Sources of growth and recovery: from demand to supply and back again

I have just finished reading an interesting and useful book, simply titled ‘Macroeconomics’, now thirty years old, by the late Wynne Godley and Francis Cripps. Godley worked at the UK Treasury and then with Cripps at the University of Cambridge Department of Applied Economics. He was Professor of Economics at King’s College, and was famous for his pessimism about the British economy and its performance. In the early 1990s he was appointed as one of the chancellor’s advisory panel of economists known as the ‘wise men’, after predicting the UK’s turn from the Lawson boom to economic bust and recession. After his retirement from Cambridge in the mid-90s he moved to the USA and worked at the Levy Economics Institute of Bard College, modeling the US economy and analysing its performance and likely prospects. In the late 90s and subsequently in the mid-2000s he predicted that the US was heading for trouble due to its macroeconomic imbalances, and that a major recession was likely at some point. In fact, he also predicted the UK recessions of the mid-1970s, early 1980s and ’90s. Of course, if you are pessimistic about likely future events for long enough, you may eventually be proved right, but in a world in which economists are often wrong in their predictions, Godley was quite often right. He was probably too pessimistic about the UK’s prospects for economic recovery after the ’90s recession, but his methods and forecasts have proved in my view to be sufficiently prescient to merit serious consideration.

The aforementioned 1983 book Macroeconomics presents the results of ten years work building models of the economy in what would now be termed the post-Keynesian tradition, although they argue that their models are not ideological and are non-denominational in terms of schools of economic thought.

One of Godley and Cripps’ central insights is the role of aggregate demand in determining real national income, output and employment, subject to capacity constraints, which are often not binding, especially in the short to medium run. In more detail, in an economy open to international trade, the ‘fiscal stance’ and the ‘foreign trade performance’ are the key factors constraining expenditure flows. The fiscal stance is written as G/θ, where G is government spending and θ is taxation as a proportion of national income. Foreign trade performance is determined by X/μ, where X is the volume of exports and μ is imports as a proportion of national income. The overall constraint can be written as     Y= (G+X)/(θ+μ)   where Y represents national income.

If foreign trade performance improves for whatever reason, exports may increase and μ may fall although it may not. If G and θ remain constant, Y can increase. If on the other hand, G increases and θ falls or remains constant, while X and μ are constant, Y may similarly increase. In this way, the flow of expenditure from an improved foreign trade performance or from a fiscal stimulus, or both, can increase national income and output.

In the long run, the growth of income at some desired rate is constrained by the foreign trade performance or the growth of exports relative to imports. If imports grow faster than exports over time, this implies an accumulation of debt held by foreigners as the current account deficit expands relative to national income. In the long run, ever-increasing holdings of debt by foreigners will have to be repaid, and the current account will have to move back towards balance or into surplus. It is in this sense that foreign trade performance constrains growth.

In the short to medium run, the growth of demand from consumers abroad will affect foreign trade performance and hence economic growth. Other things remaining equal, a given growth rate of the rest of the world economy will increase the demand for exports from our country. This would suggest that growth is determined by demand. However, as Godley and Cripps emphasize, foreign trade performance is more generally determined by supply-side factors.

Supply-side factors represent the ability of companies to sell in expanding markets and to expand capacity to meet growing demand. So demand is not enough. Price and non-price competitiveness are vital, as are the ability to expand production, which may require access to finance as well as labour with the required skills. Despite growing demand, if firms are unable to meet it, then buyers may take their custom elsewhere as supply is unable to respond; in such cases, prices may rise in the short term; alternatively or in addition, there will be shortages. And these supply-side factors are vital for firms supplying both domestic and foreign markets. This would suggest that growth can be determined or constrained by both demand-side and supply-side factors, across the economy. Whichever is the more dominant constraint in any period can vary.

