Thoughts on a Pro-Growth Policy Mix

There are three key macroeconomic questions facing the country as it prepares for the Presidential and Congressional elections in November.

First, is it possible to adopt policies that would lead the economy to achieve materially super-normal rates of growth in the coming four years?   I answered this question in the affirmative in this post.


Second, would it be socially beneficial to adopt policies that would lead the economy to achieve materially super-normal rates of growth in the coming four years?  I answered this question in the affirmative in this post and in this one.   My conclusion was that, given the low level of real interest rates and real wages compared to historical norms. it would be beneficial to adopt policies that would lead the economy to grow at 5-6% per year over the next four years.  

In this post, I turn to the final question: what policy mix should be pursued in order to deliver the desirable super-normal growth rates?   In what follows, I’ll distinguish between two kinds of pro-growth policies: 

  • Demand-side: those that tend to push up on inflation and growth simultaneously
  • Supply-side: those that tend to push up on growth and down on inflation.

Demand-side policies are familiar: they include more accommodative monetary policy, increased government expenditures on public infrastructure, or tax credits for private consumption/investment. 

On the supply-side, we should certainly consider standard ideas, like reducing corporate income taxes. Personally, I am more drawn to what I would call pro-competition polices: relaxing regulations that hinder start-up activity, significant bolstering of anti-trust, and (possibly) subsidizing expansions of hiring. For reasons that will become more clear: it’s more important in my mind for these policies to constrain inflation than to generate growth on their own.

However, I’m not going to try in this post to isolate which demand-side policies and which supply-side policies would work best.   Instead, I will make three points:

1. It is likely that an appropriate policy mix will use both demand-side and supply-side policies.

2. Timing matters: there should be a heavy reliance on demand-side policies until the Fed sees monetary policy as having “normalized”. 

3. The Fed should focus on keeping inflation at target, as opposed to restraining employment growth.

Point 1: In my assessment, there could be a lot more slack in labor markets than most observers believe.  Nonetheless, I would agree with the conventional view that using demand-side policies alone to generate 5-6% growth per year in the next four years is likely to generate inappropriately high inflation and inflation expectations.  (It’s not guaranteed to do so, though - corporate profits are very high.  There is a possibility that corporations would absorb rapid wage increases by reducing profits, rather than raising prices.) 

The answer to this risk of unduly high inflation is not for the Fed to simply put on the brakes if inflation starts to rise too much - that kind of response would kill growth   Instead, the answer is to augment demand-side policies with supply-side policies that tamp inflationary pressures while being supportive of growth.  Put another way, it is likely that we will need policies that support super-normal growth in potential output - and that’s exactly what supply-side policies are designed to do.

Point 2: Inflation remains low and disinflationary pressures are strong.   The Fed seems unwilling or unable to combat these forces with more accommodative monetary policy.  In this context, overuse of supply-side policies risks creating a dangerous disinflationary/deflationary spiral that would lead to a deep recession.  It seems prudent to rely primarily on demand-side policies until the Fed has “normalized” policy to an extent that it is able and willing to be appropriately responsive to adverse macroeconomic shocks. 

Point 3: There is a “risk” that pro-growth policies will create the appearance of tight labor markets (low unemployment and rapid employment growth).  The Fed should certainly use its tools to ensure that these tight labor market conditions don’t create unduly high inflation.  But it should not automatically tighten policy only because labor markets are tight.  After all, the whole point of using supply side policies is to create rapid employment growth without inflation. 

My thoughts in this post and my prior ones are surely too rough to be seen as anything close to definitive.  But I hope that my posts will help spur other macroeconomists to also ask: What are the boundaries to economic growth in the next few years?  And what policy mix will push the economy to those boundaries?  

N. Kocherlakota

Rochester, NY, February 23, 2016

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