What to worry about on the supply side

A younger observer of the U.S. economy would be forgiven for thinking that the major problem with the economy is always and everywhere a demand phenomenon. The collapse of the housing bubble and resulting economic crisis in 2008 and 2009 caused a massive decline in demand across the economic landscape, with the slump in growth still being felt today. Considering that, we now have a sustained –though unspectacular– economic recovery, perhaps it’s time to consider the potential problems on the supply side of the U.S. economy.

The Wall Street Journal’s Greg Ip does just that in a recent column. Ip notes a variety of potential problems for the long-run growth potential of the U.S. economy. He points out that there appear to be issues with both the growth rate of productivity and the supply of labor, following the conventions of Solow growth accounting.

Ip notes that productivity picked up in the late 1990s and early 2000s but then slowed down in recent years, pinpointing the problem on the economy’s declining ability to efficiently use capital and labor. Research by San Francisco Federal Reserve economist John Fernald pegs this decline on the lack of new advancements in information technology. So an increase in innovation might help boost productivity.

But perhaps a better allocation of already existing technology and workers could be helpful. A new paper by economists Stephen G. Cecchetti of Brandeis International Business School and Enisse Kharroubi of the Bank of International Settlements argues that an over-bloated financial sector can reduce productivity. They contend that by drawing talented workers toward Wall Street, the finance sector lowers the total productivity rate. And because the financial services industry increasingly is focused on mortgage finance (despite the recent housing and financial crises), more resources are funneled toward the less productive construction industry. A possible supply-side reform, then, could be to rein in the finance sector to make the economy more productive.

There are other ways to boost the growth potential of the U.S. economy. As Equitable Growth’s Robert Lynch documents in a recent paper, reducing educational inequality would have a significant effect on the long-run growth of the economy. Raising U.S. students’ test scores to match that of Canadian children, for example, could raise gross domestic product by 6.7 percent in 2050.

It’s important to remember that supply and demand aren’t as easily untangled as we’d like to believe. Ip argues it’s unlikely that many more unemployed workers will return to the labor force. Yet with the lack of acceleration of wage growth, the labor market appears to still have some slack left in it to draw in more jobseekers, which in turn would boost the economy’s long-term growth potential. Short-term considerations can help alleviate our long-run problems.

Our economy still has demand-side issues, especially in the labor market. But we can’t forget about the supply-side problems that lurk further downstream. Our future prosperity depends on it.

February 20, 2015

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