Needed: More Aggregate Demand: The Keynesian Cure

J. Bradford DeLong (2008), "The Keynesian Cure," for Project Syndicate: BERKELEY -- It is not yet foredoomed that the world economy will undergo a substantial recession in the next three years or so: we might still escape. But governments should play it safe by starting to take more steps now to cushion, soften, and shorten the period of high unemployment and slow or negative growth that now looks very likely.

It is a fact of nature – human nature, at least – that prudent and appropriate policies now will later seem excessive. At some point, the world economy will begin expanding rapidly again. But it would be most imprudent to assume that the turning point is right now, and that things are as bad as they will get.

Perhaps the best way to look at the situation is to recall that three locomotives have driven the world economy over the past 15 years. The first was heavy investment, centered in the United States, owing to the information technology revolution. The second was investment in buildings, once again centered in the US, driven by the housing boom. The third was manufacturing investment elsewhere in the world – predominantly in Asia – as the US became the world economy’s importer of last resort.

For 15 years, these three locomotives kept the world economy near full employment and growing rapidly. When the high-tech boom ended in 2000, the Federal Reserve orchestrated its replacement by the housing boom, while investment in Asia to supply the US market was chugging along at an increasing pace.

Many today are complaining about Alan Greenspan’s monetary stewardship, which kept these three locomotives stoked: “serial bubble-blower” is the most polite phrase that I have heard. But would the world economy really be better off today under an alternative monetary policy that kept unemployment in America at an average rate of 7% rather than 5%? Would it really be better off today if some $300 billion per year of US demand for the manufactures of Europe, Asia, and Latin America had simply gone missing?

The first locomotive, however, ran out of fuel seven years ago, and there is no clear technology-driven alternative leading sector, like biotechnology, that can inspire similar exuberance, rational or otherwise. The second locomotive began sucking fumes two years ago, and is now coasting to a halt, which means that the third – the US as importer of last resort – is losing speed as well: the weak dollar accompanying the housing finance crash makes it unprofitable to export to the US.

The world economy, as John Maynard Keynes put it 75 years ago, is developing magneto trouble. What it needs is a push – more aggregate demand. In the US, the weak dollar will be a powerful boost to net exports, and thus to aggregate demand. But, from the perspective of the world as a whole, net exports are a zero-sum game. So we will have to rely on other sources of aggregate demand.

The first source is the government. Fiscal prudence is as important as ever over the medium and long term. But for the next three years, governments should lower taxes – especially for the poor, who are most likely to spend – and spend more.

The second source is private investment. The world’s central banks are already cutting interest rates on safe assets, and will cut them more as the proximity and magnitude of the likely global slump becomes clear.

But low interest rates are entirely compatible with stagnation or depression if risk premia remain large – as the world learned in the 1930’s, and as Japan relearned in the 1990’s. The most challenging task for governments is to boost the private sector’s effective risk-bearing capacity so that businesses have access to capital on terms that tempt them to expand.

Comments

[a]

"Perhaps the best way to look at the situation is to recall that three locomotives have driven the world economy over the past 15 years. The first was heavy investment, centered in the United States, owing to the information technology revolution. The second was investment in buildings, once again centered in the US, driven by the housing boom. The third was manufacturing investment elsewhere in the world – predominantly in Asia – as the US became the world economy’s importer of last resort."

I thought there was only one locomotive: the American consumer.

Sure let's keep him and her spending! More debt! Let's party!

[ottnott]

Your proposed cure is different from serial bubble blowing in what way?

Based on commodity prices and the negative US savings rate, I'd say that demand is already pumped up like Barry Bonds.

Maybe we should stop looking for ways to keep moving at locomotive speeds. Take a walk for a while.

[vt codger]

So, the levees have failed and flooding has ensued. Your plan is to pump like mad then rebuild in the same place. Are there other plans that might appeal more to those who thought that was kind of a dumb place to put a town?

[i.t.]

Certainly more aggregate demand could be a temporal solution, but no permanent and would make the later crash greater. In my opinion the American consumer is being substituted by the European consumer as an attempt to transfer both American deficits and as ECB approves the movement requires that European interest rate has to be maintained to reduce the economic cost in their economies. However to make this strategy more efficient and shorter to reduce the potential risks for both economies some steps should be taken:

1) A simultaneous and progressive interest rates increase by FED, ECB and Bank of Japan of about 100-175 basic points in a short term, to maintain actual and desirable disequilibrium but reducing stagnation risks and forcing yuan appreciation.

