Why the middle class can’t spend its way to prosperity - Macleans.ca
 

Why the middle class can’t spend its way to prosperity

Mike Moffatt on the perils of abusing demand-side economics


 
Spending your life savings

Rebecca Drobis/Blend Images/Corbis

From Barack Obama to Justin Trudeau, many politicians are promoting a middle class economic vision, where a larger portion of economic growth is captured by those of average income. It isn’t difficult to see why they have chosen this perspective, as incomes have risen much faster for the top 0.01 per cent than for the rest of the population. Naturally, a different frame of reference—say, looking at the top 20 per cent instead of the top 0.01 per cent—will yield different results. Framing aside, it is vital to study the possible causes of concentrated gains to the top 0.01 per cent. We should be asking what role public policy is playing in this phenomenon and whether a different set of policies would lead to a different distribution of economic gains. On purely utilitarian grounds, it is desirable to have a higher proportion of economic growth going to low and middle-income Canadians, so long as the policies to get us there do not reduce the growth rate of the economy.

The latest and most popular piece arguing along these lines is Eric Liu and Nick Hanauer’s ” ‘Middle-Out’ Economics: Why the Right’s Supply-Side Dogma Is Wrong.” The piece can be summarized by the first of their six premises:

Demand from the middle class—not tax cuts for the wealthy— is what drives a virtuous cycle of job growth and prosperity. The more the middle class can buy, the more jobs we’ll create.

It’s the kind of statement that, though reasonable sounding, makes professional economists cringe. Growth through consumption, or, as one of my less charitable colleagues calls it, “The Augustus Gloop School of Economics,” fundamentally misunderstands how economies operate.

During the first class of the introductory macroeconomics course I teach at the Richard Ivey School of Business, I present students with four propositions that are the basis for most, though not all, schools of thought in modern macroeconomics. These propositions are loosely based on Alan Blinder’s fantastic 1997 paper “Is There a Core of Practical Macroeconomics That We Should All Believe?” The four propositions are as follows:

  1. In most economies, real output (GDP) follows a rising trend determined by the supply side of the economy.  In other words, long-run growth is driven by supply-side factors. We can think of supply here as roughly the relationship between the price firms receive for their output and how much firms are willing to produce and sell.  This proposition is not the same thing as “supply-side economics”. James D. Gwartney has a good primer on the difference between the two.
  2. In the short run, fluctuations around the trend growth rate of GDP are dominated by demand side forces.  This tells us that the business cycle is driven mostly (but not exclusively) by demand-side factors. Similarly, a rough definition of demand in this context is the relationship between the price consumers pay and how much they are willing to purchase.
  3. Fluctuations around trend growth may be substantial (and costly) because economies, by themselves, don’t return to full speed quickly. This is because wages and prices are “sticky.” It takes time for the economy to crawl out of a recession, as it takes time for wages and prices to adjust.  Of the four propositions, this one is the most contentious, with Bils and Klenow providing a fair bit of evidence against the importance of sticky prices. A school of macroeconomics known as real business cycle theory provides an alternate explanation. However, a substantial majority of economists would agree with this proposition.
  4. Fiscal and monetary policy can, in theory, be used as discretionary instruments to adjust and stabilize fluctuations so the economy returns to its trend growth path. Naturally there are questions on how well policy works in practice, but few question that if these are used correctly that we can smooth out the business cycle.

The demand side of the economy is crucially important under these four propositions. Recessions are typically demand-side in nature (proposition two), costly (proposition three) and can be mitigated through judicious use of policy (proposition four). Policies designed to boost demand are completely appropriate (though they might present difficulties in practice) when unemployment is high and there are significant idle resources in the economy. The added demand for goods and services sees workers hired and shuttered factories and stores re-opened. Those workers then go out and spend that money, creating the virtuous cycle described by Liu and Hanauer. So far, so good. Although the added demand for goods and services is inflationary since it will cause a rise in overall prices, the increased demand will also reduce the unemployment rate, as seen in the classic Phillips curve relationship.

