The problem is 75% demand shortfall, and 75% structural

No, that’s not a typo.  And yes, I am good at math.  In this post I’ll try to reconcile two very different perspectives, each of which seems quite plausible:

1.  The problem is obviously aggregate demand.  In 2009 NGDP fell at the fastest rate since 1938.  The recession is closely correlated with that decline, and both theory and history suggests that such a decline is always bad for growth.  Financial markets respond to rumors of monetary easing in a way that suggests they believe it affects real growth.  Countries with more expansionary monetary policies tended to do better, at least in most cases.  (Australia, Poland, and Sweden, but not Britain.)  David Glasner showed that stocks and TIPS spreads are correlated during this recession, but not before.  Paul Krugman has a recent post showing that wages are obviously very sticky at low inflation.  We clearly have an AD problem.

2.  The problem is obviously structural.  Youth and unskilled unemployment is particularly high, presumably partly due to the 40% jump in minimum wages.  When European countries introduced policies like two year UI, their natural rate increased.  Now we’ve done the same.  Manufacturing firms report a shortage of skilled labor.  Nominal wage growth rates and core inflation have stopped falling, suggesting that wages and prices have reached some sort of equilibrium.  There’s an immigration crackdown.  There is rapid growth in occupational licensing laws, making it much more difficult to become self-employed.

Previously I’ve suggested that supply and demand shortfalls might become entangled.  Today I’d like to briefly summarize why, and discuss the implications.

1.  Why do demand shortfalls worsen AS?   I can see several possible reasons.  The nearly 10% drop in NGDP relative to the path expected when minimum wages increases were enacted, has effectively raised the real minimum wage by 10% more than intended.  (Wages should be deflated by NGDP, not prices.)  The demand shortfall caused Congress to extend UI benefits from 26 weeks to 99 weeks.  Since workers suffer from money illusion near 0%, the supply-side may deteriorate when nominal wage cuts are needed.  If public sector wages are sticky, it may place a burden on the private sector.  If the recession leads to big deficits (as ours has) it may lead to expectations of higher future taxes.

2.  Why do structural problems worsen the demand shortfall?  Two possible reasons (only one of which supports fiscal stimulus.)  If the Fed targets interest rates, or is passive at the zero bound, then a falling equilibrium natural rate may unintentionally tighten monetary policy.  Obviously the Fed also cares about things like inflation; otherwise the price level would be indeterminate.  But in the short run (with interest rate targeting) an adverse supply shock could reduce AD, just as fiscal stimulus could raise it.  The other problem is inflation.  Structural problems reduce AS, and raise inflation. If the Fed is targeting inflation, that causes them to do less monetary stimulus.  This channel works against fiscal stimulus.

So far everything seems symmetrical.  But I do think there is an important difference.  In my view monetary policy can solve 100% of the AD problem, but policy reforms can only solve a modest portion of the AS problem.  If we cut the minimum wage back to $5.15, and cut UI back to 26 weeks, it might cut one point off the unemployment rate, say from 9% to 8% (assuming 5% is the natural rate during normal times.)  Other structural problems are harder to address.  On the other hand if the problem is 75% AD, then monetary stimulus alone could cut unemployment from 9% to 6%.  That’s partly because it would reduce the real minimum wage, partly because it would cause Congress to end the 99 week UI program, and partly because it cuts real public sector wages, and partly because it reduces the problem of money illusion at 0%.  (Here I assume that the natural rate went up by 1% (from 5% to 6%) because of other structural problems such as labor re-allocation, which the Fed can do nothing about.)

So even if the problem is both 75% AD, and 75% structural, policymakers should be much more focused on the AD problem, at least in terms of the recovery.  Obviously structural changes like tax reform and better regulation will produce greater long run gains than any demand-side policy.  But we shouldn’t kid ourselves that those can solve the demand shortfall problem.

Deep down even conservatives must understand this.  If a Reaganite was president and doing aggressive supply-side policies, you can be sure the WSJ would be demanding easier money to help facilitate growth, just as they asked for easier money when Reagan himself was president and inflation was 4%.  Recent conservative hysteria about inflation is completely at odds with their relative silence during the Bush years, when inflation was higher than under Obama, and the dollar plummeted in value (it’s been fairly stable under Obama.)

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19 Responses to “The problem is 75% demand shortfall, and 75% structural”

  1. Gravatar of Becky Hargrove Becky Hargrove
    12. July 2011 at 06:26

    A good way to think of it – demand having been knocked out to such a degree, even the dollar stores now have declining sales. And how to back up on structural problems such as ramped up licensing requirements. When I moved back to my small hometown to help my parents, I tried to find a lot to set up a barbecue operation and discovered that no commercial zoning was available save the main street where the realtors only had some dilapidated old restaurant buildings to offer. All other available property had been zoned residential. The local businesses had already pulled up the ladder behind them in an effort to remain solvent.

