Paul Krugman thinks the War on Demand is strange. I think it's weird. But I've got a different take on what's happening.
[Update: Paul Krugman responds.
"Nick Rowe makes a good point: most of the time, in market economies, sellers feel constrained while buyers don’t. I’m somewhat surprised that he doesn’t mention why: it’s because perfect competition is actually rare, because oligopoly or monopolistic competition — in which prices exceed marginal cost — is actually the norm."
I totally agree. This is a point I've been pushing in the past more than once. Just didn't feel like repeating myself again. ]
Let's start with some very basic theory. It takes two to trade. A buyer and a seller. If the buyer is willing and the seller is willing, there's a trade. If the buyer is not willing there's no trade. If the seller is not willing there's no trade. Quantity actually bought and sold is whichever is less: quantity demanded; or quantity supplied. Q=min{Qd,Qs}. That's the short side rule. The short side of the market determines the quantity traded.
Most people figure this out.
Now look around. Not just here and today, but anywhere, at any time. (OK, maybe not Cuba or North Korea.) Everywhere you look you see people trying to sell more. If you want to buy something, and are willing to hand over the money, you can nearly always buy it. The seller is almost always able and willing to sell you one. Very willing. Would you like to buy two?
The short side of the market is nearly always the demand side. Quantity supplied is nearly always more than quantity demanded. It's easy to buy, and hard to sell. Any fool can be a buyer. A job in sales is hard work.
Put theory and observation together. If you increase quantity supplied, without increasing quantity demanded, nothing will happen. But if you increase quantity demanded, even if you don't increase quantity supplied, the quantity bought and sold will increase.
There's a limit of course. If you increase quantity demanded too much, without increasing quantity supplied, eventually quantity demanded will exceed quantity supplied, and the seller will be on the short side of the market. But we so rarely seem to hit that limit.
That's how the world should look to somebody with no economics education. The policy conclusion is that we should almost always increase demand, at least a bit. It will almost always make us better off.
For many people with just a little economics education, the world looks just the same way as well. The Keynesian Cross model teaches the same thing. It is demand that limits output and income, not supply. The Keynesian Cross model is a very dangerous model. It should be kept on the Index of books that only economic Jesuits secure in the true faith should be allowed to read. Instead it is regularly taught to the masses in first year macroeconomics. And the limitations of that model are taught in more advanced courses for those entering the true church.
If there's one macroeconomic model that journalists and educated lay people vaguely understand it's the Keynesian Cross. And that vague understanding filters down into an even vaguer understanding by the masses.
So what's really strange is that we could ever get people to believe that demand is not the problem.
For decades my job has been to teach students that, despite the evidence of their senses, and contrary to their hearsay of the heretical teachings of the Keynesian Cross, aggregate output is basically supply-determined. Which it is. Basically. Though short-run fluctuations in demand can and will cause short run fluctuations in aggregate output around an average level that is determined by the supply-side.
And, for once, the memories of their parents are actually supporting me in my job. Look what happened in the 1970's, when demand increased. Printing too much money and increasing demand really did cause inflation. It really didn't make us all richer. It didn't reduce unemployment.
Now, just for once, we have to switch gears. These times are not normal. Just for once, the demand side really is the problem. Just for once, the overly obvious truth your senses are telling you really is the truth. Just for once, your parents' experience of the 1970's doesn't apply. Just for once, it really is OK to have a drink, even though you are a recovering alcoholic.
Worthwhile Canadian Initiative 
“Using money makes your economy fundamentally different in nature (not degree) from a coconut island economy.”
Perhaps. But REAL “coconut island” economies were also fundamentally different in nature from the imaginary ones conjured by economists. Real coconut island economies had money AND they had gift exchange. Barter was an anomaly that took place at the boundaries. The notion of a barter economy is an anachronistic back projection from market economies already incorporating money and debt. Has there ever been a “barter economy”?
Sandwichman, very interesting comment. Gift economies are generally modeled as a kind of “reciprocal altruism”, in which you make useful gifts to others in the community because these have pre-committed to making gifts in return.
