Tuesday, August 16, 2011

How to Grow an Economy

People treat economics like it's some kind of mystical thing, but it's really not rocket science.  In fact, in my opinion, all you really need to understand about economics can be boiled down into one concept:  supply and demand.  Practically the entire subject is derived from that.

Markets determine prices based on supply and demand.  If demand exceeds supply prices rise to the point that the two are once again in balance.  If the return (i.e., profit) to suppliers at that point is higher than the risk that the endeavor requires then new supply can be expected, resulting in a new equilibrium.  The reverse is also true.

With that in mind, let's look at the two policy responses that United States government officials have employed while trying to restart the economy:  Keynesian stimulus and Quantitative Easing.

The theory behind Keynesian stimulus is that, by government increasing its spending at times of reduced private demand, prices will rise to the point that supply follows (i.e., that higher prices result in increased supply) and employment will rise with it.  As pointed out in a previous post, Keynesian-ism fails for the simple fact that the government can't spend what it doesn't take--any demand increase from government spending has to result in an equal demand decrease by private spending.  [It would be funny if it weren't so tragic that the other side of the transaction is so often ignored by "economists" making the case for their own policy preferences.  I can't tell you how many economics classes I sat through in college where that was the case.]  And, as also pointed out previously, the cost of the bureaucrats who run the government programs further act to reduce supply, resulting in higher prices and less productive employment.  Stagflation is the expected outcome and is the situation now found in the United States.

So Keynesian stimulus doesn't work.  What about Quantitative Easing  (i.e., printing money)?  Once again, the reason it cannot work is easily grasped if one understands the concept of supply and demand.  Printing money shifts a country's aggregate demand curve higher, which results in higher prices.  Unfortunately no supply response (i.e., supply increase) can be expected because once inflation is subtracted, the return to producers will not have changed.  All printing money does is increase prices, nothing else.

It's clear that both Keynesian stimulus and Quantitative Easing have failed to restart our economy and now you at least know why.  What, on the other hand, would work?  If we think about it from a supply and demand perspective, there really is only one answer and it's so simple it almost leaps out at us:

If you want to increase demand for workers you make it more, not less, profitable for people to hire them--it's that simple.  Make it more profitable to hire people and you will increase hiring!!!  That means you don't impose new healthcare costs or higher taxes or new regulations.  Doing this only makes sure that fewer people are hired.

As more people get hired, more goods and services are produced and the economy grows.

Like I said in the first sentence, economics is really not that complicated.

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