Delong Explains Recessions

Brad Delong wrote a great post about why recessions happen. First he explains that inflation happens when there is more money than people need for managing market exchanges of goods and services,  and when there is too little money to be able to exchange all the goods and services that are wanted, a recession, or "general glut" happens.

Sometimes when you go the market, you find the money prices that you have to pay higher than you expected—perhaps 10% higher than you expected last year when you made your plans. It seems that, somehow, there is too much spending money chasing too few goods. How is this that this happens? And what should the government do to make sure that it does not happen?

Conversely, we can have the opposite problem—not a glut of money relative to goods, but what early-nineteenth century economists used to call a “general glut” of unsold commodities, idle factories and workshops, and idle workers all across the economy. Economists have important things to say about how to try to prevent these episodes and what to do when they happen to cure them. And this sixth role of economists as public intellectuals in the public square is worth going into in more depth.
Back in the 1820s the question of whether the circular flow of economic activity as mediated by the market system could break down and the economy become afflicted by a "general glut" of commodities was a live theoretical question. Everybody agreed that there could be particular gluts. Cosider what happens should households decide that they want to spend less on electricity to power large-screen video and audio entertainment systems and more on yoga lessons to seek inner peace. The immediate consequence—within the "market day," as late-nineteenth century British economist Alfred Marshall would have put it—of this shift in preferences is excess demand for yoga instructors and excess supply of electric power. Prices of electricity (and of large-screen TVs, and of audio systems) fall as unsold inventories pile up in stores and as generators spin down and stand idle. Yoga instructors, by contrast, find themselves overscheduled, working ten-hour days, and stressed out—and find the prices they can charge for their lessons going through the roof. Workers in electric power distribution and in video and audio production and sales find that they must either accept lower wages or find themselves out on the street without jobs.
Over time the market system provides individuals with changing incentives that resolve the excess-supply excess-demand disequilibrium. Seeing the fortunes to be earned by teaching yoga, more young people learn to properly regulate their svadisthana chakra and teach others to do so. Seeing unemployment and stagnant wages in electrical engineering, fewer people major in EECS. The supply of yoga instructors grows. The supply of electrical engineers shrinks. Wages of yoga instructors fall back towards normal. Wages of electrical engineers rise. And balanced equilibrium is restored. Thus we understand how there can be a glut of a particular commodity—in this case, electric power. And we understand that it is matched by an excess demand for another commodity—in this case, yoga instructor services to properly align your svadisthana chakra.
But can there be a general glut, a glut of everything?
Some economists early in the nineteenth century said yes. Other said that the idea of a "general glut" was logically incoherent. Jean Baptiste Say, for example:

Letters to Mr. Malthus: I shall not attempt, Sir, to add... in pointing out the just and ingenious observations in your book; the undertaking would be too laborious.... [And] I should be sorry to annoy either you or the public with dull and unprofitable disputes. But, I regret to say, that I find in your doctrines some fundamental principles which... would occasion a retrograde movement in a science of which your extensive information and great talents are so well calculated to assist the progress....
What is the cause of the general glut of all the markets in the world, to which merchandize is incessantly carried to be sold at a loss?... Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own. To the proprietor of the mines whence this money is obtained, it is a production with which he purchases such commodities as he may have occasion for.... From these premises I had drawn a conclusion... “that if certain goods remain unsold, it is because other goods are not produced; and that it is production alone which opens markets to produce.”...
[W]henever there is a glut, a superabundance, [an excess supply] of several sorts of merchandize, it is because other articles [in excess demand] are not produced in sufficient quantities... if those who produce the latter could provide more... the former would then find the vent which they required...

Yet Say changed his mind. By 1829, in his analysis of the British financial panic and recession of 1825-6, Jean-Baptiste Say was writing that there could indeed be such a thing as a general glut of commodities after all: "every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared..." The general glut, Say wrote in 1829, had been triggered by a panicked financial flight to quality in financial markets. What was going on? The answer was nailed by John Stuart Mill:

Those who have... affirmed that there was an excess of all commodities, never pretended that money was one of these commodities.... What it amounted to was, that persons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute.... The result is, that all commodities fall in price, or become unsaleable.... [A]s there may be a temporary excess of any one article considered separately, so may there of commodities generally, not in consequence of over-production, but of a want of commercial confidence...

Note that these financial market excess demands can have any of a wide variety of causes: episodes of irrational panic, the restoration of realistic expectations after a period of irrational exuberance, bad news about future profits and technology, bad news about the solvency of government or of private corporations, bad government policy that inappropriately shrinks asset stocks, et cetera.
It seems as if there is always or almost always something that the government can do to affect asset supplies and demands that promises a welfare improvement over, say, waiting for prolonged nominal deflation to raise the real stock of liquid money, of bonds, or of high-quality AAA assets. Monetary policy open market operations swap AAA bonds for money. Quantitative easing that raises expected inflation diminishes demand for money and for AAA assets by taxing them. Non-standard monetary policy interventions swap risky bonds for AAA bonds or money. Fiscal policy affects both demand for goods and labor and the supply of AAA assets--as long as fiscal policy does not crack the status of government debt as AAA and diminish rather than increasing the supply of AAA assets. Government guarantees transform risky bonds into AAA assets. Et cetera...
And what if there is a glut not of commodities but inflation? Simply apply the same policy tools in reverse.
That is the last of the six things economists have to say in the public square: that the economy does not consistently balance itself at high employment with stable prices. The principle that it does economist have called Say’s Law—even though Say abandoned it by 1829. And it is important for economists to say, loudly, that Say’s Law is not true and theory, and it takes delicate and proper technocratic management to make it work in practice.

