America needs supply-side reform
It's can't just be an excuse — we need to improve our policies
Economic data clearly shows that the demand side of the economy has been running “too hot” this year, and to fight inflation, the Federal Reserve has to raise interest rates and Congress has to try to reduce the budget deficit.
At the same time, only a relatively small fraction of our economic pain can be attributed to excessively stimulative policy. American Rescue Plan spending isn’t the reason that 2022 crude oil output is running behind the 2019 level, and ARP spending definitely isn’t the reason for the unprecedented ratio of gasoline prices to crude oil prices. It also isn’t behind the global food crisis. The airline industry is creaking under the strain of rising demand for travel, but overall air travel demand remains below pre-pandemic levels due to a decline in business spending. Difficulties are compounded by the fact that during the summer of 2020, major airlines offered pilots financial incentives to take early retirement to cut costs.
But stepping back from the Twitter trench warfare, I think there’s something a little perverse about the dialogue surrounding the role that ARP spending played in inflation. We’re stuck in a game of rhetorical ping-pong in which ARP’s critics, who raised the specter of inflation, are spiking the football now that inflation is here while the Biden administration and its allies defend ARP by emphasizing all the supply-side factors driving inflation.
But the argument we should be having is the one about making policy right now.
If all our economic problems were due to the ARP, then the good news is ARP spending is phasing out and the Fed is raising interest rates and it’s all going to be fine.
Except that things might not be fine, because even if you believe ARP is to blame, these negative supply-side issues are real. You can’t wave them off as excuses — whether ARP was “too big” or “just right,” it definitely wasn’t too small — but the economy is fully-stimulated for the first time in the 21st century. This means that economic growth is going to need to be powered by supply-side reforms.
Both things matter
If you’re interested in the supply versus demand argument, I recommend Adam Shapiro’s research brief for the San Francisco Fed which shows — tada! – that both are factors.
In particular, looking at overall inflation, which includes food and energy prices and drives overall living standards, it’s clear that Russia-related supply shocks have, in fact, been a very big deal.
But demand-side factors are also an important part of the overall inflation story, and that’s especially true if you focus on core inflation.
In other words, it’s not “did we overstimulate the economy or did we face negative supply shocks?” It’s “we both overshot the target on demand somewhat and also are facing a bunch of negative supply shocks.”
And the fact that it’s both is unfortunate because it tends to muddle the dialogue. For example, I both support what the Fed is doing in raising interest rates and also worry that the Fed will soon go too far. But that’s not a good tweet!
The conversation has veered away from the sort of boring, basic economics that people got lazy about during the Great Recession when it seemed like a good time to throw the whole neoliberalism playbook out the window. But when the economy is a bit overstimulated and also hit by negative demand shocks, it’s the perfect time to talk about boring neoliberal stuff like free trade.
The classic case for free trade
There’s been a fair amount of discussion of the Trump tariffs and the possibility that the Biden administration might back off of them.
But it’s worth recalling the bigger-picture, classic textbook economics case for free trade. The standard comparative advantage argument is that opening up the borders to trade costs some jobs in the short term, but that labor is eventually reallocated to its best use, resulting in higher living standards for everyone. This argument was politically discredited by the lived experience of the past 20 years. But at no point during that period did we ever have a really robust job market with strongly rising nominal wages and plentiful job openings. And if you think about that standard case for free trade, it implicitly assumes that sort of robust demand as a background condition.
That turns out not to be a law of nature. You can have really prolonged labor market slumps, creating periods where protectionism really does create jobs.
But we are not, right now, in a period like that. The United States, for example, levies tariffs on a lot of the products that frackers use to drill for oil and gas.
Absent those tariffs, yes, some people might lose jobs in pipe factories. But other people would gain jobs in the oil and gas industry. And cheaper natural gas prices would help other American industries, save people money on their electricity bills, and help bolster the economy.
And this is the general situation throughout the economy. The Biden administration is looking at regulatory policy measures to increase the housing supply, which is good. But the United States has, for a mix of longstanding and Trump-specific reasons, a bunch of tariffs on foreign-made construction materials.
Some of this is China-specific and can be written off as the cost of our foreign policy objectives. And I suppose there’s an argument that solar panels are a national strategic industry. But quartz countertops from India? Steel nails from Vietnam? Japanese cement? Those are our allies.
And it goes to the same point as the pipes. In a tight labor market, allowing more imported construction materials doesn’t mean fewer jobs; it means a transition of jobs out of nail-making factories into making houses with nails. And that means an overall more prosperous economy.
It’s become fashionable to deride “Econ 101” thinking.
But my view is that Econ 101 has become badly underrated as a result of the prolonged labor market slump. Paul Krugman wrote a book way back in 1999 called “The Return of Depression Economics,” and its prescience made him one of the most influential writers of the 21st century. The point of the book is that for various reasons, major world economies were at risk of slipping into recessions that couldn’t be easily ended by quick interest rate cuts from the central bank. And when that happens, you are in a world of “depression economics” where the rules of Econ 101 don’t apply. It’s a great book, and Krugman got to write a lot of columns based on depression economics themes because he was basically right.
But guess what? We’re not in depression economics now. Interest rates are going up and inflation remains high. So “101”-type considerations dominate.
For example, I’ve long complained about how weird it is that the New York City Subway uses conductors on its trains rather than single drivers like almost every other mass transit system in the world. Depression economics says laying those conductors off might save the city money, but it’s also macroeconomically cruel.