Can this process go on forever? No. Eventually the pool of employable workers and idle resources dries up. Policies that ratchet up demand when the economy is already running at capacity gives inflation without growth. We have seen this time and time again, from stagflation in the 1970s to the Zimbabwe hyperinflation. In the long run, there is no trade-off between inflation and the unemployment rate.

Boosting demand is only useful and appropriate when repairing the economic damage caused by a recession. How we get economically sustainable long-run growth is not through increasing the demand for goods and services, but rather in increasing their supply. We do this largely through innovation and increased productivity—by creating new, improved goods and services and finding ways to produce more with less.

A set of policies aimed at middle class growth does not require us to reject the widely accepted understanding that the supply side of the economy determines long-run growth. Matt Bruenig found the same basic problems with the Liu and Hanauer piece that I did; he recognizes that “when the economy is operating at capacity and there are no idle resources, reducing inequality should not have any demand-side stimulative effects.” In this post, however, Bruenig attempts to rescue the idea of linking middle-class economic policies to economic growth by proposing three ways policies aimed at increasing middle-class welfare may have positive supply-side effects. I find the second of the three the most interesting:

When income is distributed very unequally, the only way for less well-off people to have the same material possessions as more well-off people is to spend all of their income and even to go into debt. So, in a world with high inequality, poorer people save less than they would in a low-inequality alternative world. This savings drought means less investment, which reduces growth, and more systemic financial risk due to the high levels of indebtedness, which can reduce growth via financial crises.

Unfortunately Bruenig does not provide any empirical evidence on his three proposals, so whether or not they are valid in practice is an open question. However, unlike the arguments of Liu and Hanauer, they are compatible with standard macroeconomics.

It is tempting to ask, “What does it matter if the supporting logic is incorrect, if the core goal of middle class economics is reasonable?” In my view it matters a great deal. Basing middle class economics around demand is going to lead to a raft of bad policies. The policies are likely to have deleterious impacts, including creating inflation that must be stomped out by the central bank. It can also lead to reduced level of personal savings for retirement, fears of which are top of mind for Canadians. This would in turn actually increase wealth inequality. Finally, less savings leaves less money available to loan for the productive investment that can grow the economy.

Improving the welfare of lower- and middle-income Canadians is a noble and worthwhile goal, but the policies to get us there must be based on empirical evidence and sound economics.


 

Why the middle class can’t spend its way to prosperity

  1. This is such a friggin’ quality article. More like this, Maclean’s!!

  2. I’ve never believed in “demand-pull” inflation. I should clarify, I’ve never believed excess demand was a cause of inflation. I’ve always seen it as part of the inflationary process; one that occurs only after expansionary credit conditions are left in place for too long. In the 1970s, the economy was not at capacity, and we had recession and inflation at the same time. That’s what stagflation is. So it was not an issue excessive demand at a time of full capacity. It was the timidity of central banks in the 1970s, and their reluctance to tighten credit to the point where it needed to be to rein in inflation. Not until Paul Volcker got serious about crushing inflation in the early 1980s was it brought under control. And of course it took a severe recession to accomplish that. John Crowe did much the same thing a decade later, with similar results.
    However, I do believe the main premise of this article is correct. Stimulating demand is precisely what the middle class does not need right now. They’re already taking on far too much debt as it is.

    • I was puzzled by MM’s use of full capacity too. Unless it has a definitive meaning that escapes me, i can’t see how it was a factor in the hyper inflation of the 70s.

  3. “Policies that ratchet up demand when the economy is already running at capacity gives inflation without growth……… We have seen this time and time again, from stagflation in the 1970s to the Zimbabwe hyperinflation.

    REALLY????.. That paragraph makes no sense and ..Zimbabwe’s “economy” had crashed it’s output.. and they were indebted to foreign nations..

    As to stagflation:
    Contemporary Keynesian analyses argue that stagflation can be understood
    by distinguishing factors that affect aggregate demand from those that
    affect aggregate supply.
    While monetary and fiscal policy can be used to stabilize the economy
    in the face of aggregate demand fluctuations, they are not very useful
    in confronting aggregate supply fluctuations. In particular, an adverse
    shock to aggregate supply, such as an increase in oil prices, can give
    rise to stagflation.[13]
    also:
    “Basing middle class economics around demand is going to lead to a raft of bad policies.”….