  2. Gravatar of Hyena Hyena
    12. July 2011 at 06:54

    I think there’s a lot we can do on the structural side but I suspect that no one who talks about this has experienced a recession from the inside. I collect UI and have a good idea how the incentives play out at the “my-cro” level. I think the best change we could make is to allow UI beneficiaries to work at a discount. Their employer would pay them their salary less the value of benefits, which would take the edge off training people and solve near term wage stickiness problems. Currently, that’s not possible and just taking a job is very risky; you could lose benefits altogether and the costs associated with even low wage work aren’t minor compared to staying home.

  3. Gravatar of Scott Sumner Scott Sumner
    12. July 2011 at 07:51

    Becky, Yes, the economy has all sorts of structural rigidities, but they are politically hard to end.

    Hyena, That’s a good suggestion, I think some European countries might have a similar program, but am not sure.

  4. Gravatar of Morgan Warstler Morgan Warstler
    12. July 2011 at 08:32

    “If we cut the minimum wage back to $5.15, and cut UI back to 26 weeks, it might cut one point off the unemployment rate, say from 9% to 8% (assuming 5% is the natural rate during normal times.)”

    If we cut the minimum wage to $1 and end UI, unemployment will fall below 5% in less than 30 DAYS. Everyone will have a job – even at only $1, because that is the only way to get the Guaranteed Income under my plan.

    That we know 100% for sure. So it is COMPLETELY STRUCTURAL.

    On the other side, you are unable to put a real number on how much QE3 is needed, how much inflation will occur as we chase that target – so we’re just left guessing and hoping.


    Scott, the fact is businessmen who say it is structural have FAR GREATER SCOPE in what we say is rational policy.

    You don’t get to shoe horn conservatives into a shitty assumption of Minimum Wage and half a years UI and then play umpire.

  5. Gravatar of Morgan Warstler Morgan Warstler
    12. July 2011 at 08:34

    Hyena, you are right on… please consider:

  6. Gravatar of Howard Howard
    12. July 2011 at 08:46

    How about supply-side and AD: “like the blades of a scissor…”

    One can always dream.

  7. Gravatar of Benjamin Cole Benjamin Cole
    12. July 2011 at 09:02

    At this point, a military coup with Scott Sumner as the new leader would not be a bad idea.

    Crickey-Almighty! Why not just hire Bank of Japan senior staffers to run out monetary policy?

  8. Gravatar of Benjamin Cole Benjamin Cole
    12. July 2011 at 10:07

    The Tale of Two Banks

    China is growing rapidly–and not surprisingly, China’s central bank emphasizes economic growth over fighting inflation.

    This is from “China Economic Issues” published Jan. 2010, by the Hong Kong Monetary Authority:

    “In the basic specification with only growth and inflation when the official targets are used (Column 1 of Table 4), the coefficients on economic growth and inflation are highly significant, demonstrating the importance that the PBoC attaches to its legal mandate of maintaining stable
    economic growth and low inflation. Among the two targets, the policy response for economic growth is stronger than that for inflation.
    This suggests that the PBoC shows stronger reaction to each percentage-point deviation in economic growth from
    the official target than that for inflation.”

    The Bank of Japan, in contrast, for the last 20 years has made fighting inflation Job One.

    The Tale of Two Banks

  9. Gravatar of Lucas Lucas
    12. July 2011 at 14:14

    Your explanation of the inter-wired nature of AD and AS shocks is the reason I think the optimal macro policy is tons of monetary expansion (when the zero bound is reached) and supply-side measures such as a cut in the employer part of the payroll tax (your idea and already implemented in Singapore) and Mankiw’s idea of incentivizing interest-sensitive components of spending.
    Now thinking in my own country, which supply-side measures should accompany restrictive monetary policy (needed to fight off 25% inflation) so as to reduce the possibility of overshooting and causing a recession?

  10. Gravatar of Scott Sumner Scott Sumner
    12. July 2011 at 18:06

    Morgan, That’s actually a great plan you link to, and indeed I used to talk about similar ideas way back in 1980. I don’t know why more economists don’t push that sort of plan.

    Howard, Good analogy.

    Benjamin; You said;

    “At this point, a military coup with Scott Sumner as the new leader would not be a bad idea.”

    Certain un-named elite members of the military are already working with me on a plan.

    The China/Japan distinction is stark, although in fairness it’s by no means just monetary policy. China has catchup growth.

    Lucas, Are you from Brazil or Argentina? There would be plenty of supply-side reforms, just copy Chile.

