OK, I've said that Joseph Stiglitz gets Aggregate Demand wrong. It's only fair that I say that Bryan Caplan gets AD wrong too, for much the same reason.
Where are you Mark, Paul, and Brad? Seriously, you're not allowed to do any posts criticising Bryan Caplan for this, until after you have said that Joe Stiglitz is wrong too! It's only fair!
But, curses, I have exams to mark. And I really shouldn't be spending the time to explain fully why Bryan is wrong, until after I've marked my exams.
So here's a quickie:
Bryan Caplan and Joseph Stiglitz are making the same mistake. They are forgetting that income = output. And in a demand-constrained economy, output is determined by output demanded. And output demanded depends on output (=income). The only way to increase output in a demand-constrained economy is to do something that changes that relationship between output demanded and output, so that more output is demanded for any given level of output. That's what monetary and/or fiscal policy are supposed to do. All that micro stuff, messing around with relative prices like the price of food (Stiglitz) or labour (Caplan) won't do anything unless, as a by-product, it happens to change the relationship between output demanded and output.
Macro is not the same as micro. The micro labour demand curve slopes down because it assumes that the extra output produced by the extra workers can in fact be sold. But that's precisely what's at issue here. Otherwise, wage cuts simply cause an equal cut in prices, or else cause a change in the distribution of income only. Unless price cuts cause AD to increase (which depends on how monetary and/or fiscal policy responds), or unless a change in the distribution of income causes AD to increase (which depends on relative marginal propensities to hoard), they won't increase AD.
And none of this applies to me (though it might apply to them others):
"At this point, Keynesians could just bite the bullet: "Wages must fall!" But in my experience they don't – and I don't think they're going to start now. The reason, I'm afraid, is politics. Keynesians lean left. They don't want to say, "Wages must fall!" They don't want to think it. "Wages must fall!" sounds reactionary – a thinly-veiled reproach to centuries of anti-capitalist intellectuals and militant unions."
I'm no pro-union lefty.
Off to mark exams. Too bad. I ought to do a much better job on this, and write about Say's Law: where it's right, and where it's wrong. Because that's what's at root here.
Worthwhile Canadian Initiative 
I think that Caplan addresses the ambiguous nature of wage cuts. They could result in higher aggregate income if enough work is created by the lower wage. I am not sure about his conclusions because I do not have enough knowledge to truly evaluate them, but they do seem to follow some logical path. I am a firm believer in Say’s Law, so I would be very interested in hearing some valid criticism of it.
Peter A: “They could result in higher aggregate income if enough work is created by the lower wage.”
Which is exactly where he’s wrong. He’s assuming the conclusion.
Put “Say’s Law” in the search box on the right.
I didn’t get into much of the rest of Caplan’s post, which you cover here – but I couldn’t even get past the first paragraph without thinking he’s wrong: http://factsandotherstubbornthings.blogspot.com/2011/12/caplan-on-wages-and-labor.html
Nick Rowe
I read some of the things you have written about Say’s Law. I guess I have always assumed that prices are flexible enough to eventually clear all markets. Walrasian equilibrium has a strong hold on my thought processes. I am obviously not as well read on this subject as the majority of commenters. Thanks for pointing me in the right direction.
Peter A –
Markets may indeed clear – a balance between goods offered for sale and goods demanded may indeed by struck. But there’s no guarantee that that balance will be struck at a full employment level, which is what we are really concerned about.
Of course, because of the very monetary issues that Nick has written a lot about, in the short term (aka – the time span we experience life in) monetary economies can propagate disequilibria into general gluts.
The idea that the economy is constrained by demand is the most preposterous thing I have ever read on an economics blog. There is absolutely, positively no possibility of reconciling that statement with the fundamental theorem of economic science: The economy consists of unlimited wants and limited resources.
But because all Keynesian/Monetarists believe in polylogism (“Micro is not the same as macro”) we can expect nothing less. We as a species are therefore doomed to want fewer things in aggregate than we do on an individual basis. Figure that one out.
No wonder Peter Boettke repeatedly asserts that consistently applying the most basic economic theories is one of the most intellectually demanding things an economist can do.
Ryan: it ought to be a preposterous thing to say, but it isn’t. Because we live in a monetary exchange economy, not a barter economy, and demand for goods is totally ineffective unless it’s backed by a willingness to supply money in exchange for the goods you demand. An excess demand for the medium of exchange screws up all the other signals that people would otherwise send about wanting more goods.
