Supply side economics postulates that tax cuts and deregulation will lead to increased investment and economic growth. Supply side economics was popularized under US President Ronald Reagan and became the basis of the “trickle down theory,” which is that economic gains by the wealthy will “trickle down” to the poor. It was epitomized in pop culture by the famous Laffer Curve, formulated by supply side economist Arthur Laffer, showing that high tax rates purportedly discourage savings and investment, while lower tax rates do the opposite.
The title of this column doesn’t refer to this type of supply side economics, which has been shown to be “voodoo economics,” in the words of former US President George Bush. Wealth didn’t “trickle down.” Rather inequality and fiscal deficits widened.
By supply side economics, I mean the study of the supply side: what constrains production and increased capacity in order to well, increase supply. The reason we have to do this kind of supply side economics is the imbalance we are now seeing with the global economy starting to recover from the pandemic. Prices are rising because supply can’t meet demand.
A number of factors are causing these supply issues: shortages in labor in developed markets; limited supply of critical components like computer chips; energy shortage in China, a major global manufacturer; and problems along the supply chain, from shipping to trucking.
Supply side economics had never been a real focus of economics before, especially in the West. This is because the principal problem, before the pandemic, that Western economies were facing was lack of effective demand, rather than lack of supply.
The main pre-pandemic economic issue for developed economies was “secular stagnation,” a theory of economist Alvin Hansen proposed in the 1930s but resurrected by Harvard University economist and former Treasury Secretary Larry Summers. It’s about savings exceeding demand, but monetary policy, or low interest rates, unable to bridge that gap. Economies, therefore, face persistently low investment demand, and therefore, low growth, according to Summers.
In the US, a robust fiscal policy and aggressive monetary policy in response to the pandemic has caused inflation to spike, and there’s real fear that the stagflation of the 1970s will recur.
However, Larry Summers himself says that the phenomenon of demand exceeding supply may just be temporary as long-term interest rates are very low or negative. In other words, the markets are predicting that secular stagnation will persist. The Japanization of the global economy, meaning a scenario of low growth, low inflation, and declining GDP growth per capita, will remain the main problem of the global economy. The structural problems depressing demand — the demographic decline, the growing income inequality, the exhaustion of globalization, and the fall in total factor productivity — haven’t been swept away by the pandemic and will return.
On the other hand, lack of capacity and supply remains our problem and it would be well for us to focus on supply side economics. Our growing trade deficit (we increasingly rely on imports to solve our domestic supply problem), our inability to export and our low investment to GDP ratio show that capacity and supply remain our problem.
Moreover, unlike much of the world, we have a young and growing population that can be a source of sustained demand. Also, our population’s average low-income levels result in high propensity to consume. Say’s law: supply creates its own demand, still applies to us.
We should therefore ask ourselves — what are the factors constraining capacity and supply? We should do an industry-by-industry analysis to pinpoint specific industry constraints, but I will venture on a few hypotheses that apply across the board.
One is self-imposed capacity limits. I’m referring to quantitative restrictions on agricultural products. The quantitative restrictions on corn imports, for example, affect the supply of feeds to the livestock industry. Therefore, by maintaining quantitative restrictions on corn imports, ostensibly to protect our local corn farmers, we are imposing a capacity constraint on our livestock industry.
Another self-imposed capacity limit is that imposed by the agrarian reform law, which caps the land retention limit to five hectares. What this tells successful farmers is that they aren’t allowed to expand beyond five hectares. That’s strange because if you are a successful farmer producing P5 million on your five hectares of land and your neighbor is producing only P500,000, government says you shouldn’t buy him out and make the adjacent land as productive as yours.
With these self-imposed capacity limits, is it any wonder that the country has the worst balance of agricultural trade in Asia? We keep decrying food imports, yet do everything we can to limit our production potential.
Another policy that constrains supply is price controls. For example, the government, wanting to appear populist, recently issued price caps on medicines, specifically 34 drug molecules or 71 drug formulas through Executive Order (EO) 155. With these price caps, expect pharmaceutical companies to limit supply not only of these medicines, but also new and innovative medicines, lest government impose price caps on them too. Moreover, expect the generic distributors to sell at or near the price cap.
Price controls are never good. A price cap on peak power rates, for example, disincentivizes investment in peaking plants, and therefore limits our energy supply and our ability to satisfy energy demand in cases of sudden supply shortage.
Three is blanket bans. The government has issued a mining permit ban and an open pit mining ban, which has not been lifted. Instead of smart risk-adjusted policies to counter environmental damage, the government has been quick to issue blanket bans. This is a very dumb and lazy way to manage risks. However, the overall result is that the entire industry suffers and capacity is capped.
Fourth is property rights uncertainty. Do you know that the government has issued 26 log bans of varying degrees since 1975? If you are a tree farmer, will you invest, not knowing if you can harvest after the long maturity cycle of trees from 10 to 20 years?
Property rights uncertainty is happening with PPP projects. Can the government hope to attract investments for projects if it unilaterally changes contracts and refuses to abide by decisions of international courts? Instead, what the government will attract are politically connected bidders who believe that their political connections (payoffs) will provide them some form of insurance.
Uncompetitive industry structures — the Philippines being the most concentrated economy in Asia — also cause capacity limits. Without fear of new entrants, monopolies will not invest in additional capacity that may lower prices, but rather optimize its monopoly rents. Pro-competition and anti-trust policy is therefore necessary to expand supply.
Another uncertainty that is capping investment and supply is energy insecurity. Successive governments have failed to bring new energy sources online. In the past summer, the energy outlook went on yellow alert since the reserves were quite thin and the country’s aging power plants could break down at any time.
Now, what rational investor will expand his factory capacity if he believes, given the government’s failure, that his plant will become idle or frequently shut down by power blackouts? Energy intensive industries like cement and steel are particularly sensitive to energy supply.
Again, while the BBB will perk up the demand for cement and steel, imports will fill the demand because the government hasn’t given investors energy security.
Finally, a lot of our laws, particularly our Constitution, signal to investors that they aren’t welcome here to invest and expand the nation’s capacity. The Filipino First and Filipino Only provisions in the Constitution signal to foreign investors they aren’t welcome here to increase capacity and provide consumers better and more affordable choices.
Let’s be clear-headed: the issues facing Western economies are different from the issues facing us. They have a demand problem, which is very much harder to solve. How, for example, can you reverse demographic decline? Instead, we face supply and capacity problems, which are within our powers to solve. We just need to do supply side economics.
Calixto V. Chikiamco is a member of the board of IDEA (Institute for Development and Econometric Analysis).