  11. Gravatar of Lucas Lucas
    12. July 2011 at 19:50

    I’m from Argentina, Brazil doesn’t has 25% inflation.
    I was thinking in specific supply-side policies that could make the required disinflation less traumatic: there’s always the risk of a recession or an uptick in unemployment which may kill the political support of nominal tightening and give rhetorical ammo to those saying that even the smallest cut in AD growth will be catastrophic.
    Regarding Chile, there’s some sort of political/social consensus that their policies, imposed by a totalitarian government (Pinochet) and labeled with the boogeyman of neoliberalism (our dreaded 90s), are about to fail at any moment. Many times I (a moderate left-winger) am looked upon as an heretic by fellow progressives critical of the current government if I say nice things about the Chilean model.
    Fortunately, there are strong rumors that the presidential candidate with most chances to beat Mrs. Fernández de Kirchner in the upcoming election and a solid progressive is taking advice from Andrés Velasco, the finance minister of the last social-democratic Chilean government [1]


  12. Gravatar of TheNumeraire TheNumeraire
    12. July 2011 at 22:45

    “Countries with more expansionary monetary policies tended to do better, at least in most cases. (Australia, Poland, and Sweden, but not Britain.)”

    Scott, of the four aforementioned countries, three of them had significant supply-side policy changes in 2008-09. Poland and Sweden both had significant supply-side tax cuts; Britain on the other hand had a “soak the rich” style hike in MTR’s and a hike in the capital gains tax.

    Australia didn’t have much in the way of cuts to MTR’s, but over the past decade it greatly increased the income thresholds at which the highest MTR’s take their bite. Plus, Australia is probably the OECD country with the highest correlation to Chinese industrial production.

    Anyway, my point being that supply-side is probably demonstrating that it is still largely relevant to creating higher real growth from whatever higher level of NGDP growth that the quasi-monetarists are hoping for. Higher NGDP is the steak, but what we really want is the sizzle (higher real GDP). But more steak without the proper grilling techniques (positive supply-side adjustment) appears not to produce enough sizzle — at least judging by the difference between Britain and Poland/Sweden.

  13. Gravatar of ssumner ssumner
    13. July 2011 at 12:09

    Lucas, I hope that’s not your real name, you could be arrested for that slanderous remark about Argentina’s inflation rate.

    Seriously, That’s good news about Velasco. I don’t know enough about the specifics, but do reforms in such a way that labor doesn’t get overpriced–that’s political poison. Focus on pro-growth polices first, then gradually try to reduce inflation.

    TheNumeraire, You don’t need to sell me on supply-side reforms, they are the key in the long run, and might have helped a bit even in the short run. But NGDP also grew more strongly.

  14. Gravatar of TheNumeraire TheNumeraire
    15. July 2011 at 03:03

    Prof. Sumner, don’t undersell the importance of supply-side in the short run.

    Here’s another example that i think bolsters the case for necessity of supply-side; Poland vs. Hungary in 2009.

    Neither country was subject to ECB policy; both countries appeared to have expansionary monetary policy (the forint and zloty both depreciated against the Euro by more than 20%)….

    ….but here’s the difference — Poland pursued large cuts in MTR’s in 2009, the Hungarians flirted with implementing IMF-advised tax hikes and general austerity until reversing course after a change in political regime.

    Using Eurostat, I find that RGDP has expanded by approx. 7.5% in Poland from pre-Great Recession peak and has shrunk by approx. 4% in Hungary. Poland actually only had a single quarter of negative RGDP (Q4 2008).

    It’s gets more interesting when you consider that Hungary has enacted a flat tax for 2011, cutting in half the previous top MTR. RGDP appears likely to grow faster in 2011 than 2010, despite the fact that the forint has increased more than 5% against the Euro in the past year.

  15. Gravatar of ssumner ssumner
    15. July 2011 at 10:04

    TheNumeraire, I do think supply-side is important (note the 75% figure.)

    That’s really good news about Hungary. What will be the new top rate? How about corporate taxes?

  16. Gravatar of TheNumeraire TheNumeraire
    15. July 2011 at 10:10

    The flat tax rate is 16 %, previously there were two brackets of 17 and 32 percent.

    Hungary and Poland are however facing a rather huge headwind because of the soaring Swiss Franc. Both countries have a lot of franc-denominated mortgage and corporate debt.

  17. Gravatar of ssumner ssumner
    16. July 2011 at 10:01

    TheNumeraire, I read that a few years ago, and it struck me as absolutely nuts. The Swiss franc has always been an incredibly strong currency, why would people want to borrow it?

  18. Gravatar of TheMoneyIllusion » We know wages are extremely sticky, we just don’t know why TheMoneyIllusion » We know wages are extremely sticky, we just don’t know why
    15. September 2011 at 12:15

    […] shocks shouldn’t last for more than a few years.  I’ve already argued for the “entanglement theory” of this recession (between structural and AD factors), but let me provide three reasons why […]

  19. Gravatar of Supply Theories of the Business Cycle « azmytheconomics Supply Theories of the Business Cycle « azmytheconomics
    13. February 2013 at 14:11

    […] Reading The problem is 75% demand shortfall, and 75% structural Tyler Cowen on Real Business Cycle Theory (video) Bad outcomes lead to bad policy Arnold Kling on […]

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