Arnold Kling  

Lectures on Macroeconomics, No. 11

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This lecture discusses what I think of as the Leijonhufvud interpretation of macroeconomics as an attempt to characterize an economy that is far from classical equilibrium.

How do we reconcile macroeconomics, which uses ratios, with microeconomics, which does not?

Macroeconomics often deals in ratios. For example, the simple Keynesian multiplier equation is:

Y = A/(1-c)

where Y is total national income, A is "autonomous" demand (including investment) and c is the marginal propensity to consume.

From a microeconomic perspective, making predictions using simple ratios is typically wrong. For example, if you think that the ratio of food production to land is fixed, you will predict that soon we will see people starving. In the 1970's, environmentalists made many incorrect predictions based on this sort of ratio analysis. They saw "limits to growth" based on fixed quantities of natural resources.

Simple ratios do not take into account prices, adaptation, and technological change. If a natural resource becomes scarce, its price will rise, and the economy will adapt. Over time, entrepreneurs are developing new recipes that use resources (including labor) more efficiently.

One of the problems that I have with the quantity theory of money is that it is a ratio-based theory. If the quantity of money were to gradually become scarce, would people not be able to create money substitutes? In practice, that sort of thing does happen, which is why velocity is not a constant. Of course, if you print money fast enough, I do believe that you can reach the point where substitution effects are relatively minor, and you will see strong correlations between the money supply and the price level.

Axel Leijonhufvud (henceforth AL) suggests that when the economy is close to equilibrium ("inside the corridor," he might say), trade and employment can be maintained by small price adjustments and simple adaptations by consumers and producers. However, outside the corridor, the standard adaptive mechanisms do not work sufficiently well to maintain full employment.

In this interview (from 2002), AL says,


When I talked about situations where the system is not recovering rapidly by itself due to effective demand failures, there are basically two of them that we can find in [Keynes'] General Theory. First, a fresh act of saving is not an effective demand for future goods. Second, the wishes of the unemployed for consumer goods do not constitute an effective demand. But there is a third effective demand failure that can be very important. This is when the financial system is in a state where for most entrepreneurs it is not possible to exert an effective demand for today's factors of production by offering future goods. That is, it is not possible to make a deal by saying: 'I have this investment project that will pay off in the future and I want to trade that prospect for the factors of production today necessary to produce those future goods'. And that's where we end up if the financial system is totally clogged up with bad loans. That has been and still is the Japanese situation.

The first type of effective demand failure is a shortage of "animal spirits." No matter how much people want to save, entrepreneurs don't have projects that they want to pursue. The result is that instead of an increase in investment, we see a decline in output.

The second type of effective demand failure is what I think of as the standard multiplier effect. When people lose their jobs, they cut back on consumption.

The third type of effective demand failure is a credit crunch. Entrepreneurs want to engage in projects with reasonable risk-return trade-offs, but banks are busy shoring up their own balance sheets.

I think that in the United States today, we do not have a shortage of "animal spirits." We have a credit crunch. But we have something else, not included in AL's list. We have savers suddenly wanting a lower ratio of risky assets to risk-free assets. This is somewhat akin to Keynes' liquidity preference. It reinforces the credit crunch.

However, the main issue for this lecture is the "corridor" theory. Think of the economy as a kite. Under normal circumstances, it flutters around but stays aloft. However, a sudden, sharp change in the wind might send it into a tree or hurtling into the ground.

I am not sure we know how to distinguish wind shifts that the kite can withstand from wind shifts that will bring it hurtling down. A housing crash, particularly when so many decisions had been made under the assumption that house prices would never fall, might constitute such a major wind shift. But was it really such an enormous wind shift? If you had known that a large correction in home prices was in store, would you have predicted such a large overall macroeconomic impact? Why was the popping of the housing bubble more of a wind shift than the popping of the dotcom bubble?

I am not sure that we know how to pull the kite out of a dive. Pulling out of the dive means continuing to make appropriate adjustments to relative shifts in supply and demand while somehow stopping or offsetting adjustments that are counterproductive, such as multiplier effects. There is a widespread view that printing money and/or increasing the Federal deficit are policies that can do this. However, it is always worth stopping to think about whether that view is correct. What I think of as the Japan problem (and what many of us fear is taking place in the U.S.) is one where policy works to inhibit necessary adjustments.

