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 
Patrick: “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 …”
I think this once again shows a gross misunderstanding of the nature of private debts. Private debts, as they are measured in our economic statistics, are not of the “I borrowed 1000$ from Patrick”: type. Private debts are TO financial institutions via mortgages, credit cards, car loans and the like. Everyone in the world (with an income) can be indebted to a bank at the same time. Now some people, (like myself)could if they had to, liquidate their savings, pay off all debts and still have something left over. Most people could not. If you are saying that the amount left over, of those who would have some left over, is equal to the amount lacking in those who would be lacking I would say that may be true, but its also somewhat trivial.
Here is what I see as the real crux of this “private” debt problem. We are granted worthy of servicing a nominal level of debt by a bank based on how much income we have AND by the nominal level of our savings. Also the nominal level of that which we may use as collateral. WIth our mortgages (probably the most significant factor in our private debt scenario), the house itself is part of the collateral and part of our net worth. This house is subject to great changes in value (as we’ve learned) and when it falls significantly it is not an example of “my loss in value means a reciprocal increase in someone elses value”. No! When my house value collapses, I am in significantly greater debt ( I owe 100,000 on something worth only 50,000 maybe) AND the banks position is significantly worse. They might “get” the house but the fall in value leads to a deterioration in their balance sheet as well. Its a lose lose lose scenario. Everyones position is made worse nominally.
Im continually amazed by the number of smart people who think that banking is just a middleman for me to loan my excess to Patrick. Its not anything close to that. Banks are outside, just like the govt is and we can ALL be made worse off relative to the banks and it will be to everyones demise when this is so.
Scott: you have a downward-sloping AD curve in mind. But that is precisely the assumption that a Keynesian (e.g. Paul Krugman) would question. Why does a fall in P cause the aggregate quantity of output demanded to rise? (E.g. a Canadian New Keynesian would answer: “because a fall in P, relative to the Bank of Canada’s 2% target, would mean that the BoC would cut real and nominal interest rates, so output demanded would rise.”). Whether or not a fall in W leads to an increase in Y depends on the monetary policy being followed by the central bank.. If the central bank really is targeting NGDP, then sure. If the central bank were following some really stupid monetary policy (targeting a rate of interest?) then it wouldn’t. But you have to talk about monetary policy to address this question. You can’t just talk about downward-sloping labour demand curves because of diminishing MPL.
Kevin: IIRC, Stiglitz said that the financial stuff was not a crucial part of his argument, and more of a side-effect.
As I interpret Ryan, the choice of some to hoard money is a market decision, the decision to opt out of the market. That those with money want nothing other than money and those without have nothing anyone with money wants is not a failure but the market working. Exchange declines because only money has value, those with money won’t part with it, and those without any have none to exchange. Wants may be unlimited, but only for money, or only by those with nothing of value to exchange for it.
Ryan: really not my intention. The point was “if I can understand it, anyone can ’cause I’m not that smart”. Look, I think you’re wrong and I think Nick and PK and others have more compelling arguments that might convince you if you gave them an honest hearing. But who am I? Just a guy wasting time on economics blogs. There are some very smart people who agree that AD isn’t the issue. John Cochrane, for example. I think he’s totally wrong but again he’s the Chicago Prof and I am just a wage slave nobody shooting my mouth off.
“IIRC, Stiglitz said that the financial stuff was not a crucial part of his argument, and more of a side-effect.”
I’ve looked again and I can’t find this. Maybe you’re thinking of remarks like this: “The banking crisis undoubtedly compounded all these problems, and extended and deepened the downturn. But any analysis of financial disruption has to begin with what started off the chain reaction.” If that’s what you have in mind I don’t think it fits your interpretation.
Kevin: This bit of Stiglitz, for example:
“For the past several years, Bruce Greenwald and I have been engaged in research on an alternative theory of the Depression—and an alternative analysis of what is ailing the economy today. This explanation sees the financial crisis of the 1930s as a consequence not so much of a financial implosion but of the economy’s underlying weakness. The breakdown of the banking system didn’t culminate until 1933, long after the Depression began and long after unemployment had started to soar. By 1931 unemployment was already around 16 percent, and it reached 23 percent in 1932. Shantytown “Hoovervilles” were springing up everywhere. The underlying cause was a structural change in the real economy: the widespread decline in agricultural prices and incomes, caused by what is ordinarily a “good thing”—greater productivity.”
