Chapter SummaryMost of this chapter was written in the late summer of 1996. It is now Dec. 30, 1997, as I write, and the year and a half that have passed since have had their surprises. With just one day to go in 1997, we can sum up the year with good confidence.
During 1997, the rate of unemployment has dropped below 5% for the first time in about a generation, without causing inflation to speed up. On the contrary, inflation has continued to slow. The rate of inflation is now between 1 and 2 percent, and (given that there is some upward bias in the measurement of inflation) some observers regard that as virtually nothing. Throughout the year, economists, administrators, journalists and others have been surprised again and again as economic growth continued, and unemployment fell, without any increase in inflation. One result is that the government deficit has dropped faster than anyone had expected. This seems to be a result mainly of the lower interest rate on government debt, itself a consequence of slowing inflation, and of cuts in transfer payments. The cuts in transfer payments, in turn, are partly a result of lower unemployment -- more people can get jobs and don't need transfer payments -- and of changes in the law that have made fewer people eligible for transfer payments. Also, there will have been some increases in government revenue with more production and a larger tax base.
There is an "orthodox" interpretation, and it goes like this. During the past year or more, the NAIRU has decreased by something over a percentage point, and for this reason both the LRS and the SRS have shifted to the right. Thus we are seeing a "supply-side disinflation." And some observers believe that the increase in the demand for labor will produce a speed-up of inflation in the near future. Indeed there is a lot of talk about "labor shortages" -- we see signs on restaurant place mats and behind cash registers encouraging people to apply for jobs -- and perhaps some tendencies for wages to rise. Time will tell.
This experience seems to give some support to part of the supply side approach, but not much support to the specific proposal to cut taxes. On the one hand, it shows that an increase in Aggregate Supply can, in some cases, lead to rapid decreases in the government deficit. On the other hand, there has been no supply-side tax cut, and the shift in supply must have come about for other kinds of reasons. One might argue that the "welfare reform" that reduced eligibility for transfer payments was a successful supply-side policy, in that it induced people to get jobs and thus shifted aggregate supply. But one could also argue that the "reform" only worked because of the lucky coincidence that it came along at the same time as a labor shortage that continues to run ahead of the supply of labor, even now. Perhaps eventually we will have evidence enough to determine which of these interpretations is true, if either.
No one has ever doubted that a supply-side stimulus would be a good idea, if it were possible. The question is: is it possible? On the one hand, it seems a bit clearer that Long Run Supply and the NAIRU are not constant, but quite variable. That could give hope to the idea that government policy might change them deliberately. On the other hand, changes in supply and the NAIRU seem to be unpredictable. That suggests that we do not (yet?) know what policies will reliably stimulate supply, and that we may need to keep flexible to adapt to changing aggregate supply by policies that change aggregate demand.
Chapter Summary
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