Ryan: this is why Nick evoked that Say’s Law. Try to think about it – do you think that there could be overhang of supply on a particular market? If the answer is yes, do you think that there can be overhang of supply on the market of newly created consumption goods? And this is where Mr. Say says no. He says, that people participate in economic activity meaning they create goods only as far as they want to to obtain other goods from other people. But this has been proven as wrong, and the reason is the existence of money. One can truly desire to work and produce – but not in exchange of the product of other people, but just to obtain the medium of exchange. If this behaviour prevails on aggregate, all participants have to fail because one’s expenditure is another’s income. The solution is to generate enough nominal demand so that they can satisfy their need and move on without any damage to real economy.
What JV said.
I’m not sure you’re right that this is the same Stiglitz mistake or that it is a micro-macro mistake. I think it’s actually a reflection of the key difference between how you see a monetary recession and how, say, Scott Sumner sees one. Let’s say you thought the only nominal problem was sticky wages. That is, that demand-recessions are really about relative price distortions disrupting the market for labor amid deviation from a nominal income trend. From this perspective even though Sumner or maybe some NKs might describe a recession as about AD, it really can be equally described as about AS once it reaches some kind of quasi-equilibrium of excess unemployment. It seems like you could have what is essentially an AS fix to this problem so long as that fix didn’t cause a secondary AD problem.
So if we’re in one of these recessions, then what would determine whether lowering wages would clear the labor market and thus bring output back to potential where demand=output? I think the answer is how lowering wages would interact with Fed policy. That is, would lowering wages somehow cause the Fed to engage in a policy that subsequently puts pressure on nominal variables such that the lower-but-still sticky wages are again rendered too-high? This kind of reaction function doesn’t seem impossible to imagine, but it does seem unlikely. I think it seems okay for Caplan to assume that the Fed would not counteract the AS benefits of this new policy (far more so than allowing Stiglitz to assume that the natural interest rate was negative 10% of whatever in 1929).
In Krugman’s model lower wages seem to lead to deflation, which implicitly assumes some kind of reaction function from the CB which allows a departure from its pre-wage change inflation target. Then he makes the somewhat odd claim that deflation won’t work in a liquidity trap (because it is really a form of increasing real money balances and monetary easing of that sort is worthless at the zero bound). He also argues that this deflation (which again is dependent on some sort of CB reaction function) would cause debt-deflation problems.
On the other hand, I think you see monetary recessions , including the aftermath, as about more than just sticky wages (am I right?), but about a continuing shortfall in the supply of the medium of exchange relative to demand for all things (i.e. not just labor but goods and services, perhaps with some price distortions thrown in). In this world Caplan’s argument does seem misguided, but I don’t think this is the world he is assuming.
JV/Nick,
Income = expenditure.
The “overhang of supply” to which you’re referring can only be generated if someone pays for it. I can only accumulate “the medium of exchange for the medium of exchange’s own sake” if someone is willing to pay me the medium of exchange. Whatever I happen to be saving in the short run is actually the money that someone else is spending on me over the same time period.
The argument is circular. What you’re doing is holding one side of the same transaction constant. My wages “don’t count as AD,” but my income does. How is that possible?
One explanation might be that wages are “I” and my income is “C” whenever I spend it. Since “I” doesn’t change but “C” goes down, then we’ve experienced an AD shock. But 0.97 of every dollar I keep in the bank ends up as “I” via the stock and bond markets. Is my savings then paying for my own salary? Another circular argument…
Another way to look at this is that if “money is just another good,” then demand for money is also part of AD. Excluding it from the calculation understates AD makes it look like AD is a real problem. But imagine a situation in which society’s demand for Obama T-shirts suddenly EXPLODED and everyone wanted to accumulate literally hundreds of them. The demand for everything else would contract, but we would never count this as an AD shock because people would be spending one good that doesn’t count as AD (the medium of exchange) for another good that does. That’s independent of what such demand would do to the commodities or pharmaceuticals markets or whatever.
The problem is the framework. The problem is that the AD concept allows us all the circular reasoning we need to make virtually any theoretical claim we want. That might not initially look like a problem, but when we get to the point when we are contradicting the fundamental tenets of economic science, we must finally admit that there is a problem.
“consistently applying the most basic economic theories is one of the most intellectually demanding things an economist can do”
Just because it’s “intellectually demanding” doesn’t mean the conclusions are true. I’m sure the study of alchemy is intellectually demanding.
I’ve noticed hot air and nonsense coming from Stiglitz more than once.
