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!