2) Introduce political reforms with the main objective of a Transatlantic Economic Free Trade Union (NAFTA+EU) to make more effective the deficit transference between economies during crisis periods and to be more competitive against emerging economies.

3) Stop the irrational commodities speculation in the financial markets, especially bio-fuels (i.e. cereals and derivates) and crude oil to stop inflation and make more competitive our energy models compared with the used by emerging economies.

The next G7 meeting could be a good start point to take right decisions.

[Neal]

Time to be blunt. It is the US economy that is in trouble for now. Europe is holding it's own. Asia and India are booming, much of it internally driven now. Africa has a bright future, based on it's resources in demand from the rest of the world.

The tech locomotive benefited the ROW more than it did the US. There were no more secrets, and jobs could be off-shored easier. The "US consumer as customer" locomotive accelerated the off-shoring, increased US indebtedness, increased the growth of the ROW. The benefit of this was the stagnant wages within the US were disguised behind Walmart's "lower prices every day".

The "real estate" locomotive was the on shortest rail line ever built for a n economic locomotive. How many years of 30% house price appreciation could anyone stand, given that ultimately the consumer would have to pay those prices in order for the market to be sustained?

So the question should not be "what new locomotive can be built?". The question should not be, "would the world be a better place if the US had not burned through the 3 main locomotives?"

Instead, the issue is why the US has not worked on developing a sustainable economic model.

We burned through the biggest and most powerful locomotive, real estate, in 3 peak years. The tech locomotive burned out in 10 years. The US consumer model is failing after 30 years.

What is the sustainable model for the US economy?

Is there a sustainable model?

Those are the big economic questions. The powerful but ever shorter-lived locomotives of the example have not served the US well.

Meanwhile the balance books of the US--personal, corporate and governmental--are solidly in the red. We are in for some really bad times.

But what is really appalling and scary is that the best answer you and others can come up with is "go out and spend" until we find the next locomotive.

[Iqbal Latif]

>

''So we will have to rely on other sources of aggregate demand.''

Global consumerism with new consumers ability to spend can be compared to Ford global vision, with consumerism as the key to peace. Ford did not believe in accountants; he amassed one of the world's largest fortunes without ever having his company audited under his administration.

Ford had been criticized by other industrialists and by Wall Street for starting the 40-hour work week and a minimum wage. He proved, however, that paying people more would enable Ford workers to afford the cars they were producing and therefore be good for the economy. Ford explained the change in part of the "Wages" chapter of My Life and Work. He labelled the increased compensation as profit-sharing rather than wages.

In the "Keynesian cross diagram," a desired total spending (or aggregate expenditure, or "aggregate demand") curve is drawn as a rising line since consumers will have a larger demand with a rise disposable income, which increases with total national output.

Chinese and Indians in 1990’s were nearly broke pauper states with absolutely minuscule reserves and controlled economies, in the last 15 years the dynamics of global economy have changed for better. USA is no more the only country that is the locomotive of the global economy; it is the economy of last resort undoubtedly as ‘R&D Mecca’ of global economy. No immediate threat is visible to $, $ remains for foreseeable future the currency of reserve, Chinese reserves as well as Indian reserve are mostly in $’s, not out of charity but there is no single country in the world where these reserves can be gainfully invested. From $ at 1.18 to Euro to its movement to 0.95 and 1.59 the phenomenon is more explained by currency speculation and cycles of strength and weaknesses. We have seen Yen at .79 in 90’s and at 101 is in the range that is historically understandable.

We need to learn that if we are seeing a rising demand with rise in disposable income amongst a huge populace of the world we are freeing ourselves from uni-centric old reliance on US as the oasis of the global economy, that exactly what USA needed in this point in time, hundreds of millions of new prosperous workers ready to buy products. This was Ford vision of prosperity and this is how prosperity will be ensured for new global society, commodity price have risen for two reasons one mass speculation by the hedge funds to demand for raw products, both of these factors has helped poorer nation to build on reserves and ignite aggregate demand. . In this new global economy China and India are growth engines, the rise in price of commodities and appreciation of added value of intellectual capital are increasing consumer demand in the two most-populous nations. Investors will do fine as strong economic growth, rising productivity and an ample supply of increasingly skilled labour will help steady growth of global economy.