Ryan: money is different from other goods in one important way. If you want to say in terms of goods, if you for example wish to save in form of 1000 Obama T-Shirts, the only way to this is to go out and buy those T-Shirts. If Obama T-shirts are sold out because everybody wants 1000 of them, then your desire to buy them will be left unsatisfied, even if you have a lot of money in your pocket. But you may still use the money to buy and “save” in something else. Money however is special. Money can be stored not only by actively purchasing them (e.g. increasing your hours worked and exchanging your labor for money), but money can be saved by not buyng. This is not possible with Obama T-shirts. You will not get your hands on any obama T-shirt by not spending your money prepared for their purchase. That is, individually there is nothing that can prevent anyone from “saving” medium of exchange by buying less.
Then there is your belief, that every dollar you do not spend will be used for purchase if bonds or stocks. Really? And how should this happen? We assume that everyone wants to save, so why would anyone want to sell their stocks or why would government issue any bonds? For someone to sell stocks or bonds they hold in exchange for your labor (if that is the source of income) means dissaving. “Investment” in terms of purchasing new productive capacity and hiring new people to do stuff also means dissaving by the company that is doing it. They are using money earned by selling stocks to purchase labor and machines. So yes – in a world where there is not an aggregate desire to save in terms of money, and where every desire to save is mirrored by someone’s else desire to dissave we do not face the risk of the general glut. But this is not the world we are living now.
Stiglitz and Rowe are walking along on a crowded sidewalk when Stiglitz exclaims, “Look! A twenty-dollar bill!”
“Ridiculous,” Rowe replies, “If there was a twenty-dollar bill lying on the sidewalk somebody would have already picked it up.”
Stiglitz and Rowe are marooned on a desert island. A case of canned food washes up…
JV – In your first point, you are basically saying that money is special because it can be manipulated by a central authority. You’re right, but the justification for this belief is the advent of fiat, floating currency. It’s another circular argument. “We need money manipulators because money needs manipulating.” What happens when I step outside the argument is that it no longer makes sense.
In response to your second point, I was referring to the function of banks and the reserve requirement. Basically, if you’re not going to invest your savings directly, the bank does it with your reserves. You rightly point out that this is “dissavings,” and I agree.
But we don’t live in a world where every government, bank, individual, and importer unanimously declares that they will hoard currency and stuff it under a mattress. The scenario you’re suggesting we live in is one in which the “surplus demand” that went away in the AD shock is currently residing in our checking accounts collectively.
How does that jive with the fact that personal and government debt are both at historically very high levels? It basically doesn’t. What you perceive to be a hoarding of dollars is really a mass-deleveraging. It’s not “savings,” because the money we are talking about was actually consumed in previous time periods.
But given that reserve requirements exist, where did all that leverage come from? Isn’t there only one, unique kind of entity that has the power to create leverage out of thin air, and isn’t that entity called a central bank?
Once we go that far, ACBT kicks in (or PSST if you prefer). The monetarist/Keynesian approach traps us in an endlessly circular debate about how to conduct our GDP accounting. We’re chasing out tails. Looking outside the AD paradigm, we suddenly see the whole answer.
Or at least, that’s how it appears to me.
My interpretation of Caplan is that he assumes final goods prices are more or less prefectly flexible and that wages are the only sticky prices.
When aggregate demand falls, then the price level falls appropriately, but wages don’t. Real wages rise, and firms optimize, and hire less labor, produce less, and so, prices fall too little for real expenditure to match productive capacity.
If wages fall, then prices fall too. And that raises real expenditure, production, and employment.
The story is simplest if you just assume that the initial drop in nominal expenditure is given, and that nominal expenditure on output now stays at that new, lower level. Lower wages allow lower prices, which raises real expenditure to potential output.
But you can instead go with the nominal quantity of money staying the same and real balances rise. Wages fall enough, prices fall enough, real balances rise enough, real expenditure rises back to full employment output.
But why does Caplan bring up stuff like labor demand elasticity and spending out of profit? I guess that all looks bad for my argument.
In some kind of long run, I suppose that even with real output lower, we could see a shift in production technology to more labor intensive processes. In effect, potential output will fall.
Quantity of money drops, price floors on all final goods, real expenditure and real output falls. Surplus of labor. Nominal and real wages drop, eventually. Firms shift to more labor intensive production processes. Full employment of labor. What about capital and saving? Well, the business class fails to replace some of the existing capital goods and instead produces lots of yachts and mansions. When the capital stock is at the lower level (using all of those less capital intensive processes) we settle to a new equilibrium. The workers have a smaller share of a smaller pie. The capitals have a bigger share of a smaller pie.
OK? Full employment due to lower real wages without raising real expenditure on output.
Not a scenario that I (or Caplan, I imagine) finds attractive.
But you can imagine that from a micro perspective, these isoquant effects would be important. And that we macro/money theorists kind of blow over all of that might be irritating.
