And The Circle Is Complete, With Gluts And Missing Inner Keynesians

Brad DeLong:

In a normal microeconomic case of market adjustment–excess supply of one good and excess demand for another–it is clear how adjustment proceeds. Those entrepreneurs making the good in excess supply find themselves selling for less than their costs and so losing money. They cut back on the wages they pay and dismiss workers. But this is not a tragedy, because the profits they have lost have gone into the pockets of entrepreneurs in expanding industries, who are eager to expand production, raise wages, and hire more workers. After a short time the structure of production is better-suited to make what people want, and wages and profits in total are higher than if the structure of production had remained frozen in its old pattern.

But what if there is a general glut of commodities? What if the excess supply is for pretty much all goods and services, and the excess demand is for liquid cash or for safe investments that will not lose their value no matter what? How do you expand labor employed in the liquid cash-creating or in the AAA asset-creating businesses to make more of such assets?

One possibility is to rely on the private sector, saying: risky assets are at a discount and safe assets a premium? Good!

Make the profits from creating safe assets large enough, and Goldman Sachs and company will find a way. They will raise some capital willing to run large risks for large returns. They will hire people to shuffle the papers. They will finance enterprises, and then slice and dice the cash flows from those enterprises in order to create lots of AAA-rated securities. And when they do, the excess demand for safe assets will be satisfied, and that will by Walras’s Law erase the excess supply of goods and services, and unemployment will return to normal.


You say nobody trusts Goldman Sachs or Standard and Poor’s when they say: “we know we lied last time when we warranted that the assets we were selling were AAA, but this time for sure!!”?

Well, how about investing abroad? There are still lots of AAA assets out there in the wider world. Suppose everybody devalues, puts people to work in newly-competitive export industries, and thus runs an export surplus and, in exchange, imports AAA assets from abroad for our savers and investors to hold.


I see. Everybody can’t devalue at once. Greece can run an export surplus only if Germany is willing to run an import surplus. The United States can boost its net exports only if China shrinks its own.

Maybe we could ship millions of our citizens to South Africa equipped with picks and shovels and put them to work as gastarbeiteren mining the gold of the Witwatersrand?

I know! Let’s cut the price of every good and service by 25%! then our same stock of nominal AAA assets will meet a 33% larger demand for real AAA assets, and there will be no excess demand for safe assets, and thus no excess supply of goods and services! The problem with this “solution” is that “money” is not just a medium of exchange and a store of value, it is also a unit of account. Suppose that a 33% increase in the real supply of genuine AAA assets would fix the problem, and suppose we do succeed in cutting all goods and services prices and wages by 25%. Have we then fixed the problem? No. A lot of people have debts denominated in money and were counting on selling their goods and their labor at something like their previous prices to pay off their mortgages, their loans, and their bonds. A whole bunch of assets that were AAA before the decline in the price level are no longer AAA. You haven’t fixed the imbalance. Each nominal AAA asset does indeed satisfy a larger slice of demand for real AAA assets as a result of the price-level decline. But the price level decline has shrunk the (nominal) supply of AAA assets just as it has shrunk the (nominal) demand for them. And how have you managed to reduce nominal wages and prices? By years if not decades of idle capacity and high unemployment.


So now–drumroll–it is time to pull the rabbit out of the hat. The solution is… the government! The government has the power to tax! And so the government can make AAA assets when nobody else can!

Matthew Yglesias on DeLong’s post:

In an odd way, commentators on the economy have a strong bias toward talking about supply-side problems. Misguided policies that prevent the economy from operating as efficiently as it might. Policies like a “License Raj” that stifles innovation and entrepreneurship among a nation of over 1 billion in South Asia. Policies like Mao Zedong’s Five Year Plans that trampled on the aspiration of another nation of over 1 billion in East Asia. But though the policy environment is not ideal in China or in India it’s really extraordinarily better than it was in the recent past. And the physical infrastructure is much better too. And something similar, though to a lesser extent, could be said about improved governance in Indonesia and Brazil. A number of Central European countries have likewise been rescued from Communism and embedded in liberal democratic regimes. Meanwhile all around the world transmitting information is dramatically cheaper and easier than at any time in human history. And yet in newly productive China and India hundreds of millions of people continue to live lives as subsistence or near-subsistence farmers. This in a world where the total production of calories far, far, far exceeds the number of calories needed to keep five billion people alive.