[bigTom]

If you look at the world economy from a gross natural input perspective, you see various commodities being transformed into various goods. Now add in a rapidly increasing flattening of the distribution of wealth, and depletion -or at least a rough plateau, for many of the crucial commodities (not just oil). You now get a world economy which is much closer to a zerosum game than most economists would to admit. The commodities price run up is far more than the effect of speculation, but rather an indication that the world economy is straining against fundamental physical limits.

[mudduck]

"At some point, the world economy will begin expanding rapidly again."

Why? How? Oil supplies are short of increasing demands, and the price surely will go higher. Corporate agriculture and long-distance shipping of goods will become uneconomic. Maybe we can keep electricity to power the computers (and DVDs) going with wind power or geothermal, but cheap energy is coming to an end. Important minerals sources are also peaking. New times ahead, not more of the same with variations.

[Bram Cohen]

Isn't 'cutting taxes' already way overdone? dubya has cut taxes to completely unsustainably low levels, so there's no room to create stimulus by cutting further. About the best we could do would be to make all the necessary tax increases happen on the rich and give modest tax cuts to the poor.

Since all bubble-blowing has basically run out, the only thing left to do is increase direct government spending and add regulatory oversight which reduces the risk premium. The really legitimate criticism of Greenspan is that he allowed mortgage reselling to be opaque enough that many mortgage resellers came to be in danger of collapse if interest rates or housing prices moved only a tiny bit, but the end investors had no visibility.

The real fixes in the US are for the government to create national health care, thus reducing expenses dramatically and creating a stabilizing effect on prices, and to end the expensive and negative economic value war which we're in. Cancelling the DHS could save some dough too.

A longer-term fix is to introduce proper regulatory oversight of the mortgage resale industry, and probably other financial instruments as well, but that's a move to curtail the next recession, not pull us out of this one.

[Matt]

Brad,

One of the events that fed the dot com expansion was the release of technical resourrces from the defense industry, as happened in Silicon Valley, I was there. One can dispute cause and effect, but I think we should covariance between the relative reduction in government under Clinton vs Reagan coincided with the expansion and development of the information business. There is no reason we cannot duplicate the same cycle under Obama, and revive the information industry.

If you should worry about a weak government, then your worry will be with Obama, because as he starts to gradually reduce the percentage take of federal government, we will see an overshoot, as local governments dump resources onto the private sector, lowering the cost of business too far.

[save_the_rustbelt]

Could it be that the great globalization scheme is moving too fast, like a carnival ride off its morrings? The pig is going through the python too rapidly? American workers are being dumped too fast?

Stay tuned!

[Matt]

Here is the quick analysis from the viewpoint of the "atomic" theory, as Solow calls it.

I go to the yield curve. Ben has that thing nicely shaped, but it is shorter and narrower. It is narrower, because, as a Fourier spectrum (the half we can see), we are all using shorter integration times to estimate future values. We use shorter integration times because values are high, and out of phase with transaction rates, which are low. In the instability, we are in the period when energy is concentrated in value and flows are minimal. So, Brad's law of large N comes into play, with small transaction rates, each new transaction is innovative, and causes large adjustments in estimated long term value. We are trying to extend out outlook period back to longer periods, and this is possibly the restoring force.

We have a generalization of Gordon's Law for computing present value, and the cause behind Brad's possible "zero" in his pole zero alalysis of equity values. When integration times shorten too rapidly, then residual noise rises as the expected future flows in the economy are no long estimated out to 20 years. That flow gets washed into noise in our current predictors. The noise level rises, and possibly nearing the peak value of Ben's yield curve, and though he has it nicely shaped, if something else (besides money) is wrong, whoops.

So what could go wrong? Our adaption to global institutions could run afoul of our national monopolies. For, it is the gap in global institutions, that the atomic theory predicts will cause fission. The atomic theory needs the X axis distributed nicely gaussian, and we have a mismatch between global demands and national monopolies.

[benamery21]

It isn't a bubble if it is at rational cost levels and focused on long-run productive assets. How about spending some money on restructuring transportation and energy towards lower intensity modes? I'd suggest about $300B additional per year in U.S. federal domestic infrastructure investment, and about $1.5T/yr additional internationally.

