Take A Walk on the Demand Side

Over at his erudite blog, Unlawfl Combatant has an excellent explanation of demand side economics, as opposed to the more well-known supply side economic theory. Unlawfl Combatant, along with Paul Krugman, the New York Times columnist and award winning MIT economics professor; Steven Roach, from Goldman-Sachs; and Joseph Stiglitz, Nobel prizewinner from Columbia University; (all of whom Unlawfl Combatant cites) predicts that we are heading for another recession as the demand for consumer goods softens.

I’m afraid we may already be seeing this prediction come true. The latest economic statistics, as reported in Friday’s New York Times, show that economic growth slowed during this past quarter. It went from 3.8 percent in the last quarter of 2004 to 3.1 percent in the first quarter of 2005.

Now, traditionally, 3.1 percent is not a shabby rate of growth for the Gross Domestic Product (GDP) and it is far from a sign of recession. Economists don’t consider an economy to be in a real recession until the GDP dips below 2 percent. However, a decline of .7 percentage points is not good news. It’s not the raw percentage, but the direction the economy is moving in that should concern people. What’s significant is that the economy has contracted at a precipitous pace in only three months. Not a very good sign, especially since the rate of job growth has been so sluggish even during the height of the recovery.

While the GDP was roaring along at 4 and 5 percent last year, new jobs were not being created at a fast enough pace to improve the unemployment rate. Also, wages have stayed flat. While corporations were enjoying record profits, little of that bounty was trickling down to the employees who were the ones responsible for that remarkable success . And we are now past the peak of the recovery and heading into the next dip in the GDP.

One of the major factors contributing to this economic slowdown is the high price of gasoline. People are being affected by the rise in prices at the gas pump so they are cutting back on other discretionary spending. Keep in mind that the major engine of our economy is consumer spending. It was the only thing that kept the last recession as mild as it was. And it was consumer confidence and spending that brought us out of that recession as quickly as it did.

Now, at a time of rising fuel and food prices, the demand for retail goods is contracting. So far, stores have managed to keep consumers buying by offering deep discounts and almost constant sales. But as retailers’ own costs keep going up, due to higher shipping expenses, they are being hit by the dilemma of how much of these higher costs they can absorb, or how much they will be able to pass on to their customers, who have come to expect low prices and perpetual sales discounts.

A businessperson can actually go bankrupt even if he is selling at a high volume. If his expenses exceed his gross revenue they will erode his profit margin. And that is the danger now facing many companies, who, although their raw volume of sales looks good on paper, are posting disappointing profits for the first quarter.

In economics, you truly see how tightly interrelated things are. Sluggish job growth and nearly flat wage growth can dampen demand for goods. So, when businesses send manufacturing overseas, boost their productivity at home by extensive use of automation, lay off domestic workers or cut their hours and wages, they do cut costs and temporarily boost profits.

However, in the long run, they kill the goose that lays the golden egg. That’s because the largest market for consumer goods is the United States. The low paid workers of China and Mexico still can’t afford even the deeply discounted goods that they produce which are shipped back to Wal Marts over here.

We are now in a situation that Benjamin Franklin would have called “pennywise and pound foolish.”

Eventually, low paid and laid off workers, even in the prosperous U.S., have to stop buying stuff, no matter how much Wal Mart discounts their merchandise. And when we stop buying, the world economy suffers, including our own. And higher prices for necessities such as food and fuel, only hastens the day when Americans have to stop purchasing clothes, cars, DVDs, CDs, and other discretionary items.

The largest factor now leading to suppression of demand for goods in the U.S. is higher gas prices. People need gas to get to work, to go shopping, to transport their kids to after school activities. And this is just the beginning of the summer vacation season. That's a time when traditionally people take to their cars for road trips, and gas prices usually rise as demand goes up. So, higher gas prices probably haven’t even peaked yet. But the hotel and leisure industry is nervous that it won't be getting as many visitors this summer, as travelers choose to stay closer to home because of expensive fuel costs. A contraction of the hotel and leisure industry will also impact the economy badly.

Rising oil prices also will mean that the cost of doing business will get more expensive for retailers. The first place we’ll see this is in grocery prices. Food isn’t a discretionary item. Everybody needs to purchase foodstuff. So grocers are in a better position to pass along any rise in their expenses to their customers than other retailers are. And more food is imported from far away than ever before. Lots of urban areas don’t have the luxury of locally grown produce and farmers’ markets, so look for higher prices for perishables such as meat, vegetables and dairy products, especially during next winter, when such goods will need to be shipped from further south and from Mexico and South and Central America.

Higher fuel and grocery costs will also put inflationary pressure on the economy at a time when consumer demand for discretionary purchases is slowing down. Inflation is pernicious because it eats away at both corporate profits and ordinary workers’ earnings and buying power.

According to classical economic theory, inflation is caused by an expanding economy and accelerating growth rate, which leads to higher wage increases and therefore higher prices for goods and lots of available credit for borrowing. In other words, the money supply is abundant.

In such a scenario, inflation is controlled by raising interest rates, tightening the money supply, and slowing down growth to a more manageable pace. With slower growth, prices drop back down and consumer buying power once again picks up. So do profits for businesses.

The ideal situation, in all cases, is slow, steady growth that produces neither inflation nor recession. But in reality the economy goes through cycles of slow growth (recession) and fast growth (which leads to inflation) and the cycles are hopefully self-correcting. That, at least, is what classical economics used to tell us.

It’s an overly optimistic view.

In the 1970s, a new phenomenon emerged called stagflation. It’s a situation where the economy is slowing down and hitting recession, yet prices are climbing, causing inflation at the same time. The first time this happened, it baffled the classically trained economists. Back in the 70s, this situation was thought to be impossible. After all, you slowed inflation by introducing slightly recessionary conditions. So, how could you have both occurring at once?

The wild card, then and now, is oil prices. The first time we had stagflation was during the last oil crisis in the 70s.

Today, wages have not risen with the recent recovery. So no inflationary pressure is coming from that sector. Prices have been so low that until recently there was actually fear of deflation, which is when prices get so low that they flatline growth, which is what recently happened to Japan's economy. So wage increases, a traditional cause of inflation, can’t be blamed this time.

It’s oil, not just the prices consumers are encountering at the pump, but also oil’s impact on shipping costs for retailers, that is driving food prices higher. Since the ordinary worker never got a raise during the last recovery, now that prices are finally starting to climb, the American consumer (who is also, needless to say, the American worker) can no longer sustain this nation’s long shopping spree.

Given how much manufacturing now takes place overseas and how much the opportunity for well paying jobs is shrinking at home – our burgeoning trade deficit, which also harms our economy, could be the subject of a whole other blog – we need to go to Plan B fast. Only, the Republican Administration doesn’t have a Plan B, except to keep rewarding its same cronies at the expense of everybody else. But this time, continuing to do the same thing that you’ve been doing and expecting a different outcome is – a recipe for economic disaster.