Evidence For “Demand Side” Economics

In my last post I described how all economies depend on demand for goods, and this demand depends on income. Hence, for an economy to meet its productive potential, income needs to be distributed to all citizens to enable there to be a demand for the production of goods.

I also explained that mainstream economists ignore the need to focus on demand, and pay all their attention to what is called “supply side”. And I admitted that while heterodox economists do understand the importance of demand…

“…I have not yet found a systematic, empirical study of this aspect of the economy that satisfies my thirst for knowledge. I’m sure it exists, and that as I continue my studies I will find it.”

Then just 3 days later I came across an empirical paper which, while not being the complete “systematic, empirical study” I am looking for, does reach the conclusion based on empirical research that poor productivity is because of weak aggregate demand.

This is such an exciting coincidence that I have to write about it (my planned post on the most important book this century will have to wait). I wasn’t even looking for papers on this – Twitter sends notifications to my phone of random tweets by people I follow (it’s very annoying, but I don’t know how to turn it off without turning off all notifications), and this paper simply came up in a tweet by @JoMichell. And when I say “exciting”, it’s worth emphasising why this isn’t just a joke at my own nerdiness.

Scientific study should be based on empirical research – actual observation and testing of the real world, conducted in a controlled and systematic way. The conclusions in this blog build up from descriptions of empirical fact and logical argument. The economics field is so woefully short of such true science, particularly investigating the most critical components of the economy, that it is genuinely exciting to find such a paper.

So anyway, the paper is titled The UK (and Western) Productivity Puzzle:Does Arthur Lewis Hold the Key? and is by economist Nicholas Oulton. It was published in March 2018 by the Centre for Macroeconomics at the London School of Economics (LSE), National Institute of Economic and Social Research (NIESR) and Economic Statistics Centre for Excellence. NIESR published a very brief overview by Oulton here, and Intereconomics published a more detailed summary here.

It’s worth noting how “mainstream” all these institutions are. Indeed, Michell’s tweet that alerted me to this paper was making the point that now even orthodox economists are reaching hererodox (specifically Post-Keynesian) conclusions, but without acknowledgement. Oulton himself used to be Senior Economist at the Bank of England, so he’s no lightweight. In his long career he has specialised in researching productivity, including its measurement. (Empirical research into productivity is, of course, a major theme of this blog, so I’ve now added Oulton onto my loooong reading list.)

And now finally to get onto the content! Since the global financial crisis Britain has had zero productivity growth. The orthodox explanation is that this had nothing to do with the great recession, and is rather the result of a decline in innovation that predates the crisis. Having researched this issue, Oulton has reached the opposite conclusion:

“…weak productivity performance is a macro phenomenon, mainly due to weakness in aggregate demand which in turn is due to constrained demand for each country’s exports since 2007.”

As you can see, this is exactly the conclusion reached in this section of the blog, as described last week. Even the point about constrained demand for exports relates to another theme covered in the blog, the balance of payments constraint.

Oulton analyses the data for total factor productivity (TFP). Whereas labour productivity is the value of output per unit of labour time, TFP measures the increase in the productivity of labour and capital combined. Think of it this way – if the amount of labour and the amount of capital remain constant, and productivity nonetheless increases, that’s an increase in TFP. This can only happen because these inputs are being used more efficiently, and this is usually down to advances in technology.

Hence, orthodox economic theory suggests that increases in TFP are the most significant driver of GDP growth. In mainstream models of the economy, such technological advances are something that “just happen” – there are no factors in their models that explain these advances (the technical term for this is “exogenous”, meaning outside – the advances to technology happen outside the model). As a result, these models act as if increases in TFP raise GDP, but that increases in GDP have no impact on TFP.

According to the standard measures, TFP dropped sharply following the financial crisis, and has failed to recover. The mainstream economic view is that this decline is not in fact because of the recession, and rather is down to factors that predate the crisis. In particular, that the impact of the ICT revolution is now fading. But Oulton’s own research shows that the fall in TFP is actually caused by the decline in GDP (the exact opposite of the assumption on which mainstream models are based). The changes in TFP for each country closely correlates to changes in GDP, and Oulton’s statistical analysis indicates that causation is running from TFP to GDP, not the other way around (and if you want the mathematical detail, there’s pages of it in the paper).

One aspect of this I find particularly interesting is that while this result for TFP is consistent across all economies, changes in labour productivity vary far more from country to country. I made the point in the last post that mainstream economics ignores the need to stimulate demand, and instead always reaches the conclusion that we need “supply side” reform – less worker protection, less regulation, lower taxes. Where such policies are in place (e.g. in the UK) labour productivity is actually falling. Employers have been able to force wages down, and employ more people in low-skilled, low-paid jobs. The result is lower unemployment than the rest of Europe, but also lower labour productivity. Our workers are literally less productive because we simply employ more people at lower wages. Several weeks ago I summarised Adair Turner’s work on automation, in which he shows how increases in efficiency can actually lead to an increase in low productivity, low skilled, low paid jobs rather than an increase in TFP overall. This is exactly what Oulton is saying has happened.

But to return to the main point, TFP has fallen as GDP falls. It does seem obvious that lower levels of GDP mean less resources available for investment, research and development, and hence TFP should fall. But mainstream economic models are constructed with the assumption that TFP drives GDP, not the other way around. In this context Oulton’s own conclusions (as a mainstream economist) are striking:

“If the analysis here is accepted, then one theoretical possibility is a coordinated fiscal and/or monetary expansion across the Western world, combined perhaps with incentives to raise investment. To state it in these terms merely emphasises how implausible such a policy sounds.”

Let me put that in plain English. Coordinated fiscal and monetary expansion means increased public spending, funded by increasing the money supply. Coordinated across the Western world means that Governments have to cooperate in the implementation of such a policy, it is not something that can be successfully implemented by one country going it alone (something Oulton explains in some detail). And measures need to be in place to ensure that some of the increased money in circulation is used to fund investment.

These are exactly the conclusions reached by this blog. I mean EXACTLY (it’s all through the blog, but summarised here, particularly points 1, 2 and 6). You can see why I’m excited. Although Oulton is a mainstream orthodox economist, he simply cannot deny that this is what the evidence of the empirical data that he has analysed points to, not matter “how implausible” this sounds.

Just to emphasise the last point, I find this video of Oulton very interesting. In the final two minutes (from 4.15) he gives a very clear summary of his essential arguments. In his gentle, lilting upper class tones he describes “the very popular view … that international institutions like the IMF strongly promote”, and then “the other argument, which I think I tend to favour myself now”. He makes it sound like simple differences of opinion, when in fact the positions he presents sit across a gaping ideological divide. And note again, that what he advocates at the end of the video are exactly the conclusions reached by this blog.

Science should not be about ideology, so to find a respected mainstream economist willing to present such heretical conclusions, because this is what the empirical evidence points to, is very exciting.

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