DeLong Smackdown Watch: Underemployment Equilibrium Edition
Dan Kuehn:
Facts & other stubborn things: Nick Rowe, Brad DeLong, and Me on Whack-A-Mole General Gluts and Money: The other day I took some issue with the idea that general gluts are just excess demand for [bonds, money, secure assets] and excess supply of goods and services. The idea isn't absurd, of course. If there happens to be no excess demand for money but there is an excess demand for bonds and surplus of goods and services, that will sure feel like a recession to workers and look like a recession in the data. In that sense I don't think Brad DeLong's version of the story is wrong per se. In all likelihood we've had many downturns characterized by this sort of general glut. But there's something ultimately unsatisfying about this approach when you're going through a downturn that just doesn't bounce back - when you have a stable underemployment equilibrium. Why would this "whack-a-mole" general glut not work itself out? Brad provides several great reasons why not: disrupted credit channels, the zero lower bound, etc. All of these reasons are very good reasons for why a whack-a-mole general glut would lock in for a while. And perhaps that's all there is to it.
But I have my doubts that that's all there is to it, and so does Nick Rowe. However, Nick takes a somewhat different approach from me an in a lot of ways, my approach to why the whack-a-mole theory is incomplete is closer to Brad....
I like to think in terms of a linear system, because when we worry about recessions we're worrying about slack, and with a linear system it's very easy to conceptualize exactly what the source of the slack is....
Everything comes down to money and the interest rate, and everything comes back to Keynes. In this post, Brad explains why the interest rate is really one price functioning in two markets: the bond market and the money market. People want loanable funds and people want liquidity. Let's bring this back to our system of linear equations where Brad is an out-of-the-closet Walrasian (who is open about the fact that the price level squares the system of linear equations) and Nick is a still-in-the-closet Walrasian (who still insists we have n goods and n-1 markets even though it's clear that that n-th good - money - is related to all the other goods through the price level). What does the interest rate do to this system of equations?
It overidentifies the system, introducing the very real potential for slack. Before we had n-1 goods, n-1 prices, and money for a total of 2(n-1)+1 columns. We had 2(n-1) market relations (supply and demand in each of the n-1 markets) and the price level for a total of 2(n-1)+1 rows. This is a well-identified system where we can have whack-a-mole general gluts but no reason to think those gluts won't be arbitraged away eventually (by adjustments in the price level, a la Brad's point, if nothing else). But Keynes points out that we are missing one row - one market relation. We are missing the money market or the market for liquidity - that market that Nick says doesn't exist. This is the liquidity preference theory of the interest rate - the interest rate is determined by the desire to stay liquid. The problem is that while we add this market relation as a row in our linear system, we don't add another column so that the system remains identified. Why? Because we already have the interest rate as a column - because the interest rate is the inverse of the price of bonds (which are presumably already there as one of our n-1 goods and n-1 prices).
This is a major problem. Now we have 2n rows and 2(n-1)+1 columns. That introduces slack. Now, where that slack shows up isn't entirely clear. Keynes said investment was made based on the investment level that would equalize the marginal efficiency of capital and the interest rate. So he thought a lot of the slack would show up in investment. It's not a bad approach - we do see the sharpest drops during recessions in investment. Keynes was a sharp guy. Hicks took a slightly different approach that was perhaps better suited to the new wave of national accounts measurement. In his model, he forced the loanable funds market to actually clear at the same interest rate as the money market. This means no slack in the loanable funds market, so the slack would be felt in the prices or quantities of goods and services. Hicks strikes me as being a little more presumptuous than Keynes in this respect, so I somewhat prefer Keynes - who left the question open.... And this, I should add, is why despite Brad's quite justifiable praise of Say, Bastiat, Mill, Bagehot, Fisher, and Friedman - there is a very good reason why Skidelsky calls Keynes "the master", and why I write so much about him on here...
Nick Rowe:
Worthwhile Canadian Initiative: Walras' Law vs Monetary Disequilibrium Theory: Walras' Law says that a general glut (excess supply) of newly-produced goods (and services) has to be matched by an excess demand for some other good.... Daniel Kuehn calls this the "Whack-a-mole" theory of general gluts. The excess demand that matches the excess supply of newly-produced goods could pop up anywhere. Monetary Disequilibrium Theory says that a general glut of newly-produced goods can only be matched by an excess demand for money. There's only one mole to whack. Money is special. A general glut is always and everywhere a monetary phenomenon. In a monetary exchange economy, Walras' Law is wrong; Monetary Disequilibrium Theory is right. We live in a monetary exchange economy. Walras' Law is the worst fallacy currently taught in economics as gospel truth....
