How To Spot A Supply Shock

Casey Mulligan thinks the recession wasn’t caused by a demand shock but is instead a “redistribution recession” caused by the fact that shifts in labor market incentives have made it less worthwhile to work. John Quiggin says we can no this is wrong by looking at the international data, since there’s a curious coincidence in timing of the fall in employment in the United States, Iceland, Estonia, United Kingdom, Japan, etc. that seems hard to explain by Barack Obama’s Medicaid policies.

But I think there’s an easier way to tell that it’s wrong, and that’s by looking at the inflation data above.

Imagine we passed a law putting the top federal income tax rate up to 75 percent and lowering the threshold for the top bracket to $100,000 for a single person and $200,000 for a married couple and used the revenue to finance a progam that pays you a cash grant of $10,000 a year if you don’t have a job but gives you nothing if you’re employed. It’s pretty obvious that a policy along these lines really would cause some affluent people to downshift their careers and would cause some low wage workers to just quit and live off a combination of the 10 grand and under the table earnings. But in response you’d also see inflation. With some affluent professionals working shorter hours or quitting their jobs to launch the cupcake factories of their dreams, the price of hiring the services of the remaining affluent professionals would be bid up. Similarly, many minimum wage employers would have to raise nominal wages to compete with the increased appeal of not working.

In other words you’d see exactly what you’d see from any other kind of supply shock—a reduction in real output (fewer willing workers) combined with an acceleration in the price level (scarcity) rather than what we actually saw (see above) which is a collapse in the price level at the exact same time as the collapse in output.

Something to recall is that although “supply-side economics” came to just be code for “let’s cut taxes” there’s an actual reason that phrase came into currency in the late-1970s namely that we were precisely facing a combination of high unemployment and high inflation. That high inflation was an excellent indicator that boosting demand would not be effective in boosting output. So even if you think the specific proposed supply-side remedy was cranky, it was smart to seize the “supply side” label.

But that’s not the situation we’ve been facing.