Calling all Economists: Stimulate Supply or Demand? Why?

[OxyMoron]

I recently got into interesting if somewhat futile debate that essentially boiled down to demand stimulus versus supply stimulus. The reason the debate was futile is that laywers, for chrissake, were doing the debating (i.e. my friend Larry and I). Larry’s argument went like this:

“What this country needs is for ordinary people to get a nice fat tax refund, so that people can go out and spend money. I mean, think of what people could do with an extra thousand dollars - suddenly they can buy a new sofa, or a washer-dryer, or a computer - real durable goods. That’ll have a tremendous impact. And, if they don’t spend, people with ordinary incomes tend to put their money in banks, which really makes the capital available.”

“But, Larry, wouldn’t we have even more impact by cutting tax margins and providing greater incentive for people to work harder? A refund doesn’t do that - it’s kind of a one-shot deal, and although it’s enough to stimulate spending, it isn’t enough to stimulate saving or working. Right now what’s killing the market is a lack of investment, like all of these companies who are whacking back their IT purchases. A lower tax margin might help.”

Now, a couple of other factors that occurred to me later:

Pro-demand-stimulus: Asset prices are still inflated, even if stock prices are down a bunch and the Nasdaq is but a shadow of its former self. If we encourage people to invest more, it’ll simply extend the life of the bubble. Plus, people may well decide stocks are too risky and instead put the assets into the remaining parts of the market that are overvalued, like residential real estate, since they’re maintaining the illusion of keeping their value.

Pro-supply-stimulus. First of all, it’s not clear that ordinary-income people who save put their money in banks rather than mutual funds. Second, it’s not clear that even if they do that’s a Good Thing, or a Better Thing than buying stock [hey economists, do you think it is or isn’t?]. Third, a lot of ordinary-income people are so mired in debt that instead of spending or saving the money, they’ll pay down a credit card, which is a long-term help for the economy but short-term doesn’t do much. [Am I right on this point]?

To me the question boils down to the multiplier effect: which produces a greater one (I’m thinking just short-term here, although for extra-credit explain the long-term issues as well), supply stimulus or demand stimulus? Why?

I realize that this comes dangerously close to asking you economists for your Theory of Everything (and in 200 words or less), but I think it would help us mortals who are worried about our jobs and only vaguely remember our Econ 101-102.

[The_Ryan]

Seems to me that any economic expansion due to demand stimulus would be largely illusury. Sure, we might increase the GDP, but a lot of the extra production would be spent making stuff that people wouldn’t have wanted if the government hadn’t encouraged them to buy it. What’s the point of that? The economy exists to serve us. We do not exist to serve the economy. What matters is satisfying existing demand, not creating more demand just for the sake of creating demand.

[Measure_for_Measure]

An immediate spending increase would stimulate aggregate demand more than an immediate tax refund. Why? Some share of the tax cut will be saved, rather than spent. In contrast, any purchase of goods and services represents a direct increase in spending.

Timing:
If a cut in tax rates means that additional cash won’t enter people’ pockets before 4/2002 (or optimistically, 7/2001, via witholding taxes), then an immediate refund (5/2001?) would stimulate demand earlier.

*Originally posted by xtnjohnson *
“But, Larry, wouldn’t we have even more impact by cutting tax margins and providing greater incentive for people to work harder? A refund doesn’t do that - it’s kind of a one-shot deal, and although it’s enough to stimulate spending, it isn’t enough to stimulate saving or working. Right now what’s killing the market is a lack of investment, like all of these companies who are whacking back their IT purchases. A lower tax margin might help.”

Empirically, the responsiveness of work hours to tax cuts tends to be pretty small. Theoretically, tax cuts tend to encourage additional work as people substitute work for non-work, as the rewards for work increase. BUT ALSO, when people are richer, they tend to like to consume more: and one of those consumption goods is leisure. Since these factors work in opposite directions (and for other institutional reasons), it isn’t especially surprising that those sorts of supply-side effects tend to be very small.

In contrast, a more rapid resolution of the California electricity crisis, however, might be a better “Supply Side” solution to our current economic troubles.

However, it is also true that when a tax cut is perceived as permanent or recurring, people tend to spend a larger share of it. If it is perceived as temporary, people tend to save a larger share of it.

Extra tax cuts that are planned for the 2005-2010 period probably won’t make much of an impact on current spending. So some of the arguments being made for the 10-year tax cutting schedule are rather spurious on their face.

Of course, the Fed could also just cut interest rates by another percentage point. That would affect the economy with a 6-24 month lag.

Pro-demand-stimulus: Asset prices are still inflated, even if stock prices are down a bunch and the Nasdaq is but a shadow of its former self. If we encourage people to invest more, it’ll simply extend the life of the bubble. Plus, people may well decide stocks are too risky and instead put the assets into the remaining parts of the market that are overvalued, like residential real estate, since they’re maintaining the illusion of keeping their value.

Um, I think you’re saying that higher stock prices make people feel that they’re richer, so that they spend a higher share of their income. This is known as “the wealth effect”. It’s thought to be small. As equity ownership is becoming more widespread, some believe that it is growing larger. I would be interested in seeing estimates of the wealth effect during the 1990s.

Pro-supply-stimulus. First of all, it’s not clear that ordinary-income people who save put their money in banks rather than mutual funds.

Um, how does this matter?

Second, it’s not clear that even if they do that’s a Good Thing, or a Better Thing than buying stock [hey economists, do you think it is or isn’t?].

For whom? The individuals? That depends on their appetite for risk. For economic growth? It matters little to me whether companies raise funds via the equity market, the bond market or the banking system. I’m not sure what you’re asking here.

Third, a lot of ordinary-income people are so mired in debt that instead of spending or saving the money, they’ll pay down a credit card, which is a long-term help for the economy but short-term doesn’t do much. [Am I right on this point]?

Right. I think. Paying down debt is essentially increasing your savings.

(Does this look good to you Collouns…? )

[jshore]

A debate along these lines, although with a bit more of an inequality twist to it was dealth with in a thread that I started a couple months ago: “Trickle up economics—A new theory” (http://boards.straightdope.com/sdmb/showthread.php?threadid=59313). You might want to take a look at that.

[system]

Flow, don’t be trying to pull me into this tar baby. I’m working hard…

(But yeah looked good to me, reducing debt = increasing savings: same effect)

But re the OP, try taking a look at the 10 March and the 24 March editions of the Economist for some present situation oriented discussions.(*)

Also, TR, demand stimulation in no way means forcing people to buy shit which they don’t want, it just means putting more oomph in demand via various means whether they mean increase in consumer demand bec. of increase in income or increase in government demand bec. of fiscal stimulas

(*: Actually there is a lot of interesting discussion in these two issues in re Am econ.)

[kabbes]

… and of course you have to worry about the various different types of crowding out if you’re going to attempt any kind of stimulation via monetary and fiscal policy.

If you just crank up demand then prices will be bid up and inflation kicks in to take away your gains. If you play the game wrong you may end up in a worse position than you started from.

I think the trick here is to establish at what level the economy is running versus its optimum and what factors are dragging it down.

As Flowbark said, in the short run especially you may get a bigger kick from government spending than tax cuts or returns. But it all depends on your current economic cycle.

pan