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Tuesday, February 24, 2009

ECONOMIC RECOVERY AND LONG-TERM GROWTH: DEMAND-CONSTRAINED OR SUPPLY-CONSTRAINED. ALSO, THE SURPRISING PERSISTENCE OF THE USA'S CENTURY-OLD ECONOMIC LEAD

Today's Buggy Topic: Actually Two of Them

The two lengthy buggy posts --- data-filled as usual; also with lots of links to good, easy-to-follow comments, diagrams, and tables elsewhere --- were posted earlier today at Economist's View . . . the praiseworthy economic blog run by Professor Mark Thoma, a well-known New Keynesian specialist at the University of Oregon.

The thread where prof bug's stuff is found there was actually started by Professor Nick Rowe --- another well known New Keynesian, who teaches in Canada and has a very good web site of his own.    Prof Rowe analyzed whether, all in all --- in the long-term --- economic growth is supply-constrained or demand-constrained.  Early, old-fashioned Keynesianism of the 1940s and early 1950s confused the two constraints.  If anything, it was simply concerned with aggregate-demand and took supply-side inputs for granted. 

The Problem 

That was true, note quickly. not just in the short-run, where, conceivably, a totally horizontal supply curve can be assumed --- which free-market economists, in any case, dispute.  Worse, though, lots of Keynesians in those days assumed that proper demand-management by means of fiscal policy --- monetary policy was regarded as impotent, even short of a liquidity trap --- would enhance long-term growth of the economy.

The reality?  Long-term growth is a matter of strict supply-side inputs, efficiently allocated: growth of the capital stock (capital investment), growth in the labor force, improvements in the quality of the labor force (formal education, job-training, flexibility, ability to cooperate spontaneously, and the like) . . . plus, most important of all, technological progress: the growth of knowledge, whether embodied in improved old production machinery, or in revolutionary new technologies of a far-reaching sort (like the PC and the Internet, or a century ago the internal combustion engine and Fordism in mass producing cars), or disembodied but reflected in better knowledge of managing firms. 

And some economists, prof bug included, would emphasize the importance of bold risk-taking entrepreneurs determined to start a new business and, where they have the talent and drive and opportunities, to bring new radical technologies and products successfully to the market place.  Think of Microsoft, Apple, Walmart, MacDonald's, Intel, Google, Amazon, and so on.  They didn't exist 30 years or so ago.  In fact, by the late 1990s, 75% of the Fortune 500 biggest companies didn't exist in the early 1970s.

Prof Bug's Two Comments

No need to say more.  Prof Rowe's lengthy intro --- be sure to click on the link at Economist View to his full commentary --- is somewhat demanding, but not technical; and in any case prof bug's first lengthy analysis in reply clarifies what Prof Rowe means by a long-run aggregate supply curve (LRAS) that is vertical.  That means changes in fiscal or monetary policy can't increase supply side output ---- only prices (up or down).  In effect, New Keynesians rightly note that this is the pre-Keynesian neo-classical view of economic growth.

That said, the NEW classical economists --- starting with Milton Friedman and especially the followers of Robert Lucas (Friedman's student and the major purveyor of rational-expectations in economics) --- generally regard short-term fluctuations around long-term trend growth (set by supply side inputs) as due to real shocks to the economy: hence recessions arise out of new technologies that dislocate temporarily the sectoral distribution of labor and capital on the supply side, along with other real shocks like resource-problems such as OPEC's huge oil-price rises in the 1970s (or more recently maybe), or marked changes in consumer preferences such as a switch from horse-and-buggies or bicycle transportation to new affordable Ford-produced cars, or maybe wars abroad. 

That theory of the business cycle --- booms and busts --- is called Real Business Cycle Theory, whose two pioneer scholars , Edward Prescott and Finn Kyland (the latter at UC Santa Barbara, prof bug's former employer), won the Nobel prize in economics in 2004. 

New Keynesians, by contrast, explain the business cycle's fluctuations as due to rigidities in various markets: products, labor-supply, and the like.  In particular, they argue that there are market failures due to at least three main problems --- sticky wages, sticky prices, and coordination problems --- that prevent the market economy from being self-adjusting in the way NEW classicals say it is. 

Click here for prof bug's comments.