Nick,
Yes, the story is: rising productivity -> optimism -> borrowing -> falling agricultural prices and incomes -> bankruptcies -> slump in demand.
I don’t know whether that story will convince economic historians but I can’t see any theoretical howler there, as you seem to.
As someone who works for a company that makes lab equipment (think CSI on a budget) Stiglitzs theory makes a lot of sense
I really think economists who want to understand this should get the computer program Solidworks, and go through it, and then go to any small company that makes things out of plastic, and talk to them about solidworks, and protomold, rapidprototyping, and CNC machining, and Trinet for HR.
I know some famous economists quipped that you can see computers everywhere but in the statistics, but that is, finally, changing.
what makes it work is the personal discomfort of firing an employee; you may not be aware of this, but firing someone is very, very, very unpleasant.
So, when times are good (<2008) you might have a number of employees who, from a strict ROI perspective, are not really doing that much, but for psychological health reasons, it is worse to fire them then keep them on.
Comes the crunch; its fire ’em or loose your house, at which point the psychic pain tips.
Ezra: I’m a computer geek by training and trade, so I’m sympathetic to your view but I’m still not convinced.
On the micro level you’re assuming that the result of investment is always unemployment. I think markets can adjust in other ways. Say, for example, the elasticity of demand is such that lowering the price a little increases demand a lot. The increased productivity might result increased employment.
Now take all markets and add them up. It isn’t clear, to me at least, what the end result will be. Higher employment? Maybe. Sure looks like that’s what happened in the 1990’s.
As for the Stiglitz’s alternate explanation for the depression … Of course he’s an accomplished economist and smart guy and I’m not, but I just don’t buy it. In the US in the ’30s it just wasn’t that hard for people to shift from the farm to the factory. Ok, they might not have liked it all that much, and it probably caused all sorts of heartache and woe, but a farm worker and a factory worker are reasonably close substitutes. Fast forward to the present and I’m less skeptical. It seem plausible to me that we could run into problems because what the economy ‘wants’ is people with PhDs in math, engineering and computer science, but all it has are mere mortals like me with a B.Sc. And lawyers. Lots of lawyers. And FWIW, I don’t think this is the major problem we are experiencing currently.
Following up on Scotts remarks. What Bryan says is wrong but I read it as intentionally wrong. The issue is that the says law failure is about money demand; that is, it is a nominal story.
The old Keysenians were obsessed with telling a story about a shortfall in real output–that’s their demand deficiency. That’s why Keysenian policies are always structured around multiplier assumptions.
Keynes may have punchered says law in the general theory; but the next 70 years were spent in the wilderness preaching a policy prescription whose only attachment to disproving days law was in the need to claim recessions were always self correcting.
Bryan’s tongue in check mockery was thus pointing at a quite right observation: the problem isn’t about real output at all, if it were we could cut wages an recover. No the problem is nominal and because it’s nominal cutting the flow of income by allowing deflation only makes quenching the demand for money harder because if the implied real rate on money rising or even going positive.
@K:
“What would you call the ensuing collapse it if the Fed suddenly raised rates to, lets say, 20%.”
Whether or not setting the rates at 20% would result in a “collapse” depends entirely on market conditions. It wouldn’t be pleasant, but it would only trigger a collapse if the market rate were substantially >20%.
Because 20% is well above the competitive rate, I think a more likely scenario is that private lenders with very large reserves would be willing to offer more competitive loans to the financial sector at a rate of X%, where X<20.
Or perhaps it would be enough of an impetus to get people using currencies more competitively.
This is all speculation based on a very unlikely scenario, though.
Ryan: “I think a more likely scenario is that private lenders with very large reserves would be willing to offer more competitive loans to the financial sector at a rate of X%, where X<20.”
The Fed doesn’t bring the interbank rate to 20% by lending to the financial sector! It gets it there by borrowing from the financial sector. And if somebody wants to lend to the financial sector at 10% so the banks can turn around and dump the money at the Fed at 20%, I’m sure the banks would find that quite thrilling. It’s pure arb. But it doesn’t work that way. If the CB wants a 20% interbank rate it gets it, and every rate in the economy will set off expectations of that rate plus credit risk plus risk premium plus costs. And yes, the economy will PUKE. And fast. Even the RBC types will acknowledge that.
