The American economy is far weaker than it should be. Unemployment is low, but this overstates our economic strength given troubling long-term trends in labor force participation. Inflation is still more than twice as high as the Federal Reserve’s target. Real output growth is anemic. We have lots of workers, plenty of capital, and abundant natural resources. So why do the recent boom years of 2018-2020 seem like another era?
Stagnation isn’t a fact of life. It’s a policy choice. And the policies we’ve chosen since 2020 have not served us well. We’ve failed to rein in surging aggregate demand, while at the same time counterproductive laws and regulations have stifled aggregate supply. Goods are scarcer and more expensive than they should be.
It doesn’t have to be this way. By fixing demand-side instability, we can lay the foundation for a supply-side revival.
The demand-side of the economy is the dollar economy. The supply-side of the economy is the real (goods and services) economy. The former is the realm of ordinary transactions and payments. The latter is the realm of actual resource allocations, which determine long-run prosperity. Though conceptually separate, these two economies significantly overlap in the short run. To paraphrase a well-known economic maxim: When the dollar economy flutters, the real economy sputters.
The price system, not the political system, should allocate the vast majority of society’s scarce resources. The private sector faces strong incentives to create value for consumers. The public sector faces no such pressure; if anything, it is waste-maximizing rather than value-maximizing. We need to structure our political-economic institutions so that the demand side of the economy keeps output and employment as high as they can sustainably be. Supply conditions then determine the best uses of labor, capital, and natural resources.
In the long run, wealth depends on productivity. You can’t consume more than you produce. The job of demand-side stabilization policy is to keep us maximally productive. In economics jargon, we want to find the right point on the production possibilities frontier: Out of all combinations of cars, computers, insulin, prime ribeyes, sports coats, European vacations, and countless other goods we could produce, we want the mix that maximizes the well-being of society. By ensuring dollar prices reflect real resource scarcities, demand-side stability creates the foundation for supply-side flourishing.
To stabilize the demand-side economy, we need to keep nominal spending growing at a steady and predictable rate. Nominal spending is the value of all transactions, expressed in current dollars. Economists sometimes call it “aggregate demand.” The Fed is uniquely positioned to stabilize nominal spending. By offsetting changes in money demand with changes in money supply, the central bank can prevent nominal fluctuations from knocking the real economy off-course. Stable nominal spending means supply-side considerations, namely productivity, will be the only major driver of economic fluctuations. There’s no such thing as perfect economic policy, but this is about as good as it gets.
Monetary policy ultimately determines aggregate demand. Fiscal policy can change its composition, but rarely affects its level. This suggests a division of labor between the central bank on the one hand, and Congress and the President on the other. The Fed is responsible for keeping demand conditions stable. Congress and the President should make spending considerations based on the comparative advantage of the public sector, such as national defense.
Stable demand is only half the battle. We also need supply-boosting policies. That means we need to rein in government spending. The recent debt ceiling deal is an acceptable start, but only that. When the government consumes larger shares of society’s resources, we all become poorer because resources are diverted from productive purposes. We need strict caps on spending at the federal level. It should grow by, at most, the sum of population growth and inflation, keeping real resources used per citizen constant. Our ultimate goal is shrinking Uncle Sam’s consumption as a share of the economy.
The economic might of the United States is built on free enterprise. The assaults on private property and the rule of law by Washington insiders threaten the system on which our prosperity depends. The public must demand their elected officials take up the reins of government and redirect it to productive rather than parasitical ends. That means developing institutions and policies that stabilize demand while unleashing supply. We’ve had low inflation, plenty of jobs, and robust growth before. We can have it again.