    Bad policies are by definition bad regardless of what they are targeting.. Increasing middle class wages and spending power doesn’t necessarily cause increase in debt..Nor decrease savings.. Quite the opposite in fact.. Debt increased as the middle class stove to stay EVEN w/ increasing prices and frozen wages..
    your article has some good insights except for the hyperinflation part and the above conclusion.. like the chicken and the egg.. One will not “produce” of there is no “demand” for production.

      • Yes, his dates are off, but perhaps that makes a very good point: would it have made a difference for the national or international economy if those dates had been not 1968 or 1973?

        In other words: we don’t see everything coming. Theories are good – in theory, but real life gets in the way most of the time.

        Real life is what theories cannot incorporate, ever. That is the weakness to be found within any theoretical thesis.

          • Don’t get me wrong: I understand you are showing/ working with real data. But such data is always after the fact. That is my point. Real life happens even without data collected or not. Collected data always runs behind, not in front of.

            No one can predict with certainty what influences will be the determinate factors. Who would have predicted the oil embargo of the seventies? (Never did we think we could play freely on closed off hiways – Sundays only – because gasoline had to be rationed for a while.) And so forth.

          • Oreo57 argued that supply side factors caused inflation. Mike Moffat showed that that isn’t the case, as stagflation set in a full five years prior to the supply side shocks of the 1970s. I don’t see where he’s arguing that we should have forseen the embargoes and planned accordingly. You seem to be taking issue with an argument he never made. However, to take up your thread, this inability to predict is precisely why we need theories. In the absence of a crystal ball, we need some sort of theoretical framework, supported by as much empirical evidence as we can get our hands one, to help us create decent – if still highly imperfect – policies. Or, in the absence of creating better policies, hopefully a theoretical framework could help us avoid creating even worse policies.

          • Why then was the collapse of 2008 not foreseen? With all the theories on economics, and BANG, the collapse happened regardless.

            I could just as easily argue that economic theories implemented could have been a contributor to the 2008 collapse.

            I could just as easily argue that because it could be just as true.

          • …Keen was one of a small number of economists who predicted there would be a major financial crisis before the 2008 crash. He argues that if we keep the “parasitic banking sector” alive the economy dies, and says that conventional economics provides an unwitting cover for “the greatest ponzi schemes in history”…..

            http://www.bbc.co.uk/programmes/b01j5h51

            more:
            http://www.washingtonsblog.com/2012/06/the-biggest-myth-preventing-an-economic-recovery.html

            The answers are there.. few believe it and even fewer want you to know it..

          • Inflation is not necessarily a bad thing.. Stagflation is..as seen here:
            “Production and income rose rapidly in 1968 and employment remained at high levels..”
            http://research.stlouisfed.org/publications/review/68/12/Inflation_Dec1968.pdf
            So what you want constant low wages and high unemployment to keep inflation down?? Seems counterproductive to me..

          • There is a “theoretical framework” unfortunately nobody “important” is paying attention.. As to 2008 many predicted it ..see Steve Keen… a few other MMT-ers and asst. others ..
            “MMT eviscerates the many crackpot ideas that have been and continue to
            be promulgated by our criminal ruling oligarchy, its puppet political
            leaders such as President Obama and Congressional leaders of both
            parties, and our superficial national media of misinformation and
            corporate propaganda”…………..
            http://themoderatevoice.com/185758/what-i-have-been-reading-since-february-2013/

      • The inflation rate, January 1973 is exactly the same as that in January 1968, per your own data. Even lower throughout 1972. There was a bump that leveled out, not a period of escalating inflation.

        • Moffatt is just another neo-con book-cooking pseudo economist.

