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?

*****

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).

*****

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.

Who said it? (no cheating)

"I believe that deflation has no recognizable function whatever, and that there is no justification for supporting or permitting a process of deflation"

A Staggering Graphic

"The world has been slow to realize that we are living this year in the shadow of one of the greatest economic catastrophes of modern history. But now that the man in the street has become aware of what is happening, he, not knowing the why and wherefore, is as full to-day of what may prove excessive fears as, previously, when the trouble was first coming on, he was lacking in what would have been a reasonable anxiety. He begins to doubt the future. Is he now awakening from a pleasant dream to face the darkness of facts? Or dropping off into a nightmare which will pass away?

He need not be doubtful. The other was not a dream. This is a nightmare, which will pass away with the morning. For the resources of nature and men's devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life—high, I mean, compared with, say, twenty years ago—and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time."

- John Maynard Keynes, Essays in Persuasion


The point Keynes makes is actually quite hopeful, and it puts to rest the willfully ignorant refrain that "Keynesians think downturns go on forever without the govenrment". But it's equally sad and sobering. We are not suffering because we cannot recover - we are suffering because we will not recover. The means are there - the will to put it into motion is absent either because of institutional contradictions and paradoxes, deliberate inaction, or both. That is perhaps the saddest part of the Keynesian insight. As Einstein put it (somewhat radically and combatively, but nevertheless presciently) in the late 1940s:

"Production is carried on for profit, not for use. There is no provision that all those able and willing to work will always be in a position to find employment."

Kling on Keynes and Bohm-Bawerk

One more post today, also on Kling, also on competing macroeconomic theories.

He shares an essay on "labor as capital" and a Bohm-Bawerk type model of the economy vs. what he contends is the Keynesian picture. I haven't read it yet, but it sounds interesting. This is the quote he highlights:

"If labor is capital, then we have lost the automatic tight connection between spending and employment. Firms can vary their output with little or no variation in employment. This explains how we can have a "jobless recovery," meaning a large percentage increase in output without a comparable percentage increase in employment."

I think this is a good point. I don't think you can read the literature on labor contracts, search theory, or labor flows and not conclude that to a certain extent labor does act like capital. I've always liked these points from Kling. Of course as I've opined before, I don't think this provides any reason at all to discount the Keynesian liquidity preference story - which is what motivates the effective demand arguments that Kling discounts here. Corporate liquidity preference explains jobless recoveries just as well. Kling and Keynes do just as well explaining why new hiring doesn't happen - but Keynes arguably does better explaining the coincidence of a failure to hire in addition to high profit rates (I'm not sure how the "labor as capital" story explains that, although perhaps it does). Now when I say this is a "Keynes" point, what I really mean of course is that it is an application of Keynesian insights about liquidity preference. I've mentioned before that Keynes doesn't seem to sketch out this relationship in the General Theory as well as he could have.

As I said in this recent post, there's no reason to treat two theories as opposing theories unless they actually contradict each other. I think the Kling/"labor as capital"/Bohm-Bawerk approach makes great sense, and I see no reason not to think both that and the Keynesian's story are going on.

Immortal, tentacled sea creatures

Hmmm... immortal, tentacled sea creatures.

I know the post is a year old, but I'm enjoying catching up on the Discovery blogs. Besides, not a single one of the 106 comments mentioned "Cthulu", and it had to be said.

"That is not dead which can eternal lie;
And with strange aeons even death may die."

Cosmology seems to make macroeconomics look decisive!

So I was watching the History channel last night, and they were showing an episode of The Universe called "Beyond the Big Bang", which covered cosmology, the Big Bang, and the formation of the universe immediately after the big bang. Neil deGrasse Tyson had a very interesting thing to say about cosmology:



"There were more theories running around than data"

Wow - that sounds familiar! It certainly doesn't seem to lead Tyson to call cosmology "fake science", as Russ Roberts likes to call macroeconomics.

Wikipedia confirms - check out the number of cosmological theories. You can even scroll down to the twentieth century, and it still puts macroeconomics to shame (Brad DeLong recently identified seven basic macroeconomic theories, compared to my count of twenty cosmological theories in the twentieth century alone).

I think another important point is that we fight over these macroeconomic theories, but ultimately that's kind of a weird thing to do. There's no good reason why most of them can't be integrated. Arnold Kling puts forward a mixed Minsky-Austrian story. I think Keynes, Minsky, and the Austrians all make sense and I'm perfectly comfortable with major tenets of monetary disequilibrium theory, and of course I believe real shocks can matter which means I don't think there's anything especially wrong with Real Business Cycle Theory. The problems come in when people point to a specific theory and say "this, and only this, is how macroeconomic fluctuations happen". Every recession is different, and presumably they're going to have a mix of causes. Macroeconomists have done a pretty decent job outlining these causes. What we need more of is understanding how these theories integrate together and what factors are important for what specific episodes. What we need less of is this attitude that there is one answer.

Are the twenty cosmologies as easily integrated and traded off? Well, they're explaining a single event and many of them contradict each other on the very nature of the universe, so probably not - but I'm sure to some extent they do.

I'm not trying to ridicule cosmology - as Tyson says, it's a matter of the data that's available - that's a limiting factor in science. But challenges don't make something non-scientific! Science is all about the method of gathering and testing knowledge.

Anyway, I just thought this was interesting. Phsyics is usually held up by the critics as some sort of gold standard. My response is "well, economics is really more like biology", but the fact is physics is struggling or has struggled with the same things that certain sub-disciplines of economics struggles with. That's life - science is hard.

Martin Rees on "Life's Future in the Cosmos"

I'm having trouble uploading the presentation, but I suggest you download Martin Rees's address on "Life's Future in the Cosmos". Rees delivered this address to The Long Now Foundation, which seeks to "creatively foster long-term thinking in the framework of the next 10,000 years".

