Demand Side VS Supply Side and The Return of Depression Economics, by Krugman


Being familiar with supply side views on the Great Depression, and on fiscal stimulus, but open minded and interested in hearing the other side of the story, I read Krugman's book.

Krugman's book begins with an anecdote. In the 1970's, according to a published account, there was a baby-sitting co-op in Washington DC in which, for every hour of baby-sitting performed, participants earned scrip exchangeable for 1 hour of baby-sitting of their own kids. As the story goes, at some point there wasn't enough scrip in circulation, and the co-op suffered a "recession" in which participants were unwilling to go out (spend scrip) because they had relatively little on hand and felt a need to build up reserves in case they wanted to go out several times in the future. But since noone wanted to go out, no-one could earn scrip, and the economy ground to a halt. Eventually, the board of governors of the babysitting co-op injected more scrip, essentially increasing the money supply, and the recession was magically cured.

This is an easily appreciated story, just-so, but if it is to be regarded as historical evidence, or even as a central metaphor, this anecdote has a few problems. Did it really happen that way and for those reasons-- or did economists who already had a conclusion in mind to some extent imagine it/ superimpose it on whatever actually happened? Even stipulating it's gospel, various features are missing from this model that might be critical in reality-- such as prices (1 scrip fixed at 1 hour of babysitting, no variable price) and investment.

In fact, its not obvious how to map this anecdote onto the Great Depression. Savings rates during the Great Depression were not high-- in 1932 and 1933 they were actually negative, as people drew down savings to get by. Seemingly people spent money as they had it-- unlike babysitting scrip. On the other hand net capital investment during much of the Great Depression was also negative-- not surprisingly since the US Government attacked successful investors and businessmen, essentially nationalized the fastest growing sector of the economy (electric power), raised taxes on investments to 80% or more, passed measures such as the Wagner act that greatly impacted profits, and in 1936 placed a 74% tax on "undistributed profits" that prevented businesses from reinvesting profits, practically legislating out of existence any possibility of corporate growth. A supply side picture focused on investor incentives has no difficulty understanding why the Great Depression lasted so long.

Krugman next turns to a series of financial panics that happened around the world over the last few decades, such as Argentina's and Mexico's crises, Japan's lost decade, the Asian crash in 1997. Its worth noting in passing that other authors describe these events rather differently*. But leaving all that aside, even in Krugman's telling, the driving force in these panics was not a lack of demand-- it was the confidence, sentiments and actions of investors, not consumers, that was critical. Krugman is actually quite clear on this point, he goes so far as to finger hedge funds as "the villains in the plot". So while these stories are interesting, and illustrative of the dangers of bubbles, no case is laid out that they constitute evidence for a demand side picture or the importance of the baby-sitting model; quite the contrary.

On p182 (of a 191p book) Krugman comes to the question: "What is Depression Economics? ...[E]ssentially it means that for the first time in two generations, failures on the demand side of the economy-- insufficient private spending to make use of the available productive capacity-- have become the clear and present limitation on prosperity for a large part of the world." Now I'm perfectly open to his making a case for this, but he doesn't actually present evidence or argument. Here is how Krugman supports it: "The specific set of foolish ideas that has laid claim to the name 'supply-side economics' is a crank doctrine that would have had little influence if it did not appeal to the prejudices of editors and wealthy men... over the past few decades there has been a steady drift in emphasis in economic thinking away from the demand side to the supply side in economics... "

Why did the supply side take over? Krugman says(183): "Briefly the source of the theoretical disputes was this: in principle shortfalls of overall demand would cure themselves if only wages and prices fell rapidly in the face of unemployment. In the story of the depressed baby-sitting co-op, one way the situation could have resolved itself would have been for the price of an hour of baby-sitting in terms of coupons to fall, so that purchasing power of the existing supply of coupons would have risen, and the co-op would have returned to 'full employment' without any action by its management. In reality prices don't fall quickly in the face of recession, but economists have been unable to agree on exactly why. The result has been a series of academic battles... the public has understandably concluded either that economists don't understand recessions or that demand side remedies have been discredited..."

"Paradoxically if the theoretical weaknesses of demand side economics are one reason we were unready for the return of depression-type issues, its practical successes are another.... central banks have repeatedly gone ahead and used [monetary policy to get an economy out of recession]... Surely the Federal Reserve and its counterparts in other countries could always cut interest rates enough to keep spending high; except in the very short run, then the only limitation on economic performance was an economy's ability to produce-- that is, the supply side."(183)(emphasis added)

"Meanwhile, in the short run the world is lurching from crisis to crisis, all of them crucially involving the problem of generating sufficient demand. Japan from the early 1990's onward, Mexico in 1995, Thailand Malaysia, Indonesia, and Korea in 1997, Argentina in 2002 and just about everyone in 2008..."(184)

This is the entirety of Krugman's case, as far as I am able to determine, so lets deconstruct it. He mentions the first defect of the baby-sitting model (lack of prices) but utterly ignores the second (lack of investment). His answer to the first defect is, to paraphrase 'take my word for it although its controversial, but it doesn't happen that way'. I think most economists would agree that prices didn't drop adequately in the Great Depression, but some would make a case that the reason prices (and particularly wages**) didn't drop adequately was direct government intervention by first Hoover and then FDR and his congress, indeed some economists would argue that this particular intervention was a principle reason the Great Depression was so great. Arguably we could choose to fix the laws to avoid that trap in the future, a possibility Krugman doesn't consider. The plunge in oil prices in the last few months shows that some unregulated prices can react rapidly to contractions.

