Supply Or Demand: Where’s The Problem?

We are all familiar with those old supply and demand curves so beloved of economists. Ever since Alfred Marshall introduced them to the world, economists have deployed them to illustrate and to help solve every problem imaginable. Yet the current crisis has opened up a chasm between the two. There are some who believe our crisis is driven by a shortfall in demand – fix that and all will be well. There are others who decry such a view and call for the bolstering of the supply side. These supply siders typically call for the easing up of corporate regulations, the elimination of wage restrictions like the minimum wage, reductions in payroll taxes, additional corporate incentives to encourage investment and so on. Their idea being that by freeing up businesses to generate profits we will simultaneously create the environment in which business starts to hire workers. Thus our unemployment problem will go away. To the supply siders the fact that we still have high unemployment is evidence that the market is being prevented from working its magic.

As you all know by know I find the supply side argument so weak that it is non-existent. It is vapor born of a belief in magic. The facts destroy it in an inkling, yet it persists.

Here’s a little evidence:

Corporate profits are booming. That’s right. Even though the economy remains mired in a no jobs malaise, business is wallowing in cash. This implies that the connection between productivity, profit, and wages has been undone. It was this connection that provided the engine for middle class comfort and wealth throughout the post war decades. As productivity grew, usually from technology improvements and the displacement of workers by machines, the profit generated was shared with the remaining workers. Wages rose in line with productivity. The perfect example of this from history is American agriculture: we produce far more now than we did a hundred years ago and yet the number of farm workers has shrunk to almost negligible levels. The labor thus freed up from the land went into other sectors of the economy, providing the workforce for industrialization and then the service economy we now have.

But corporate profits are booming now, and wages are flat. Not only that, but corporations are not hiring despite being flush with cash. They are hoarding instead. And many are contemplating raising their dividend payout to shareholders.

This means that providing extra incentives is completely unnecessary. Companies already have cash to invest if they wanted to. We don’t need to give them tax breaks or reduce red tape. They don’t want to invest. Giving them more cash is just a waste of time.

Plus, many of the big companies – GM is a good example – are creating more of their profit abroad rather than here. There’s no harm – perhaps – in that as long as we don’t provide the cash with which they go and generate jobs abroad. American taxpayer money should be used to bolster employment here not in China and elsewhere. GM now employs 52,000 workers in the US. It has 32,000 workers in China. It now sells more cars in China than it does here. In the old days a boom in a foreign market meant more jobs here and a similar boom in exports. No more. That surge in GM sales in China is met from production based there. Yet American taxpayers bailed GM out to save jobs here. The cash we infused into GM has gone towards building facilities offshore. Yes the skeleton of the old Detroit based GM was saved. But that 52,000 workforce today compares with a peak of 468,000 back in 1970. Now that’s a productivity gain. Coupled, as it turns out, with a ton of offshoring.

So GM’s shareholders are seeing a very different picture than its workforce. The two groups have a totally different perspective on the economy.

Profits are booming. Dividends are rising – Wall Street is clamoring for higher payouts rather than higher investments. And jobs languish. Capitalism flourishes while the middle class swoons.

The supply side argument has no impact on any of this.

Cutting wages, as many of them suggest, merely inflates profit. There is no evidence that business would hire more workers even if wage costs dropped. Why? Because there are no sales to justify expansion. Companies like GM are content to meet demand from current capacity. Even a near term growth in demand would be met from extending work hours of the current workforce rather than adding more workers. In other words GM would drive up productivity rather than add capacity. It’s more profitable in the short term.

That is where we are. Business is raking in the cash and simply sitting on it. Rather than boost capacity, and rather than make more stuff, they prefer to hoard cash or pay it out in dividends. That’s their right of course. My point is not to decry dividends – at least not in this discussion – but to argue that we obviously don’t have a supply side problem.

All the evidence contradicts the supply side argument. Yet we still hear it in influential circles. I am sure the Chamber of Commerce would like taxpayers to ante up more goodies for business. I understand why those folks want to press the supply side argument. But anyone else? That baffles me.

Meanwhile, back in the evidence based world of reality, our economy continues to suffer from a severe shortage of demand. That’s why corporations are forecasting poor sales volumes. With households using their incomes to cut debt rather than increase consumption, and with middle class wealth under siege from collapsed house prices, negligible wage growth, cuts in benefits, and perpetually rising health care and education costs I just cannot see a reason why consumption will accelerate much near term. Our lack of demand is set to be with us for a while.

So we have a demand problem. This, of course, screams out for more stimulus. But with serious minded people like Bernanke now warning about the size of our deficits the chances we will solve the demand problem is diminishing. That leaves us looking at the likelihood of a long slow and perilous climb out of our malaise. Along the way we will forego a massive amount of wealth we will never be able to recoup. The loss will fall mainly on those in the middle whose opportunities will narrow well below what they were even a decade ago. We seem determined to diminish ourselves. Quite why, when we know how to stop the rot, I cannot say. Our demand problem is tractable and solvable. We know how to deal with it. We just lack the will. In a sense we have capitulated to the scope and size of the problem. We imagine it too large, so we succumb.

That’s a shame.