Ryan: “The “overhang of supply” to which you’re referring can only be generated if someone pays for it.”
Displaying my usual inability to understand the basics. Confused about the role of time, and stocks versus flows, in this discussion.
Nick, I think this relates directly to the idea of “notional” supply and demand that you and I have discussed, and that you’ve suggested is missing from economic discussion. I’ve been trying very hard to wrap my brain around it.
What does (overhang of) “supply” mean at a given instant in time, as represented by a S/D diagram in a particular state?
o The currently available inventory at that moment (wholesale and retail)? A stock.
o Producers’ future ability to create the good? (A flow, necessarily specified over a period — not an instant.)
o Producers’ future willingness to produce/provide the good at a given price? (Again, a future flow necessarily specified over a period of time.)
Wikipedia: “supply is the amount of some product producers are willing and able to sell at a given price all other factors being held constant”
1. Doesn’t this mean the quantity that producers “will be willing and able to sell” over a given period extending into the future? (During which period the S/D diagram will constantly change from instant to instant?)
2. In the context of an S/D diagram depicting a particular “supply” at a particular instant in time, what does “all other factors being held constant” mean? How could they not be held constant in that instant?
Are they talking about “supply” at a given instant, or the flow of “supply” in the future?
Again, notional (i.e. potential future) supply and demand seems to be the key concept here, but that thinking doesn’t seem to be incorporated in the discussion. How am I not getting this?
Education much appreciated as always.
Bingo! I think Steve Roth has nailed it. William Thornton was talking about this little problem back in the 1860s.
“Thornton played a greater part in the history of economic thought. His first edition of On Labour was a blistering critique of the laws of supply and demand and served to mobilise the major players in the burgeoning neo-classical movement – Jevons, Edgeworth, Jenkin and Marshall – to reply with mathematical responses to the debate.”
Suppose the quantity of money falls and there are price floors on all products. Real expenditure falls and real output falls. Firms hire less labor. There is a surplus of labor. Eventually, money and real wages fall.
Now, the firms switch to more labor intensive technology. The quantity of labor demanded rises. The workers consume less bread. The owners of the firm build more mansions and yachts.
During the transition, the owners of the firms get an extra large amount of yachts and mansions, as the old capital goods are being replace by newer, less productive ones.
The productive capacity of the economy has fallen to the given output, and it fully employs all the workers. If the quantity of labor falls due to the lower real wage, the shift in factor shares would be less, but the decrease in total output larger.
I don’t think Caplan favors anything like this. But I think his micro-intuition is bothered that these effects are ignored by money-macro types like me and you.
Really, he is just assuming that sticky wages are the problem and product prices are pretty much perfectly flexible. The quantity of money falls, nominal spending falls, the price level falls, but wages don’t. Real wages rise and the firms do a micro optimization so that real output falls. The price level is lower, but not enough for real expenditure to match productive capacity.
If nominal wages fall, the price level falls, real money balances rise, real expenditure on output rises, production rises, and employment rises.
Caplan understands that process and that is what he has in mind. He might just be assuming that the flow of nominal expenditure on output decreases and then stays constant as prices and wages fall, so that real expenditures fall. But if you pressed, you would get a real balance effect on the quantity of money.
oops.. output was given. If the lower real wages reduce the quantity of labor supplied, then the shift to more labor intensive production methods would the smaller. Still, the capital stock declines.
Ryan:
We don’t live in a barter economy, we live in a monetary economy. In a monetary economy where all goods are sold for money and money is the only thing that can purchase goods. So each good to good transaction is really two transactions: a goods for money sale and a money for goods purchase.
In this world money acts like a noose or chokepoint on the goods market, the stock of money is finite and determines whether the market for each good can clear or not. If the stock of money is reduced (easy, we have confidence-based money through the banking system plus the variations introduced by deliberate banking policy) a certain amount of goods-to-goods transactions will not clear because of lack of money. You will retort prices should fall, to which I respond that in an economy with confidence-based money and intertemporal contracts price decreases will further contract the money supply and cause defaults.
A “general glut” is an excess of goods and a shortage of money. It is a social creation, a product of the rules gone amok to be sure, but the phenomenon exists. An economy can be choked by money.
Ryan: ” … “surplus demand” that went away in the AD shock is currently residing in our checking accounts collectively. … How does that jive with the fact that personal and government debt are both at historically very high levels”
Try this:
Click to access debt_deleveraging_ge_pk.pdf
The basic idea is that debtors get overstretched, have to pull back, and creditors don’t make-up the resulting shortfall in AD. Recession results.
Also, Nick had a post a couple of years ago about patient vs. impatient people and debt. It was a thought experiment about China IIRC, but I think it applies.
