A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Sunday, May 3, 2009

Stimulus from the market

Demand side stimulus, Keynesian stimulus, traditionally is seen as deriving from government spending or tax cuts. It is hard to find an economist or politician today who argues for no use of these. Even the sacred tax cuts for the rich, established under the supply side prediction that they would lead to ever greater output, are now defended from the demand side. That is, reversing these tax cuts will reduce much needed demand for products and services.

But demand side stimulus can come from the market as well, if the appropriate incentives are in place.

The supply side market stimulus is most often seen in state tax breaks to businesses to encourage them to site a factory or other facility in the neighborhood. The theory goes that the new private facilities will produce jobs which will make the economy better. But as Yogi Berra said, "In theory there is no difference between practice and theory. In practice there is."

All too often the new facilities undershoot their targets. Some local businesses may be pleased, but rarely will it stop their complaining about the taxes which necessarily shift away from the newcomers and onto the current rate base. And at bottom, studies have shown, there is a tendency for businesses to site according to more salient factors, then just game the local jurisdictions to cut their tax exposure. More primary to business siting decisions, for example, are -- one, two and three -- market access, four, workforce availability, five transportation in and out, six educational facilities, and among the category of "also may be important" comes tax considerations.

And even here, the supply side stimulus is a zero sum game. When one jurisdiction is chosen, the others are neglected. If one community scores a Wal-Mart, businesses in all affected communities suffer.

But regardless of any of this, there are market-based measures that can stimulate from the demand side.

One is the forward commitment procurement process. You may remember Dr. Jonathan Frost, featured repeatedly here on the podcast, advocating this technique. Government simply commits to purchasing products in the future which meet the desired specifications. Frost used the example of the British prison system's procurement of a zero-waste mattress.

They described the attributes they wanted in a mattress. In this case, not being flamable, usable as a weapon, and so on, and particularly including the attribute of producing no waste for the landfill. The prospect was described by some as impossible. Even if such a product could be produced, it would be prohibitively expensive.

In fact, they received over thirty responses to their proposal, and the one selected produced a mattress that actually -- when disposal costs were included -- was more economical than the previous version.

A more famous example cited by Frost is the mandate by the state of California for a halving of emissions from automobiles. This was issued in the 1970s when the atmosphere of Southern California was nearly viscous with pollutants. The premise was that autos could not be sold into the California market unless they met strict emission requirements.

Of course, the common response was that even if such a product could be produced, it would be prohibitively expensive. The actual outcome, after billions in overwhelmingly private investment activity, was the catalytic converter and skies cleaner by far more than half.

The two salient features are the simplicity of the mandate -- two paragraphs describing the product as to its emission effects -- and the absence of government interference or micromanaging. A great error of the ethanol debacle, for example, was to describe the technology, not the desired result. Let the market do what it does best, innovate to the desired outcome

And here let us extend what is really a long digression. One of Frost's insights was the difference between R&D and innovation. Research and development is always successful, he says, because you always discover something you didn't know. It is essentially an intense study. Innovation is extremely difficult and often not successful. You begin with an idea of the desired result and the process of innovation is essentially a creation of a path from here to there.

It is difficult, expensive, and as said often not successful. The only reason to do it, Frost says, is because there is no other option. That is the situation we have with global climate change. There is no option other than solving the energy and transportation carbon problem.

End of digression.

The point we began with was that by mandating an emission level in order for automobiles to be sold into the California market, that state generated tens of billions of dollars in private investment and economic activity. The same sort of opportunity could generate multiples of that number without a dime of public spending.

For example, if the national government mandated zero emission vehicles within ten years, and the mandate were credible, we would be looking at a complete turnover of the automobile fleet in addition to the investment in technology up front. New plants, facilities, et cetera. This is economic activity. This is stimulus that produces jobs.

Would it be economically efficient? Unless you believe that the destruction of the planet's climate is economically efficient, the answer has to be yes.

And it overcomes a basic dynamic of depression, the collapsing consumption function. We'll go into this more deeply in another podcast, but the basic idea is that people are hoarding and cutting back spending in the face of economic uncertainty. This restriction of spending is exacerbating the downturn. Also discouraging spending from the monetary side is the collapse of credit markets, including pullbacks in credit cards, and you have a downward vector greater by perhaps a factor of three than the sum of the upward vectors of the stimulus and the various ad hoc measures being cobbled together by the Fed and Treasury.

Of course, a ten-year turnover over of the auto fleet is not realistic. A workable plan would involve the mandate -- the carrot of being able to sell cars -- and penalties for gas guzzlers. But this is another point on which Frost and I agree. Taxes cap-and-trade schemes are not sufficient. They will lead simply to expensive use of the same technologies. The mandate, the necessity to innovate, is essential.

That said, you would generate a lot of investment and a substantial turnover of the fleet by higher carbon taxes. Simply higher oil taxes. The runup in oil prices between October 2007 and July 2008 brought to the fore a new generation of energy options and sold a lot of Toyota Priuses. The retreat in oil prices carried many of these survival options out with them.

In this case, you generate new economic activity by making the status quo too expensive.

So those are market-based stimulus techniques that are economically efficient.

These could be combined with publicly sponsored stimulus in the form of infrastructure spending to create real progress, both in the short-term economic situation and in long-term security and stability. Notice the publicly sponsored stimulus overcomes the problem of a declining consumption function by taxation. This is forced consumption of public goods. It is stimulative, but not necessarily a cut in taxes.