RBC Austrian Thought

Russ Roberts wrote:

Love that word—stimulus. It sounds so scientific. ...Sounds like the perfect prescription for an ailing economy.
But if politicians know how to stimulate the economy, why wait for a recession? If you can make the economy grow, why wait for bad times?
...Maybe we don't know how to make a $14 trillion economy move very quickly. And if we did, it would take a lot more than an injection of even 125 billion dollars.
There's that scientific language again—an injection. The politicians are always going to inject some amount of money into the hands of consumers and into the economy, like a doctor giving a lifesaving blood transfusion. But where does the economic injection come from? It has to come from inside the system. It's not an outside stimulus like the chest paddles or the transfusion. It means taking money from someone or somewhere inside the system and giving it to someone else.
The standard stimulus package doesn't change incentives. It's a check from the government. The hope is that the receiver will spend it. But when you just send out checks from the government, whoever gets stimulated is likely to be offset by someone who gets unstimulated.
The money has to come from somewhere. If you raise taxes to fund the plan, the people who are taxed are poorer and they'll spend less. If you borrow money to fund the plan, the people who buy the government bonds have less money to spend and that offsets the stimulus. It's like taking a bucket of water from the deep end of a pool and dumping it into the shallow end. Funny thing—the water in the shallow end doesn't get any deeper.
And even the people who get the money often save more of it than they spend.
That's why stimulus schemes based on giving people money have a poor track record... Usually, the only thing that gets stimulated is a politician's approval rating.
I'm not saying that economy policy is irrelevant. Economic policy matters because it affects the long-run growth of the economy. I'm all for policies that make us more productive or innovative by changing incentives. But those policies take time. There's little any economic doctor can do to move our $14 trillion organism of an economy in the next few months.
Politicians who work in the Oval Office—or those who seek to work there—would be wise to remember that patience is a virtue. Focus on the policies that lead to growth over time. Expecting results overnight is bound to lead to disappointment.

1. Roberts asks, "if politicians know how to stimulate the economy, why wait for a recession? If you can make the economy grow, why wait for bad times?" How would you answer him? 
2. Roberts asks, "But where does the economic injection come from?  It has to come from inside the system."  Is it possible to create an injection into GDP from within the circular flow of the economy during bad times? 
3. Roberts says that with an economic stimulus, "the only thing that gets stimulated is a politician's approval rating." Why would approval ratings increase if a stimulus does nothing?  
4. Evaluate the following quote:  "But when you just send out checks from the government, whoever gets stimulated is likely to be offset by someone who gets unstimulated.  The money has to come from somewhere. If you raise taxes to fund the plan, the people who are taxed are poorer and they'll spend less. If you borrow money to fund the plan, the people who buy the government bonds have less money to spend and that offsets the stimulus. It's like taking a bucket of water from the deep end of a pool and dumping it into the shallow end. Funny thing—the water in the shallow end doesn't get any deeper.  Does that make sense?  How does a recession happen if the money is always there anyhow? 

Financialization of the Macroeconomy

Bruce Bartlett writes about the financialization of American macroeconomics and the instability it creates:

Ozgur Orhangazi of Roosevelt University has found that investment in the real sector of the economy falls when financialization rises....Adair Turner, formerly Britain’s top financial regulator, [suggests] that the financial sector’s gains have been more in the form of economic rents — basically something for nothing — than the return to greater economic value.

Another way that the financial sector leeches growth from other sectors is by attracting a rising share of the nation’s “best and brightest” workers, depriving other sectors like manufacturing of their skills.

The rising share of income going to financial assets also contributes to labor’s falling share....This phenomenon is a major cause of rising income inequality, which itself is an important reason for inadequate growth.

Kevin Drum asks a really big question:

The finance industry doesn't grow because some fundamental feature of the modern economy demands it. In fact, it's really more mysterious than it seems. After all, we know why, say, the car industry grew during the 20th century: because more people wanted cars. Likewise, we know why the tech industry is growing now: because more people want to surf the net and play video games.

So why has finance grown? Because the world needs more finance? Up to a point, sure: availability of capital is a key requirement for economic growth in a modern mixed economy. But we passed that point quite a while ago. Capital has been freely and easily available in America and most of the developed world for decades. So again: Why the continued growth?

Relatedly, at VoxEU, Sheila Bair recently posted 12 answers to important questions about finance and ways to regulate finance.  It is worth a read. She argues for higher capital ratios.