Clearly, gift economies have some advantages in terms of transaction costs/benefits, at least within limited social groups. For instance, we exchange gifts in the holiday season because we like nice ‘surprises’ and as a form of social bonding. Unfortunately, our knowledge of gift economies is very limited, so we do not know how efficient they are and whether they are immune from conventional demand-side issues.
Yes, monetary issues are clearly irrelevant, since gift economy is basically barter + a vague account of “favors owed”. But if money was the only issue, why not advocate complementary community scrip, which is closer to a market solution?
Jacques Giguere: “Physicists and other “real” scientists, even the theoretical ones, live by experimentation. When new facts arrive, they have no mental blocks.”
And idealization. “Science marches on, funeral by funeral.”
Whether they exist or not. We need to imagine barter economies, for two reasons:
1. Because for some questions money might not matter, and it’s simpler to understand it if we ignore money.
2. Because for some other questions money might matter. And we can understand better why money matters if we can imagine a world without money, and compare the two.
This is economics without scarcity, without re-coordination, and without non-permanent production processes that must constantly replaced and updated.
Are we back to secular stagnation economics?
“Quantity supplied is nearly always more than quantity demanded.”
Greg: no. It’s just what you get when you take a standard model and assume monopolistic competition instead of perfect competition.
http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/11/excess-supply-under-monopolistic-competition.html
I see nothing terribly wrong with imagining barter economies. It might well be a useful strategy for finding answers to questions where “money might not matter” (if there are any such questions).
What I’m wondering, though, is whether it is useful to also pretend that such imaginings are realistic, primitive, foundational or really all that simple. They may indeed look simple to us because we already possess the conceptual rudiments of commodity exchange. Starting from that concrete experience, we can easily repress the idea of money and debt and come up with money-less, debt-less barter. Voila! But how simple would it be to explain such a concept be to someone who had no such experience?
I don’t think this is a hypothetical or academic question either. There is an extraordinary investment in the myth that Say’s Law is the law of nature, which is of course elevating a special case to a first principle. Wouldn’t that constitute a fallacy of composition?
Sandwichman: actually, when you model a barter economy really properly, they can be more complex than a monetary economy. Because they have a lot more markets than a monetary economy. So there isn’t just one demand for apples. There are n-1 demands for apples (assuming n goods). What economists call a barter economy is usually really one with a centralised exchange. Where all goods exchange for all goods all at once.
Nick, so then you’re conceding my point that a barter economy only appears simpler than a monetary one? Or are you now claiming that a barter economy is BOTH simpler AND more complex than a monetary economy?
I use the coconut-only example as a counterpoint to money-using one as a teaching device.My students are in cegep, not graduate school. They don’t read academic journals but newspaper op-ed by Chamber of Commerce type who clearly believe we live in a coconut-only,not a multiple markets + gifts, universe. They don’t call it coconut. Usually it’s “you economists haven’t met a payroll but we really know.” I must protect these young vulnerable souls before they succumb to the sirens of Commmon Wisdom punditry and hand them to you undamaged for their BS and PhD…
Behind the “La Presse” paywall (and you can dredge up the same sludge from your favorite ROC or U.S. business publications), I could show you letters from financial types, one even boasting that students should take more economics course so they could understand how Say’s law prove there was no recession ( in fact he talked about Bastiat, showing how confused an MBA will leave you…). In business schools, they don’t show you what money does, just how to steal it…
Of course there are currently no, and have not been for a long time, real (non-currency using)economies, because money is so useful. Imagining them is not for me but for explaining how the guest on the Newshour will falsely explain what’s going on.
Most people still haven’t understood the consequences of inventing money. And that those consequences show up only when enough people effectively use money. There were no recession in Imperial Rome or during the Middle Ages. The first one we can clearly identify is in England (1815) and the first where monetary policy was used as counter-cyclical tool was in 1825 (England again).
Same kind of people who could not understand that if you don’t accept payment in kind and forbid Germany to export, they won’t be able to pay reparations after WW1 ( not that they ever intended to pay but still).