With regards to government policy aiming to improve economic performance, attention should be paid to both demand-side and supply-side factors. In the current crisis, a lot of evidence in the UK points to weaknesses on both sides. Those who see the economy through a Keynesian lens want to see a loosening of fiscal policy to expand domestic demand and accelerate the recovery. The government persists with deficit reduction and token supply-side policies, although it is claiming to be allowing the ‘automatic stabilizers’ to work by not cutting the deficit any faster than it is. However, as the independent watchdog the Office for Budget Responsibility has stated, deficit reduction has ‘stalled’; the deficit in cash terms is forecast to be about the same in 2013 and 2014 as in 2012, at around £120bn. The government has also stated that it wants increased monetary activism on the part of the Bank of England. Allowing the automatic stabilizers to work and relying on monetary policy shows that in fact the government believes that aggregate demand should be supported. Perhaps it is all a matter of degrees and political spin! To date however, demand is not being supported sufficiently. In my view, with the private sector deleveraging despite record low interest rates and the use of quantitative easing to expand the money supply, monetary policy has lost much of its effectiveness and there is now a need for more expansionary fiscal policy to accelerate the recovery. If this were carried out across the advanced world where possible, the effects could prove contagious and minimise leakages in each country through rising net imports.

Returning to the sources of growth considered above, while both demand and supply-side factors can act as constraints on growth, the premature turn to austerity across much of the advanced world has had a depressing effect on growth in the wake of the global financial crisis. Foreign trade performance is a vital consideration, but of course one country’s exports are other countries’ imports, and with a deflationary environment abroad, companies that export their goods and services are having to compete harder to maintain sales in stagnant or shrinking markets. Supply-side factors can determine competitiveness, but taking these factors as given, deflationary policies are acting to constrain growth.

Turning from demand back to supply: given a deflationary environment, each country’s firms competing harder in stagnant markets may improve competitiveness in the longer term, but only if they survive. If they go to the wall, hysteresis effects may mean that demand-deflation over a number of years may reduce supply and make it harder for output to respond when decent rates of economic growth return. So a persistently deflationary environment can damage supply in the longer term, even while it stimulates some firms to become ‘leaner and meaner’. And the application of Verdoorn’s law suggests that buoyant demand conditions can stimulate more rapid productivity growth, especially in manufacturing but also in the more dynamic kinds of service industries, due to economies of scale and learning-by-doing effects. In this way, the growth of demand leads to growth by cumulative causation, as supply responds to demand, leading to increased price and non-price competitiveness, stimulating further demand for output and so on. There must be limits to this process, which could take us beyond economics to social and political factors, but it remains an important element of the growth process and should not be ignored in formulating policy.

Thus demand affects supply and supply affects demand in a number of ways in the growth process and both elements should be considered when it comes to formulating policy at the national and international level. At the moment, deleveraging in many advanced countries and stagnation or recession due to ‘balance sheet’ problems suggests a supportive role for fiscal policy until recovery is underway, allowing government debt to temporarily take the strain, and supply-side policies to aid restructuring of private debt as consumers continue to pay it off, and to encourage the mainly larger firms with financial surpluses to invest in new capacity and employment, while unblocking lending to smaller and medium size firms. Only when recovery is underway should governments attempt austerity policies, as private sector investment and consumption once again become the demand-side factors driving growth in the advanced countries as a whole, and contribute to expanding world trade.

The United States (and UK) will never turn into Greece

A useful piece by Matthew O’Brien showing the lack of evidence that countries that can borrow in their own currency face debt tipping points. For countries with a floating currency (outside the eurozone), there is therefore highly unlikely to be a spike in interest rates as the national debt rises with continued budget deficits during a recession. It also contains some evidence that, as Paul Krugman has argued, the eurozone countries in crisis face a balance of payments problem disguised by the single currency as a debt problem.

Growth in net exports as the motor for UK recovery in an ideal world

The UK economy is currently stagnating and may even fall into a triple-dip recession if growth proves to be negative in the first quarter of 2013. I have already written about the importance of fiscal policy in supporting recovery in a balance sheet recession, when nominal interest rates can hardly fall any further. However in the longer term, a sustainable recovery can only occur if the UK economy re-balances away from over-reliance on borrowing for consumption and financial bubbles and towards exports and private sector investment.

Recent UK trade performance has been poor, with a persistent deficit on the current account of the balance of payments, despite a substantial devaluation of the pound in trade-weighted terms since 2008. Sterling has depreciated by around 25% since then, with no discernible improvement in the current account.

