I have a new paper on how we conceptualize the supply side of the economy, coauthored with Arjun Jayadev. I presented a version of this at the Political Economy research Institute in December 2022. You can watch video of my presentation here — I come on, after some technical difficulties, around 47:00. (The other presentations from the conference are also very worth watching.) The paper will be published in the upcoming issue of the Review of Keynesian Economics. (The linked version is our draft; when the published version comes out I’ll post that.)
Our fundamental argument is that while macroeconomic supply constraints are normally conceptualized in terms of a level (or level-path) of potential output, in many contexts it would be better to think in terms of a constraint on the rate of change — a speed limit rather than a ceiling.
While this is a general argument, it’s motivate by the experiences of the pandemic and the post-financial crisis recovery of the preceding decade. We think the speed-limit conception of supply constraints makes sense of a number of macroeconomic developments that are hard to make sense of in the conventional view.
First, deviations in output are persistent. We saw this clearly in the wake of the Great Recession, but it seems to be a more general phenomenon. There’s a long-standing empirical finding that there’s no general tendency of output to return to its previous trend. One way we could explain this is the real business cycle way — short-term as well as long-term variation in output growth are driven by changes in the economy’s productive capacity. But of course, there is lots of evidence that business cycles are driven by demand. Alternatively, we could argue that potential grows steadily but actual output may remain far below it indefinitely. I was making arguments like this a few years ago. The problem is that direct evidence on the output gap (unemployment, growth in wages and prices, businesses’ reported capacity utilization rates, etc.) suggest that the output gap did close over the course of the 2010s. So we’re left with the idea that potential output adjusts to actual output — hysteresis. But if we take this idea seriously, it rules out the conventional idea of a level of potential output. In a world where hysteresis is important, a zero output gap is consistent with lots of different level-paths of output; supply constraints only bind the speed of the transitions between them.
Second, there’s no well-defined level of full employment. (Here we have to ding Keynes a bit.) Employment grows steadily over business cycles — there’s no sign of convergence to some long-term trend. Estimates of the NAIRU or natural unemployment rate follow actual unemployment more or less one for one. And if we try to make a bottom-up estimate of full employment — what fraction of the population could plausibly be engaged in paid work — we end up with a value much higher than actual employment even at cyclical peaks.
Third, we observe inflation and other signs of supply constraints in response to changes in the composition of output and employment, and not just in the level. This has been very clear during the pandemic, but there’s good reason to think it’s true in general.
Fourth, increasing returns are pervasive in real economies. This is a bit of a different argument than the first three, since it’s not pointing to a directly observable macro phenomenon. But it’s important here, because it means that we can’t assume that businesses are already using the lowest-cost technique and increasing output will cause unit costs to rise. One way of thinking about this is to imagine a cost landscape that is rugged, not smooth. Moving from one locally low-cost position to another may require traversing a higher cost region, which will appear as supply constraints during the transition. A clear example of this is the transition from carbon to renewable energy sources.
We also argue that this perspective is more consistent with a sociologically realistic view of what “the economy” is. Real economies are not homogeneous “factors” being added to a “production function” which then spits out some quantity of output. They are complex systems of cooperation between human beings, which are embedded in all kinds of other social relationships and the reproduction of households and other social organisms. These relationships cannot be torn up and recreated at any moment — changing them is costly. They evolve only gradually over time. From this point of view, it is wrong to divide the facts about the economic world into a set of long-run, fundamental, exogenous factors and short-run endogenous factors. Who is actually working, and at what, is as much a part of the economic data, no less easily shifted, than the number of people who are potentially available for work.
This way of thinking about the supply side has several implications for policy. First, rising prices and other signs of supply constraints cannot be taken as evidence for the long-run limits on the economy’s productive potential. In general, we should be skeptical of suggestions that recent rises in the prices of energy, food and other essential commodities reflect the “end of abundance”.
On the positive side, our view suggests that the response to positive output gaps should include not only conventional “supply side” measures, but measures to overcome the coordination and information problems and other frictions that limit rapid changes in productive activity. This implies planning of some sort, though not necessarily central planning in the traditional sense. Another implication is that because prices can adjust more quickly than productive activity can (the emphasis on price stickiness is backward in our view), rapid shifts in activity can generate large price spikes that are not informative about long-run production possibilities and produce undesirable shifts in income. This suggests that price regulation has an important role in smoothing the transition fro one pattern of activity to another.
Specific examples and evidence on all these points are in the paper. You should read it! A final point I want to emphasize here is that we are not saying that supply constraints are limits on adjustment speed in an absolute, universal sense. We are saying that insofar as we need a simple, first-cut description of the supply side, we will usually do better to imagine a constraint on adjustment speed rather than on the level of output and employment.