To the G-20: It Is Demand Deficiency, Not Supply

The Eurozone countries and Japan are now falling back into recession/depression and deflation, and their public debt levels are grossly excessive, and still rising. The deepening economic crisis in these two large economic blocks could have serious implications for other G-20 countries, as aggregate demand is already weak globally.

Nonetheless, based on the advice of their officials, G-20 Leaders will soon begin arriving at this month’s G-20 meeting in Australia believing that all monetary and fiscal policy options have been exhausted.   Based on that understanding, they will announce around 1000 supply-side structural and infrastructure policies:  a display ─ like fireworks ─ that will greatly impress the public.

However, while microeconomic reform and infrastructure spending have their place, such policies cannot possibly provide the locomotive power needed to sufficiently lift aggregate demand and steer troubled economies to safety.

Supply Side: Structural and Infrastructure Policies

It has long been accepted that structural reform policies play a vital role in improving productivity and competitiveness.  These policies have traditionally been regarded as ‘supply-side’ measures which have their main effects over the medium and longer terms.  Early benefits may take several years to materialise.

However, when demand is deficient and unemployment is high, increasing supply potential could be deflationary and counterproductive.

The OECD (‘Pursuing strong, sustainable and balanced growth: taking stock of structural reform commitments’, OECD, July 2011 and April 2012; and ‘Economic Policy Reforms, 2012, ‘Going for Growth’, OECD) identified various types of policies that may potentially increase short-term demand and growth:

  • Reforms to unemployment benefits were claimed by the OECD to be able to increase employment and participation relatively quickly and have positive effects on investment and output growth.  Importantly, however, the OECD acknowledged that reducing unemployment benefits can have negative short-run effects when an economy is very weak.  This acknowledgment suggests that reforms to unemployment benefits are unlikely to raise aggregate demand in troubled countries in the short-term.
  • Product market reforms and removing barriers to entry.  Again there was an important qualification.  The OECD acknowledged that these policies would work when there is pent-up demand.  An unlikely situation in troubled countries at this time.
  • Reforms that raise productivity, business profitability and create expectations of higher future incomesThe OECD acknowledged that with financial markets in crisis, and financial institutions with impaired balance sheets, such policies are unlikely to be effective in providing positive short-term demand effects.
  • Reforms that reduce inefficiencies in firms and industries can have favourable short-term effects on productivity (possibly at the expense of unemployment).

There are, of course, other structural reforms that one can think of that may potentially have positive, but most likely limited, short-term effects on demand:

  • some reforms that improve the flexibility of labour markets ― for example, increasing freedom to hire and fire and outsourcing of contract workers;
  • reducing business regulations and the administrative burdens of business start-ups and barriers to entrepreneurship;
  • the opening-up of closed professions and reductions in licencing costs;
  • reforms aimed at limiting widespread poverty.

But, in countries where public debt is already excessive, the financing and fiscal impacts of new structural reforms and additional infrastructure spending must be carefully weighed, greatly limiting the room for action in many cases.

And if the public sector is unable to finance additional infrastructure spending who would in countries where demand is weak, and where the cost/benefit ratios are being dragged-down as a consequence, becoming negative in some cases.  The private sector is not about to commit suicide on the altar-of-infrastructure, an area where in the best of times financial returns are precariously balanced.

Of course, a number of potential structural reforms could worsen demand, output and employment in the short-term. Such reforms could include:

  • cuts to transfer payments and certain labour market reforms (of unemployment benefit systems and job protection, in particular);
  • reforms directed to achieve greater trade openness could dampen, or reverse, any positive demand effect on the domestic economy to the extent the increase in imports exceeds any increase in exports;
  • reforms that have negative confidence effects (say, due to households’ perceptions of higher income insecurity in the wake of certain reforms, or due to greater job insecurity) could lead to higher precautionary savings and lower aggregate demand, particularly in the short-term;
  • job protection reforms, and even some product market liberalisation reforms, are likely to increase lay-offs more quickly than they provide for new firms to develop to generate job creation, adversely impacting demand and unemployment.

In summary, structural reforms and new infrastructure spending will be very difficult to implement in current circumstances, particularly where the shorter-term net benefits of individual reforms are uncertain, reform and austerity fatigue has already set in, where governments have been toppled because of their earlier attempts at structural reform, and where political instability is threatening.

The limited ability of Eurozone countries and Japan (the third arrow) to deliver on structural reform in recent years is telling: a fact that seems to have been completely overlooked by those officials who planned this year’s G-20 agenda.

It will be interesting, indeed, to see how the G-20 Communique deals with the many question-marks that surround the effectiveness and financing of structural reforms and additional infrastructure spending.  These issues will have a major bearing on ‘confidence’.

The OECD, the IMF, Germany, the ECB and Australia among others have arguably created unrealistic expectations in relation to the prospects that structural reforms could lift demand and economic activity in troubled countries in the near-term.  By creating a hope and expectation that structural reforms may provide ‘the panacea’, those who planned the G-20 meeting have spawned complacency, and that has created a major distraction from the search for appropriate macroeconomic policy combinations.

