocation goes like this: Troubled bank rolls over loan to troubled firm to avoid the pain of realizing losses on that loan. Troubled/inefficient firm remains alive for too long. TFP drops. (see here).

Japan’s story can also vindicate supply-siders, however. As highlighted in a recent speech by the Bank of England’s Adam Posen (a vocal demand-side guy), Japan’s TFP growth during 2002-08 actually exceeded that of major advanced economies (the US included). Posen presents this as evidence that Japan’s potential growth was not permanently damaged by the chronic recession.

Interestingly, part of the explanation he offers has to do with (supply-side) “structural reforms undertaken over the course of the 1990s. These included, energy market deregulation, some better utilization of women in the workforce, new entrants in retail due to the rise of Chinese and Asian production and telecoms deregulation [..], as well as financial market liberalization”.

Posen adds that “[w]hat was necessary [my emphasis] was the clean-up and recapitalization of the banking system, the further loosening of monetary policy […] and the avoidance of any further premature fiscal tightening”.

Why “necessary”? One can find the answer in that same speech: Protracted periods of recession, unemployment and financial sector weakness can lead to a destruction of an economy’s production potential. Those who stay out of work for a long time lose their skills, at the cost of lower future productivity; banks that remain weak for too long impede the allocation of resources to productive firms, per the storyline above.

As Posen states, “this is why a number of central bankers, myself included, have argued for very strong immediate response to negative shocks, so as to forestall this process insofar as possible”. In other words, fiscal and monetary stimulus policies should be geared towards preserving and expanding the economy’s production potential, while the private sector remains on the defibrillator. This is particularly relevant for the US today, where (per the latest Bureau of Labor Statistics report) the TFP of the private nonfarm business sector grew by just 0.1% in 2008—the slowest rate since 1995.

So what measures fit the bill? On the fiscal side, tax breaks for companies that retain their workers during a recession (as in Germany) or programs to build up the skills of the long-term unemployed (whereby private firms would receive government support for training unemployed workers) would be more effective for safeguarding the economy’s productive potential than the mere extension of unemployment benefits.

Similarly, programs such as the first-time homebuyer credit (not to mention the multibillion dollar transfers to Fannie and Freddie) were a complete waste of taxpayer money: They provided a boon to people (with jobs) who could afford to buy a house; and they artificially supported house prices (at least temporarily) at a time when the average American household is still enjoying a substantial positive equity in its home. Instead, fiscal policy should have focused on measures to relieve those households with negative equity in a permanent way and stop the vicious circle of foreclosures-price declines-more negative equity-more foreclosures and so on.

On the monetary side, I am planning to write a more comprehensive piece but my theoretical framework is one I already laid out here. As a “preview”, the Fed wasted the sense of urgency prevailing back in March 2009 by going after the wrong type of assets (MBS) in its asset-purchase program.

So where have demand-side fanatics fallen short? In that their prescription for fiscal and monetary stimuli is, basically, “bigger is better”. There is little link between the size, type and duration of stimulus measures and the objective of safeguarding and promoting the economy’s productive potential.

Ultimately, it is hard to disagree that accommodative monetary and fiscal policies can help an economy during a recession. The question is what measures are the ones that will help the private sector reach what Larry Summers called “escape velocity” without undermining the commitment to medium-term fiscal discipline. “Not enough” is not economics; it’s a political statement.

1/ For the uninitiated, TFP measures the impact on output of technological change, reallocation of resources, economies of scale, etc after taking into account the amount of capital and labor inputs that go into the production process. (In other words, it’s the output per unit of joint labor and capital inputs).

PS And yes, I’m back after a long summer Odyssey!

Originally published at Models & Agents and reproduced here with the author’s permission.  

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One Response to "On the Demand Side and the Supply Side: The Stimulus Debate"

  1. Guest   September 9, 2010 at 3:12 pm

    I am on the Demand side camp and would suggest a three pronged strategy to economic recovery that will also help the private sector reach “escape velocity” (I previously have posted my suggestion on other Web forums as well):Firstly, a housing stabilization program (where the government would receive first rights home equity in return for making part of the monthly mortgage payment for those facing foreclosure, with the government disposing of its share in 10-15 years by having the homeowner to either refinance or sell the home then). The current foreclosure rescue plans are too indirect, they involve some write offs on the part of the lender and also give away government money. Under my plan, there would be no government giveaways, the burden would be on the homeowner (by not building equity) and the banks possibly having to writeoff some mortgage balance in 10-15 years time. In return the homeowner gets to stay in his home for 10-15 years (as long as he or she does not default) and the bank to receive monthly mortgage payments for the same period of time. At the end of the period, the homeowner would either have to refinance his mortgage or sell his or her home and thegovernment would get its money back with any remainder first going to the bank and then the homeowner. By reducing the number of homes being foreclosed, new housing construction employment will increase, housing prices stabilize and possibly even increase.Secondly, a temporary bank to lend to those borrowers who otherwise would be able to borrow during normal economic times, but can not now due to risk averse banks. By the bank hiring employees with commercial banking experience and deferring part of their compensation to be based on loan repayment, it would help ensure sound lending decisions. Also it would only accept loan applications that have been rejected by commercial banks to avoid competing with them. After economic recovery, the bank’s loan portfolio would be sold off to commercial banks and the temporary bank shut down.Thirdly, to a limited extent and depending on how the first two programs work out – a stimulus program. By the way, the first stimulus program is still expected to have an effect, there was a delay because stimulus work needs to be planned first to avoid waste. Check out the article “Stimulus Money Unspent as Economy Struggles” dated August 16, 2010 on the CBS News website for more info on unspent stimulus. The way to tell if there is too much stimulus is if the inflation rate rapidly starts increasing above 3% (what I consider to be normal inflation), in which case the stimulus program should be rolled back.The first two programs would be revenue/expenditure neutral (debt to be paid back by eventual revenues). My recommended goal is 5% unemployment and 3% inflation rate before the above programs are closed. Another way of looking at the economic situation, is that the money supply flowing through the economy should not cause either too much or too little inflation and unemployment.We seem to be close to a deflationary period hence the need for the above strategy.By the way, incurring debt is not bad in the short run if there is low inflation and the purpose is to reduce unemployment to more normal levels. There has been huge debt incurred since the Great Depression and the Second World War, and the American economy has still thrived. The American economy has a further advantage in that the U.S. dollar is widely accepted overseas, so that to a certain extent, excess local demand (created by stimulus spending, for example) can be satisfied by importing foreign products without sharply increasing U.S. inflation.For those advocating tax cuts, keep in mind that people may just hold on to their additional money or pay off debt, thereby not stimulating the economy and not reducing unemployment. Therefore, I believe my strategy is much better for economic recovery. As the economy moves to a new equilibrium (one that reduces the proportion based on real estate to one relying more on other industries), I believe my economic strategy will reduce the pain involved in the transition.