But the second oversight is even more problematic. Although all the examples he gave were (according to his discussion as he gave them) crises of investor confidence, and although he believes monetary stimulus has been repeatedly effective and should focus attention on the supply side, he totally ignores the issue of investor incentives. The critical but open-minded reader can be excused if, finding Krugman's only argument for his position is (a) just-so stories about baby-sitting that ignore major aspects of reality, and (b) name calling about "crank doctrines" that by Krugman's own account have become rather widely accepted, the reader becomes more, rather than less, skeptical about Krugman's position. If Krugman has actual arguments, why doesn't he present them?

Krugman endorses, as a remedy for our current economic problems, fiscal stimulus. "Some readers may object that providing a fiscal stimulus through public works spending is what Japan did in the 1990s-- and it is. Even in Japan, however, public spending probably prevented a weak economy from plunging into actual depression."(188) It would be nice to see some evidence for such pronouncements. Unmentioned in Krugman's book, for example, is the fact that between 1970 when growth in Japan was around 9% and the 1990's when growth in Japan was minimal, the fraction of GDP taken by taxes nearly doubled, and in particular, according to OECD estimates, the average tax on capital gains went from around 23% (much less than the US, drawing investment) to 44% (higher than the US, and incenting investment to flow out). Japan famously sold vast numbers of products overseas, eg to the US which was on a major consumption binge in the 1990's. So why should we believe Japan's problems were inadequate demand?

The fact is, that while there is no lack of clear examples where rate cuts and monetary stimulus have stimulated economies, at least in the short term, and no lack of clear examples where marginal tax-rate cuts have stimulated economies-- I'm not aware of any convincing examples where fiscal stimulus has worked, and Krugman doesn't present any***. Extensive fiscal stimulus failed in the 1930's to bring the US out of Depression, in the 1990's to bring Japan out of recession, and arguably the taxes to pay for it extended both recessions for years, for example through their impact on the supply side. Fiscal stimulus also failed in the US in the 1970's, in Mexico during their depression, and elsewhere. The contrast between the successes of monetary policy, and of tax cuts, and the lack of successes, in fact arguably the huge negative impact of fiscal stimulus, is striking.

I am a skeptical but open-minded reader. I'm open to a case for fiscal stimulus-- but I'd like to see one actually made, rather than assumed. I find it highly plausible that Americans (who are aging, and have just lost their nest eggs) are going to cut back radically on consumption (and I find it somewhat dubious that any amount of stimulus will cause aging America to consume with abandon). (Krugman doesn't state this, but its true.) I believe there's vast amounts of deleveraging going on right now, and think its plausible that printing lots of money is a good idea. But I find it very scary that Obama's campaign promises were all negative in their impact on investors, and that Krugman doesn't consider the impact on investors in his proposals, even though most of his anecdotes were driven by investor actions. At the very least, I'd be grateful for some evidence that Obama, or Krugman, has understood the supply-side picture, and has an actual argument, supported by actual data, against it.




* For example, Krugman states Argentina's problems came from a currency board, but currency board guru Hanke presents detailed evidence to refute the claim Argentina even had a currency board (a point that's particularly pertinent since in Hanke's telling, under actual currency boards the supply of local currency automatically adjusts just as the baby-sitting scrip could have if prices were flexible); Krugman's discussion of Mexico's crisis presents it in a rather different light from my recollection of the WSJ op-ed page at the time-- and driven by that recollection I checked and found his picture contrasts equally sharply with Wikipedia now...

** Note added: just saw an article in the WSJ (subscription may be needed) that companies are cutting wages in the current crash. The main reason why prices are said not to fall adequately in deflations to automatically adjust the money supply is often said to be that wages are frozen. Apparently not. Arguably, the main thing preventing adjustment is (a) unions, which are arguably also a government intervention that hasn't added value and (b) other government interventions.

*** I'm open to a case for WW2 as ending the Great Depression through fiscal stimulus, but, again, Krugman doesn't make one. WW2 certainly didn't stimulate *consumption* (at least until the late 1940s) or spending by anybody other than the government so again, its hard to map it onto the babysitting picture. And there was a lot else going on at the time.
Eric Baum
Last modified: Wed Jan 21 08:12:59 EST 2009