Finally, keep in mind that for every debtor there is a creditor. For the world as a whole, net debt is 0. I think Canadian mostly owe money to other Canadians. So what is ‘too much debt’? Well, it’s meaningless. The issue is the distribution of debt: who owes how much to whom and under what circumstances will defaults cascade etc …
Sandwichman:
Are you referring to “just assume we have a can opener?”
Nick,
Here’s a quote from Bill Vickrey on Say’s Law: The supply-side notion that “supply creates its own demand,” a maxim often cited as “Say’s law” simply fails whenever part of the income derived from the production of the supply is shunted aside as savings, without an effective mechanism to insure that the corresponding resources will be utilized for capital creation. Actually, if an entrepreneur obtains an extension of credit from a bank, possibly facilitated by expansion of the reserves provided by the Federal Reserve System, and utilizes it to hire unemployed workers to lay bricks and mortar, then if this is done prudently the capital created is additional wealth that will be directly or indirectly owned by someone. This increase in wealth is ipso facto someone’s savings. Instead of Say’s law, we should have “capital creation generates its own savings.” Saving, unless done by the one responsible for the creation of the capital, is neither a prerequisite nor a stimulus to capital creation. What, say (no pun intended), you?
Nanute: Yes. Or… just assume we have a “law” of supply and demand…
Nick,
In your “insufficient AD” view of the current state of affairs, do you think that we are experiencing an increase in the demand for money (relative to other goods), or a decrease in the supply of (M2-ish) money as credit markets dry up, or some mix of the two?
Is the goal of fiscal spending to jack up the M2-ish measure by increasing the amount of base money?
Or am I misreading this analysis?
If one needs to assume sticky prices for Say’s Law to fail, and one assumes that wages are the only prices that are sticky, what can one say about the necessary wage adjustments to return to an equilibrium consistent with Say’s Law? Or, alternatively, what is nonsensical about my question?
Ken: the difference between first-best and second-best can be quite large. The New Keynesians point out that nominal rigidity can be characterized as a collective action problem – it is in the interest of everyone to change prices and wages, but not in the interest of any given individual to do so. The social and private good is worse off if only a few people adjust. By the same logic, one should be cautious about partial wage adjustment. It only “works” insofar as you trigger an ensuing price adjustment toward general equilibrium. If not you just make one group of people worse off and another better off (i.e., a distributional effect).
“It would be good if prices were at the point were at the point where markets clear” is not the same as “it would be good if prices were closer to the point where markets clear”, so to speak. Improvement is not monotonic in price adjustment.
Thanks David. So some set of wage adjustments would lead to a full-employment equilibrium if all other prices are flexible I suppose? This is the confusing part for relative beginners (like myself). I’m understanding that sticky prices is a necessary condition for potential monetary disequilibrium (or maybe I am misunderstanding this), but few seem to believe that “unsticking” prices would be helpful. Like Caplan (who knows orders of magnitude more than I do), I’m confused as to why wage adjustments is never considered even a potential part of the solution.
For one thing, real wages in past recessions appear to be acyclical (i.e., poorly correlated with non-trend changes in national output), which contradicts the hypothesis that business cycles are due to excessively high or low real wages. We would expect real wages to be anticyclical (i.e., being too high during recessions, etc.). So there is disagreement over whether “excessively high real wages” is even the problem.
For another, where wages (and price) are accepted to be slow to adjust, there are generally also known to be at least some real reasons why this might be so: morale, actual costs of negotiation, actual costs of arranging different payments, etc. Real rigidities can be significant.
The other extreme of the NK position suggests that long-term real wages are in fact flexible in practice (because long-term employment tends to be longer than the business cycle, so rational employers and employees adjust for the long-term) and so focusing on short-term real wages is illusory. The problem is then argued to be in sticky prices (which are rigid for whatever hypothesized reason).
Thanks David. This is helpful. I wonder if Nick at some point would comment in the context of one of his fantastic simplified models.
Fantastically unbelievable, or fantastically illuminating? 😉
Ryan said: “The idea that the economy is constrained by demand is the most preposterous thing I have ever read on an economics blog. There is absolutely, positively no possibility of reconciling that statement with the fundamental theorem of economic science: The economy consists of unlimited wants and limited resources.”
I’m going to add to the preposterous of that.
http://finance.yahoo.com/blogs/daily-ticker/finally-rich-american-destroys-fiction-rich-people-create-152949393.html
“The customers of most companies, Hanauer points out, are ultimately the gigantic middle class — the hundreds of millions of Americans who currently take home a much smaller share of the national income than they did 30 years ago, before tax policy aimed at helping rich people get richer created an extreme of income and wealth inequality not seen since the 1920s.