“It wouldn’t be pleasant, but it would only trigger a collapse if the market rate were substantially >20%.”
Based on what?! Are you kidding me?
“Yes, sir, the new rate on your mortgage is 26%. But not to worry. Monetary super-neutrality requires the necessary nominal adjustments. So obviously price and wage inflation will rise by 20%. But whatever you do, DON’T CUT YOUR SPENDING. Cause if everybody did that in the belief that maybe their nominal income wont rise by 20%/year then prices might FALL instead. We recommend, instead, that you go to your employer and demand a raise. Have a nice day.”
“This is all speculation based on a very unlikely scenario, though.”
But the answers we give and the conclusions we reach have very real consequences for the scenario in which we find ourselves.
K,
I have never agreed with you so much for so consistent a period.
BDL responds:
http://delong.typepad.com/sdj/2011/12/i-dont-fully-buy-stiglitzs-argument-that-our-macro-problems-have-deep-structural-roots-but-i-do-see-its-coherence.html
dlr, Yup, That’s a good comment.
Nick, You started by saying that Paul, Brad and Mark needed to call out Bryan. (Which as you know means they will call him a moron.) And now you say this is because Bryan assumes the AD curve slopes downward, like it does in all textbooks (including I’d guess Krugman’s). Is that his big mistake? I am aware of Krugman’s bizarre theory that it slopes upward, but I read your post as claiming that Bryan made some elementary error, when it seems you are actually accusing him of not buying into Krugman’s avant garde theory of upward sloping AD. That’s a completely different class of “error” from Stiglitz, so I still don’t think they should be lumped together.
Or maybe I’m still missing your point.
BTW, Didn’t you once argue that inflation targeting central banks produce a horizontal AD curve? And doesn’t that also get Bryan’s results?
Scott: Bryan is arguing against the Keynesians, but trying to do so without talking about money, monetary policy, and the shape of the AD curve. If you are a Keynesian who believes the AD curve is vertical (or even upward-sloping) in a liquidity trap, and who believes the US is now in a liquidity trap (if you are PK, in other words) the whole of Bryan’s argument is based on an implicit assumption that you are wrong.
Try this thought-experiment: suppose, just suppose that the Fed were really daft, and had a real interest rate target, so the AD curve is vertical. And suppose the Fed targeted a real interest rate above the natural rate, so there were deficient AD. Would nominal wage cuts help? No. That’s how the world looks to many Keynesians.
‘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.’
Erm, no, it’s not political. Keynes explicitly assumes flexible wages in chapter 19 of TGT and comes to the conclusion that sticky wages are good because they prop up AD, due to workers higher MPC.
As I am fond of pointing out, if real wages cause unemployment, then why has the period of stagnant real wages (1980+) coincided with high unemployment whilst the ‘golden age’ of rising real wages coincided with low unemployment?
Ryan:
I did not say an economy could drown in money, though that can happen, but more critically an economy can be choked by a lack of money. A fall in the money supply means that an economy can fall into a depression. A fall in money, particularly broad money is like tightening the noose.
Second, you can think of savings, possible consumption and investment together with production as a second-order differential equation, just like a resistor/inductor/capacitor circuit or a mass/damper/spring system. In a second order system there is a fundamental frequency where production will equal consumption. At all other frequencies either savings or investment will act as additional resistance and reduce actual consumption. In a second order system both savings and investment can act as the limiting case relative to consumption.
It is rather frustrating to me to see economists argue that a perfectly good second order system is actually a first order system. Sorry guys, too much simplification there.
Nick, I interpreted Bryan’s point 3 as a response to Krugman’s upward sloping AD curve argument. It seems to me that Caplan basically said he didn’t buy the argument that lower wages will reduce AD (and I agree.) And if that argument is not correct, then lower wages would spur recovery. How did you interpret his point three?
I suppose our disagreement hinges on how much the unconventional slope of the AD curve has become conventional Keynesian dogma. Also whether Caplan was making a general argument, or a liquidity trap argument. I sort of assumed it was a general argument. I don’t see Keynesians calling for wage cuts during non-liquidity trap recessions either.
On the other hand even I don’t call for wage cuts during recessions, mostly because I don’t think it’s very likely to occur, but perhaps partly because I assume people will misinterpret me as calling for lower INCOMES of workers.