Another aspect of the "corridor" theory or the kite theory is the role of beliefs. When people believe they are wealthy, in some sense this causes them to be wealthy. As long as none of Bernard Madoff's investors knew that he was running a Ponzi scheme, they were able to treat their funds with him as real wealth. Until the respective bubbles burst, the owners of dotcom stocks and of mortgage-backed securities could treat those assets as real wealth.

One way to look at fiscal stimulus is that its effectiveness depends on beliefs. Think of deficit spending as a Madoff scheme. As long as people view their holdings of our government bonds as real wealth, a larger deficit will be stimulative. If instead people were to see government bonds as deferred taxes, the stimulative effect would be less. If investors were to come to believe that the U.S. is a banana republic, the stimulus effect would be nonexistent, or even negative.

With the "corridor" theory, one can say that when the economy is inside the corridor, you should forget about macroeconomics. Normal adjustment mechanisms, including responses to relative prices, take care of solving economic problems. However, when the economy gets pushed outside the corridor, normal adjustment mechanisms are ineffective or even counterproductive. At that point, one can describe the economy in terms of ratios, such as the Keynesian multiplier. If such multipliers are to be trusted, then fiscal and monetary stimulus can offset some of the otherwise counterproductive adjustments.

Previous lecture here


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CATEGORIES: Macroeconomics



COMMENTS (6 to date)
fundamentalist writes:

The theory which has been guiding monetary and financial policy during the last thirty years, and which I contend is largely the product of such a mistaken conception of the proper scientific procedure, consists in the assertion that there exists a simple positive correlation between total employment and the size of the aggregate demand for goods and services; it leads to the belief that we can permanently assure full employment by maintaining total money expenditure at an appropriate level.

We know, of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.

The correlation between aggregate demand and total employment, for instance, may only be approximate, but as it is the only one on which we have quantitative data, it is accepted as the only causal connection that counts.

Hayek “The Pretense of Knowledge” 1974 Nobel address.

In short, Hayek is saying that mainstream econ is looking under the lamp post for its keys because that is where the light is.

Al Abbott writes:

In the same vein as the post from fundamentalist, it seems that increasing government involvement in the economy increasingly scales up the activity under the lampost and limits activity beyond. We are more and more becoming in thrall to a limited few minds as government coercively attempts to hammer the "economy" into something responsive to the centralized few by attempting to remove or suppress the myriad effects possible via local knowledge in millions of decentralized minds beyond that little puddle of lamppost light. The best role for government seriously needs more thought.

Larry writes:

I'd like to see someone say "if we do X, we'll be ok, and here's how it will work". That would do a lot to restore confidence, which would in turn speed the path to normalcy (whatever normal is, post-crash.) I know, I'm dreaming.

fundamentalist writes:

Larry, As long as mainstream economists think the boom was normal and the bust an aberation, then we'll never be OK. The artificial boom, caused by credit expansion resulting from very low interest rates set by the Feds, was the aberation. It caused over-investment in housing, cars and financial industries. They employed too many people for the demand for their products and services. Things will get worse until the excess workers in those industries find work in other industries and that will take a while. As long as the state tries to keep those workers in their old jobs as long as possible, the recovery will be pushed back farther into the future.

Larry writes:

@fundie - I get that. I'm just wondering how/whether we can get back to full employment without the crutch of ever expanding debt. We can't expand debt (as a % of GDP) forever.

fundamentalist writes:

Hayek in "Profits, Interest and Investment" wrote that the turn-around will come when profits have fallen to the point that businesses start purchasing labor-saving equipment. Austrians emphasize that the greatest amount of unemployment is in the capital producing industries, those that produce labor saving equipment. The bust comes when high profits in the retail sector, and those industries producing directly for retail, cause businesses to add more labor because it is relatively cheaper and stop buying labor-saving equipment.

After the bust, prices and profits fall, making labor relatively more expensive. So businesses gradually start buying labor-saving equipment. That puts more people to work in the capital equipment sectors where unemployment is the highest and the economy starts growing again.

But if we follow Keynesian nonsense and try to stimulate consumer spending, more dollars chasing limited goods will cause prices and then profits to rise. If wages don't rise as well, then labor becomes relatively cheaper and businesses hire more laobr instead of labor saving equipment. So the stimuli thwart the recovery rather than help it get started. This is all covered by the Ricardo Effect.

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