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Home Publications Blogs Beat the Press Teaching Robert Samuelson About Supply and Demand

Teaching Robert Samuelson About Supply and Demand

Monday, 24 June 2013 04:16

Last week we had to teach Robert Samuelson about inflation. He noted that the wealth of households was back to its pre-recession level, but spending was not. This led him to think that the wealth effect no longer applied. However, when we adjusted the data for inflation and then brought in Mr. Arithmetic it turned out that people were spending more than would be predicted by the wealth effect, not less.

This week it looks like we have to teach Mr. Samuelson about supply and demand. His column is a warning that "cheap money" (e.g. the quantitative easing and low interest rate policy pursued by the Fed) may do more harm than good. This comes in the context of the drop in world stock markets following Ben Bernanke's indication of a pullback from these policies.

Never mind that the drop in world stock markets is exactly what would be predicted if cheap money actually was helping the economy (in that case, the pullback would be expected to lead to lower growth and likely lower profits, therefore we would expect to see lower stock prices), let's deal with the rest of his story. The basic problem in the column is an inability to distinguish clearly between supply and demand.

This first comes up when he complains that in spite of cheap money:

"the speed of the U.S. recovery (about 2 percent annually) is roughly half the average of all recoveries from 1960 to 2007. As for the global economy, it grew 2.5 percent in 2012, down from the 3.7 percent average from 2003 to 2007, says IHS Global Insight."

This one is easily explained by lack of demand. Housing bubbles in the United States and elsewhere had been driving the economy prior to the downturn. Those bubbles have mostly burst, although Canada, Australia, and the UK have seen bubbles reemerge. The fact that the downturn was caused by a collapsed bubble instead of the Fed raising interest rates meant that the recovery would be much slower and more difficult than in prior recessions. There was no easy way to replace the consumption and construction demand created by these bubbles. Some of us were yelling this at the top of our lungs back at the start of the recession, but apparently Samuelson didn't hear us and is therefore surprised by the weakness of the recovery.

Okay, so the simple and obvious explanation for the weak recovery is lack of demand. (Samuelson sort of makes this argument, but because he still hasn't learned about inflation he repeated his line from last week that attributed a falloff in consumption to a lack of confidence as opposed to the more obvious explanation of a lack of wealth.)

He then flips over to the supply side. Citing work about the long-term prospect for productivity growth by Robert Gordon and a new study from the Fed he tells readers:

"from 1995 to 2004, labor productivity — a measure of efficiency — in the nonfarm business sector increased 3.1 percent a year, with about half the gain coming from IT. From 2004 to 2012, average annual gains dropped to 1.6 percent, with IT providing slightly more than a third."

There are two points to note about this one. First the timing on productivity growth is always erratic. We always see unusual patterns year to year that are much more likely just measurement issues rather than real changes in the rate of productivity growth. For example, productivity grew at a 3.5 percent annual rate from the fourth quarter of 1990 to the fourth quarter of 1992. It then fell in the next year. The Samuelsons of the world may think we had great technological breakthroughs in this two year period followed by a sudden dearth. The rest of us would likely attributable this to timing quirks.

If we want to time the slowdown as beginning in 2004 it is probably worth noting that productivity growth averaged 3.5 percent from 2000 to 2004. This might look like another timing issue rather than a sudden ending of productivity growth. Of course after 2007 we did have a different story of weak demand growth. In this context many workers who can't get good-paying high productivity jobs instead turn to low productivity low-paying jobs.

In this sense, weak productivity growth can be seen as a direct outgrowth of weak demand. One way to distinguish the demand and supply side story is that if productivity was being limited by the ability of firms to produce goods and services then we should be seeing substantial inflationary pressures in at least some sectors of the economy as firms are up against constraints in terms of their ability to produce goods and services. Since we don't see price pressure in any substantial segment of the economy, the demand story seems much more plausible.

It is also worth noting that the weak productivity story is 180 degrees at odds with the robots will make us all unemployed story. Think this one through, unlike our elites, you cannot believe both if you understand the arguments.

Then Samuelson comes back to the demand side, although surprisingly with a discussion of the aging of the population:

"Finally, demographics may hurt. As Americans age, they may restrain their spending. (In 2000, the 65-and-over population was 12 percent of the total; by 2025, it is projected to be nearly 19 percent.)"

Note Samuelson is not making the supply-side argument that aging will limit the growth of the workforce and therefore reduce growth. (It will.) He is instead saying that we might expect to see lower consumption as a share of disposable income because of aging, a demand side story. Of course we see no evidence of this to date, as wealth adjusted spending is actually higher than before the downturn, but Samuelson's story will explain slower growth in future years if savings rises.

In short, Samuelson might be confused about the weakness of the recovery but there is no reason the rest of us should be. A bubble was driving demand, the bubble is gone. There is nothing to replace the bubble. It's all very simple.