And here’s something for Krugman to think about. In August 2010 when core inflation had fallen to 0.6% in America he did a post calling for strong monetary stimulus to boost inflation expectations. The Fed did QE2 soon after and core inflation is now up to 2.2%. So the Fed did what Krugman wanted and it seemed to “work” (for inflation not NGDP.) So would Krugman still argue that the Fed stops inflation targeting once rates hit zero? Haven’t recent events shown that’s not true? But if they are inflation targeting then Caplan’s right.
Scott: “I suppose our disagreement hinges on how much the unconventional slope of the AD curve has become conventional Keynesian dogma. Also whether Caplan was making a general argument, or a liquidity trap argument. I sort of assumed it was a general argument. I don’t see Keynesians calling for wage cuts during non-liquidity trap recessions either.”
Fair point. I would say that if inflation is at or above target, and the central bank has room to manouver, and you believe unemployment is too high, and if you believe that there is an excess supply of labour, then you should be calling for wage cuts.
I made a similar point in this old post:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/02/we-are-all-paid-too-much.html
But a Keynesian who argued that we are in a liquidity trap right now, and that the Fed had no room to manouver, could consistently argue against wage cuts right now.
W Peden: Thanks. Glad to know that you agree.
Nick, Scott: I’d guess Stiglitz doesn’t feel any great need to justify that the Fed wasn’t doing a particularly solid job of stabilizing demand in 1929. It pretty well goes without say. In which case all you need to do is tell a good story about why the natural rate declined. Which he does.
As far as the current situation goes, he clearly states that he thinks the fed failed during the bubble and there is no question that he now considers us to be in a liquidity trap. So, no, he doesn’t believe in the Fed maintaining constant equilibrium and validity of Say’s law, and he says so quite explicitly. But if you really want to know what he believes you should read the Stiglitz J of European Economics Association paper that was already linked to by a commenter in the other thread rather than judging him by a Vanity Fair article that obviously will neglect a lot of technical details. It’s a really great paper.
W.Peden: 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) Wow. My only specifically economic policy job was in labour market policy, so labour market issues push my buttons. But dismissing a dramatic surge in unemployment as uninformative is startling.
A sudden surge in unemployment tells me an economy likely has a cyclical issue. (There is the possibility of some dramatic structural change, but that is unlikely and should be easy to spot: it is not in any way a presumptive hypothesis.) A persistently high level of unemployment regardless of economic fluctuations tells me an economy has structural problems in its labour markets. Either way, high levels of unemployment are a pretty strong indicator that an economy is well below capacity.
Lorenzo from Oz,
I agree that a rapid CHANGE in unemployment indicates a lot. I also agree that a persistent 9% unemployment rate indicates structural problems. By “tell you anything”, I mean tell you anything about demand; obviously a 9% unemployment rate always tells you SOMETHING.
What do you mean by “well below capacity”?
Nick, Thanks for clarifying that. I plan another post on Stiglitz.
K: thanks for that link. Hmmm. maybe Stiglitz’s problem is that he just did a really bad job of explaining himself in the Vanity Fair piece. Because in that paper he does talk about differing marginal propensities.
W.Peden: well, that is clarifying, thanks. By “well below capacity” I mean that output could be increased with minimal investment in capital, so, in an important sense, the economy is operating at a significant distance from its (short run) supply constraint.
As for “not telling us anything about demand”: perhaps not on its own but, short of some clear supply shock, a sudden increase in unemployment creates a presumption of demand issues.
Lars Christensen even provides a nice graph to chart the demand shock the Fed imposed on the US economy in 2008 by its sudden (if “passive”) shift to a deflationary monetary policy.
Down here in Australia, we have a central bank that does us the courtesy of telling us explicitly what its target is. That is better. Particularly for unemployment. From down here in Australia (a first world economy, really it is) talk of sudden shifts in sklll needs just sound like very parochial crap.
Thanks Lorenzo for mentioning it…I hope that Nick agree that I got it right with AD…and demand inflation.
Thanks so much for this article and comments. If this is an example of “professional” economist’s logic and critical thinking, I now know why things are so f*cked up.
Ryan said:
“@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.”
We’d have to expand on some points to find out.
And, “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.”
That sounds like some form of the demand deposit and reserve requirement form of debt creation. I don’t believe that is how banking works. Would you be willing to listen to another “story” of how debt is created?
Sorry, it took so long to reply.