Worst-of-Both-Worlds Fiscal Policy
In the Shadow of the Hoover Institution Tower...

Microeconomic and Macroeconomic Excess Supply

In our normal, microeconomic world it is not a big deal when excess demand emerges in one market and excess supply emerges in another--it is, in fact, a good thing, because it induces shifts in production that make the structure of what is made correspond more closely to what people want (or perhaps to what the people with money want). There is excess demand in one industry. Sales exceed production, inventories fly off the shelves, and cupboards and supply chains become bare. Producers and entrepreneurs see large profit opportunities if they expand production to rebuild inventories and satisfy higher demand--and they do. They expand factories. They run more shifts. They offer workers more money for overtime, they offer workers more money to stay with their firm, and they offer workers not in the industry more money to come on over.

Where does the added supply of workers to swell the ranks of those in the industry whose products are in excess demand come from? From the industry whose products are in excess supply. There, producers see inventories piling up on their shelves. They are forced to liquidate products and lines of business at a loss. They are forced to lay off some workers, and lay off others lest they lose all their capital.

Overall unemployment may rise a bit or for a while as this process of adjustment takes place--it depends whether entrepreneurs and producers in the expanding industry where excess demand emerges are more or less on the ball, keen-eyed, and keen-witted than those in the industry where excess supply emerges and where businesses shrink. But the process of adjustment, even with frictional unemployment while it takes place, is a good thing--it makes us all richer. Attempts to stop it in its tracks or short-circuit its mechanisms are counterproductive and harmful. The end of the process comes and excess demand and supply are eliminated when there are more people making the things that are wanted more and fewer people making the things that are wanted less.

But in macroeconomics things are different. The excess supply is economy-wide--throughout all commodity markets, producing supply in excess of demand for goods, services, labor, and capacity. Producers and entrepreneurs respond to an aggregate demand shortfall just as individual producers respond to a particular shortfall of demand for their products: they hold sales to liquidate inventories, they cut prices, they cut wages to try to preserve margins, they fire workers. In the macroeconomic case, the dynamic process that leads to the elimination of excess supply and its counterbalancing excess demand in the microeconomic case gets underway--or, rather, half of it gets underway.

The problem is that the set of industries that are shrinking is made up of pretty-much-everybody. There are no industries that are expanding. The excess demand is not for the products of a goods-and-services producing industry that can rapidly ramp-up production by employing lots more labor. The excess demand is in finance: for means-of-payment, or safe high-quality assets, or for long-duration sales vehicles. There is a rise in unemployment from the flow out of goods-and-services producing industries where the excess supply has appeared. But there is no countervailing flow out of unemployment. How do you put large numbers of people to work making more Federal Reserve notes or increasing the supply of liquid assets that are means-of-payment that are the reserve deposits of banks? How do you shift the flow of production to instantaneously raise the stock of long-duration assets, of claims to wealth that are shares in companies with secure long-run prospects that are vehicles for moving purchasing power across time from the present to the future? You can't.

Thus workers fall into unemployment from the excess supply in the goods and services industries. But no workers are pulled out of unemployment by expanding production in growing goods-and-services industries. Incomes fall as the unemployed sit idle. Asset prices jump in the financial markets until markets clear. But markets clear and excess demand in finance is eliminated with incomes reduced by the amount of the lost earnings of the unemployed. The excess supply in goods-and-services is also eliminated in this rationed-equilibrium situation: inventories are no longer growing--but that is because the unemployed are not making anything.

And there the economy sits.

Whether this is an "equilibrium" or not is a matter of taste and definition.

Supply equals demand market by market in the markets for goods, services, and assets. There are no falling inventories or rising inventories to signal that any branch of production should be expanded or contracted.

There are, however, lots of unemployed workers who would like jobs. Their existence should aid employers in their bargaining with workers. Wages should then fall. And when wages fall higher profits should induce employers to expand production even without any increase in spending. Eventually wages should fall low enough that the economy returns to full employment and to normal levels of production and capacity utilization even without any increase in asset supplies.

Or will it? Falling wages means that households have even less money. Some of them will default on their loans. Some banks will find that their reserves are no longer large enough to provide an ample cushion because of these loan defaults. They will cut back the number of deposits they accept--and the money supply will shrink as a result, producing another round of excess demand for financial assets. Or if they are not deposit- but are themselves bond-financed their bonds will suddenly become shaky in quality, and we will see the emergence of an excess demand for safe, high-quality financial assets. In either case, Walras's Law will kick in again and this excess demand will be reflected in another round of excess supply for goods, services, labor, and capacity. Relying on nominal deflation of wages to restore full employment runs the risk of creating yet another shock of excess demand in finance and excess supply in goods and services to deepen the depression. The hoped-for cure's first effect is to worsen the disease.

We trust the market to take care of a microeconomic excess-demand excess-supply situation in a few industries in a productive way in a short period of time. Do we trust the market to do the same way to a macroeconomic imbalance, to quickly resolve a depression in a productive way without help? No, we do not. Rather than relying on economy-wide deflation to eventually restore balance, we should pursue other alternatives.