Supply-Side Solutions? Beware (Wonkish)
There’s a new Vox paper suggesting that supply-side policies — structural reform that makes workers more productive, prices more flexible, or whatever — may be the answer to a liquidity trap. Some people may seize on this claim. So it’s worth pointing out that a casual interpretation here gets it all wrong.
Here’s what we already know: in the looking-glass world of the liquidity trap, supply-side improvements are generally counter-productive. I know that sounds weird, but that’s what liquidity trap economics is like. A few years ago Gauti Eggertsson identified the “paradox of toil”; in our joint work we sketched out the related “paradox of flexibility”.
The basic point is that the aggregate demand curve is actually upward-sloping, because any fall in prices does nothing to reduce interest rates but does increase the real burden of debt. So making wages more flexible, say, does nothing except worsen balance sheet problems.
So how does the Vox paper get a different story? By assuming that the payoff to supply-side improvements doesn’t come until the economy has already spontaneously emerged from the liquidity trap, and so these perversities are gone. The idea then is that consumers, rationally perceiving this future improvement, feel richer and spend more now.
Oh, Kay. It might be true, although it depends on consumers being very well informed. I don’t know anyone in the Princeton economics department, let alone Main Street USA, who does family budgeting based on perceptions about how reforms in tax law or labor regulation will affect incomes five years from now. But whatever.
The important thing is not to lose sight of the fact that what we have now is a demand problem. Demand, demand, demand.
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