To say that the world has solved its supply-side problems would be absurd. Greece really is overburdened with bureaucracy, Italian governance is a mess, we have too many useless homes in the Inland Empire and the suburbs of Las Vegas, and too much of Ireland’s GDP growth was based on a tax haven accounting gimmick. But Greece and Ireland are tiny, Italian governance has always been a mess, and the value of homes in the Inland Empire and the suburbs of Las Vegas has always been tiny relative to the vast productive capacity of the United States. To think that Greek overborrowing and over-bureaucratization could somehow maroon a global economy that’s featured the invention of the Internet and the liberalization of China and India is slightly insane. We right now have the capacity to produce more—much more—than has ever been produced before in the history of the planet. There are dozens of supply-side policies that could be improved in every country on earth, but that’s not a new fact about the world. What’s new is the lack of demand, the willingness of the key leaders in Tokyo, Frankfurt, Washington, Berlin, and now it seems London as well to tolerate stagnation and disinflation in the face of some of the most exciting fundamental new opportunities for human economic betterment ever.

Tyler Cowen on Yglesias’s post:

First, I am fully on board with Scott Sumner-like ideas to boost AD through monetary policy, as is Yglesias and are many other Keynesians.  There is no practical disagreement, but it remains an open question how effective such measures (or a bigger stimulus) would be.

Consider a simple model, in which uncertainty goes up, first because of the U.S. financial crisis, now because of Greece and the Euro and the open questions about Spain and how well Europe can cooperate.  I’m not saying that’s the only or even the prime cause of what’s going on, it’s simply an illustrative story.

With higher uncertainty, investors pull back, wait, and exercise option value.  Aggregate supply declines, as does employment.  As a result, aggregate demand declines too, and that includes real aggregate demand, not just nominal aggregate demand.  Until the underlying uncertainty is resolved, the economy remains in the doldrums.

Note that there is still a case for fiscal policy, based on the idea of intertemporal substitution.  With some labor unemployed, a sufficiently finely targeted fiscal policy can build a new road at lower social cost than before, by drawing upon unemployed resources.  But even if that fiscal policy is a good idea, it won’t drive recovery, at least not for plausible values of the multiplier.

There is also still a case for countercyclical monetary policy.  As real AS and real AD are falling (see above), there is also downward pressure on nominal variables.  Aggressive monetary policy, or for that matter the velocity-accelerating aspect of fiscal policy, can limit the negatives of this process and check the second-order fall in employment.

I’m all for countercylical AD management, noting that for other reasons I prefer monetary to fiscal policy in most cases and even if you don’t agree with me there it suffices to note that the monetary authority moves last in any case.

That all said, the countercyclical monetary policy won’t drive recovery either, or set the world right again, it just limits the damage.  We still have to wait for the uncertainty to be cleared up.

Reading the Keynesian bloggers, one gets the feeling that it is only an inexplicable weakness, cowardice, stupidity, whatever, that stops policies to drive a more robust recovery.  The Keynesians have no good theory of why their advice isn’t being followed, except perhaps that the Democrats are struck with some kind of “Republican stupidity” virus.  (This is also an awkward point for Sumner, who seems to suggest that Bernanke has forgotten his earlier writings on monetary economics.)  The thing is, that same virus seems to be sweeping the world, including a lot of parties on the Left.

Romer, Geithner, Summers, know all the same economics that Krugman and DeLong and Thoma do.  If a bigger AD stimulus would set so many things right, they’d gladly lay tons of political capital on the line to see it through and proclaim triumph at the end of the road.

Kevin Drum on Cowen’s post:

Now, there are a few things to say about this. First, Tyler’s definition of “marginal” might be different than, say, Krugman’s. Would a two-point drop in unemployment be marginal? Or dramatic? Second, it doesn’t have to be weakness or cowardice driving the Obama team’s actions. If, for whatever reason, they’ve concluded that a second stimulus is simply politically impossible, then they’re going to turn their attention elsewhere no matter what they think about it. That’s just common sense. Third, even if a ton of political persuasion might (barely) push a second stimulus bill through, it might be too late. They might disagree with Krugman et. al. not on fundamental grounds, but simply on timing.

But despite all this, there’s one pretty good reason to think that Tyler is basically right: tax cuts. Lefty economists might generally believe that increasing spending is a more efficient way of stimulating consumption than reducing taxes, but they’d almost certainly accept a big tax cut as an almost-as-good substitute. And tax cuts have two big advantages over spending. On the substantive side, they work faster. Spending takes time to work its way through the economy, but a tax cut (for example, a payroll tax holiday) boosts the economy almost immediately. And on the political side it’s quite doable. Republicans would be persuadable because they love tax cuts and Democrats would be persuadable because it would help the economy. For Obama, then, it would be the best of all worlds: a fast stimulus that gets bipartisan support, something that boosts the economy while dampening the inevitable criticism he’d get for blowing up the deficit.

But he’s not pushing for this. Not even quietly. And this suggests that Tyler is right: Obama’s advisors might be in favor of further fiscal stimulus, but not by much. And the best explanation for this is that lefty or not, they’re genuinely afraid, as Tyler says, that it would bring only marginal improvements at the cost of significant problems down the road.

