Thursday, January 5, 2012

An intriguing, but I think wrong, statement by Eric Falkenstein

He writes about a statement by Brad DeLong that:

"Keynesians think $97B was created via this spending and taxes this year, which is why they love government spending regardless of what it is spent upon. But if they issued $100B in bonds to create this 'new demand', where would that $100B have have gone otherwise? I don't think this makes sense in general equilibrium. I guess if you could caricature the two views: one thinks supply creates its own demand, the other that demand creates its own supply."

I find the bolded point interesting, but not quite right. I think the better thing to say is:

"...the other that new demand creates its own supply when the economy is demand constrained, and supply creates its own demand when the economy is supply constrained, and market economies are demand constrained, not supply constrained"


Oh, and one could add: "Even when there is a balance between supply and demand, there is no guarantee that that balance will be struck at a full employment level"

For the umpteenth time, I'll remind people that a clearing labor market is not the same thing as a full employment labor market.


  1. "For the umpteenth time, I'll remind people that a clearing labor market is not the same thing as a full employment labor market."

    There are veteran economists having written popular textbooks who still mention them as one and the same.

    I still wonder whether it is a) a simple explanation for laymen, without necessarily believing in it, or b) a blatant fallacy held even by the most intelligent economists.

  2. Speaking of labor markets:

    By 53 BCE, Caesar had ten legions. From the north, he turned around and swept through Gaul again, making sure all of the tribes knew who was in charge. He crushed a string of stubborn Gallic tribes one by one, selling women and children to the slavers who followed his army everywhere it went. Plutarch reports that a million Gauls were taken captive during Caesar’s campaigns. The flood of cheap slaves into Italy eventually impoverished the Roman working class, which in turn undermined the democratic foundations of the republic.

    Change 'Caesar' to 'the 1%', 'cheap slaves' to 'chinese slaves' and 'Roman working class' to 'American working class' and not much has changed.

    Invisible Backhand

  3. Wait, what Keynesians think that $97B was "created" via taxes? It can be many things, but Keynesians don't ignore monetarism entirely (that would be awkward for the monetarists who are also Keynesian followers).

    On the topic of the balance between S&D: I can't think of any set of circumstances that guarantees full employment, given a free market. Some people will be inbetween jobs; others will be deemed unsuited for the jobs they are seeking. What conditions will guarantee the balance will be struck below full employment? Myriad, I'm sure.

    @ Prateek: Interesting question, but where are these people saying such things? Maybe I've missed all the economists claiming that altering the unemployment metrics to be more inclusive is left-wing social engineering - but even this knee-jerk response would admit that a cleared labor market is not the same thing as full employment, unless they want to attack any metric for unemployment as giving the unemployed strange ideas about the cause for their laziness :) I have a hard time believing it.

  4. I think the two views may match the two ways of addressing a fall in AD

    1. AD falls and demand curve shifts to the left. The government increase AD (via fiscal or monetary stimulus) , the demand curve shifts back to the right and supply shifts up the supply curve. In a sense demand has created its own supply.

    2. AD falls and demand curve shifts to the left. Supply of all goods (including labor) move down the supply curve and prices fall. Observing that prices have fallen the supply of labor curve move to the right (the same nominal wage level now buys more stuff) and wages fall further. Profit spreads increase because wages have fallen. Greater profits drive more output. This new output can all bought up by the combined income from wages and profits (the new AD). Supply has created its own demand.

  5. Well, for example, books by Thomas Sowell and Walter Williams, and textbooks by the balanced and fairly middle-of-the-road Pyndick and Rubenfield display "minimum wage and unemployment" sections, and what is a labour surplus on the diagrams is labelled as unemployment.

  6. Falkenstein's epigram is a lot snappier!

  7. "I can't think of any set of circumstances that guarantees full employment, given a free market. Some people will be in between jobs..."

    Edwin, you had better look up what "full employment" means.

  8. I actually think you can have supply constrained economies. "Supply constraint" is one of the preconditions of hyperinflation and I think you can talk about a supply constraint from 1966-70ish and obviously, WWII. Both of those examples suggest that after a certain point demand does not create its own supply. I'm not sure what that means in regard to your point.

    I also don't understand the refusal to acknowledge the basic point delong always brings up about how there is an enormous excess demand for safe assets which will be simply held as cash if the safe assets aren't supplied. Since that basically means that there is no opportunity cost to government spending. I mean, I guess I just answered my own question.

  9. Sure, but it wasn't a market that was introducing a supply constraint in either of those cases, Andrew.

    We would expect supply constraints in a non-market setting.

    This is an excellent discussion of those issues by Peter Dorman:

  10. There's quite a big difference between an "economy" and a "market", in other words.

    We need to keep track what allocative institutions are governing a particular economy.

  11. Wait, when did we switch to talking about specific markets?

    Anyway, not all supply curves are elastic particularly over the short run, which is the issue here. After all this is all business cycle theory which is necessarily short run. Short run shocks, like WWII or the build up to the Vietnam War are unlikely to create their own supply.

    Just to make it clear, though, these are two very specific instances and not at all relevant to any discussion about our current problems. However, in principle supply constraints are a legit business cycle issue.

  12. I dunno, I'm not sure if what i'm saying is true, but now I'm interested in this question.

    I just don't see why--in principle again--the private economy cant push things above potential output.

  13. @ Gene Callahan:

    Yes, what I've written reflects a basic error. Thank you for pointing that out.

    My thinking (which I should have elaborated slightly) was partly that I do not see how one can avoid cyclical unemployment: Some people will be part of a labor pool that is made redundant by advances in technology and automation, who will find themselves unemployable due to a mismatch between their skills set and the labor market's demands (or even its size for reentry).

    Perhaps I was not thinking clearly - perhaps it is possible to, in a given period, approach full employment. However, I don't see the situation being sustainable.

    This may still be unsatisfactory but I hope it at least clarifies my reasoning.


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