Wednesday, April 6, 2011

Ryan's Plan and the Fallicy of Say's Law

Several days ago, I complimented Representative Ryan for actually addressing the primary problem facing the US -- medical payments as a percent of the federal budget. While he should still be complemented for that act, this plan is an absolute disaster. First, here was my initial reaction the "meat" of his plan:
This is not an endorsement of Mr. Ryans plan, as it has many problems which I believe are insurmountable -- the least of which is that $15,000 for private insurance for a person or couple aged 65 is not enough by far. I should also add that I fully advocate 100% public health care. The US is one of only three OECD countries that does not have fully funded public health care. At the same time, we pay far more than other countries, yet have a higher infant mortality and lower life expectancy. In short, we are clearly not getting what we are paying for.
Now we have more detail about the underlying assumptions of his plan. Professor Krugman has already chimed in with this analysis:
Except briefly during the Korean War, the United States has never achieved unemployment as low as Ryan and co. are claiming. The Fed believes that the lowest unemployment rate compatible with price stability is between 5 and 6 percent — that is, twice what Ryan is claiming he will achieve.
What Krugman notes is the Heritage Foundation is projecting an unemployment rate of of 2.8% in 2021 (they are also arguing for an unemployment rate of, 6.4% next year, which is also highly doubtful, as I will argue later today). This is, well, laughable. But more to the point is how their analysis gets there. Their analysis assumes the following order of events: tax cuts lead to more investment, which expands the need to labor which increases hiring. Because workers face lower taxes, they have higher incomes, which increase spending (see page 3 in the report linked above). For those of you who are unfamiliar with this chain of thought, it's based on and around Say's Law. Say was a French economist who basically argued that supply creates its own demand. When business in operating, it has to pay labor (wages), lenders (interest) and producers of raw materials (which are converted into other products). All of this money going out from producers creates the income to purchase goods. However, notice one thing missing? Demand is never discussed.

The theory assumes that business is simply stimulated to produce a good out of thin air. While it is important to talk about supply and the factors the effect supply, demand is just as important; if there is no demand for a good, there is no reason to produce it. By focusing their analysis on one side of the demand/side equation, the Heritage Foundation completely misses the economic boat.

In the current environment, there is little reason to think a tax cut will lead to an increase in investment. First, capacity utilization is still very low, indicating there is currently excess capacity that business can access before adding more. Second, although consumers are spending, they are also saving more as well, indicating the demand side of the equation will be weaker. Third, China has been aggressively raising rates in hopes of slowing their economy. As China has been one of the primary drivers of the latest expansion, this does not bode well for the possibility of boosted US production.

As I previously mentioned, Ryan does deserve credit for actually talking about the real problem facing the government: medical expenses. However, the more the details of his plan emerge, the more it becomes obvious he and his backers have engaged in pure economic magical thinking rather than a serious policy debate. For more, see this from Rex Nutting at Marketwatch.