The Problem isn't Deficient Demand! It's Deficient Demand!

Ed Phelps is a great economist. He's also one of those guys that's got Keynes running through his blood without always making it obvious in what he says and advocates. He did a lot of work with Friedman, he speaks favorably of the Austrians, and he doesn't come out and get excited about Keynesianism which can obscure his Keynesian roots. I suppose that can partially explain Paul Krugman's reaction to this New York Times article by Phelps where Phelps writes:

"The prescription will fail because the diagnosis is wrong. There are no symptoms of deficient demand, like deflation, and no signs of anything like a huge liquidity shortage that could cause a deficiency. Rather, our economy is damaged by deep structural faults that no stimulus package will address."

Krugman responds with the post "Phelps vs. Phelps", where he points out that Phelps taught all of us that we would see disinflation in response to deficient demand, not necessarily deflation (and... ummm... deflation might not be that far off anyway). But even this strikes me as a little odd because you don't need to cite the Phelps of many years ago to refute the Phelps of today. All you need to do is cite the Phelps of today to refute the Phelps of today! This article was astounding because it started with Phelps making some dubious claims about why there is no deficiency in demand, and then he went on to describe in great detail a series of demand deficiencies! He writes:

In established businesses, short-termism has become rampant. Executives avoid farsighted projects, no matter how promising, out of a concern that lower short-term profits will cause share prices to drop. Mutual fund managers threaten to dump shares of companies that miss quarterly earnings targets. Timid and complacent, our big companies are showing the same tendencies that turned traditional utilities into dinosaurs.

Meanwhile, many of the factors that have long driven American innovation have dried up. Droves of investors, disappointed by their returns, have abandoned the venture capital firms of Silicon Valley...

...First, high employment depends on a high level of investment activity — business expenditures on tangibles like offices and equipment, and also training for new or existing employees, and development of new products.

Sustained business investment, in turn, rests on innovation. Business cannot wait for discoveries in science or the rare successes in state-run labs. Without cutting-edge products and business methods, rates of return on a great many investments will sag. Furthermore, innovation creates jobs across the economy, for entrepreneurs, marketers and buyers. State-led technology projects do not.

High business investment also depends on companies having confidence in the future. A company might be afraid to invest in research or product lines if it fears the rest of the economy is not doing the same — or if it fears the government might become hostile to its goals.

He's got paragraph after paragraph highlighting demand deficiency driven by concerns about the future! The problem isn't deficient demand... it's deficient demand! Hard to know what to make of this. I don't know if Phelps is thinking that "demand" is "consumer demand" and that there is no consumer demand problem. If he thinks that then I still think he's wrong, but at least I'm only disagreeing with him on half the picture. I really don't know what to say - it was a surreal article to read. You could sum up a lot of it as "firms don't want stuff". Umm... isn't that deficient demand?

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Anyway, it's not all bad. He makes a lot of really excellent points (as Ed Phelps has a tendency to do):

1. He doesn't discount technological unemployment which I think is very important. In the long-term, technological development is a net positive but people are often too rosy about the serious short-term dislocations that can result from it. This was a very common interpretation of the Great Depression at the time. It was largely eclipsed by Keynesian economics and nobody talks about it nowadays - I think people are afraid it's Ludditism or something too - but I think it's probably more important than we give it credit for. It is coming back as an explanation for relative labor demand concerns. You rarely see people talking about technological development as a problem for employment in general - but you will see people now talk about "skills biased technological change", or (SBTC) as a problem for specific sub-populations. That's a start I suppose.

2. In explaining investment demand, Phelps puts firms concerns about the future and their high discount rate front and center, which is very important I think. He mentions business confidence and policy uncertainty later (to Austrians, "the Higgs argument"), granted. Survey after survey (and this recent article too) highlight the fact that demand weighs heavier on executives' minds than policy. Oh well - for Phelps it seems to be a throw-away line. It doesn't hold that much water with me, but I don't mind it as long as it doesn't disrupt good policy.

3. He mentions the idea of a state sponsored innovation bank. I like the idea a lot. Phelps's point is that a lot of these solutions need to be structural rather than counter-cyclical. I agree and would also point out what Rizzo has always said about Keynes: his solution was essentially structural rather than counter-cyclical. He also advocated the standard counter-cyclical stuff but that wasn't the unique Keynesian contribution.

4. Finally, he supports a low-income tax credit. It's a little different from the hiring credit I've advocated here on occasion, but I like this idea a lot too. It's another structural labor demand policy. In the U.S. we are far too focused on labor supply policies, and I think this could do a lot of good. It's also an old Keynesian idea (goes back to Nick Kaldor at least).

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So one way to read this op-ed is to fume at how Phelps contradicts himself. Another way is to recognize how fundamentally Keynesian it is. Why Phelps felt a need to take a shot at demand deficiency early on and then go on to make a series of demand-side arguments I have no idea. Sometimes I think people get this weird idea that "businesses are suppliers and people are demanders". That's not based in economics at all, but it's something people can slip into. Anyway, it's a good article.