What to buy: Repair of aging U.S. infrastructure, expansion of rail and inland waterway capacity, associated intermodal transition facilities, residential energy efficiency improvements, 200,000MW of wind power, 100,000MW of pumped storage, BACT for all existing coal plants, associated transmission, methane digesters for all CAFO's, intra and inter city transit, natural gas strategic reserve, LNG plants, traffic control upgrades for air/rail networks, .

Internationally: Freight transport (rail/water) network for Brazil and others, non-petroleum generation for oil exporters, agricultural development capital for 3rd world, etc.

[piotr]

I do not have statistics at hand, but it seems to me that from ca. 1950 to 1990 there was a consistent decline of primary products like oil, corn, lumber, cocoa, in the global economy. Part of it was that increasingly sophisticated finished products were adding more and more value, but part was the declining terms of trade for the primary products.

Those two facts are related, because the increase in supplies were more than adequate.

But now we have two phenomena. Countries with huge populations are rapidly industrializing, and they have huge needs on relatively low level of "sophistication". As they have more money, they satisfy those needs better. For example, Americans and Europeans have more than adequate supply of animal products in their diet, so new needs would be for products of higher quality, more natural etc. But Asians move from vegetarian or semi-vegetarian diet to one richer in animal products, rapidly increasing the demand for grain.

And now there is a bidding war for all commodities. Including, alas, oil. And in the last 20 years we made huge investments in larger personal vehicles, larger homes, homes located further from places of work than before, and we also have build a lot of new power stations fueled with natural gas.

And we did not invest as much in production capacity to have product to pay for this oil.

There is some evidence that we can regain competitiveness in manufacturing at the radically reduced exchange rate, but without drastically lower consumption of oil, and perhaps other primary materials, this will not be enough.

Simply increasing the "aggregate demand" is weird in the world that has already an excess of demand, or insufficient supply, for primary goods. We need to start actively altering the way our civilization is functioning.

Basically, how can we convince the "world" to give us 20-25% of the global supply of various raw materials without offering some huge amount of more attractive goods that we are able to make now? And if we fail, we can purchase them for credit for a while, but this opportunity is declining right now. So (a) we have to learn to do with less, (b) we have to offer an attractive consumer model that is doing with less.

At some point, our civilization has to learn how to keep population employed and happy without consuming more primary products every year. For all talk about "post-industrial economy", we did not do it, except for moving part of the manufacturing, and the direct demand for primary goods, to other countries.

Some people think that one way of doing it, right now, would be to tax carbon fuels and use the proceeds to retool our energy consumption in the form of doubling the efficiency of personal vehicles, non-carbon production of electricity (mostly nuclear, I guess, but with alternatives too), increasing energy efficiency of homes and commercial buildings etc. Doing all of that would create a lot of demand, although the end result would be that we do not have larger and more numerous goods, just better ones.

[bakho]

there is no clear technology-driven alternative leading sector

But there should be and it is the energy sector. This administration has done everything in its power to stall forward moves in energy conservation and innovation. They have done everything they can to maximize profits for the oil and energy industry.

Unfortunately, these windfall profits are hurting the world economy. High energy prices fueled economic downturns in both 1974 and the late 1970s. It was only after CAFE standards and other energy conservation had kicked in to drop oil consumption by 20% and the downward pressure on energy prices that the economy came out of its funk. The same thing is happening today with the same effect. Auto, Airline and tourism are all most negatively effected by high energy prices.

AG created the only bubble that could be created with monetary policy, housing. It will be up to the next administration to start stimulating the energy conservation and alternative energy structure.

[N]

http://www.chicagotribune.com/business/chi-thu_futuregenjan31,0,2119234.story

U.S. pulls the plug on funding for FutureGen
By Joshua Boak and Monique Garcia | Tribune reporters
January 31, 2008

The Department of Energy on Wednesday officially quashed a $1.8 billion clean-coal project slated for central Illinois, leaving the experimental venture to capture carbon emissions dependent on Congress for survival.

The FutureGen Industrial Alliance was cooperating with the Energy Department to develop a coal-fired power plant designed to gasify and store carbon emissions deep within the Earth, a process known as sequestration. But the Energy Department withdrew its support because of ballooning cost estimates on what was initially supposed to be a $1 billion project.

