Macroeconomic policy can be divided into two types, stabilization policy that attempts to keep the economy as close as possible to full employment, and growth policy that tries to make the economy expand as fast as possible over time. These two types of policy are sometimes interrelated. For example, a failure of stabilization policy can cause high employment and permanent dropouts from the labor force, and that lowers long-run growth. But the two types of policy are largely separable and it is a useful distinction to make.
Prior to the onset of our recent economic troubles, much of the research in economics and much of the political debate was about growth policy rather than stabilization policy. The political right was particularly focused on promoting growth and the policies the right advocated — tax cuts in particular — came to be known as supply-side economics. There were other goals behind the push for tax cuts of course, for example using tax cuts to increase the deficit and force cuts to social programs, but the main economic arguments centered around taxes and growth.
The focus on growth is understandable. Before the Great Recession in 2007, our last serious recession was in 1982. During this long period of tranquility, growth rather than stabilization became the main concern.
That changed when the Great Recession hit. Suddenly, questions about stabilization policy came to the forefront. Unfortunately, the macroeconomic models in use at that time, which were centered on questions of growth and the conduct of monetary policy in the presence of moderate fluctuations in output and employment, provided little guidance in how to respond to a deep and prolonged downturn in output.
Since then, there has been a considerable body of work looking at stabilization policy during deep and prolonged recessions, the role of fiscal policy in particular, and we will see how successful this effort turns out to be. But when the recession hit we were unprepared to answer important questions about the best course of action to take to stabilize the economy.
Now that we are beginning to come out of the recession, too slowly, but hopefully surely, the focus is once again turning to economic growth. And it's not just the political right that is thinking about the growth question. The left is thinking about growth too. For example, Larry Summers recently put forth a modern version of Alvin Hansen's "Stagnation Thesis," the idea that we are headed for a period of secular stagnation, and this set off an extensive discussion of the best policies to pursue in the face of an economy plodding along with zero interest rates and insufficient demand.
In the past, the focus of supply-side policies has been to remove tax and regulatory distortions that prevent capital markets from functioning efficiently, to promote saving and investment, and to lower the taxes on corporations and the wealthy.
Those efforts will surely reemerge as the focus turns once again to growth (though hopefully we've learned something about deregulation). But there will be something new this time around, and it will be driven by the political left.
Increasingly, the idea that the ever-growing inequality can be harmful to economic growth has been taking hold. As I pointed out in my last column, Joseph Stiglitz explains one way that rising inequality can have a negative impact on economic growth:
Many at the bottom, or even in the middle, are not living up to their potential, because the rich, needing few public services and worried that a strong government might redistribute income, use their political influence to cut taxes and curtail government spending. This leads to underinvestment in infrastructure, education, and technology, impeding the engines of growth. [The Guardian]
Or, to give another example of how reducing inequality can promote growth, if wages were higher, would we see such a large number of permanent dropouts from the labor force, a drag on economic growth? As Atif Mian and Amir Sufi document, ever since 1980, the tight link between the growth in productivity and median household income has been broken. Gains from growth that used to flow to typical households now end up at the top of the income distribution. Wouldn't a more equitable distribution of the gains from growth motivate people to remain in (or return to) the labor force?
For yet another example, if a larger share of the gains from growth had gone to lower income households, how much better off — healthier, better educated, and more productive in the future — would our children be? How much faster would the economy grow if more children were able to reach their potential?
Cutting taxes in the heyday of supply-side economics did not produce robust economic growth and ever lasting prosperity, and it did not solve the problem of rising inequality. If anything it made the problem worse. As we begin to focus on economic growth once again, it's time for a new approach, one that recognizes the advantages of a more equitable distribution of income.
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