  4. On purely utilitarian grounds, it is desirable to have a higher proportion of economic growth going to low and middle-income Canadians, so long as the policies to get us there do not reduce the growth rate of the economy.
    ——-
    From Little Shop of Horrors:

    Feed me, feed me, feed me
    Feed me Seymour
    Feed me all night long

    That’s right, boy!
    You can do it

    Feed me, Seymour
    Feed me all night long
    ‘Cause if you feed me Seymour
    I can grow up big and strong

    Would you like a Cadillac car
    Or a guest-shot on Jack Paar?
    How about a date with Heady Lemarr?
    You gonna get it
    If you want it, baby

    How would ya like to be a big wheel?
    Dinning out for every meal
    I’m the plant that can make it all real
    You’re gonna get it

    Hey, I’m your Gennie
    I’m your friend
    I’m your willin’ slave
    Take a chance, feed me yeah

    You know what kinda eats
    The kinda red hot treats
    The kinda sticky licky sweets I crave

    Ow! Come on, Seymour
    Don’t be a putz
    Trust me and your life will surely
    Rival King Tuts
    Show a little initiative, boy
    Work up some guts
    And you’ll get it

    I don’t know, I don’t know
    I have so, so many strong reservations
    Should I go and perform mutilations?

    Think about a room at the Ritz
    Wrapped in velvet, covered in glitz
    A little nookie gonna clean up those zits
    And you’ll get it, uh huh

    Gee I’d like a Harley machine
    Take it around like I was James Dean
    Makin’ all the guys on the corner turn green
    So go get it, woo woo woo

    If you wanna be profound
    If you really gotta justify
    Take a breath and look around
    A lot of folks deserve to die

    {Stupid woman!
    Crashed one of freakin’ scatter brains
    I’m sorry, [Incomprehensible]
    Files of the murder [Incomprehensible]}

    If you want a rationale
    It isn’t very hard to see, no, no, no
    Stop and think it over pal
    The guy sure looks like plant food to me
    The guy sure looks like plant food to me
    The guy sure looks like plant food to me

    He’s so nasty treatin’ her rough
    Smackin’ her around, and always talkin’ so tough
    You need blood and he’s got more than enough
    I need blood and he’s got more than enough
    You need blood and he’s got more than enough
    So go get it

    • Bravo!

  5. Angels dancing on the head of a pin……….

  6. Statistical information can only be gathered AFTER the fact.

    Tabulating the rate of inflation, for instance, can also only be calculated after the fact.

    Statistics, therefore, always run behind real life. Real life is what those statistics come out of AFTER the fact.

    Human behaviour (need for food, housing, entertainment etc) will go about its way regardless of what the rate of inflation is. And because the tabulated rate of inflation is always running behind real life, it is impossible to introduce policies which will pretend that tabulated inflation numbers will be albe to run in front instead of behind. It is indeed impossible to do the impossible.

    • True enough, but central banks can control inflation by tightening credit. Volcker in the 1980s. Crow in the 1990s here in Canada being two recent cases. We don’t need to know future inflation to know what it’s been for the past 12 months and act accordingly.

      • Yes, it is true that to a certain extent, inflation can be kept in check. But inflation is not the only number which decides whether the middle income earnings are stagnating.

        Many, many factors play a role and the highest wild card in all of this is the human characteristic doing its thing regardless of what economic theories hold within.

      • Your talking baby inflation and a certain amount shows that the “workers” are getting paid err.. better.. ect.

        Also no amount of “interest throttling” would stop inflation caused by such things as say.. a wheat shortage caused by drought or an oil embargo..

        http://en.wikipedia.org/wiki/File:Oil_Prices_1861_2007.svg

        As to Volcker.. BRILLIANT huh..

        “What followed was an extraordinarily painful recession. Unemployment
        rose to near 11%. Manufacturing states were battered by the downturn;
        the near 17% unemployment rate in Michigan was worse than the state
        sustained in this latest recession. Mortgage lenders were devastated by
        high interest rates. The banking system was pushed to the point of
        insolvency. Things were quite bad. And while growth snapped back to
        trend rather quickly after the Fed took its foot offf the brake for
        good, there was considerable suffering through the recession, and the
        effects of unemployment, on health and earnings of sacked workers,
        persisted for years”…………………..

