Excess supply, lack of demand, or the other way around?

Photographer: ChinaFotoPress/getty imgae

Econ 101 Might Be Wrong About Supply and Demand

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
Read More.
a | A

As you might expect, economists tend to talk about lots things in terms of supply and demand. Macroeconomics is no different. The basic model of recessions and booms that gets taught in undergrad classes relies on the notions of aggregate demand and aggregate supply. Just like the demand for oranges is the number of oranges people want to buy at a given price, aggregate demand is the amount of things in general that people want to buy -- cars, back massages, video games, the works. And aggregate supply is the amount of everything that sellers want to sell. The interaction between these two determines whether growth is high or low.

The public conversation, too, is full of references to this model. Self-described Keynesians believe that recessions -- or at least, most of them -- are caused by shortfalls in aggregate demand, which the government then needs to rectify. Monetarists use the supply-and-demand framework too -- Scott Sumner, now at the Mercatus Center at George Mason University, once described it as “the goldilocks model.”

But deep in the bowels of academia, economists have long questioned whether it makes sense to think about the macroeconomy in this manner. There are plenty of ways that demand and supply could be indistinguishable in practice.

About 10 years ago, economists Paul Beaudry and Franck Portier showed one way this could be true. They theorized that a recession could happen because people realize that a productivity slowdown could be coming in the future. Anticipating lower productivity tomorrow, companies would reduce investment, lay off workers and cut output.

Would that recession be caused by a shock to supply, or demand? Traditionally, we think of random changes in productivity as supply shocks, because they affect how much companies are able to produce. But in the short term, the cutbacks in investment and hiring in Beaudry and Portier’s model would look at lot like a demand shock. The two terms just aren’t very distinct once things start getting complicated.

Recently, some macroeconomists have been thinking about the opposite direction of causality. There are ways that a short-term hit to demand could cause supply to fall in the long term.

One reason this could happen is that reduced economic activity could cause companies to invest less in new technologies. New technology is one of the main drivers of productivity growth, but it doesn’t usually fall from the sky. It takes money -- first to do the research, then to implement and adopt the new technologies. Self-driving cars, for example, are going to take many billions of dollars to create. In a recession, with companies strapped for cash, companies have less money to spend. So new technologies might get delayed for years, leading to slower long-term growth.

This is the basis of two new theory papers. The first, by Diego Anzoategui, Diego Comin, Mark Gertler, and Joseba Martinez, takes a standard model of demand-based recessions -- the kind of thing central banks use, and that Nobel laureate Paul Krugman and many others advocate -- and adds the idea that technology costs money. They find that productivity growth goes down after demand takes a hit, and that this can cause recessions to last years longer than they otherwise would. The second paper, by Gianluca Benigno and Luca Fornaro, reaches similar conclusions.

That seems to fit the experience of countries hit hard by the financial crisis and recession of 2007-9. First, everyone panicked and stopped spending -- consumers stopped consuming, companies stopped investing and hiring, and employers started laying off workers. It was a classic, textbook drop in aggregate demand. But the recession then dragged on for years, and productivity growth slowed, just as these models would have predicted.

There are other ways that drops in demand can cause supply to fall as well. Economists Brad DeLong and Larry Summers have suggested that when recessions throw people out of work, their job skills, work ethic and business connections can decay, making them less productive workers in the future. Another group has theorized that low demand could decrease productivity by making people search less hard for things they want to buy, preventing companies from finding new ways of meeting their needs.

Any of these theories will need a lot of empirical confirmation before it becomes conventional wisdom. But the idea that demand can affect supply raises the possibility that we think and talk about macroeconomics all wrong. It could be that measures to raise demand in a recession -- fiscal stimulus, perhaps, or monetary easing -- could make productivity growth faster too, giving the economy a boost not just in the short term, but for many years. 

This idea, sometimes called “Verdoorn’s Law,” hasn’t yet gained mainstream acceptance in economic circles. The idea that productivity just grows on its own, and can’t be accelerated by stimulus, is deeply entrenched. But these new theories show that there’s at least a possibility the conventional wisdom is wrong, and that boosting the economy in the short run can reap dividends many years into the future.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net