J. Bradford DeLong
Depression Economics in a Nutshell J. Bradford DeLong U.C. Berkeley November 19, 2010
Let me present to you how you should think about the topic of “depression economics”: the spine of the subject. The US employment to population ratio over the last three years has crashed from 63.4 down to 58 point something percent of American adults. This collapse is not because we have forgotten how to make things. It is not because we’ve all decided we want to take longer vacations, or go back to school, or get in touch with our inner selves. It is not because our capital goods have mysteriously rusted away. This collapse in employment is the result of a collapse in spending, a generalized deficiency of aggregate demand, an excess of aggregate supply, pretty much everywhere in the economy. There is only one sector I am aware of that is still at capacity: high-end restaurants within a mile of the capital in Washington DC. Those still appear to be at full employment and at full capacity. Nothing else in the economy is. The question of why this should happen is an important one. Why should there be such crashes in the level of employment? How can it be that there
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is not enough spending, not enough demand in the system to put everyone who wants to work to work productively? Back in 1803 Jean-Baptiste Say observed that nobody makes except to use or to sell. and nobody sells except to buy. Thus, he argued there can be particular shortages of demand in some commodities balanced by excesses of demand for others. But “overall excess demand” is self-contradictory because everybody’s spending is someone else’s income and everyone’s income is then spent sooner or later on something. How is it that the economy can wedge itself into a position like it is in today? That is an important question. And this question has an answer. The answer is that what we try to spend our money on does not have to be currently produced goods and services. Say’s Law says that if there is excess supply for something there has to be excess demand someplace else in the system is sound. But the excess demand does not have to be for currently-produced goods and services. The excess demand can be for financial assets. People can be trying to switch their spending away from currently-produced goods and services in order to build up the amount of financial assets they have. That is what gets the economy wedged in a position of high unemployment—like it is today. This is bad news for Say and good news for us. It is bad news for Say because it means there is a hole in his logic that the market system would always work well on a macroeconomic level. It is good news for us because it suggests a way to cure even a big down turn in employment and production. Such a downturn should have a cure in the form of a strategic financial intervention by the government. Find a way for the government to fix the excess demand in financial markets, and you fix the deficient demand for currently-produced goods and services—you fix the economy. Historically, we have had three types of excess demand for finance that have produced big downturns in economies. First, we have seen excess demand for bonds—for the pieces of paper corporations and the government issue that pay interest and eventually return your principal—for the savings vehicles that enable you to take
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your purchasing power, store it up, and use it in the future, with interest. When there is an excess demand for bonds—when planned savings is greater than planned investment—we then have downward pressure on the flow of currently-produced goods and services as individuals try to build up their stock of savings vehicles beyond what is possible. How large a downturn? We have a master equation from the income-and-spending approach to enable us to calculate how far the level of production will fall. We fix this kind of downturn by having the government do something to restore balance in the market for savings vehicles, the market for bonds. If it can reduce the demand for bonds or increase the supply, it can fix the excess demand for bonds and thus the deficient demand for currentlyproduced goods and services. That is the type of downturn we saw in 2002. It is not the kind we have now. If it were, then bonds would be expensive—there would, after all, be high and excess demand for them. But right now risky bonds are cheap. Second, we have also seen in history excess demands for liquid cash money. Such an excess demand produces a monetarist downturn as nearly everybody cuts back on their spending on currently-produced goods and services in order to try to build up their holdings of liquid cash money above what is possible. It is possible to tell when there is monetarist downturn: since everybody is trying to build up their stocks of liquid cash money, everybody is selling their other financial assets and thus their prices—stocks, bonds, whatever—and all their prices are low. That is not the kind of downturn we have today: today the prices of some financial assets—the liabilities of credit-worthy governments, for example—are very high. In a monetarist downturn there is also a master equation to calculate the size of the fall in production: the quantity theory of money equation. And here again we know how to fix the problem with the economy. If the Federal Reserve increases the stock of liquid cash money in people’s pockets enough by buying short term government bonds for cash, it relieves the excess demand for cash and so cures the deficient demand for
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currently-produced goods and services. That is the kind of downturn we saw in 1982. Today, however, we have a third kind of downturn: a different kind of downturn than one generated by a shortage of money or of bonds, than a monetarist or a Keynesian downturn. We know we do not have a monetarist downturn because the prices of a number of non-money financial assets are very high. We know that we do not have a Keynesian downturn because the prices of some savings vehicles are very low. So what do we have? We conclude that the excess demand in financial markets right now on the part of investors is an excess demand for safety: for high quality AAArated assets for people that hold in their portfolios. Prices of risky financial assets are low—there is no excess demand for them. Prices of safe financial assets are high—there is an excess demand for them. Thus businesses and households have cut back on their spending on currently-produced goods and services as they all have concluded: “We don’t have enough safe assets in our portfolios. We need to stop spending so much until we build up our holdings of safe assets to a higher level.” And the fact that they cannot do so because there is a shortage of safe assets in the economy is what is keeping us wedged in this current situation of high unemployment and low capacity utilization. Where did this excess demand for safe assets come from? It came as a consequence of the deregulation of finance and of the securitization of mortgages, from the housing bubble and the crash, from the fact that then it turned out that investment banks that had created brand new derivative securities based on mortgages had not originated-anddistributed them but had, to a remarkable and astonishing degree, originated and kept them. They were supposed to sell off all the pieces o real estate risk in small bundles to savers all over the world. They did not. When it turned out that these mortgage-backed securities were actually a lot riskier than had been claimed, the natural response was to fear. For not
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only were those securities exceptionally risky, but all debts of any financial organization thought to be holding any significant amount of mortgage-backed securities became risky as well. Thus the economy-wide supply of safe assets fell massively just at the very point in time when increasing uncertainty and the coming recession made everyone wish to hold more safe assets in their portfolios. So what do we do now? Cutting-edge macroeconomic theory—the theory of Say (1829) and Mill (1829)—tells us that we can fix the real-side economic downturn if we fix the excess financial market demand for safe assets. Successfully doing that would be a neat trick. Figuring out how to regulate financial markets so that we can keep it from happening it again would be an even neater trick. So how is the government doing at this task? There are two ways to look at it: half-full and half-empty. The half-full way is that of Alan Blinder, adviser to the Obama campaign, and Mark Zandi, adviser to the McCain campaign. They have a paper claiming that if the government had simply stepped back in the fall of 2008 and let the economy “liquidate” itself, that right now our unemployment rate would be 16%. The fact that the unemployment rate now is only 9.6% rather than 16%— Henry Paulson who was Bush’s secretary of the treasury and Tim Geithner who is Obama’s secretary of the treasury take pride in that as a substantial accomplishment: their policies have kept 6.5% of the American labor force from becoming unemployed. The half-empty way is to say: “Wait a minute. The unemployment rate ought to be 5%. Even an generous estimate of how much extra structural unemployment there is in America today the unemployment rate should still not be much above 6%. But it is 9.6%. It is way above where it ought to be if the market were working smoothly and well. Policy simply has not done enough.”
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That is the spine of the topic of depression economics. November 19, 2010: 1697 words
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