The Fallacy of Demand-Side Solutions to US Economic Stagnation

Innovation economist Bret Swanson dissects a recent speach by Obama Administration chief economist Alan B. Krueger in his most recent column at (24 December 2011). In “The 12 Keynes of Christmas,” Bret notes the contradiction between the widespread recognition that supply-side entrepreneurship and innovation is critical to sustained economic growth and a policy based on increasing demand. Bret writes, in part:

“But at no time in memory has the basic idea of American free enterprise — “entrepreneurship,” “education,” “reinvent” — been more in question. In recent months, the government blocked the Keystone XL pipeline, AT&T‘s next generation wireless expansion, and educational innovations by for-profit colleges. It wants to shut down almost 10% of the nation’s coal-based electricity supply.

“If you think recent policy choices, on balance, mean the U.S. might grow just 2% per year for the next few decades instead of 3%, then you intuitively know that U.S. GDP in 2020 could be $2 trillion less, in 2030 almost $5 trillion less, and in 2040 almost $10 trillion less. Maybe you are even underestimating America’s potential and the severity of wrongheaded policy.”

And noting:

“The crude Keynesians think shoveling money into the economy will encourage people to buy stuff, thus encouraging businesses to increase capacity and hire, thus expanding the number of people with jobs, who might consume more goods and services. Virtuous circle in theory, but it doesn’t work.”

Swanson also notes that a group of economists has emerged advocated a monetary policy that focuses on increasing nominal (non-inflation adjusted) gross domestic product (NGDP), regardless of the inflation rate. So, in principle, even if real GDP growth was zero, inflation of 5 percent could keep nominal growth at 5 percent:

“The NGDP advocates have a slightly more sophisticated expectations-based theory. Make sure people and companies know the economy will expand at least 5% per year, even if it’s all inflation, so no one will stop spending. Trouble is, for how long will consumers and firms buy stuff based purely on a government guideline that they will still be buying stuff in the future — without regard for the productive capacity or performance of the real economy? And if they don’t believe in this demand-now-because-there-will-be-demand-later dictate, will it work for any amount of time at all?”

But this is only the tip of the iceberg in terms of the damaging effects of inflation. Missing in this discussion is the perverse effects inflation plays in skewing consumption decisions. The housing bubble wasn’t driven just by the increase in sub-prime and near-prime mortgages. Rather, these financial instruments enabled consumer decisions based on incorrect information about the relative value of homes and their ability to pay for them. In short, housing price inflation led to over consumption of housing. Not only was the absolute level of housing consumption higher than could be sustained by household income, the higher prices led households to buy the wrong kind of housing in the wrong place. The bursting of the housing bubble is part financial market readjustment and part property market readjustment. Inflaton makes these problems worse, not better.

Kruger’s speech, delivered in Charlotte, North Carolina on December 20th, can be found here.