Monday, September 5, 2011

Is it Demand or is it Uncertainty?

The first step in addressing a problem is to correctly identify what caused the problem, or what has prevented the problem from being solved.

Why aren't we creating more jobs?

Republicans argue that the problem is either that businesses have uncertainty, or that they have insufficient money to invest in jobs (or both).

The alternative position is that the problem is a lack of demand, and that businesses won't hire anyone unless their sales increase.

Obviously, which diagnosis of the problem is right has a huge impact on which solutions would actually work.  The Republican  solutions center around removing that uncertainty, or providing more money to businesses (or both).  Those concluding that lack of demand is the problem propose increasing the buying power of consumers.

Play this mind game: Imagine Company A and Company B, both in the business of making and selling widgets.  Like a great many U.S. corporations, their sales have not increased greatly, but both have cut costs in recent years and have made record profits, and furthermore are sitting on record amounts of cash.  They don't know if the regulations that affect their businesses are going to change, and they don't know if their tax rates are going to change.

Now imagine that demand for widgets increases dramatically, as more consumers begin having more money to spend on widgets.  Company A responds by hiring more workers and stepping up its production line.  Company B continues to hold back, because it still doesn't know if the regulations that affect its business are going to change, and it doesn't know if its tax rates are going to change.  Which of these two companies is more likely to prosper?

Now imagine that demand for widgets remains depressed, but regulations are removed and tax rates are lowered.  Company A sees no growth in sales, and doesn't hire additional workers (although its after-tax profits go up).  Company B says that since uncertainty has been removed, it hires more workers.  But since it can't sell any more widgets, its labor cost per widget goes up, and its profits go down.  It thereupon fires the new workers it had just hired.

OK, a little simple, I admit.  The idea beyond the uncertainty theory is that if businesses suddenly became optimistic about the future, they would take the hit of hiring people before sales actually increased, and the act of hiring and paying those people (if a whole lot of businesses do the same) increases demand in the economy, thereby increasing sales, thereby requiring more employees, etc., in a virtuous cycle.  But the problem is that right now, businesses are looking at each other, saying, "you go first."  "I'm not going first, you go first."  Somebody has to take the first step.

That somebody, unfortunately, needs to be someone whose first goal is not self-profit, but rather a concern for the overall well-being of the nation.  Which business is going to be patriotic, by hiring more people when demand does not justify it?

When actual business people, as opposed to propaganda organs such as the U.S. Chamber of Commerce, are asked what the single biggest problem is, for most common answer for the last couple of years has been "sales."  More than taxes, more than regulations.

Source: National Federation of Independent Business, "Small Business Economic Trends, August 2011."  The preparer of this report is certainly not biased towards a progressive view, since he devotes his commentary to complaining about Paul Krugman.

Small business owners, who used to complain mostly about taxes, have singled out sales since the middle of 2008.

One way to test whether the problem is lack of sales (i.e., lack of demand) on the one hand, or taxes and regulations on the other hand, is to look at job creation  in the past compared to what business said was the problem at the time.  Unfortunately, I do not have the raw data that went into the NFIB charts, so I can't make one simple chart that superimposes the data.  Instead, we need to look at several charts at once.

So first is a chart that I made that counts the number of jobs added during each presidential term, by comparing the number of jobs reported by the Bureau of Labor Statistics in the first January of a president's term to the number reported in the last December of that term.  Here is what that looks like:

We note that the lowest terms of job creation--George HW Bush's one term and George W Bush's first term, correspond to the two previous humps in the NFIB chart above when businesses identified lack of sales as a growing problem.

Now note that the line in the NFIB chart identifying taxes as the major problem tended to be the highest during Clinton's two terms, when job creation was the best it ever was, and that job creation plummeted at the same time that complaints about taxes declined, during George W. Bush's first term.

Now we'll look at one more chart from the NFIB, which shows other factors that have been identified as the single more important problem, including government regulation:
Identification of "regulation" as the most important problem was highest during Clinton's first term, which did not prevent the best job creation record ever.  Concern about regulation was considerably lower during George W. Bush's two terms, but job creation was horrible.  Today, small business owners say that regulation is not choking their business.

So whenever you hear someone claim that all we need to do to create jobs is cut taxes and cut regulations, point out that these remedies have been tried before, with very poor results.  On the other hand, when sales have increased in the past, job creation is robust.

In a subsequent post, we'll look at ways to increase demand.


  1. Could not agree more. The continuous and reflexive desire to view everything from the supply-side lens is killing our ability to effectively respond to the disaster we are facing. I think that your widget example really brings the point home.

    Oh, and while this is anecdotal, I know for a fact that the small business I work for would not hire one additional person with a tax cut. There has to be an increase demand for our services before we would hire.

  2. Right, and furthermore, I would wager that even if its taxes went up, your small business would hire more if demand for your services increased to the point of needing to service the new business.

  3. Thanks for the blog, Paul. Many good points made here, the most important of which is we have to understand the problem before we can correct it. I also agree that the main driver of economic action is the market itself, which you call demand, rather than the government. That is a point I have made over and over to people who think that Obama can solve unemployment, or that Keynesian solutions are effective. The market will drive most decisions.

    The main problem I see with your analysis is that it supposes a kind of instant economic response to government intervention. We cannot divide the economy into neat 4-year periods, and try to correlate microeconomic decisions to those periods. Rather, we need a better sense of the fundamentals over a longer period. No one disagrees that regulation increases the cost of production, which either reduces wages or increase consumer prices, which reduces demand. Cutting regulatory costs has the good effect of increasing demand or real wages, both of which you support.

