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.