Same kind who rejoice about a trade surplus one week and next week worry that capital is leaving. That “business” columnist was so-bad-it’s-funny that at the annual ASDEQ (Association des Économistes Québécois) meeting we had a bunch of us holding a dinner to award him the worst column prize of the year ( he was the sole contestant, nobody could rival him. A Steven Seagal of business punditry).
Same kind who tell you (last week in Le Devoir) that an appliance manufacturer had closed its plant because the public debt is too high.
Those people are in command of the public conversation, not us. Be afraid, be very afraid.
There’s little reason to believe that either construction describes the world — the problems with the monopolistic competition model are as well known as those with the perfect competition model (or, should be).
Nick writes:
“It’s just what you get when you take a standard model and assume monopolistic competition instead of perfect competition.”
Has there ever been a “barter economy”?
Yes. Ancient Egypt had one, though they had standardized official goods exchange rates ad were pretty much a centrally planned economy (and a successful one, at that), so only the Marxist central-planning economists are likely to study that.
Mesopotamian economies had a pure barter economy prior to the Proto-Sumerian invention of tokens representing goods After that, they developed into an economy with money but lots and lots and lots of different units of money — cow units, goat units, sheep units, etc. It took quite a long time for generic money to appear, hundreds of years.
“Most people still haven’t understood the consequences of inventing money. And that those consequences show up only when enough people effectively use money.”
Yep. There are an awful lot of ancient economies, even after the invention of money, in which money-shortage wasn’t an issue; anyone could and did manufacture scrip or credit as needed, or revert to barter. Only with the rise in trading among people who didn’t know each other well, and therefore didn’t trust that they’d be able to get satisfaction from a witnessed promise, did money become critically important. (That was always what it was used for, deals with distant strangers, but that was a minority of trade in the ancient world.)
I think the point of dispute here is the comment
“For many people with just a little economics education, the world looks just the same way as well. The Keynesian Cross model teaches the same thing. It is demand that limits output and income, not supply. The Keynesian Cross model is a very dangerous model. ”
In reality the economy is almost always less than at full output. It is unable to employ everyone. There is typically large numbers of potential labor hours — e.g. 15% or so — that are left idle due to the failures of the free market.
If they don’t teach that in grad school, it is a failure of the models taught in grad school.
It’s almost always the case that government, if it were to marshall these idle resources or increase demand, would result in more output produced, not just higher prices. The rare case is the one in which additional deficit spending or external demand increases do not result in increased real output. The situation of the 1970s and early 1980s in which rate hikes driving businesses under is actually good for the economy — that is the unusual situation, the atypical situation.
Printing too much money and increasing demand really did cause inflation. It really didn’t make us all richer. It didn’t reduce unemployment.
Yes, but did inflation make us poorer in real terms and did it worsen unemployment? And would the opposite reaction, i.e. ‘printing’ less money, have made things better? From observing that one particular policy did not work under one particular circumstance it does not, ever, follow, that the opposite policy would have worked better. Supply constraints or external cost pushes that limit the powers of demand management don’t mean that demand should have been ignored and supply measures favoured instead. It means that both sides should have been attended to simultaneously.
Demand vs. supply is a false choice. If pushing demand leads to inflation instead of causing unemployment to go down, that is a sign that there are supply-side bottle necks that need attending, not that demand has been pushed too far.
RSJ: “It’s almost always the case that government, if it were to marshall these idle resources or increase demand, would result in more output produced, not just higher prices.”
That does not follow, unfortunately. That’s what they teach you in grad school (and in undergrad). Even if there is excess supply, it does not follow that shifting the demand curve to the right will increase output and employment. It depends on how prices adjust. And that in turn may depend on whether the increase in demand was expected or not. And that in turn will depend on the whole policy regime, not just this particular instance.
It took us a long time to learn this stuff. Not that we have really learned it. But we have learned that it really isn’t as simple as it looks.
In other words, what we learned is that the question “Will increasing demand in circumstances X have good consequences?” doesn’t make any sense. Instead we have to change the question to “Will following a policy of always increasing demand in circumstances X have good consequences?”
It took us a long time to understand the difference between those two questions.