        Based on fundamentals, the inflationary impact of oil crises would likely have diminished significantly into the 1980s, with or without a Volcker Recession.”
        http://www.economist.com/blogs/freeexchange/2010/03/volcker_recession

        Idiots…

  7. Economists try to bottle that which we call human characteristics so that the bottled up contents can then be poured out in measured quantities.

    But human characteristics cannot be bottled up to be poured out in measured quantities, no matter how hard the trained economist tries to do so.

    Even if a politician, any politician, would take the economist at his or her word that indeed particular economical theories could be implemented, then, too, human characteristics will prevent the politician from doing so completely; there will always be pressure from various individuals/groups needing/wanting other priorities to be solved and so forth, and those various priorities will not always jive with the intended policy to be implemented. A politician lives or dies by the vote of the collective. Whether those various group’s priorities stem from need or want does not matter; humans are by need AND wants regardless of what policies the theoretical politician or economist would like to implement.

    Greed is a human characteristic. Greed is beneficial AND detrimental to mankind. Finding the balance within the meaning of greed is what cannot be bottled by any economist.

  8. Long before Bush II was in the White House, policies were put in place to give more people the chance to own a home (group pressure) and so when the door was opened up by means of newly implemented policies, many people took advantage of the new policy: the people who could now buy into the market (good advantage for them and good advantage for the politician), but at the same time many other people took advantage of the newly implemented policy, namely, the bankers and speculators (negative advantage I would call it).

    So whereas the newly implemented policy was to be an advantage for the average or below average buyer, the newly implemented policy also was taken advantage of by the banks and stock investors.

    In 2008, the economic market collapsed because of greed – the good AND the bad kind.

    It was good policy to let more people be able to buy into the housing market. That then would be like satisfying a good greed. But the bad greed was simultaneously fed into by the very same policy, namely that mortgages which could not be sustained were being given out anyways, and were then, as highly risky bundles of speculative commodities, sold all over the world!

    Particular rules and regulations for Canadian banks prevented our banks from being sucked up in the downfall; our banks never were effected much by the 2008 collapse and neither was our economy to the extent other countries experienced it.

    Economists could not have prevented this. Nor did economists see this collapse coming. And that is because the difference between good and bad greed was not taken into consideration alongside the implementation of the policy to begin with.

  9. A good article that is on the mark. There’s far too much voodoo in modern economics, particularly macroeconomics. Better to stick with widely accepted and empirically supported theories. There is no magic bullet – stimulating demand may have its place (and in my opinion the only beneficial way to stimulate is to put more money in peoples’ pockets, not by government spending and creating more public sector debt). However, as the article points out, it is not always and everywhere a beneficial thing.

    • So. More money in people’s pockets, but no more spending by gov’t, and no more debt.

      Where, exactly, do you think that money in people’s pockets is going to come from, then? The money fairy? Reducing taxes will cause more debt, unless there’s a reduction in services. But if there’s a reduction in services, that’s taking money *out* of people’s pockets.. specifically those workers who were providing the services.

      Which means a broad based group gets a very small percentage more, while a small group, likely localized in communities based around gov’t or military activities, loses all income and so becomes a net *drain* on the public coffers. This means that those tax reductions don’t save as much as they were going to, and the broad-based gain doesn’t have the same economy of scale as the localized loss does. ie, a military base closes up shop.. most of the town around it — all those private enterprises that sprung up to meet those people’s needs.. close up shop as well. Meanwhile, the extra video that the rest of the people in the country can rent simply isn’t enough to create a similar amount of new jobs.

      A knee-jerk aversion to public debt is non-sensical. There are times when increased public debt should definitely be avoided, but during a recession is not that time.

  10. Can anyone explain what supply side driven growth looks like and why I would think it is good? Who benefits from such growth and please don’t insult me with the word “trickle”. Does everyone agree we just want growth for it’s own sake and it doesn’t matter about the quality of people’s (the majority at least) lives?

    • Economic growth is wealth creation. More is better. The problem is, where does it go?

      In the post-war era, we employed centrist Keynesian economics that ensured all levels of society benefited from GDP and productivity growth (machines and energy doing more of the work.) Keynes predicted we’d have a 15 hour work week by now.