Keynes failed to escape Walras' Law. He said (somewhere) that if Silvio Gesell succeeded in eliminating an excess demand for money by taxing money, people would switch to wanting to hold land instead, and the general glut could continue. The excess demand just pops up somewhere else. Whack-a-mole. But Keynes was wrong; Gesell was right. New Keynesian (Neo-Wicksellian) models say that a general glut of goods-produced-today is matched by an excess demand for goods-produced-tomorrow, not by an excess demand for money. That's another application of Walras' Law. Walras' Law is not a zombie theory. It's a poltergeist. It doesn't realise it's dead (Clower killed it decades ago). You have to first understand why it was once alive before you can persuade it to rest in peace....
[A]gents aren't stupid. They know that if there is an excess supply of apples some of them will be unable to find buyers and so won't be able to sell as many apples as they want to sell. ... They are quantity-constrained. So they revise their planned demands and supplies of other goods taking that constraint into account. The demands and supplies we actually observe in markets are those constrained demands and supplies.... [W]e live in a monetary exchange economy.... In a monetary exchange economy there are n-1 markets with 2 goods traded and 2(n-1) excess demands. OK. So can't we just re-state Walras' Law as saying that the sum of the values of the excess supplies (demands) for the n-1 non-money goods must equal the sum of the n-1 excess demands (supplies) for money? The short answer is: "No, you can't". Or rather: "You can if you like, but it's a very different beast from the original Walras' Law, and is totally useless". Let me explain why.
Let there be three newly-produced goods: haircuts; manicures; and massages. Let there be one non-money non-produced good: "land". And let there be one medium of exchange: "money". There are four markets: for haircuts; for manicures; for massages; and for land. Money is traded in each of those four markets.... [T]he hairdresser decides she wants to buy land instead of a manicure; the manicurist decides she wants to buy land instead of a massage; and the masseuse decides she wants to buy land instead of a haircut. (Substitute "bonds" for "land" and this is the New Keynesian theory of general gluts.)... Walras' Law says there is an excess demand for land and an offsetting excess supply of newly-produced goods... which will cause all three women to be unemployed.... WRONG!...
Either the price of land adjusts or it doesn't. If it adjusts, so that all three women stop wanting to buy land at the new higher price, we are back in equilibrium. If it doesn't adjust, all three women will learn that they cannot buy land, because they can't find a willing seller. They are quantity-constrained in the land market.... [They] re-formulate their demands and supplies for other goods.... One plausible scenario is that, since they can't buy the land they want, they go back to doing whatever it is they were doing before they suddenly decided they wanted more land. They go back to buying haircuts, manicures, and massages.... So there's an observed excess demand for land, but no observed excess supply of haircuts, manicures, or massages. Walras' Law fails....
Back to my three women. Start back in equilibrium. Hold prices fixed. Then all of a sudden all three women decide they want to hold more money and less land. Walras' Law says that there's an excess supply of land matched by an excess demand for money. But no excess supply of newly-produced goods like haircuts, manicures, or massages. WRONG!... Either the price of land adjusts or it doesn't. If it adjusts, so that all three women stop wanting to sell land at the new lower price, we are back in equilibrium.
If it doesn't adjust, all three women will learn that they cannot sell land, because they can't find a willing buyer. They are quantity-constrained in the land market. And being rational utility-maximising agents, they take that new constraint into account and re-formulate their demands and supplies for other goods.... One plausible scenario is that, since they can't get extra money by selling land, they try to get extra money by selling more haircuts, manicures, and massages. But that won't work either, since they can't find extra willing buyers. A second plausible scenario is they they try to get more money by buying less haircuts, manicures, and massages. That's what causes an excess supply of newly-produced goods. That's what causes a general glut. Nobody can ever stop you buying less other goods.
What makes money different? What makes money special?... Money is different because it is the only good for which every person is both a buyer and a seller.... [W]hile the individual agent can always get more money by buying less other goods, that's not necessarily true in aggregate. And the individuals' attempts to do something which is collectively impossible are what cause the general glut of other goods.
Leave money out of the picture, and it becomes impossible to explain why there should be a general glut of haircuts, manicures, and massages. If all three women are unemployed, why don't they just do a 3-way barter deal? The hairdresser gets a manicure, the manicurist gets a massage, and the masseuse gets a haircut. All three women are better off. Any theory of general gluts which ignores monetary exchange and the excess demand for money assumes the three women are irrational in leaving unexploited gains from trade lying on the table.
And Paul Krugman:
There's something about macro: [T]he intellectual problems with doing macro this [Mill-Hicks] way are well known. First of all, the idea of treating money as an ordinary good begs many questions: surely money plays a special sort of role in the economy...
