Monday, May 14, 2012

Why Keynesian Stimulus -- Not Supply Side Economics -- is Exactly What We Need

The above chart shows two important concepts: where we could be and where we are.  The difference is called an output gap.  The question is how do we fill it?

To answer that questions, let's look at a few important definitions.

Gross national income:
The GNI consists of: the personal consumption expenditures, the gross private investment, the government consumption expenditures, the net income from assets abroad (net income receipts), and the gross exports of goods and services, after deducting two components: the gross imports of goods and services, and the indirect business taxes. The GNI is similar to the gross national product (GNP), except that in measuring the GNP one does not deduct the indirect business taxes.
Or, expressed mathematically:
Gross Domestic Product (GDP) = C + I + G + NX

2. GNP = GDP + Earning of U.S. Citizens and Corporations Abroad - Earnings of Foreign Citizens Working in the United States - Earnings of Foreign Corporations from Operations in the United States

3. Net National Product (NNP) = GNP - Depreciation

4. Net Investment = Gross Investment (I) - Depreciation

5. National Income (NI) a. NI = NNP - Indirect Business Taxes and Other Adjustments b. NI = Sum of Factor Payments
Eisen, Peter (2000-09-01). Economics (Barron's Business Review Series) (Kindle Locations 1376-1383). Barron's Educational Series. Kindle Edition.  
Put another way, gross national income is another measurement of GDP, but from the perspective of consumer's income.  It also means that the real GDP chart above comes close to expressing national income.  Most importantly, the chart tells us that we should have more income than we currently have.  This drop in national income, in turn, lowers demand:
The  average income of consumers is a key determinant of demand. As people’s incomes rise, individuals tend to buy more of almost everything, even if  prices don’t change. Automobile purchases tend
to rise sharply with higher levels of income.
Samuelson, Paul A (2009-04-08). Economics (Page 48). Business And Economics. Kindle Edition.

We see evidence of the drop in demand in the following charts:

 Real retail statistics are just now approaching their pre-recession levels.

While real personal consumption expenditures are above pre-recession levels, they have done so largely because of the growth in durable goods purchases -- which only account for about 14% of PCEs.  Non-durable and service purchases are growing at a far slower rate -- and these account for a far larger portion of PCEs at 22% and 64% respectively.  The charts above tells us consumers are only buying goods they absolutely must have and can't make for themselves or fix.  For example, instead of buying new clothes, people are simply keeping or making do with what they have.  As for services, people are still spending on some (such as household expenditures and medical care) but they're probably cutting back on things like yard services or dry cleaning.

The reason for the drop in demand is the drop in income which is directly caused by the high unemployment rate:

A drop in jobs (or an increase in the unemployment rate) means there is less income to spend and less upward pressure on wages.  Hence the output gap above (remember that GDP and Net National Income are very closely correlated).  As NDD pointed out a few weeks ago:


This is the increase that 50% of workers are getting more than, and 50% are getting less than, on a year-over-year basis.  It has been running at under 2% at all times since the financial collapse of 2008.

So, even if inflation runs at the very modest rate of only 2% (and for most of the time since the bottom of the recession in 2009, it has been higher than that), more than half of all workers fail to keep up.

You simply cannot have a durable economic expansion where most workers are consistently falling behind.
Put a bit differently: slow job growth = slow wage growth = slow demand growth.

There are two standard responses to this gap in output or potential national income.  The first is "supply side" policies, which will not be effective right now.   I explained this more fully in this article, but the summation of the argument can be broken down into four points:

1.) Corporations have more than enough money on their balance sheets to hire if they wanted to .  In addition, they've been investing strongly in equipment for the last two years.  In short, it's not a lack of cash holding businesses back.

2.) The country is not over-taxed; in fact, tax rates are near 60 year lows.  This means a tax cut will only be effective at the margins.

3.) Supply side economics is geared toward income; not spending.  What the economy needs is spending especially given that monetary velocity is near multi-decade lows.

4.) Supply side economics will increase current income; it will not directly create new incomes in the form of new jobs.   See also point number one; companies have plenty of cash on hand -- but it's not translating into jobs.

The second way to deal with the problem is the standard Keynesian stimulus.  There are two ways a standard stimulus could be used.  The first is to simply rehire the government employees that have been laid off during the recession:

Since the end of the recession, the economy has lost about 600,000 government jobs.  I realize that some people think this is a good thing, but policemen, firemen and teachers all provide important services to the country.  In addition, they spend money in the economy.

In addition, the chart above shows that the only area of the economy where we are not seeing job growth is in the government sector.

Secondly, we could engage in infrastructure spending.  I've dealt with this issue extensively; see here and here.

In conclusion, the economy needs more income at the national level.  However, to do that, we need more incomes -- people earning wages.  The country has been trying to use supply side economic principals for the last two years in the form of an already low tax rate.  This isn't working.  And the entire EU region has tried austerity -- which has worked so well that all of them are headed back into a recession.

In short, Keynesian policies are the only option left.