General Gluts, Unemployment Equilibrium, and the Whack-A-Mole Theory of the Business Cycle

Brad DeLong picked up my post commenting on Gene Callahan the other day. He writes: "Damned if I know why Lucas thinks that there can never be an excess demand for bonds the flip side of which by Walras's law is a deficient demand for goods and services, and which could be cured by getting the government to spend-and-borrow and thus issue bonds to soak up the planned excess demand. The logic is exactly parallel to the idea that when the money stock is too low there is an excess demand for liquidity the flip side of which by Walras's law is a deficient demand for goods and services. Or why Lucas thinks that disrupting the credit channel--which in this framework means that the private sector cannot create safe assets and so there is an excess demand for safety, etc.--cannot have an impact on production and employment, but he doesn't. Damned if I know what Hayek thought about anything macroeconomic. "His logic was not at its best," was what Milton Friedman once said to me--and Friedman had tried to teach."

So I think this is pretty good. General gluts - which are really gluts of goods and shortages of some kind of asset - emerge in the way that DeLong relates and ties back to Say, Mill, Friedman, etc. He also points out that institutional disruptions to market clearing (like disrupted credit channels) can make a general glut stick around for a while. This is also a good point.

But Nick Rowe raised a criticism in the comment section: "An excess demand for bonds cannot cause demand-deficient unemployment. Remember my three women? The hairdresser, manicurist, and masseuse? Suppose they all have an excess demand for bonds. They want to sell their services for bonds. But they can't, because none of them wants to sell bonds. So do they suffer deficient-demand unemployment? Not if they can barter their way back to full-employment. And Walras' Law is supposed to be true in all economies, whether barter or monetary.

Could an excess demand for unobtainium cause a deficient demand for actually existing goods and services? No. If it did, we would be in a permanent state of deficient demand. Because everybody wants more unobtainium. But we know we can't get more unobtainium, so we go back to spending our income on the stuff we can get more of.

If unobtainium sounds too science-fictiony: Does an excess demand for rent-controlled apartments in NYC cause deficient demand for goods and services? By Walras' Law it must.

Walras' Law is the biggest fallacy we are still teaching in economics.

An excess demand for money? Now we're talking about something that *can* cause deficient demand for goods and services.

The logic is not exactly parallel. It's non-existent in the case of bonds, and watertight in the case of money."

Nick leaves it there, and it's a little vague. What's different about money? Why would excess demand for money keep us in a stable position of underemployment when excess demand for other goods wouldn't (I'm not sure I agree with Nick entirely - bonds have qualities which introduce the same problems that money does - in that sense I agree with DeLong).

Money is really two products trading at the same price: it's a medium of exchange and it's a source of liquidity. The whack-a-mole theory of the business cycle that DeLong presents (i.e. - when demand for bonds/money/assets is high the demand for goods and services is low) isn't wrong, and it is characteristic of Say, Mill, and others in the 19th century. It's just somewhat incomplete. The whack-a-mole theory of the business cycle still maintains Walras' Law. The problem is that since money is essentially two goods trading at one price, there's no real reason to mainatin Walras' Law. Walras' system is over-identified. Deficient demand is a symptom and it's something which (because of the multiplier) aggravates and locks-in the problem. Deficient demand is proto-Keynesian (which is why DeLong can find so many 19th century writers propounding the whack-a-mole theory of the business cycle). It's good stuff but it's incomplete. What causes that to be a stable equilibrium? The liquidity preference theory of the interest rate which overidentifies Walras' system and creates slack. Keynes left the question of where that slack would express itself relatively open. Hicks - by forcing both the loanable funds market and the money market to clear - modeled it so that the slack would all show up in output. Those details aren't important. The point is, Walras' Law need not hold when the system is overidentified.