The middle class has been pummeled, in part, by tax policies that reward “the 1%” at the expense of everyone else.(It has also been pummeled by globalization and technology improvements, which are largely outside of any one country’s control.)
But, wait, aren’t the huge pots of gold taken home by “the 1%” supposed to “trickle down” to the middle class and thus benefit everyone? Isn’t that the way it’s supposed to work?
Yes, that’s the way it’s supposed to work.
Unfortunately, that’s not the way it actually works.
And Hanauer explains why.
Hanauer takes home more than $10 million a year of income. On this income, he says, he pays an 11% tax rate. (Presumably, most of the income is dividends and long-term capital gains, which carry a tax rate of 15%. And then he probably has some tax shelters that knock the rate down the rest of the way).
With the more than $9 million a year Hanauer keeps, he buys lots of stuff. But, importantly, he doesn’t buy as much stuff as would be bought if that $9 million were instead earned by 9,000 Americans each taking home an extra $1,000 a year.
Why not?
Because, despite Hanauer’s impressive lifestyle — his family owns a plane — most of the $9+ million just goes straight into the bank (where it either sits and earns interest or gets invested in companies that ultimately need strong demand to sell products and create jobs). For a specific example, Hanauer points out that his family owns 3 cars, not the 3,000 that might be bought if his $9+ million were taken home by a few thousand families.
If that $9+ million had gone to 9,000 families instead of Hanauer, it would almost certainly have been pumped right back into the economy via consumption (i.e., demand). And, in so doing, it would have created more jobs.
Hanauer estimates that, if most American families were taking home the same share of the national income that they were taking home 30 years ago, every family would have another $10,000 of disposable income to spend.
That, Hanauer points out, would have a huge impact on demand — and, thereby job creation.
It’s time we stopped mouthing the fiction that “rich people create the jobs.”
Rich people don’t create the jobs.
Our economy creates jobs.
We’re all in this together. And until we return to more reasonable tax policies that help the 99% instead of just the 1%, our economy is going to go nowhere.”
I keep trying to say the problems of the U.S. economy are wealth/income inequality, too much currency denominated debt, and going from mostly supply constrained to demand constrained.
Peter A said: “I am a firm believer in Say’s Law, so I would be very interested in hearing some valid criticism of it.”
currency denominated debt
Ryan said: “Income = expenditure.”
income in the present may not equal expenditure in the present because of currency denominated debt
Peter A said: “They could result in higher aggregate income if enough work is created by the lower wage.”
I believe that assumes supply constraints due to labor shortages. That may not be true if the economy has gone from mostly supply constrained to mostly demand constrained so the number of hours of work does not increase.
dlr said: “On the other hand, I think you see monetary recessions , including the aftermath, as about more than just sticky wages (am I right?), but about a continuing shortfall in the supply of the medium of exchange relative to demand for all things (i.e. not just labor but goods and services, perhaps with some price distortions thrown in).”
Add financial asset prices in there too. Next, how does the amount of medium of exchange both rise and fall?
Ryan said: “But given that reserve requirements exist, where did all that leverage come from? Isn’t there only one, unique kind of entity that has the power to create leverage out of thin air, and isn’t that entity called a central bank?”
What about commercial banks and hedge funds? I equate leverage to mean currency denominated debt.
Ryan said: “But 0.97 of every dollar I keep in the bank ends up as “I” via the stock and bond markets.”
Could you define keep in the bank?
Heck, even the Sandwichman believes in a soft version of Say’s Law. And a soft version of the Coase theorem… Also if wishes were horses I believe that beggars would indeed ride.
But I wouldn’t stake my livelihood on axioms that are only true if a whole bunch of other restrictive assumptions are also true. Consider the following propositions, for example:
The above propositions are not a random collection but a mostly faithful (if occasionally sarcastic) enumeration of Dorning Rasbotham’s main points in his 1780 pamphlet, Thoughts on the Use of Machines in the Cotton Manufacture, whose unique contribution and enduring legacy consists of point #11, which has come to be known as the… now, what was the name of that fallacy?
Patrick said: “Finally, keep in mind that for every debtor there is a creditor. For the world as a whole, net debt is 0. I think Canadian mostly owe money to other Canadians. So what is ‘too much debt’? Well, it’s meaningless. The issue is the distribution of debt: who owes how much to whom and under what circumstances will defaults cascade etc …”
If more and more currency denominated debt does not produce price inflation (or is used to prevent price deflation), does that mean there is probably a distribution of debt problem and/or one of the major economic entities is experiencing negative real earnings growth?
