What shape is your Supply-Curve ?

John Maynard Keynes (1883-1946)


Keynesian Stimulus is the order of the day.

President-Elect Obama's proposed Government Stimulus package currently stands at $600 Billion and is rapidly approaching $1 Trillion with still more than 30 days to go before his innauguration.

The Federal Reserve's aggressive actions over recent months, and its December 16th Statement, have made clear that it will pour Money into the economy to spur growth: "The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level."


In times of crisis, it is comforting to know that we can do something. The Supply-Side models of "Augmented Expectations", and "Rational Expectations", promise modest and temporary effects (if any) from fiddling with the "G" (Government Spending) and "M" (Money Supply) policy levers.

The Keynesian model, by contrast, demonstrates that increasing "G" and "M" can both induce economic activity. In times of crisis, Keynesianism offers the ability to do something to change the situation. Adjust "G" and "M" and the stage is set for recovery.

A key assumption underlying the Keynesian model - THE key assumption, in fact, is the "downward stickiness" of wages. At a very basic level, this means that a downward shift in the price level is not matched by a downward change in wages.

This is what gives the Keynesian AS (Aggregate Supply) curve its positive slope and allows for Demand-side stimulus.




In the above illustration of the Keynesian model, increasing "M" or "G" will push Aggregate Demand to the right, generating an increase in "Y" (Output), [with some accompanying inflation].

The following headline is of crucial importance and should give us pause as we race headlong into various Keynesian stimulus efforts:

FedEx To Cut Salaries 5%, Suspend Bonuses, Freeze 401(k) Contributions

This change affects 36,000 employees, who will all see their wages cut by 5% (or more). We cannot recall, in recent times, a similar example of an across-the-board reduction of wages on such a broad scale.

A recent WSJ article noted that "By 42, the average American will change jobs 11 times.". Such labor-market dynamism implies aggregate wage-level flexibility, both upward and downward.

If the underlying assumption of "downward wage stickiness" is inapplicable to today's environment, then, the entire Keynesian paradigm is subject to question.


In the early 1970's, the government was frustrated in its attempts at similar Keynesian stimulus, as increases in "M" and "G" produced only inflation. That is what happens when your supply curve, rather than positively-sloped, is vertical:


In the above Supply-Side model illustration, pushing Aggregate Demand with "G" or "M" stimulus will only produce inflation.


No economic model always reflects an accurate picture at all times. Entering the Great Depression, policymakers' economic model assumed a vertical supply curve similar to that depicted above - which Keynes would later prove was inaccurate.


The Keynesian model served policymakers well from that time until.... it didn't. Stagflation resulted from attempting Keynesian stimulus in an economy that looked like the "Rational Expectations" model.

Today, we face a new situation, and, it is unclear what the paradigm actually looks like.

There is growing evidence that the absolutely crucial Keynesian assumption of "downward wage stickiness" does not reflect the facts on the ground today.

The Supply-Side model focuses on pushing out the Supply curve (rather than pushing out the Demand-curve), through deregulation and tax cuts. These policies, which were effective coming out of stagflation (high inflation and high unemployment, with an artificially-elevated AD), are unlikely to be implemented in today's political environment. However, even if they were magically put into place, does pushing out the Supply curve work in a deflationary environment ? Nobody knows - we've never been here before!


Andrew Mellon (1855-1937)


Andrew Mellon, Treasury Secretary from 1921 to 1932, has been harshly criticized for many decades for his seemingly hard-hearted "let them eat cake" prescription during the Great Depression seventy-five years ago:


"Let the slump liquidate itself. Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate... It will scourge the rottenness out of the system. High costs of living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people".

Mellon based his "liquidationist" position on his observations of the Panic of 1873 and ensuing Depression, which was nasty and brutal, but relatively short in duration.

Doing nothing, while apparently callous, is clearly better than doing the wrong things. A recent paper by John Taylor of Stamford University spells out the various ways in which "government actions and interventions caused, prolonged, and worsened the financial crisis."

If you offered a Mellonian-style "liquidation" to Japanese officials in 1990, of, say, a 50% drop in asset values and severe output decline over 12-18 months, they'd have laughed you out of the room.




Were you able to provide those same Japanese officials of 1990 with a glimpse of their economic future, with the Nikkei sliding 78% over 18 years, from 38,900 to 8,600 (today), persistent deflation, and stagnant growth, good old-fashioned Mellonian Liquidationism would have seemed like a pretty decent alternative.

Regardless, such a "hands-off" approach will not be the choice of today's policymakers, who are under pressure to act, and, it is unclear whether such a policy would even be appropriate in today's situation...


What is clear is that we are in uncharted territory.


Keynesian stimulus cannot have the predicted effect if its core underlying assumption is inoperative. Supply-side policies, even if implemented, have never been tested in a deflationary environment.

Times of great economic crisis are when new paradigms emerge. Unfortunately, these models are generally discovered looking backward, rather than forward, as data only emerges after-the-fact. The prescriptions based on these models are often developed too late to prevent a prolonged and severe period of hardship.



Whatever new model(s), and accompanying policy prescriptions, emerge, recovery for the economy can only begin when the process of asset erosion and debt default has run its course, and finally, confidence is restored.

As Todd Harrison of Minyanville often reminds us, ultimately, the only true economic pallatives are "time, and price".



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