Tuesday, July 29, 2008

Interpreting the Economy

It is very important to understand the state of the economy and the possibilities for the direction of the economy in the future. This understanding is important, not only for policy makers, but also for businesses and investors. It is my view that many analysts are still trapped in a way of thinking that does not really reflect what we are facing at the current time.

The basic tendency is for people to look at the aggregate demand side of the economy to discern what is going on and what should be done to improve economic conditions. This is because the basic paradigm of modern macroeconomics is based upon the work of John Maynard Keynes and this model focuses primarily upon the demand side of the economy. This model was developed for two practical reasons. The first was to create a model that would allow nations to conduct their economic policies independently of one another. The impetus for such a model grew out of the situation that existed in the world at the end of the First World War and the Paris Peace Conference of 1919. There was great concern at that time about the success of the Russian Revolution and the growing fear that revolution might spread to other nations through labor unrest if workers were not kept gainfully employed. This fear along with the dysfunctional efforts at the national level to handle reparations and achieve peace highlighted the need, to Keynes, to focus on full employment and to allow a nation to act independently of all the chaos being experienced in international relationships. (For a reference to this view see Donald Markwell, “John Maynard Keynes and International Relations,” Oxford University Press, 2006.)

The second reason was the need to find a way for a government to act to achieve high levels of employment and thus avoid labor unrest. Keynes grew cynical about the ability of a central bank to impact output and employment when it was really needed. The only way he saw out of this problem was to develop a model that could explain how the fiscal policy of a nation could produce the aggregate demand that was necessary to spur a nation on to high levels of employment. Keynes gave very little attention to aggregate supply assuming that businesses would respond to demand: if demand were low, output would be constrained and workers would not be hired; if demand were high, output would be expanded and workers would find employment available.

The model that focuses primarily on aggregate demand came to predominate economic thinking in the post World War II period and continues to permeate the culture of macroeconomic policy making. If a problem seemed to be one of inflation, policy makers could concentrate on slowing down aggregate demand and take the pressure off of prices. If the problem seemed to be one of slow economic growth then policy makers could stimulate aggregate demand and create greater economic growth in the future. Right now when we seem to be faced with both an inflationary situation and slow economic growth we see that policy makers are talking about the monetary authorities raising interest rates, to ward off inflationary pressures, and further tax rebates (to follow the first round of tax rebates) to stimulate the economy.

Ask yourself this question: what are the conditions of demand and supply that result in rising prices and a slowdown in the rate of growth of the economy. Take a two dimensional graph and place the rate of growth of the economy on the X-axis and the rate of increase of prices on the Y-axis. Then draw a demand curve that is negatively sloped from left-to-right on the chart and a supply curve that is positively sloped from left-to-right on the chart. Now, you are only going to move one of the curves. Which curve, when you shift it, can result in a decrease in the rate of growth of output and an rise in the rate of increase in the price level? Only a shift backwards and to the left of the supply curve can give you this latter result!

Could it be that the shock to the economy is coming from aggregate supply and not from aggregated demand? It sure could. I believe that more and more data analysis is pointing to the conclusion that maybe fluctuations in economic growth are not necessarily coming from the demand side of the economy but are coming from the supply side instead.

What are some pieces of evidence that seem to show that movements in the supply side of the economy might dominate what happens to an economy in the short run? Real consumption expenditures, for example, tend to move in a procyclical fashion with real Gross Domestic Product over the business cycle. Real gross investment is also moves with real GDP as do real wages and the real price of rental capital. Interest rates also tend to move in the same way. If aggregate demand dominated economic activity then one would not expect these variables to move in a procyclical fashion. Furthermore, inflation tends to move in a countercyclical way: actual inflation tends to be above the trend rate of inflation when the actual growth rate of real GDP tends to be below the trend rate of economic growth. All these results support the conclusion that shocks to the economy come from the supply side, not from the demand side!

Given how comfortable we have become with the models in which shocks come from the demand side of the economy, these results seem to be counter-intuitive. However, we need to look at these results very carefully because how we interpret them is very, very important for not only the governmental policies that we support, but also for the economic and financial decisions we make given the choices that government policy makers implement.

If the government acts to stimulate the demand side of the economy as a result of a negative supply shock then the basic result will be more pressure on prices with very little of the stimulus being transferred to increasing output and employment. In fact, there can be a second round effect of such inflationary stimulus. We saw in the 1970s that increasing inflation resulted in people and businesses investing so as to hedge against inflation. Most of this hedging turns out to be counter productive to the productivity of the economy. When people begin to focus on protecting themselves against rising prices, it inevitably causes them to lose their focus on good business practices, practices that include increasing the productivity of capital. Thus, this secondary effect can further slow down economic growth by causing an additional backwards shift of the supply curve. This is exactly what happened in the 1970 period of stagflation.

There are a lot of things that can produce a backwards shift in aggregate supply. We don’t have time in this post to go into them, but I will devote some time to this analysis in future posts. However, the efforts to stimulate economic growth without putting pressure on prices are dependent upon whether or not we can identify the factors that have caused the shift and the incentives that can be set up to encourage people and businesses to increase output and further stimulate economic growth. Thus, in order to create more economic growth without setting off further inflationary pressures, care must be taken to identify what has caused the shift in supply. This will allow policy makers to devise policies that will get business, once again, to focus on what they do best.

The problem…supply side policies tend to be those that create enhanced incentives for businesses. Creating such policies without taking into consideration the problems that people have in finding work, in paying their debts, and in holding their heads up, is a sensitive issue. Policy makers must find the right balance of programs to stimulate business activity while not creating too much aggregate demand that will only exacerbate inflation. This is not an easy task!

One final issue…are we in a recession? I am not going to use the standard definition of a recession associated with the National Bureau of Economic Research which focuses major attention on two quarters of negative growth in real GDP. To me the important consideration is the relationship between the trend rate of growth of real GDP and the actual rate of growth of real GDP. To me, the concern is over how far the latter growth rate falls below the former. If the actual growth rate falls below the trend growth rate by 1.5% or more, then this could be defined as a recession. That is, if the trend growth rate of real GDP is 3.0% and the current actual growth rate is 1.4%, then one could argue that the economy is in a recession because actual growth is 1.6% below trend growth. Real GDP has grown at a compound annual rate of 3.0% over the 1977-2007 period. The year over-over-year growth of real GDP from 2007-I to 2008-I was 2.5%. This would indicate the United States economy is not yet in a recession.

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