Finally it is worth noting one of Samuelson's other complaints against cheap money. Citing Stephen Cecchetti, an economist at the Bank of International Settlements (BIS), Samuelson tells readers:

"he argues that low interest rates might even be counterproductive. They make it easier to finance large budget deficits and may delay needed, though unpopular, cuts. ... Cecchetti’s preference for deficit reduction is controversial; economists disagree about the need to cut deficits."

While it may be true that economists disagree about the need to cut deficits, it is worth pointing out that almost all of the predictions of the deficit cutters have been proven wrong over the last 5 years. Long-term interest rates have not soared, the dollar has not plummeted, and there has been no runaway inflation of the sort they predicted. In fact inflation has fallen. And the 90 percent debt-to-GDP cliff that was popular among the deficit hawk crowd proved to be an artifact of an Excel spreadsheet error. 

Some economists may still adhere to the need to cut deficits story in the same way that there could be an astronomer who argues the sun revolves around the earth, but they maintain this position in spite of the evidence. In a context where economies face demand shortages, as is the case today, deficit reduction means less demand and higher unemployment. It's hard to see why any reasonable person would want to see even more hardship.

Note: Paul Krugman deals with the BIS case for further austerity.

Comments (9)Add Comment
written by foosion, June 24, 2013 6:03
deficit reduction means less demand and higher unemployment. It's hard to see why any reasonable person would want to see even more hardship.

More hardship means lower labor costs which means higher profit margins, which means more for the best off. Cutting government leads to lower taxes for the best off. The best off have a very large degree of control over the government and the media. Higher demand may mean more sales and profits, but that's much more uncertain.

The question is whether it's reasonable to profit from the suffering of others. Those who control fiscal and monetary policy have clearly decided the answer is "yes."
Best Off?
written by nassim sabba, June 24, 2013 8:31
This one rings right. Best Off instead of the 1%, actually, even better if you just simplify it to the BO. (Sorry for lowering the level of conversation, but I am interested in language that clarifies through metaphors.
When in Doubt, Always Be Certain and Blame Unemployment on the Supply Side
written by Last Mover, June 24, 2013 9:09
The usual tipoff to a flawed argument on this subject by Samuelson et al consistently emerges as some interventionist prop or other claimed to hold up demand that shouldn't be there, in this case cheap money.

From this baseline any reduction in demand or expected demand, such as that projected by a falling stock market, necessarily qualifies as "excess" demand that is adjusting itself with reductions back to where it presumably needs to be to equal aggregate supply.

This amounts to the classic Keynesian interpretation that an economy can come to equilibrium below full employment and stagnate there under market failure for a long time absent intervention.

However this result according to Samuelson et al is not an inherent failure of capitalism. The "pullback" is specifically attributed to cheap money here in the same way soup kitchens are said to have caused the Great Depression. That is, stock markets are said not to react as stated by Dean Baker to expectations of less growth per se, but instead to expectations that the growth in question is "artificial" and cannot sustain itself.

In other words, the unemployment problem is always about artificial demand taking the fall because the supply in question is framed as the real constraint, unable to grow to full employment because everyone and everything "employable" is already (fully) employed, and the only way to employ more is to free up more resources from the supply side. By definition, attempting to do this from the demand side is futile.

As Dean Baker repeatedly reminds everyone, it goes back to the hole in demand left by the bubble. But that too is conveniently erased from reality by Samuelson et al. By blaming the bubble on government instead of the private sector, the same flawed baseline of "full employment" above is made to appear consistent throughout the relevant time frame.

The bubble itself is framed to have "crowded out" fully employed resources in the first place and pushed too much of them into the housing sector. So when it burst it didn't leave a "hole" in aggregate demand, it just created upheaval on the supply side in terms of shortages, surpluses and structural unemployment in private markets that are still "readjusting" to "government intervention" in "free markets".

Of course that's not what happened at all. The bubble simply replaced demand lost from falling wage income and benefits. It did not cause a surge in demand beyond full employment. It did not represent a surge in inflation in that regard. Instead, it actually maintained full employment, and when it burst, full employment fell and has not returned since.

The deep recession started as a demand problem and it remains as demand problem. No amount of reframing it into a supply problem has a shred of credibility.
written by pete, June 24, 2013 9:13
When wages and asset prices bubbled up do to loose money, this was unsustainable. Finally the bubble burst. Housing prices fell but the bubbled wages in places like housing construction did not. Now folks are finally taking jobs, at lower wages than they were able to extract during the bubble. Sometimes this is referred to as capitulation. Growth is slow because this is a painful, embarrassing process, clearly exacerbated by extended unemployment benefits. Inflating real wages down, as Krugman has consistently called for, is a much better idea.

Of course, inflation/stimulus will exacerbate the transfer of income/wealth to the upper crust, as it has since 1970. (1968 was peak income equality...the beginning of the War On Poverty and right before the break up of Bretton Woods.)
"Malinvestment during housing bubble"
written by A Populist, June 24, 2013 1:18
The claim is being tossed around that malinvestment during the housing bubble is causing current unemployment, because of lack of investment in (something).

