While the economic response to the COVID-19 economic crisis has primarily focused on the infusion of Aggregate Demand (AD) by the government, it is important to not forget another core driver of growth – the supply side.
In every recession, AD declines, unemployment skyrockets because the private sector cuts spending on consumption and physical investment in new houses, business equipment and structures. To get the private sector going again, the government makes up for the spending gap by greatly increasing its own spending. This has been particularly true in this recession with the official interest rate close to 0 already.
In a recent virtual speech to the Australian Business Economics, Productivity Commission chairman Michael Brennan argued that the state of the supply side of the economy was crucial to our success in having the economy recovery as quick as possible. The state of the supply side is not substitute for demand side stimulation, but it is an important supplement.
He argues that supply side policy is an important enabler of the recovery for which without demand-side stimulus is incomplete or compromised on its effectiveness. Supply side economics generally focuses around improving resource allocation and dynamic efficiency – the speed at which the economy can move from one state to another.
There are three main ways that micro-economic policy can help even in the midst of a recession. First, the economic recession is not just a demand shock but a reallocation shock. When the economy eventually recovers, some industries will be larger, some smaller. Workers and capital will have reallocated between industries and locations. Entrenched onerous expenditures will be slashed and unprofitable business decisions that were hard to get rid of during good times will be stopped. Secondly, reform is needed to facilitate the forming of new businesses and offset the “belief scarring” faced by entrepreneurs as they worry about the heightened risks of future disruptions. Governments can address this by streamlining the approvals processes for businesses, improving the culture of regulators and reforming insolvency rules amongst other ways. The third way is to make the economy more resilient by minimising the impact of future recessions on the economy.
These proposed reforms, as proposed by Brennan, would leave the economy better off. However, unlike macro-policy measures, the effects of micro-reforms will take years to unfold as behaviour and norms change slowly. Rather than being cynical of their ineffectiveness, any reform conducted now will come just in time to help us with the next economic crisis.