Krugman has a great primer on austerity and the great recession

Krugman has a great primer on austerity and the great recession.  He uses some remarkable graphs to make his case that this time austerity is bigger than ever and the results are Keynesian. 

Good monetary policy raises inflation during recessions

Moneybox notes that Ben Bernanke has the worst economic record on inflation since the great depression, but he thinks he is one of the best!

Testifying before Congress recently, Ben Bernanke bragged, "my inflation record is the best of any Federal Reserve chairman in the postwar period, or at least one of the best, about 2 percent average inflation."

Catherine Rampell's numbers show that Bernanke has, in fact, delivered the lowest inflation of any postwar Fed chair, coming in at an average of 2 percent. On the other hand, Floyd Norris notes that unemployment under Bernanke has been second-highest of any postwar Federal Reserve chairman. Now if you ignore the "postwar" qualifier, the picture looks different. Several Depression-era Fed chairs had less inflation and more unemployment than Bernanke. And putting those Depression-era bankers into the mix serves to highlight how absurd Bernanke's boast is. No sensible person would look at America's economic performance in the 1929-1933 period and say "man, they did a great job of fighting inflation."

It is true that inflation was very low—indeed, negative—for most of this period, but that simply goes to show they were doing a terrible job.

Suppose Ben Bernanke resolved to deliver enough aggregate demand to get the inflation rate up to its Greenspan-era average of 2.6 percent. Unless you believe there is literally zero slack or excess capacity in the economy, that would create some extra jobs and real growth. And was inflation so terrible in the Greenspan years? Nope. At the time, Greenspan-level inflation was considered a historic victory in the war on inflation.

Moneybox later points out that there are many prominent media voices calling for higher inflation on both the political right and the left, but almost no voices in positions of political power including at the Fed. 

I regularly give Ben Bernanke a hard time for the excessively tight monetary policy he's run at the Federal Reserve, and his most recent congressional testimony has been the chance for more of that. But in Bernanke's defense I should say that the really striking thing about his appearance is the utter and total lack of influence of dovish monetary policy views on Capitol Hill.

If you read a lot of economics coverage on the Internet, you'll be struck by the amazing success of "dovish" monetary policy views. I've been pushing them here at Slate, Ryan Avent pushes them at the Economist, Matt O'Brien pushes them at The Atlantic, Tim Fernholz and Miles Kimball push them at Quartz, Josh Barro and the Stevenson/Wolfers team push them at Bloomberg, Ramesh Ponnuru pushes them at National Review, Ezra Klein pushes them on Wonkblog, Paul Krugman and Tyler Cowen have both pushed them in the New York Times, etc. It's not like an overwhelming consensus or anything, but normally a political stance with this much representation in the media could find at least one significant politician to stand up for it. But while we have Obama's former Council of Economic Advisors Chair and the chief economist at Goldman Sachs on our side, we seem to have zero members of congress.

This is not an excuse for the Fed's too-tight policies ...but it's probably a reason for it. If nobody in congress objects to crucifying mankind upon a cross of 2 percent [core inflation] targeting then realistically it seems unlikely to stop.

Broken Windows and Depreciation

Barry Ritholtz shows a graph that America's durable goods are getting old. That means that they will need to be replaced and when people start replacing durable goods, 'savings' decreases.  One of the many ways that people 'save' during a recession is by putting off purchases of durable goods but eventually their goods break and they finally shell out to replace them.  This is a 'natural' way for the economy to recover.  But it is just like what would happen if someone went around breaking them.  Moneybox: 

waiting for a "natural" economic recovery rather than relying on "artificial" stimulus in the form of fiscal or monetary policy is really just a slow motion version of creating economic growth via the broken windows fallacy. If five percent of America's cars, fridges, toasters, washing machines, and blenders vanished suddenly tomorrow that would be "good for the economy" in the sense that boosting orders for consumer durable goods would lead to a higher GDP growth rate. But the purpose of having an economy is to make people better off, and you clearly don't make people better off by destroying their appliances.

By the same token, even a steep recession will generally come to an end sooner or later. Cars and trucks and buildings and appliances will get old and need to be replaced, in effect raising the "natural rate of interest" and bringing intended savings and desired investment into equilibrium. But this happens by impoverishing the country, just as much as running around smashing windows would.
 

 

 

Models of Inflation

Inflation was too high in the 1970s and early 1980s because mainstream economists had a poor understanding of when inflation is beneficial and when it is harmful and of how to control it.  Today inflation is too low because mainstream economists have a poor understanding of the costs and benefits of inflation and how to control it.  In some ways, we are in the mirror image of the problems of the 1970s. 
Lowering inflation is simple.  Just restrict the money supply and communicate expectations clearly.  Raising inflation is also simple.  Just expand the money supply and communicate expectations clearly.  The important think in both cases is for the central bank to clearly communicate that it will keep doing whatever it takes to bring inflation to the approximate level that it wants.  Today it seems amazing that economists did not understand this in the 1970s and someday it will seem amazing that many prominent economists do not understand this today.