Economic News & Analysis—July 16, 2012

Retail sales: Reopening the "supply or demand" quandary

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist, and John Manley, CFA, Chief Equity Strategist

Monthly sales for retail trade and food services dropped in June from May, according to the advance report from the Census, which shows that:

  • The number of vehicles sold in June increased, but the dollar amount of sales dropped, showing that pricing pressures could hit automobile manufacturers’ profit margins if they can’t cut costs fast enough.
  • Clothing and food sales increased, but the increase in food sales could be due to price increases—or, it could be because people were buying an unusually large quantity of cool beverages during an obnoxiously hot June.
  • Despite the slowdown in retail sales over the past few months, retail sales, year on year, are up 3.8%.

The slowdown in sales is another piece of evidence that the economy is slowing. It will probably also rekindle debates about how to best rekindle the economy. Monetary policy is unlikely to have much effect on the economy (do banks not have enough excess reserves or are government yields not low enough?), though it could temporarily boost the financial markets. Fiscal policy seems to be hamstrung, not by a divided government so much as a divisive one.

What ails the economy—supply or demand?

Some of the political debate about what ails the economy reminds me of the ancient question, “Which came first, the chicken or the egg?” Philosophers have debated this for centuries (I think even Plato and Aristotle disagreed about the right answer). Statisticians have tried to measure it without coming to a consensus.

Maybe the answer is neither came first—it was a tie.

Perhaps that’s true for the economy as well. Some argue that the problem right now is a lack of demand: If you want the economy to grow, you need more demand, and the government can step in where the private sector has been lagging (labeled “Keynesian policies”). Others argue that it’s a lack of supply: Managers of businesses need better access to credit and lower tax rates to spur production (labeled “supply-side policies”).

This is an ancient debate in economics: Which came first, supply or demand?

The 19th century economist Jean-Baptiste Say said, “Products are paid for with products.” In other words, to consume, you must first produce. John Maynard Keynes, the 20th century economist who gave birth to Keynesian economics, paraphrased (and—in my opinion—corrupted) Say’s Law when he stated, “Supply creates its own demand.” This has since been taken to mean that producers dupe consumers into buying things they don’t otherwise need through advertising.

Keynesian versus supply-side economics—or something in the middle

For those who are interested in the economic origins of the debate, think of it as coming from different interpretations of a rather famous—and simple—model of the economy: Y=C+I+G+NX. Total spending (Y) is equal to consumption spending (C) plus investment spending (I) plus government spending (G) plus net exports (NX, which is exports minus imports, as part of domestic spending is on imported goods and part of domestic production is bought by foreigners). In an economy in which one person’s spending is another person’s income, total spending (Y) is also equal to total income (Y). Keynesians tend to think that if you want to spur the economy (increase Y) you need to focus on the right-hand side of the equation: Slow growth is due to insufficient spending. The government can then step in by being the “spender of last resort.”

People with a supply-side orientation tend to focus on the left-hand side of the equation (Y). A supply-side orientation would tend to start with saying output (Y) is a function of the technology available and the various inputs into the production process (the “factors of production” categorized as land, labor, and capital). Thus, if you want more Y, businesses need to employ more inputs or improve the way they combine the inputs into making outputs. This creates more production, which creates more real income—income that can be spent. Government can help by cutting taxes on production, promoting freer global trade, lowering regulatory burdens on business, and lowering the costs associated with hiring more workers.

I think the answer is somewhere between the two extremes of demand-side and supply-side solutions, as the market requires both producers and consumers. Government spending doesn’t necessarily lead to permanent increases in growth, and businesses don’t tend to invest in producing more unless managers think their output will be sold. It takes supply and demand.

Tax policy can address both supply and demand

Not increasing taxes is a solution that addresses both supply and demand at the same time. There are approximately 1.2 million businesses that are taxed at the individual level whose owners make more than $200,000 per year—the group President Obama wants to target for tax increases. Not raising their taxes could at least prevent a further obstacle to their expanding—or not contracting—their businesses.

There are also more than 142 million people employed in the U.S. that are affected by the two-percentage-point payroll tax cut that is expiring at the end of the year. Not forcing a pay cut on these people by extending the payroll tax cut couldn’t hurt in terms of propping up—or at least not dragging down—consumer spending.

Don’t expect any compromise or answer before the November elections. Most likely, the result will be an extension of current policy into early 2013, when the next session of Congress takes up the task of crafting policy. Until then—and even after then—expect to hear a lot of debate about which came first, the chicken or the egg.

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