Rees's presentation is a mix of astronomy and speculative evolutionary biology, tied together with broad commentary on the place of humanity in the cosmos.

Assault of Thoughts - 8/6/2010

"Words ought to be a little wild, for they are the assault of thoughts on the unthinking" - JMK

- Mark Thoma, David Dayen, and others are reporting that Christina Romer is resigning her post as Chair of the Council of Economic Advisors. Both mention reports that she may be leaving out of frustration at being shut out from the President by Larry Summers, who heads the National Economic Council. Whether that's true isn't entirely clear yet, but everybody who knows about the dynamics at the highest levels of economic policymaking, between Romer, Geithner, and Summers, should also be aware how plausible that sounds. I honestly would have rather kept Romer and had Summers go. Regardless - Romer is going back to California and Yellen has recently come from California to D.C. to serve on the Fed. Which leads to my prediction - that Nobel laureate and husband to Yellen, George Akerlof, will be asked to chair the CEA.

- Arnold Kling continues to make the case that careful explanations of what to do about market failures and the success of interventions are unnecessary. Why? Because that's what we've got the Soviet experiment for! This is getting tiring - my comment is the fifth down. This one at least starts to try to transcend the earlier bungled thesis by focusing on FDR. He did say one nice thing about Obama, though. He said "maybe Barack Obama is the next FDR" (I'm not sure he meant that to be positive, granted).

- My paper on the 1920-21 depression is moving through the steps! Got it back with reviewer comments. No rejection yet. Haven't read the comments yet - that should be an interesting experience. It'll be interesting to simply reread the paper again and see if any of my thoughts have changed.

- Mises University material is going up online. I found this panel on theory to be a very intersting discussion. Several Austrian luminaries are on a panel and they're being quizzed on theory by the students. Very interesting discussions. This is part one, and this is part two. There are also panels on policy - I haven't listened to those yet.

- Christopher Hitchens details his struggle with cancer. The piece is poignant and insightful, as one would expect.

In which I threaten my own case that I and people like me should not be evaluated in tandem with socialists...

Evan showed this to me. Zizek makes a lot of really good points here. I think it's worth noting this since in the past I've critiqued him on the blog.



There is a lot that's problematic in here, particularly some statements on "what capitalism has done", but there is a lot of good stuff too, including:

1. That we don't really purchase products alone - we purchase cultural experiences and understandings, and we should consider what it means that these things are commercialized, and how that changes standard market models that assume the sale of product, not a product plus attendant cultural experiences.

2. Some discussion of misanthropy as a basis of social theory - reminds me of H.P. Lovecraft, who Michel Houellebecq said was "against the world, against life".

3. "It is much easier to have sympathy with suffering than sympathy with thought"

4. The integration of product and culture in the process of consumption perpetuates existing institutions by eliminating the productive dynamic of the natural opposition between a product and a culture (unlike the previous three, this is much more my restatement of what he said, and should be taken only as that).

More on Kling, the Soviet Union, and Market Failure

Arnold Kling has another post up which I think is still problematic, but considerably more thoughtful. "More thoughtful" is probably even a little unfair insofar as it suggests the first one wasn't thoughtful - really it's "much better expressed".

That having been said, there are still problems. He's still shoe-horning modern conceptions of market failure into the Soviet outlook. This is simply wrong. I know the idea of "failure" is appealed to by both, but that doesn't quite cut it. Modern ideas of "market failure" are very specific, and they were around in some form or another when the Soviet Union was established, and they did a fine job distinguishing themselves from it then. I am not strictly in the Hayek-Friedman camp or the Lenin camp when it comes to my understanding of the market process. But if you were to figure out where I was, I'd be about six inches outside of the Hayek-Friedman camp and nowhere near the Lenin camp. This is where I think the vast majority of people who appeal to market failure are today. What the Soviet Union taught us is that governments can't plan economies and they can't do what the price mechanism does. It didn't teach us much of anything about the points that modern proponents of "market failure" are talking about.

One of the major mistakes I think Kling makes is in expressing the "market failure" perspective as "experts will know what to do". Needless to say, I disagree with that assessment, and its certainly not what I think. I don't have time to disagree in detail, but my series of posts contrasting "calculation problems" with "incentive problems" does a reasonable job sketching out my take on all that.

The bottom line is this: when we compare the U.S. to the U.S.S.R., what we are doing is comparing the Kuehn-Krugman-DeLong-Pigou-Mankiw "intervention in the case of market failures" position with the Marx-Lenin-Stalin-Lange-Lerner "socialism works" position. In that comparison, the Kuehn-Krugman-DeLong-Pigou-Mankiw position comes out unambiguously on top, and the example of the U.S.S.R. is very useful in that sense. What we don't have is a good clean example of the Hayek-Mises-Friedman-Kling-George-Mason position to compare to the Kuehn-Krugman-DeLong-Pigou-Mankiw position (and honestly, Friedman and Hayek could both arguably go with me in some cases!). As a rough cut, one can use the U.S.S.R. vs. U.S. example to compare the Hayek-Mises-Friedman-Kling-George-Mason position to the Marx-Lenin-Stalin-Lange-Lerner position, but that's only a very rough cut because:

(1.) The U.S. really isn't an example of the Hayek-Mises-Friedman-Kling-George-Mason position in aciton, and

(2.) To a large extent, the totalitarianism of the U.S.S.R. might even lead guys like Marx, Lange, and Lerner to say that that doesn't represent them (presumably Lenin and Stalin wouldn't hesitate to embrace it).

Why Kling thinks the Soviet Union can arbitrate between his position and mine I still don't think he adequately explains - and I think it's because he's stuck on this idea that we have some kind of mystical faith in experts and models.