If net exports (ie exports minus imports) were to grow rapidly, this would be exactly the kind of stimulus to demand that the UK economy needs. If sustained this demand from abroad for the output of UK-based companies would improve the current account and at some point stimulate investment in new capacity and employment as firms reach capacity constraints. Unemployment would fall more rapidly as GDP grows, and with falling jobless numbers and rising national output would come reduced welfare payments and increased tax revenues. The budget deficit would therefore fall from its current level even without extra cuts in public spending and increases in tax rates which are current policy in the UK. With increasing national income, household deleveraging could occur more rapidly, restraining consumption as individuals continue to save and pay off accumulated debts, while not leading to continued stagnation or even recession. All of this re-balancing would happen in an ideal economic world.

Sadly, we are not living in such a world, at least not yet. About a half of UK exports go to the EU, and much of that to the eurozone. The eurozone is currently in recession, partly due to the mindless pursuit of austerity across the continent (see graph at link). Recession among our European neighbours drags down their demand for UK exports. With the equally mindless pursuit of austerity in the UK, and the UK private sector in substantial financial surplus, where is demand to come from? The answer is: nowhere, unless private or public spending increase substantially. Despite having interest rates at record lows, UK business investment is languishing. Business as a whole is sitting on enormous cash surpluses, so the funds for investment are there, without the need to borrow. But it is quite possible that the lack of demand for their output is keeping investment plans on hold. If there is not prospect of increased sales, what would be the point in expanding capacity? A looser fiscal stance until recovery is established could help, especially if it took the form of public investment in goods and services with a low import content. Some leakage of an increase in demand to spending on imports is probably inevitable, reducing the multiplier as spending goes abroad, but suitably targeted public spending could minimize this effect.

The largest component of aggregate demand for the national income is consumption expenditure. Since the beginning of the recession households have chosen to save more, albeit relative to negligible rates of saving on the eve of the crisis, and they are paying down debt. This is to be welcomed as it helps to re-balance the economy and make it less dependent on unsustainable debt-fueled private spending for consumption. But it does act as a drag on growth. Throw in higher inflation generated by a weaker pound and therefore dearer imports, including commodity prices and the effect is compounded.

So when taking account of a drag from private consumption and languishing private investment, net exports, and the squeeze induced by the government’s austerity programme, there are no sources of demand left to generate a decent rate of growth and recovery for the UK. Despite the fact that the government is still running a substantial deficit, if the private sector is trying to run financial surpluses (ie with income greater than expenditure) greater than that of the public sector, then aggregate demand will fall and the economy will be dragged into recession.

But what if growth is not determined by demand but by supply in the long run? Well, Keynes did say that ‘in the long run we are all dead’, implying that policy-makers should act now to improve economic performance, rather than waiting for the long run to occur and hoping for the best (sounds a bit like the Cameron-Osborne strategy!), but in my opinion supply is just as important as demand, and the two elements interact in the growth process.

Those on the right of the UK Tory party are clamouring for steep tax cuts funded by steep public expenditure cuts, and deregulation, to ‘kick-start’ growth. This is all about the economics of incentives and stimulating entrepreneurial efforts, but ignores the importance of demand. Given that UK productivity has been falling recently, meaning that despite a stagnant economy, employment has actually been rising in the private sector, while real wages are falling, it might be thought that growth is not constrained by demand-side but by supply-side factors. The UK remains a ‘flexible’ economy with a ‘flexible’ labour market, as rated by the World Economic Forum on the issue, so if there are supply-side constraints, it is more likely that these are due to stagnant investment in capacity, which includes worker training, as well as relatively low levels of R&D and poor infrastructure. Since companies are unlikely to invest in new capacity and employment if they have low sales prospects, demand is important to stimulating investment. On the supply-side, if firms’ profits are taxed too heavily, or if wages take too large a share of earnings, they may once more come to the conclusion that it is not worth investing: these are supply-side constraints on growth. Neither of these sorts of constraints seem to be important at the moment. Wages are stagnant while firms are sitting on large cash surpluses, while the rate of corporation tax is not high by international standards. Demand seems a more likely constraint at the moment.

As long as firms have the capacity to increase production in response to a rise in demand, the expansion of net exports remains the most desirable route to recovery. But as discussed above, this is not presently forthcoming, especially while a turnaround on the continent looks remote in the short term. So the next-best source of growth must be domestically-led, in the form of a looser fiscal policy and incentives for UK-based firms to invest their cash surpluses in new capacity and employment. A boom in house-building would help as well! We are not powerless in the face of adversity.