      What went wrong? Milton Friedman, Ronald Reagan, etc.: a free-market counter revolution. It produced towering levels of inequality and debt and crashed and burned in another global economic meltdown. (The first free-market meltdown was in 1929 which produced the Great Depression. This led to the development of Keynesian demand-side economics that created modern living standards — what’s left of them.)

      Supply-side economics is simply economic anarchy. Letting the chips fall where they may causing chaos and destruction as one might imagine. If we are foolish enough to continue to allow corrupt businessmen to design self-serving economic ideology, then we deserve the inevitable collapse of civilization heading our way.

  11. This article is complete hogwash. So for the past thirty years we have been following supply side dogma and where are we? Lower growth, unstable economy, high unemployment and bouncing between recessions. The main argument in this article is totally wrong since you can see that business investment has fallen, not grown while taxes fall. It seems that lower business taxes are actually a disincentive to invest because you now don’t have to be competitive to show profit growth. This article is a propaganda piece and nothing else.

  12. Obama is just hot gas. Reality is the middle class has been decimated. In the the depression average net household incomes are down 40%. Many job losses mean less income. Inflation from world wide devaluation of the USA is a hidden inflation making it even worse as if the people get less, they spend less and that means they generate fewer jobs. Between job loses and inflation, sever damage has been done to the middle class.

    Longer Obama keeps on debt spending and Bernanke prints non-value inflation money to a bankrupt US Treasury, the worse it will get. By the end of Obama’s second term, he will have added more debt than all presidents before him combined. Bernanke will have created more no-value money in the same fashion. But they will not admit, printing (electronic counterfeit) money for US Treasuries no one buys at 1% is what kicked off the economic problems.

    No one legitimately lends money for returns below inflation+taxes. It is fraud to think you can do so, as it represents a negative value currency, and reflects to the economy as a negative value economy.

    While Obama say one thing, his debt-spend is actually killing the middle class standard of living.

    No recovery is possible any more. Sure, you can get a false start or two, but pent up inflation from money print will have inflation kill any recovery. Fact is this new depreciating economy is here to stay. GDP goes up 1.2%, but inflation went up 5% for a negative value will be typical. If your after taxes raises are lower than inflation, then you too are negative value on income.

  13. http://www.xe.com/currencycharts/?from=USD&to=CNY&view=10Y

    Middle class not only lost 40% of household gross incomes in 2007/8 they get the hit of lower value money than preceded it.

    US Fed deliberately is devaluing the USD since Bernanke got in with his money print for debt policy. When Bernanke got in, depression started. Bernanke should have raised interest rates to stem credit, but oh no, he hit the gas on debt.

    Debt is never free, just a mater of who and how it is paid for. And in 2007 credit crisis, the bankrupt government couldn’t afford to pay legitimate lenders inflation+taxes as a fair return. So Benanke just printed more and the problem has been feeding on itself ever since.

    Look at the depression as a government tax on money and value so it can keep its bloated size. And the more money US Fed creates, even if QE is a sexy coining of the fraud, it is fraud and why no recovery is possible until equity is restored to currency.

    But good part is I saw 2006/7/8/9 coming and made a pile of money. I didn’t ignore 2006 Bernanke money print for debt, I didn’t ignore the 2007 credit crisis I was in cash for the crash of 2008. And getting stocks so cheap in early 2009, priceless.

    As you can always count on statism greed.

  14. “Policies that ratchet up demand when the economy is already running at capacity gives inflation without growth. We have seen this time and time again, from stagflation in the 1970s to the Zimbabwe hyperinflation.”

    Here’s some inflation theory 101 to counter the flaky contrived macro:

    Economist’s View: Teaching about Inflation is Fun (but Dangerous)
    http://economistsview.typepad.com/economistsview/2013/08/teaching-about-inflation-is-fun-but-dangerous.html

    • Any article that mentions Zimbabwe in that reference should be INSTANTLY ignored.. As well as ANY that equate Greece (and the Euro) w/ the US, Canada or any sovereign nation w a fiat currency.. ;)

      • That’s the problem with economics: it’s largely agenda-driven tripe. There are no standards like there are in the sciences.