The Economy: Walking on the Supply Side

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.

Comments

[alajac:]

Right! Where is Hitler, Jr. when we need him. Oh, that`s right, he`s term-limited and his `decisions` helped get us into this mess anyway. Any `solution` that the government (and here I`m including both branches of the War Party) prescribes will be aimed toward a preconceived `outcome` and 100% likely to be completely counter-productive. (for examples, see `War on Terror`, `War on Drugs`, `Federal Reserve policies since forever`, etc.

Let the market do its thing. Get rid of all income taxes. Place a small (.5% or less) tax on every electronic debit, which is more of a tax on wealth (which is the only fair thing to tax). Such a tax is avoidable and so, arguably, voluntarily paid. No more IRS, no more tax filing at all, no more chasing businesses offshore with tax craziness.

Federal Reserve money is privately-owned, which is why we have to borrow to get more of it to give to the bankrupt banks (the ones that have lost all or most of the Fed-borrowed money that we had entrusted to their fine care), the same banks that own the Fed in the first place. (What is wrong with THAT picture?) We`re like a growing kid that has to take out a loan in order to buy more blood every time we have a little growth spurt. We need to get rid of the Fed`s debt-money and replace it with our own debt-free fiat currency, backed by the value of all of the real estate in the country (real estate of which the government is the real owner - which is obvious when you think about it. try not paying the government its `rent` - aka property taxes - for a while and see how long it stays `your` property`).

We also need the government to end support of the fractional-reserve Ponzi scheme. If people want to risk their money in banks that gamble with less than 100% reserves, then they should be willing to take their losses without any chance of government bailout.

So now that we realize that the government owns all of the real estate, we also should realize that the government has, by privatizing all the land, denied everyone free access to all of the land and other property that it claims. and we also realize that the government has not compensated us for that taking. So, as we ARE the government in this particular country, we need to vote ourselves Adequate and Equal Just Compensation (which will coincidentally, replace all forms of personal and corporate welfare and subsidies and boondoggles, including Federal Minimum Wage laws and a phase-out of Social Security). I suggest $1000 per month to every legal adult resident (compensation of minors should be held in trust to avoid incentivizing `baby factories`). Since everyone gets the same amount, the plan is not wealth redistributive, but will give the poorest the biggest advantage and a better chance to `catch up` than the current totally regressive system that keeps the rich getting relatively richer, through good times and bad.

Regarding Healthcare, we need to get the AMA and FDA to quit restraining supply and get thousands more doctors and other healthcare professionals trained up and get access to WHATEVER drugs adults want (from whatever source those adults decide thay want to obtain them) so that the market can get the price of normal medical help and pharmacology back into an affordable range paid out-of-pocket. (Cuba has 4 times as many doctors as we do per capita and medical treatment down there is DIRT cheap.) If there is going to be any `universal` insurance it should only be for major medical after, say $2000 has been spent out-of-pocket. (``But, what about the poor?`` Remember, every `poor` adult is getting $1000 a month and they can work as much as they want on top of that with no penalty...there will no longer be any `poor`. And a heck of a lot less crijme, also.)

Also, if we had 3 or 4 times as many dentists, dental offices could stay open around the clock and dental care would also be affordable.

If you want to get the country off of crude oil, add on a 10% surcharge at the gas pump (bumping it up another 10% every six months) and rebate it in monthly equi-dollar amounts to every registered car OWNER, regardless of how much or little they drive. That causes the biggest oil consumers to subsidize everyone else with no BOTTOMLINE cost to taxpayers. Cheaper alternatives will become apparent and people will use them with no direction from the dictatorship needed.