Today, though, New York is dealing with a critical shortage of bus drivers. Paying transit workers to do unnecessary work even while important transit work goes undone is just a disaster of inefficiency. Of course the impact of changing this one thing would not be that large relative to the scale of the entire American economy. And it drove me crazy back in 2009 and 2010 when conservatives would point to various micro-inefficiencies in an economy that was badly starved for demand and say “see! that’s the problem!” Because when the economy is depressed, providing a fiscal and monetary boost is a much bigger and faster-acting lever. But the economy isn’t demand-constrained right now, so we don’t have a giant fast-acting lever. What we have instead are dozens and dozens of small switches we could flip.
The Jones Act barring the use of foreign ships to move goods between domestic ports may raise the price of gasoline by as much as 15 cents per gallon. Experts estimate the impact of rescinding the Trump tariffs as shaving somewhere between 0.25 and 1.3 percentage points off the consumer price index.
None of the impacts here are all that large, so it’s easy to look at any one thing and say “eh, why bother.” This is fine as long as it’s just one thing. But as is often the case in life, ignoring lots and lots of small problems adds up to a big problem.
Timelines are another roadblock.
When a problem becomes acute, political leaders really want to do something about it and do it quickly. But the Biden administration’s willingness to increase crude oil supply is constrained by the existence of bottlenecks in oil refining — nothing they do on crude will dramatically alter short-term gas prices. Skanda Amarnath at Employ America argues that this is a little misleading. Current crude oil stockpiles remain abnormally low, so there is plenty of room for global markets to absorb more supply. But I do think it’s basically true that there isn’t a quick and easy button the administration can press to make gas cheaper.
Or take another case: the shortage of airline pilots.
In a proximate sense, this is the short-sightedness of airlines encouraging early retirements coming home to roost. So why don’t we just train more pilots? Well, back in 2009, a Colgan Air flight crashed. The investigation revealed that the crash was due to pilot error, which inspired the passage of the Airline Safety and Federal Aviation Administrative Extension Act of 2010. As a result of that law, the number of hours flying required to get a commercial license increased from 250 hours to 1,500. To be clear, the pilots in the Colgan Air flight in question had over 1,500 hours of flight time. This new rule had no particularly intimate relationship to the safety issue at hand. At the time, though, labor scarcity wasn’t a big concern.
But as Gary Leff writes, the more stringent rule is now making it hard to get new pilots into the air. The problem isn’t just that it takes longer to gain 1,500 hours of flight experience — it also costs more money, raising the number of years of work a pilot needs to do to earn back their investment. That not only makes piloting less desirable as a career, but it dramatically increases the risk profile for people who may not be sure they want to dedicate their whole life to piloting. Safety is obviously very important. But American passenger aviation was already very safe in 2009, and this new rule doesn’t seem to have improved anything. We could roll back to 1,000 hours or perhaps the European 500-hour standard.
What this won’t do, unfortunately, is suddenly eliminate summer flight chaos. Improving the “pilot supply chain” is doable and beneficial, but it would still take time to work. And the same is true of most supply-side reforms. This means that if you think of deregulation as a dirty word that you’re only willing to invoke to solve acute crises, you won’t do it.
But that’s the wrong way to think about it. The right way to think about it is that the economy is either suffering from depressed demand or it isn’t. If it is, you should fix that. But if it isn’t, the only path toward growth is a steady drip drip drip of supply-side improvements. We hope that a lot of that will come from innovation and new technology. But it can also come from steadily improving public policy. It’s true that the gains will often come with a lag, but if the demand-side authorities are doing their jobs right, then the economy is always going to be supply-constrained — there will always be things you wish you did 18 months ago, it’s just hard to predict which things those are going to be. That’s why there’s no time like the present to get cracking.
You’ve not touched on this: there’s immense institutional inertia on the *private sector* side in favor of cheap labor and against capital investment. For the better part of the last 20 years overinvesting in capital has been very risky, because you can’t defer debt service or installment payments in a downturn, but you can sack people. Basically every industry has tried to become “nimble” in this regard, aided by the weak labor market making it possible to throw people at problems instead. Even capital-intensive ones have moved to lease capital and push risks off on large leasing firms, increasing short-term costs to access productivity-enhancing equipment and foregoing the benefits of accumulation.
That will take some time to change, even though the skilled blue-collar labor shortage in particular seems set to continue almost regardless of what we do on the policy side over the coming decade. The Fed might succeed in generating a brief blip that convinces C-suites that the 2010’s are coming back, but the second interest rates go down it’ll be right back to “not enough people”.
Looking at construction, pre-fabrication, and consulting engineering, where I am now, almost *no one* at the senior level believes this to be the case, but almost everyone at the operational level does. I have actual clients where VP’s are screaming upward that they need more and better capital across the board to reduce hiring spend and get prices under control, and CEO’s are basically just sticking their fingers in their ears and belting out “LALALALALA I CAN’T HEAR YOU NEXT YEAR WILL BE 2009!!”
Policy may be slow, but corporate culture shifts are slower. We’re going to be here a while. Invest and plan accordingly, as regards inflation.
This is, of course, all basically right. But supply side reforms shouldn't mean forgetting the lessons of the past two years about the shortsightedness and risks of a fragile, excessively offshore supply chain. The covid disruptions in China and need to have flexibility to respond to Russian military aggression should have reminded us that a neoliberal trade policy based on the most rosy Pax Americana assumptions of the 90s was foolishly risky. The trick is to keep the good parts of those policies without repeating or perpetuating the mistakes. Some of the tariffs on basic products from overseas countries might make sense, even if it means a little short term pain, to ensure we aren't overly at risk if shipping was disrupted, etc. But tariffs on stuff from Mexico or Canada? That's dumb.