Of course this is absurd. Supply responds to Demand - not the other way around. Supply siders are apparently oblivious to the fact that their worldview is the same as those who believe in a communist "command economy", where the government (or in their case, omniscient investors) must of course plan and anticipate the needs of society, and spend exactly correctly, or else the economy is doomed! Never mind that this is the same logic that would result in the overproduction of some goods, and shortages of others.

Never mind that, in response to the massive demand of WWII, companies were able to rapidly staff and find materials to invent and build creative new designs, using labor that was previously untrained (Wanda the Welder, Rosie the riveter, non-degreed designers and engineers creating state of the art war goods in massive quantities). (Sarcasm on) Obviously, investors in 1925 must have been planning and investing to ramp up for war goods, or we would have had large unemployment, and no way to fight a war. (Sarcasm off).

Surely it is obvious that having an already over-educated public desperately trying to anticipate the "next needed skill" (and often failing - not getting a job), is an extremely inefficient process. This is an example of students "investing" in themselves without any obvious demand for their services - another example of the inefficiency of "supply side economics". It would be far more efficient, if workers were trained by employers to meet specific needs.

An economy which has a surplus of demand, is far more rational and less dysfunctional, than one which has a surplus of supply.

When will those commie, "command economy loving" supply siders be discredited?
Tax increases by any other name
written by Capt. J Parker, June 24, 2013 7:15
You will continue to have austerity as long as you have: fiscal conservatives who want spending reduction, progressives who want tax increases and government that is incapable running a balanced budget even in the best of times.
the only thing that makes sense ...
written by David, June 24, 2013 10:07
... about the Fed's statements is that they saw bubbles forming that needed deflation: Shiller P/E is 45% or so above its historical mean, and the housing speculation emerging in certain pockets around the country. Of course, if they're tomfool enough to actually (instead of threatening to) stop QE by the calendar instead of by better recovery data than currently exists, well, then they will be the first up against the wall when the revolution comes.
written by Chris Engel, June 25, 2013 1:10
Capt. J Parker:

The balanced budget fetish is partially responsible for the austerity push!

Riddle me this: the Fed conducts monetary policy through Treasury securities. Treasury securities are net-created through running deficits at the federal level. If this was a long-run goal, how would the Fed conduct monetary policy? Recall that Greenspan in 2000 was panicking about how he would even engage in OMO given the shortage of safe assets used in traditional tools.

Tax increases on the wealthy is not nearly as "austere" as spending decreases for the lower classes. So I wouldn't group in the liberals who want to tax wealthy individuals to offset gross inequality with the conservatives who want to just cut spending blindly.

Both parties are wrong on the issue of austerity. Because neither of them have the balls to say that we need a large jobs-directed stimulus program that includes long-term productive investments as well.
Chris Engel:
written by A Populist, June 25, 2013 5:49
I agree, but I would add that a higher minimum wage is something which should really get more attention. This would *not* increase the debt - public or private. This is a big deal. When we have large amounts of debt owed by those unable to pay (low wage workers), and that debt is backing large amounts of financial instruments, that is a dangerous and unstable situation. And, the masses of low paid workers, can only increase consumption (increase demand) by taking on unsustainable debt. Also, they aren't being paid enough to save for retirement, and so cannot make way for recent grads to get jobs. Stimulus is good, necessary, and part of the solution. If directed towards long term infrastructure (roads, dams, levies, bridges, solar, research, wind power, educating youth) it is also one means of "real savings" - a means for the present older generation to reduce the "burden" on the next generation. While in reality, this "burden" is actually not at all a problem (due to increased productivity swamping the effects of demographics), it is still not a bad idea. But a higher minimum wage, lower retirement ages, and shorter work-weeks, at least make it possible that, in the long term, we can maintain full employment without ridiculous levels of consumption, as cumulative productivity growth and increased efficiency continuously reduces the need for labor. The alternatives to higher minimum wages, are all very ugly. Continuing increases in consumption (whether in the form of stimulus spending or private consumption), at some point becomes unsustainable. Depending on government handouts (47 million on food stamps???) is demeaning, and does not represent us well - Americans are a proud, well educated, hard working people - notwithstanding all the divisive propaganda to the contrary. Americans want a chance to pay their own way. Sure, there is a very small percentage of exceptions to this. But it is a tragedy that divisive demagogues have divided the nation, and demonized many Americans, in the eyes of other Americans. It is highly dysfunctional, to devise economic policy to meet the false idea of "lazy Americans, when the vast majority of Americans just want a job, and a chance. The extremely low unemployment during the bubble, demonstrates the flexibility and work ethic of the American workforce, and it is disgusting that many have painted a false picture of the workforce, to justify policies which are terrible for the nation as a whole.

Raise the minimum wage.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.