Regarding standing armies, navies, and air forces, they are only good for invading other countries and putting billions of dollars into the pockets of war profiteers like the owners of Haliburton and Blackwater. Any attack on the US mainland will EVER only be mounted by a criminal or by our own government, because every other government knows that they are susceptible to a nuclear attack at any minute, caused by a device that might be smuggled into a main port via a sailboat or in anyones luggage. Any other nation that attacked in such a way knows that they can always be counter-attacked the same way. War as we used to know it can never again take place...that`s the blessing. The curse is that there IS NO DEFENSE to the possibility of such an attack and it is a waste of time and money to even worry about it. The only sensible thing to do is to decentralize business and residences as much as possible to limit the damage such an attack (or any other type of disaster, such as an earthquake or plague) would cause. Therefore, we don`t need the most expensive military in the world, and we won`t ever need it again. As should be obvious by now, any wars we get into from here on out will be wars of aggression fought for the sole purpose of, again, putting money into the pockets of war profiteers and to generate moutains of debt to the delight of our banker friends and others (usually Republicans) who profit from the interest we pay on those mountains of debt .

A system that rewards intrangience, gambling and stupidity seems to me to be the main problem. As Emerson (not Jefferson) said,``The government is best which governs least``. How about we get them to pretty much stop governing at all and set the whole thing up to work automatically?

2008 Aug 23 03:28 AM

[alajac:]

ps. Regarding the BIG UNKNOWNS that have all the businesses tied up in knots and unable to produce as much `stuff` as the public would like so that the public can then rush out and ``BUY MORE STUFF``... are you kidding?

Businesses just know the stuff isn`t selling, so they can`t afford to keep making more of the same stuff that isn`t selling. Doesn`t seem like rocket science to me, but I`m not a big Seeking Alpha dog, so what do I know.

Oh wait, I do know one thing...Trees do NOT grow up to the sky.

When prices get too high on anything, then the psychology that chased prices up starts chasing them DOWWWWN, and when they get low enough you get a bounce, and when they get ABSURDLY LOW you get a bottom. I`m looking for a bounce starting in January, and a bottom quite a few years DOWN the road, no matter who our `fearless leader` is nor how wise their all-knowing pronouncements.

2008 Aug 23 04:12 AM

[mouse:]

alajac, I like your ideas, but I am confused about the tax idea---isn't an income tax the only fair way to raise revenue, since any tax we pay has to come out of our income anyway? And shouldn't it be proportional to how much one makes? It seems to me that any other way of doing it would unfairly favor the higher (or lower) income taxpayers. Please help me understand this better.

2008 Aug 23 12:23 PM

[Michael Dou...:]

I believe that humanity hangs in the balance right now. The credit crisis is facing challenges beyond our ability to deal with them. But inherent in this crisis is the most incredible opportunity we have ever faced. I wrote a book called "A Prescription For Peace" that is available on Amazon. In it I advocate a new approach to the entire world where we follow the words of Thomas Jefferson, where he wrote "we hold these truths to be self evident that all men are created equal and they are endowed by their Creator with certain unalienable rights that among them are life, liberty, and the pursuit of happiness." The means that we all have the right to three square meals a day, a roof over our heads, access to quality health care, personal safety, an education and a job. For how could we ever feel liberty or begin to pursue happiness unless our basic needs are being met?

Now the debate over Socialism vs. Capitalism needs to end. You can check out my blog on the subject at aprescriptionforpeace..../

Each one of us is nothing without the people that surround us...and now we need all of those people to be working and to be paying taxes. This is the only way out of our hole. That means massive public works projects that put people to work. Borrowing money for entitlements or giving out more stimulus checks is a big mistake. But providing food, housing, services and education that leads people toward jobs makes sense. Investing in the American People makes sense. Investing in innner-city children to get them to become productive tax payers makes sense.

Now is the time...we can do what is right.

"Our work will not be done until every man, woman, and child alive has three square meals a day, a roof over their heads, access to quality health care, personal security, an education and a job." - Michael Douglas Carlin
Michael Douglas Carlin

2008 Aug 23 04:18 PM

[whidbey:]

What worries me is that the author and most of his readers can probably vote. We are in mess and now some ideas on how to make it worse. I must say I just a little concerned that the net benefits of this board are being exceeded by the net liabilities.

2008 Aug 24 07:19 PM