But would it? I’d like to hear more about this. I feel like the liberal economic community is largely getting a free pass on this because the opposition has been so stupid: if you’re arguing that inflation (or hyperinflation!) is a near-term threat that needs to be vigilantly opposed, it’s pretty easy to explain why this is wrong. But the better argument is that inflation is a long-term threat that has to be contained early, because once the genie pokes its head out of the bottle it’s very, very hard to stuff it back in. And the medicine it takes to do the stuffing is painful indeed.

Now, that argument might be wrong too. But because conservatives mostly aren’t making it, liberals mostly aren’t taking it on. But they should. Political realities being what they are, reining in the federal deficit will be hard even under the best of circumstances, and if we decide to make it worse now it’s going to become even harder to rein in down the road. That’s not a problem for today or tomorrow, but it might well be a problem in 2015. Right?

Jonathan Chait at TNR on Cowen’s post:

Two factors are at work. First, Keynesian fiscal policy is unpopular. Most Americans think deficits are the primary problem during a recession — indeed, their tolerance for deficit spending diminishes during a slowdown and expands during a boom. Conservative Democrats are currently terrified to vote for any bill that increasing the national debt. Second, the 60-vote Senate makes even popular actions difficult. As a result, economists associated with the administration understand that further stimulus, though desirable, is politically off the table.

And Brad DeLong on Cowen’s post:

Tyler Cowen: Your Inner Keynesian Is Missing…

Tyler Cowen’s inner Keynesian to the white courtesy phone please…

Tyler appears to be confused. Or maybe I am hopelessly confused. He writes:

Is there a general glut?: Consider a simple model, in which uncertainty goes up, first because of the U.S. financial crisis, now because of Greece and the Euro and the open questions about Spain and how well Europe can cooperate.  I’m not saying that’s the only or even the prime cause of what’s going on, it’s simply an illustrative story. With higher uncertainty, investors pull back, wait, and exercise option value. Aggregate supply declines, as does employment. As a result, aggregate demand declines too, and that includes real aggregate demand, not just nominal aggregate demand.  Until the underlying uncertainty is resolved, the economy remains in the doldrums…

And this I don’t understand: what is this “aggregate supply declines”? How? Where?

Suppose we have a risk neutral representative worker with a rate of time preference β and an endowment of L hours of labor, which she can either use to produce consumption goods or investment goods with a linear technology. Suppose further you have a representative financier with no endowment, who must borrow from the representative worker and who invests in risky investment projects which have an ex-ante return distribution that is public knowledge but whose actual outcome is private information to the financier.

In this situation, financiers will strike wage bargains with workers–they can’t credibly promise to give them a share of the investment project outcome–and will make debt constracts with households–they can’t credibly promist to give them an equity share. Since the financiers have no endowment, they will be unable to post bonds. Hence households will be willing to fund only those investment projects that are certain to return at least 1/β. That much labor will be devoted to making investment goods, and the rest of labor will be devoted to making consumption goods.

In this environment, an increase in uncertainty–a mean-preserving spreading-out of ex ante investment project return distributions–causes a greater share of investment projects to fail to make the 1/β guaranteed gross-rate-of-return hurdle. So production of investment goods falls…

…and production of consumption goods rises, as labor is redirected.

There is no employment-reducing fall that I can see in aggregate supply in response to an increase in uncertainty. Yes, there is a structural readjustment as investment-goods industries shed labor and consumption-goods industries gain labor. But this is no more a fall in aggregate supply that leaves an extra 5% of the labor force with nothing productive to do than there was a fall in aggregate supply earlier, when perceived uncertainty fell and labor moved into investment-goods production–remember, back when financial engineering guaranteed by S&P and Moody’s offered a way to create more of the AAA assets that the representative worker wanted to hold. There is a fall in aggregate supply in the sense that the value added by investment projects falls–but that fall shouldn’t have implications for employment.

Now it is certainly true that the rise in uncertainty is a bad thing.[1] The market failure in the model is the inability of financiers to credibly reveal their private information about the outcome of investment projects. And this market failure means that the society underinvests in the future. And the rise in uncertainty makes this market failure worse, and reduces welfare because it increases the wedge between how much the economy is investing and how much it, in first best, should be. Real output–the sum of the wages of workers and the profits of financiers–does fall.

But “aggregate supply declines” when uncertainty rises? Aggregate supply as measured by the number of workers who ought to be doing things that add value doesn’t decline. Aggregate supply stays the same–and aggregate demand should shift away from risky investment goods and toward consumption goods. But somehow it doesn’t. Instead, it declines.


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