The surprise move transformed a short-lived celebration after Mattoon, Ill., was selected last month as the plant's home into a legislative battle, once the Bush administration chose instead to spread funding across multiple facilities planned nationwide.

[N]

Soros over at Financial Times (online video) says we may need more regulation in the U.S. Industry-funded "insurance" funds might be an example. Also, more margin requirements for commodities might also be worth considering.

[V_AG]

Matt, i don't understand what you are trying to say. Can you elaborate? i don't quite get your terminology and how this applies in our situation.
Thanks

[Larry Mishel]

Geez, Brad, if we need government stimulus why do we need to rely on tax cuts? What's wrong with meeting our vast backlog of social needs through spending?
Larry Mishel

[John Drake]

The increase in demand must come from consumer spending in Europe and Asia. We spend too much, and they spend too little on consumer goods. If we simulate Americans to spend more on consumer goods (72% of the economy), we just increase employment in China and India. That might help someone get elected, but it won't help the US, which needs to rebuild its productive capacity. We also need a stable currency, and I don't think were going to get that with a Keynesian cure.

[piotr]

To add to John Drake:

we can observe to un-Keynes elements. One, as John points out, the point of stimulus and the stimulated point are different. The stimulus applied in USA prompts more manufacturing investments in Asia, and they have quite adequate pace of those investments, if not too much. Some if it "spills over" but only some.

The second difference is that during Great Depression and many recessions the demand for primary goods was going down, and so were prices, and that was creating deflationary pressure. Now we have inflationary pressure from the primary goods. So unlike in pure Keynesian recession, we have to simultanously increase the aggregate demand and decrease the demand for the primary goods: fuels, metals and grains.

Clearly, purely fiscal/monetary approach cannot achieve it. We need some kind of conservation program which hopefully would entail investments and thus, add to the demand for labor, while cutting the demand for primary goods. And we need a bold program, to make a real difference on the scale of 10 trillion economy that uses about trillion dollar worth of fuels (per year).

[John Drake]

A few more words on our productive capacity. One of the key skilled industrial jobs is that of a tool and die maker. The BLS web site says:

"Tool and die makers are among the most highly skilled workers in manufacturing. These workers produce and repair tools, dies, and special guiding and holding devices that enable machines to manufacture a variety of products we use daily—from clothing and furniture to heavy equipment and parts for aircraft."

What are the future prospects for tool and die makers? Look at the BLS National Employment Matrix 51-4111. This table displays the projected employment change for tool and die makers in various industries. Entries colored red indicate negative growth. Most of the table displays red. This is one indication our eroding capacity to produce tradable goods, a capacity we need to rebuild to remain a prosperous industrial power. I know some people think that the US should move beyond the grubby business of production. But to what? Financial services? Let's face it, China and India can do that kind of work too, and it's a lot easier to ship bits around these days than hard goods.

[Sandwichman]

From the comments above: "More debt! Let's party!" "Maybe we should stop looking for ways to keep moving at locomotive speeds. Take a walk for a while." "So, the levees have failed and flooding has ensued. Your plan is to pump like mad then rebuild in the same place." "But what is really appalling and scary is that the best answer you and others can come up with is 'go out and spend' until we find the next locomotive." "The commodities price run up is far more than the effect of speculation, but rather an indication that the world economy is straining against fundamental physical limits." "New times ahead, not more of the same with variations."

Can you say "paradigm shift"? But wait. There is a Keynesian cure available. The "ultimate solution" put forward by Keynes and identified by him explicitly as one of three essential "ingredients of a cure." Why do our self-styled "Keynesians" insist on restricting their policy tool kit to only two of those three ingredients and eschewing the third and ultimate ingredient?

In a letter to the poet, T.S. Eliot, dated April 5, 1945, John Maynard Keynes identified shorter hours of work as one of three "ingredients of a cure" for unemployment. The other two ingredients were investment and more consumption. Keynes regarded investment as "first aid," while he called working less the "ultimate solution."

A more thorough and formal presentation of his view appeared in a note Keynes prepared in May 1943 on "The Long-Term Problem of Full Employment. In that note, Keynes projected three phases of post-war economic performance. During the third phase, estimated to commence some ten to fifteen years after the end of the war, "It becomes necessary to encourage wise consumption and discourage saving, –and to absorb some part of the unwanted surplus by increased leisure, more holidays (which are a wonderfully good way of getting rid of money) and shorter hours."