Demand Side: Macroeconomic Management Policies

Rather than focus exclusively on supply-side policies, the G-20 focus should instead be on developing demand-side policies and a new macroeconomic policy framework. Current discordant and inconsistent macroeconomic frameworks are in need of urgent repair and redesign: they have failed.

Aggregate demand has been deficient for the past 5 years. The deflation tendency is spreading: a sign that aggregate demand not aggregate supply is deficient.  Business profitability is high (there are no supply-side wage or interest cost constraints) but real wage incomes and consumption demand are in decline.

For troubled countries, macroeconomic policies are everywhere in disarray.

Austerity has failed, and fiscal stimulus is urgently required. Officials from the United States have rightly been urging Germany, and the Europeans more generally, to reflate their economies.

Following those urgings, Mr Schaeuble is reported by the BBC news (19 October, 2014) to have said that;

a)    Criticism that the (German) government was not spending enough was justified and,

b)    Any improvement in spending would not be made at the expense of a balanced budget and increased public debt.

Mr Shaeuble understands that there are only two ways to achieve his objectives.

First, to provide increased spending and finance it from future taxation. Second, to provide increased spending and to finance it by creating new money.

The Japanese have recently implemented the first method, and Japanese domestic demand and output are falling as a consequence.

The second method was implemented successfully by Hjalmar Schacht in Germany the 1930s, leading to full employment without inflation.

Certainly Mr Schaeuble agrees that increased spending can no longer be financed in the Eurozone by issuing new government bonds, as that would further increase public debt.

It is the subject of speculation that the European Central Bank is embarking on large-scale bond and asset purchases (a form of quantitative easing, QE).  This would be a colossal strategic blunder: not only would it involve a waste of precious time, but also a waste of a precious resource (new money).

QE has been tried and failed in Japan on a number of occasions already. Incredibly, however, the Central Bank of Japan has, in recent days, greatly expanded the scale of its QE program. This inexplicable development flies in the face of all the accumulating evidence pointing to the ineffectiveness and dangers associated with this form of monetary policy.

Previous rounds of QE did not lead to increased investment in plant and equipment in Japan or in the United States, or significantly raise consumer price inflation.  And the full effects of QE cannot be known until the perilous ‘exit’ is completed.  QE and ultra-low interest rates are, in the meantime, distorting risk-taking and exchange rates, leading to asset price bubbles and benefiting mainly high wealth individuals and banks (sentiments expressed recently by the Bank of International Settlements and the Financial Stability Board).

Those officials who advised their Ministers to support QE over recent years should stand condemned for exercising such poor strategic judgement.

There are, of course, other combinations of monetary and fiscal policies that should be examined.

A new macroeconomic policy paradigm is required urgently for countries with high and still rising public debt, declining demand, the deflation tendency, stagnation and high unemployment.  The new macroeconomic framework could include, in appropriate cases, the creation of new money to finance increased spending or tax cuts.

This suggested approach has been advocated by Abba Lerner, Henry Simon, Irving Fisher, Milton Friedman, Maynard Keynes and Ben Bernanke. New money financing of budget deficits is the most powerful possible combination of monetary and fiscal policies.  The new money required under this approach would be small relative to the massive injections into the banking sector under QE.  Not only does the new money financing approach raise consumer demand without increasing public debt, but it will be relatively quick in countering the deflationary tendency.

G-20 Credibility

The G-20 structural reform proposals will fall far short of the locomotive effort needed to reflate troubled economies.

Fortunately, however, the advice provided by official to their G-20 Leaders that all monetary and fiscal policy options have been exhausted is fundamentally flawed.

There is, thus, still a last minute opportunity for officials and their Leaders to re-establish the credibility of the G-20 process.  The G-20 Leaders could insert a sentence in their Communique requiring that the IMF urgently develop advice for the G-20 countries on the fiscal and monetary policies needed to boost consumer and aggregate demand without raising public debt.  A single sentence of this nature would prepare the way for the development of new medium-term macroeconomic policy paradigms aimed at restoring full employment and price stability while lowering public debt burdens.  Such an approach would complement any supply-side reforms that get enacted during the years ahead, making them far more effective.

Should G-20 Leaders not address demand deficiency directly, they, and their advisers, should never be forgiven.

Richard Wood, a former Australian Treasury official, is a guest lecturer at the University of Queensland, Australia. 

One Response to "To the G-20: It Is Demand Deficiency, Not Supply"

  1. __Tom__   November 9, 2014 at 1:12 pm

    Supply always equals demand, so arguments about which is holding back the other are by nature not given to resolution. I'm not convinced that supply is terribly bureaucratically restrained, and though I'm sure debt- or monetary-emission-funded investment across the G20 would boost collective gross value, I'm not sure how much value it would add in the long run.

    Globally, investment as a share of GDP is in the high end of the range that it's been in for the last 30 years. I'm sure global growth could be somewhat faster if investment were more evenly spread and not so heavily concentrated in China, but such are our times. I don't see how G20 political leaders are going to meaningfully address that.

    A couple fact points: monetary emission financing is by standard definition (UN SNA) a type of deficit financing, and Schauble is adamantly opposed to it.