    Your point that a very short term solution does not lie in cutting regulatory costs might be true, but, then, many of us do not believe that any policy intervention will have any significant effect in the very short term. Cutting regluatory costs should have good effects in the medium term, though, as noted. So, while i agree with some of your points, I do not agree with the idea that some kind of demand stimulation will have significant short-term effects, or that ignoring the fundamentals of cost of production and real wage levels is a good idea.

  4. Thanks, Scott. I think that a major point of disagreement has been the extent to which government policy has economic effects. I think it can have huge effects, and I've seen it in action. I don't really think you disagree with that, as you must have seen the effects of governments in different countries in your line of work.

    I don't see "instant" economic response to government intervention, but one could see "pretty quick" response. I'm thinking of how the U.S. GDP reacted in 1942 to increased government spending for WWII. These days, it seems, it takes rather longer for projects to become "shovel ready," something that we may want to look into.

    On the effect of regulation on the cost of production, it certainly depends on what type of regulation we're talking about. But to take the example of emissions control, if a factory were required to spend money to hire a company to install pollution control equipment, that increases the cost to the factory to the same extent that the "pollution control industry" is benefited. Since some corporations are sitting on mountains of cash but won't hire because of lack of demand, at least the regulation would require them to put some of that cash into hiring pollution control workers. (Of course, there is not a one-to-one correspondence between which corporations have cash hoards and which are the worst polluters, which will make some companies unhappy about the requirements and complain that they don't have the money.) And, a side benefit is that we get cleaner air, which is not a bad thing.

    "Real wage levels" is also a slippery concept that I intend to get to in a subsequent post.

  5. I was "Anonymous." Somehow my daytime computer wouldn't let me comment as me.

    Romney came out with his jobs plan, which supposedly contains 59 specific proposals. I've seen summaries of it, but not the actual plan. Not on his web site, and Google doesn't know about it either.

    As soon as it comes out, I will look at it and post on it. From summaries, the Plan will perfectly illustrate the points made in this post.

  6. I want to make two more points:

    1) Government policy is important for the economy. But I do not think that "government stimulus spending" provides significant benefits. Other policies are important, though.

    2) This statement contains a common mistake: "But to take the example of emissions control, if a factory were required to spend money to hire a company to install pollution control equipment, that increases the cost to the factory to the same extent that the "pollution control industry" is benefited." If that were true, all government regulation and spending would be neutral, since someone's loss is someone else's benefit. The reason that this is not true is opportunity cost. In effect, the government is taking people and resources out of other uses and investing them in cleaner air. The opportunity cost is the market value of those people and resources, while the benefit is the value of cleaner air. You cannot count the new jobs in environmental technologies as a net gain to US welfare, because they are actually a cost (those people are lost to nursing, fighting fires, teaching, etc). The opportunity cost of the new jobs is the key. If you were correct, governments could just require businesses to dig big holes on Monday and fill them in on Tuesday - net new jobs, but a complete economic loss to wealth. So we have resources diverted to environmental protection (cost) while creating cleaner air (benefits). That is how the US federal government and 60 other countries do regulatory benefit-cost analysis.

  7. Paul Jameson has to post as "anonymous" again.

    I disagree that government stimulus spending does not provide significant benefits. We've discussed this before, and I'll post more detailed comments tonight.

    A good point about opportunity costs, and it raises the chance to talk about how the notion of opportunity costs change in economic times like these. I'll also post more comments about that tonight.

  8. OK, a more detailed response. We've started to discuss before whether there is a difference between "stimulus" and "investment." You favor the latter, while decrying the former. I simply contend that the best "stimulus" is money spent for things similar to what a company spends when it makes capital expenditures (perhaps for somewhat different things, but the same idea).

    But to basics. What is the difference, as far as the economy is concerned, between when the government pays an employee $1, and when a corporation pays an employee $1? I'd say there is no difference, and if you have a different view I'd be interested in seeing it.

    What is the difference, overall, between money spent by a corporation and money spent by the government?

    What is the difference, as far as the economy is concerned, between paying Boeing to build a 747 and paying the government to build a road? What is the difference, as far as the economy goes, between you paying a lawyer to draw up your will and you paying the government to pay for a lawyer who will bring civil rights cases?

    I'd say that as far as the economy is concerned there is no difference. The difference comes from when you pay your lawyer, you are making an individual choice, when the government pays its lawyers, it is the result of a communal choice.

    And some people just hate living in a community, where they have to go along with the decision of a majority. Those people are willing to pay economists to come up with reasons why government spending is bad for the economy while corporate spending is good for the economy. And economists are quite capable of coming up with whatever someone pays them to come up with. I've done it.

    About opportunity costs. Such costs are Economics 101. What should be in Economics 102, if not still in Economics 101, is what to do when things are different.

    When you have massive unemployment, you are not taking people and resources out of nurses and firefighters when you hire pollution control workers. When corporations are sitting on large amounts of cash, because they cannot see the demand justifying hiring production workers, making them take some of that money and spend it on pollution control workers is not diverting the money that would have been used to hire someone else. The economy would benefit from workers being hired that would not otherwise be hired, and we'd have cleaner air in the bargain.

  9. While we're on Economics 101, let's not forget the reason for regulation: to correct the negative externalities created when businesses choose to lower their cost of production by inflicting the cost of waste disposal on a third party.

  10. Definitely one of the reasons for regulation. I'd say that there are other reasons as well, depending on the regulation. We'll have a separate blog entry on regulation at some point.