Ken said: “So some set of wage adjustments would lead to a full-employment equilibrium if all other prices are flexible I suppose?”
If wages adjust downwards, will the economy get more debt defaults?
Ryan: “The economy consists of unlimited wants and limited resources.”
Sure. The problem ultimately is that we are not optimizing present consumption. We are performing an intertemporal global consumption optimization over totally unknown future states of the economy. if we knew those future states or we could hedge them perfectly then the result of that optimization would be unique. But since we don’t, and since those states depend critically on the optimization calculations of every other agent the optimal individual strategy is extremely uncertain. Under those circumstances it may be entirely rational for each individual to decide to reduce consumption and attempt to defer it till later, especially if they know that others may attempt to do the same thing thereby causing a drop in output. Output can’t drop? Of course it can. We just all have to cut consumption, right? And given that it can drop then if you suspect that other people suspect that it might drop, then it becomes rational for you to reduce consumption and save. It’s a classic coordination failure known as the Stag Hunt (I learned this from Nick a long time ago).
With expenditure way below trend and unemployment at 9%, how can one believe that the US is supply constrained? And if it is not therefore demand constrained, what is the problem? (Attempts to claim some sudden and persistent mismatch in prices and skills is to blame will have to explain how that did not magically happen down here in Australia.)
Those denying demand constraint seem to be in the situation of:
Person A: look, an unemployed person!
Person B: nonsense, wants are unlimited, therefore there is a job for him, he is just choosing to be unemployed.
Lorenzo: “how can one believe that the US is supply constrained”
Yes. And The Great Vacation just happened to immediately follow the greatest financial collapse and mass market panic in 80 years. Was it just so much fun to watch the spectacle on CNBC that no one wanted to go to work anymore? Or did we panic cause we suddenly foresaw the imminent collapse in output capacity that would result in the shedding of nearly a million American jobs per month a mere 3 months later. If there was no market failure that means we all wanted this and so I guess we must be happier now. Seriously?
Lorenzo from Oz,
I don’t think that 9% unemployment tells you anything (the natural rate has fluctuated anywhere between nearly 0% to over 10% in various countries and at various times) but expenditure being so far below trend does indicate demand-constraint. That’s not to say that supply-side problems don’t exist, but rather that they aren’t the principal cause of the phenomenon.
@Determinant:
I agree the economy can be choked by an oversupply of money; I disagree with the AD framework.
@Patrick:
You’re assuming away the intertemporal nature of debt. Savings is foregone present consumption or increased future assumption. Debt is the opposite – debt is foregone future consumption and increased current consumption. It is possible for everyone to simultaneously take on debt. The result is a future period of reduced consumption. The AD framework calls this “a demand shock,” but it’s not. There was an unsustainable increase of consumption in past periods. No one is going to “take up the slack.” The money is gone. Society ate its capital.
@Too Much Fed:
I was using the “income=expenditure” statement to demonstrate the circular reasoning of the AD framework. I’m not certain we disagree.
0.97 was a reference to reserve requirements. If I keep $100 in the bank, the bank will choose to make money off $97 of it unless I withdraw my funds.
@K:
You’re not detecting the part of the story that I’m suggesting is circular. You’re also calling something an “output drop” when I think it is better termed “prior periods of unsustainable levels of spending.” So long as debt is accessible, it is possible to increase present spending at the expense of future spending. When we finally reach “the future” it will look like a decrease in spending, but what it really is is nothing more than the predictable lull associated with the “boom” of the previous period(s). Max out your favorite credit card, and you’ll see what I mean. When you finally have to pay it off, you’ll see that you’re not actually “saving” at all. Your consumption goes down not because you’re experiencing a demand shock but because you already spent your money. There is a big difference between debt-financed consumption and a decrease in demand. Keynesians and Monetarists call it all the same thing. This is the whole problem that’s blinding them.
Nick, you’re simply missing a crucial part of Stiglitz’s argument:
I’m not saying that he’s right, but let’s not pretend that he’s making some crass Caplanesque mistake. The problem he is highlighting is the difficulty of restoring equilibrium once bankruptcy costs enter the picture. It’s not enough to say that every debtor’s liability is someone else’s asset. If creditors make large provisions for loan losses their valuation of their own net worth falls, without raising that of the debtors.
I am also sceptical about Stglitz’s idea,although we definitely need to think about frictions in the economy which prevent adjustment. I think that the difficulty of switching jobs is exaggerated. During WWII, many factories were quickly staffed largely by women who had probably never held a wrench before. This happened very fast once the necessary stimulus in the form of war-time deficit spending was applied.