It’s similar to the difference between taking $100 away from someone who drives at 110kms/hr, and passing a law that says you will be fined $100 if you drive at 110kms/hr. They aren’t the same. They don’t have the same consequences. The first is a policy action. The second is a policy regime. Drivers’ behaviour responds to the policy regime.
It is very easy to build a model in which an action of increasing demand will always reduce unemployment. But where a policy of increasing demand will have no effect on unemployment. And it’s got nothing to do with bottle-necks and stuff like that. That’s what we learned between 1970 and 1980.
Yt=Mt-Pt where Yt is output, Mt is money supply, Pt is the price level, all at time t.
Pt=E[Mt/It-1] where E[Mt/It-1] is the expectation of Mt conditional on Information at time t-1.
Mt= m+Ut where Ut is a random variable with E[Ut/It-1]=0
The equilibrium is Yt=Ut
An increase in the money supply will always increase output. But a policy of having a higher money supply (an increase in m) will have no effect on output.
I understand the points you are making, but look, prior to the Great Depression, the industrial economies, or the non-farm sector of the industrial economies, was persistently unable to employ about a fifth of the labor supply. Government was consuming a tiny sliver of output — say 8%. After the Great Depression, government consumption of output rose to 20%, with large and persistent deficits, and the trend unemployment rate was cut by more than a half. That was a policy shift.
Now the theories have no explanation (or even acknowledgement) of either the persistent unemployment (in both booms and busts) prior to the big government regime, nor the change that occurred subsequent to that. If they have no explanation for the permanent output gap, then they can’t predict the consequences of government intervention. The economy is almost never at full employment — it’s not even near full employment in the best of times. And there is no explanation for why this bottleneck would diminish when government consumes more output, even if the money supply is unchanged.
Given that the theory has so many holes, why do people believe it?
RSJ: You mean theories of the natural rate of unemployment? There are loads of theories.
Why do you think the historically observed unemployment rates were the NAIRU rates? And why would these rates fall as a result big government — did the introduction of minimum wage laws and unions lower NAIRU? Can the theories predict NAIRU? Are they testable?
Nick,
What if supply is induced by demand (by, say, the interaction between the multiplier and the accelerator – I have sometinhg like Hicks’ supermultiplier in mind)?
Hence, increases in aggregate demand would induce increases in the economy’s productive capacity.
What’s the mistake in this vision?
Rafael: I think there’s some truth in that theory. (OK, yes, “vision” is a better word). But does productive capacity increase quickly enough and strongly enough to catch up with the increased demand?
I’ve never seen anyone work out a model which did that. (Maybe it’s been done, and I didn’t see it). But it would be an interesting idea to play with. Full-blown hysterisis. Multiple equilibria.
I meant view!!! Sorry for my bad english! I was writing quite fast…
Seriously, Hicks did something like this:
http://www.jstor.org/pss/1910587 – Toward a Dynamic Theory of the Cycle by Alvin Hansen
or you can try this link: http://homepage.newschool.edu/~het/essays/multacc/hicksacc.htm
I think this class of models generate crazy dynamics. Once you simulate them, they give you too wild output swings.
(Now I’m being provocative) There’s an obscure economics school called “Sraffians”, they and post-keynesians have similar views about some issues. And they write stuff like this book: http://www.amazon.com/Theory-Economic-Growth-Classical-Perspective/dp/184376010X (See Fabio Petri’s chapter about demand contrained growth).
And this thesis: http://www.uni-graz.at/schumpeter.centre/download/summerschool09/Literature/Serrano/supermultiplier_dissertation.pdf
In a modern capitalist economy, the service and technology/information based industries are dominant. Services are provided on demand and technology/information based production uses forward contracts and “just in time” techniques to supply subject to demand orders. Then supply output is demand determined. Under conditions of imperfection (assymetry, heterogeneity, disintegration, dispersion)and complexity where transactions are not market mechanisms but processes, it can be shown mathematically that supply sets prices and demand sets quantities. Furthermore, prices incorporate a term that expresses the demand variance expected by suppliers adjusted by a response elasticity and calibrated by a surprise factor.