This is the third of three posts in which I aim to present the outline of my vision of where the economy is going into the fall. The first, “The Candidates and Economic Leadership” (August 18, 2008) framed the political environment, and the second,” The Most Important Price in the Economy” (August 20. 2008) presented my view of where the focus needs to be centered for economic policy making. This third post will be more specific as it tries to define the dilemma the policy makers are facing within the current environment.
In my view the implicit model of aggregate economic activity that we default to is one in which the aggregate supply of goods and services is assumed to be fixed or constant. That is, the aggregate supply curve is perfectly inelastic with respect to the aggregate price level. (This, of course, is a very simple picture and does not take into account the potential growth of the economy. Both of these points can be addressed. I am just trying to KISS the analysis for reasons of space and exposition.)
In this simple model, the only way that one can get a fluctuation in output is when the aggregate demand curve shifts. If output is observed as less than ‘full employment output’ (or growth is less than “full employment growth’) the only explanation that can be given for such performance is that aggregate demand must be less than is needed to achieve ‘full employment output.’ That is, demand is deficient.
If demand is less than supply at a given price level shouldn’t the price level fall?
Here we face another assumption, pervasive in modern macroeconomics, which sneaks into our analysis without our really realizing it. This is the assumption that prices either do not fall in a modern economy or at least adjust downwards at a very slow pace.
Our basic instincts tell us, therefore, that the only way we can avoid unemployment and unused resources is to “juice up” aggregate demand. We must create an economic stimulus package that will “goose” the economy so that it will achieve full employment once again. This is what the tax stimulus package enacted earlier this year was all about.
But, what if the drop in economic output (or the slowdown in economic growth) is not due to deficient aggregate demand but due to a shift in the aggregate supply curve?
In this case, with no reduction in aggregate demand, we would face a decline in aggregate output AND a rise in prices!
And, in such a case, what would happen it the economy was stimulated through an economic stimulus package? Possibly economic output would increase a little bit, but the stimulus package would certainly put more pressure on prices! This seems like the situation called STAGFLATION, a replay of the 1970s!
Stagflation is a situation in which there has been a backward shift in the aggregate supply curve combined with economic stimulus. The supply curve shift has resulted from factors, independent of demand, that impact producers…like an energy shortage or changing trade patterns or difficulties in the financial sector or government policies…and cannot, therefore, be offset by an economic stimulus package. Any government efforts in such a situation must be directed at overcoming the things that are causing businesses to produce fewer products and services at given prices.
The attempt to stimulate aggregate demand at such times does very little in the way of creating much additional output. The demand pressures that are created go into price increases that help producers to weather the difficulties they are facing in terms of their output decisions. It is a fact of life that the factors that impact the producers at this time create greater uncertainty for their businesses. Changes in the future of motor vehicles using alternative fuels as energy sources are having a major effect on auto makers. Uncertainty about the structure and regulation of the financial industry cloud the decisions of bankers. The lack of a clear vision of the future economic policy of the government affects us all. In such an environment businesses will take fewer chances with respect to increasing their output but will gladly take any increase in cash flow that they can get from increases in prices. This is the less risky strategy at this time.
How is one to get out of such a bind?
Well, my first response to this is that we need good leadership. No one likes uncertainty. But, uncertainty is rampant in the United States at this time. We see this on the evening news broadcasts. Families are cutting back on school supplies for the fall because of the uncertainty they face with respect to their budgets. What is going to happen to gas prices? What is going to happen to food prices? What is going to happen to employment? And so on, and so on. How should producers respond to this? A tax break to these families is not going to get them to spend more on school supplies. So businesses are uncertain about their future.
What about energy policy? Off-shore drilling or reducing oil reserves is not going to solve our problems. Regardless of the short term responses of the presidential candidates, uncertainty is going to hang over businesses concerning what they should be doing about their future energy sources. Solar panels on all malls or strip centers? Wind sources for electrical energy companies? Companies focusing on these big issues are not focusing on output.
What about the financial system? What about the infrastructure? What about…?
We need a leader who provides us with a vision we can believe in and in whom we can develop trust in to deliver on that vision. We need a leader who can help reduce the uncertainty that exists in the United States at this time.
My second response is that we need to get away from an emphasis on stimulus, stimulus, stimulus. What does such an attitude do? First, is that it creates an atmosphere of go, go, go. Everything is up, bailouts will be given for making mistakes, but, after any short crisis, the emphasis will always be to push the limits. This is the kind of environment in which inflation flourishes. Why should I worry about a slowdown? Inflation will be back and I can let prices buy me out of any mistakes I make. Why should I worry about over-leveraging a position? I will just be bailed-out and the process will start over again. In such situations we concentrate more on financial outcomes rather than on real production and creation.
And, finally, I believe that we need economic policies and regulations that are based upon process and not upon outcomes. An unemployment policy based upon a target number for unemployment, say 5%, is one based upon an outcome. An employment policy based providing education and transition support is a policy based upon process. Anti-trust regulation based upon market statistics and market structure is regulation based upon outcomes. Business oversight based upon openness and full disclosure is regulation based upon process. Taxing corporations that creates incentives to “go offshore” so as to avoid taxes is a tax policy based upon outcomes. Taxing corporations so as to change behavior or to punish those earning “excess profits” is a tax policy based upon outcomes. The tax system that creates incentives to focus on creative accounting and ingenious corporate structure distracts businesses from what they really should be doing. Taxing businesses must be based upon processes…and not outcomes.
I could go on…and I probably will in the future…but, at this time, I firmly believe that we need to focus on what is impacting the supply side of the economy and not the demand side. If we do not focus on the supply side at this time I believe that we are in for continued volatility in the markets and continued fragility of our financial institutions and consequently our whole economic system.