I have my own simple way of looking at slumps like the current one. Perhaps it’s simple minded,too, but it seems to fit the depression, the current U.S. situation, and Japan’s lost decade. It also fits the end of the depression in WWII, and China’s escape from the world slump in 2008-09.
If some part of the economy suddenly starts buying less stuff, it will obviously create unemployment unless some other sector starts buying more stuff. In a normal recession, the central bank gets the housing sector to buy more stuff by dropping interest rates, and the problem is solved. The problem in the U.S. today is that interest rates are at the bottom, and the housing sector still won’t buy enough stuff for various reasons. The cure would be for the government to use deficit spending to buy enough stuff to return employment to normal levels. That is being prevented by politics and stupidity.
It worked in WWII, as Stiglitz points out. It also worked, more recently, in China in 2008-09, when what was shaping up to be a disaster precipitated by declining exports turned magically into a boom following a 15%-of-GDP stimulus. It will be interesting to see if the Tsunami disaster in Japan might, just possibly, force that government to provide the stimulus that should have been provided many years ago.
Ryan: We’re talking past each other. I agree with your underlying intuition but the argument you are making is wrong. Assuming away time? Nope. The K&E paper is an inter-temporal maximizing model. Read it. It’s not that hard to get the general gist of it if you know a little math and read carefully. And Nick has done many posts about debt. You might want to read those too.
@Patrick:
That’s pretty condescending, amigo. But I’m glad you think I’ll be able to comprehend the paper with a little concentration on my part. Thanks for the vote of confidence.
Of course you agree with my intuition (we are talking about economic laws whether they are universally recognized or not), but there is an important epistemological difference you are ignoring, which is the thrust of my point. You may be glossing over this because epistemological debates sometimes look a lot like semantic debates. There is also a tendency for AD-adherents to say, “No, no, you’re confused, you just don’t get it,” and proceed under the assumption that if people just understood AD a little better, it would all make sense.
I’m telling you: I get it and I still disagree. You don’t have to agree with me, but let’s not pretend it’s a disagreement based on ignorance and paper over the problem with AD-favorable research. If I’m wrong, either engage me on the issue or don’t. I could just as easily send you a boatload of links to theses that make my point, but I’m under the assumption that we are engaging each other rather than just referring each other to our own favorite research.
Nick, I think you missed this one. Bryan simply referring to the standard model in all the textbooks that we teach out of. AD shifts left, unemployment rises. Then wages adjust lower and SRAS shifts right to bring us back to the natural rate. The self-correcting mechanism. It’s what distinguishes the old and new Keynesian models. I really don’t see any problem with Bryan’s analysis (although I of course think monetary stimulus gets us back to full employment much quicker, so I’d rather not rely on wage cuts.)
Krugman makes an argument than wage cuts might reduce AD, but that’s certainly not the textbook model, and certainly Bryan’s model can’t be compared to Stiglitz.
Ryan: What would you call the ensuing collapse it if the Fed suddenly raised rates to, lets say, 20%. Since nobody lost the desire or ability to work (and since prices are collapsing) it’s obviously not a supply shock. And I’m assuming this scenario allows us to rule out prior over-consumption? Which leaves…???
Wow. Scott Sumner and Nick Rowe disagree on something as fundamental (or, more precisely, “fundamental-seeming to a relative beginner”) as this.
My ultimate concern is the overlap with economic theory and political reality. My common sense suggests that the lack of bottom-line wage flexibility (which should include all of the legally-mandated costs of employing someone) combined with government incentives NOT to work is a huge component of our unemployment situation. This could be solved by more money and/or lower nominal wages/benefits/anti-work-subsidies.
Meanwhile, back in the world of simplified theoretical models (which I believe could be important), leading economists can’t seem to agree whether wage flexibility could move us to equilibrium. To be clear, I think we should start by agreeing on the solution in a world without debt. I totally agree that debt is critical in the real world — in fact it is the missing piece in many prominent arguments. However, we can’t even seem to agree in a debt-free world! Let’s start there.
For me Caplan and Sumner (I’m not equating them) make intuitive sense on these issues, but Krugman and Rowe (I’m not equating them) seem to disparage or minimize the theoretical utility of wage adjustments. Regardless, this issue seems to be absolutely fundamental.
Of course, the weakest link in this chain of confusion is me, so I appreciate their patience!
Scott
Did you notice my comment above? I think I anticipated your response (and even the Krugman reference). Do you also buy the distinction I made between how someone who doesn’t see the nominal problem as being mostly about sticky wages in particular (which I believe describes Nick) might see a mistake embedded in Caplan’s argument?