Economy, Heal Thyself

Lately, some smart economists (Eli Dourado backed up by Larry White, George Selgin, and Tyler Cowen) have been questioning whether it is plausible, four years after the US economy was hit with a severe negative shock to aggregate demand, and about three and a half years since aggregate demand stopped falling (nominal GDP subsequently growing at about a 4% annual rate), that the reason for persistent high unemployment and anemic growth in real output is that nominal aggregate demand has been growing too slowly. Even conceding that the 4% growth in nominal GDP was too slow to generate a rapid recovery from the original shock, they still ask why almost four years after hitting bottom, we should assume that slow growth in real GDP and persistent high unemployment are the result of deficient aggregate demand rather than the result of some underlying real disturbance, such as a massive misallocation of resources and capital induced by the housing bubble from 2002 to 2006. In other words, even if it was an aggregated demand shock that caused a sharp downturn in 2008-09, and even if insufficient aggregate demand growth unnecessarily weakened and prolonged the recovery, what reason is there to assume that the economy could not, by now, have adjusted to a slightly lower rate of growth in nominal GDP 4% (compared to the 5 to 5.5% that characterized the period preceding the 2008 downturn). As Eli Dourado puts it:

If we view the recession as a purely nominal shock, then monetary stimulus only does any good during the period in which the economy is adjusting to the shock. At some point during a recession, people’s expectations about nominal flows get updated, and prices, wages, and contracts adjust. After this point, monetary stimulus doesn’t help.

Thus, Dourado,White, Selgin, and Cowen want to know why an economy not afflicted by some deep structural, (i.e. real) problems would not have bounced back to its long-term trend of real output and employment after almost four years of steady 4% nominal GDP growth. Four percent growth in nominal GDP may have been too stingy, but why should we believe that 4% nominal GDP growth would not, in the long run, provide enough aggregate demand to allow an eventual return to the economy’s long-run real growth path?  And if one concedes that a steady rate of 4% growth in nominal GDP would eventually get the economy back on its long-run real growth path, why should we assume that four years is not enough time to get there?

Well, let me respond to that question with one of my own: what is the theoretical basis for assuming that an economy subjected to a very significant nominal shock that substantially reduces real output and employment would ever recover from that shock and revert back to its previous growth path? There is, I suppose, a presumption that markets equilibrate themselves through price adjustments, prices adjusting in response to excess demands and supplies until markets again clear. But there is a fallacy of composition at work here. Supply and demand curves are always drawn for a single market. The partial-equilibrium analysis that we are taught in econ 101 operates based on the implicit assumption that all markets other than the one under consideration are in equilibrium. (That is actually a logically untenable assumption, because, according to Walras’s Law, if one market is out of equilibrium at least one other market must also be out of equilibrium, but let us not dwell on that technicality.) But after an economy-wide nominal shock, the actual adjustment process involves not one market, but many (if not most, or even all) markets are out of equilibrium. When many markets are out of equilibrium, the adjustment process is much more problematic than under the assumptions of the partial-equilibrium analysis that we are so accustomed to. Just because the adjustment process that brings a single isolated market back from disequilibrium to equilibrium seems straightforward, we are not necessarily entitled to assume that there is an equivalent adjustment process from an economy-wide disequilibrium in which many, most, or all, markets are starting from a position of disequilibrium. A price adjustment in any one market will, in general, affect demands and supplies in at least some other markets. If only a single market is out of equilibrium, the effects on other markets of price and quantity adjustment in that one market are likely to be small enough, so that those effects on other markets can be safely ignored. But when many, most, or all, markets are in disequilibrium, the adjustments in some markets may aggravate the disequilibrium in other markets, setting in motion an endless series of adjustments that may – but may not! — lead the economy back to equilibrium. We just don’t know. And the uncertainty about whether equilibrium will be restored becomes even greater, when one of the markets out of equilibrium is the market for labor, a market in which income effects are so strong that they inevitably have major repercussions on all other markets.

Dourado et al. take it for granted that people’s expectations about nominal flows get updatd, and that prices, wages, and contracts adjust. But adjustment is one thing; equilibration is another. It is one thing to adjust expectations about a market in disequilibrium when all or most markets ar ein or near equilibrium; it is another to adjust expectations when markets are all out of equilibrium. Real interest rates, as very imperfectly approximated by TIPS, seem to have been falling steadily since early 2011 reflecting increasing pessimism about future growth in the economy. To overcome the growing entrepreneurial pessimism underlying the fall in real interest rates, it would have been necessary for workers to have accepted wage cuts far below their current levels. That scenario seems wildly unrealistic under any conceivable set of conditions. But even if the massive wage cuts necessary to induce a substantial increase in employment were realistic, wage cuts of that magnitude could have very unpredictable repercussions on consumption spending and prices, potentially setting in motion a destructive deflationary spiral. Dourado assumes that updating expectations about nominal flows, and the adjustments of prices and wages and contracts lead to equilibrium – that the short run is short. But that is question begging no less than those who look at slow growth and high unemployment and conclude that the economy is operating below its capacity. Dourado is sure that the economy has to return to equilibrium in a finite period of time, and I am sure that if the economy were in equilibrium real output would be growing at least 3% a year, and unemployment would be way under 8%. He has no more theoretical ground for his assumption than I do for mine.

Dourado challenges supporters of further QE to make “a broadly falsifiable claim about how long the short run lasts.” My response is that there is no theory available from which to deduce such a falsifiable claim. And as I have pointed out a number of times, no less an authority than F. A. Hayek demonstrated in his 1937 paper “Economics and Knowledge” that there is no economic theory that entitles us to conclude that the conditions required for an intertemporal equilibrium are in fact ever satisfied, or even that there is a causal tendency for them to be satisfied. All we have is some empirical evidence that economies from time to time roughly approximate such states. But that certainly does not entitle us to assume that any lapse from such a state will be spontaneously restored in a finite period of time.

Do we know that QE will work? Do we know that QE will increase real growth and reduce unemployment? No, but we do have a lot of evidence that monetary policy has succeeded in increasing output and employment in the past by changing expectations of the future price-level path. To assume that the current state of the economy is an equilibrium when unemployment is at a historically high level and inflation at a historically low level seems to me just, well, irresponsible.

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9 Responses to “Economy, Heal Thyself”


  1. 1 Marcus Nunes September 28, 2012 at 1:34 pm

    David, well said. If you join all the pieces that are being written, my impression is that there is an inevitability for being where we are and also that it´s impossible to move away from it. Reminds me of the “structuralist straifgtjacket” that has constrained Latin America for decades

  2. 2 Becky Hargrove September 29, 2012 at 6:24 am

    We still have a great capacity for further economic growth, it will just require thinking about a bit differently. And when all markets appear to be out of equilibrium, that means starting small, through allowing individuals to find economic equilibrium with one another in knowledge based services.

  3. 3 Frank Restly September 29, 2012 at 7:27 am

    “The Fed has a directive that calls for it to maintain stable prices as well as maximum employment, along with moderate long-term interest rates.”

    Here is the entire “directive” known as the Humphrey Hawkins Act:

    “Explicitly states that the federal government will rely primarily on private enterprise to achieve the four goals.” – FAIL (See war in Iraq / Afghanistan – militant Keynesian government spending)

    “Instructs the government to take reasonable means to balance the budget.” – FAIL (See Bush tax cuts and wars)

    “Instructs the government to establish a balance of trade, i.e., to avoid trade surpluses or deficits.” – FAIL (See free trade agreements / wars / and bush tax cuts)

    “Mandates the Board of Governors of the Federal Reserve to establish a monetary policy that maintains long-run growth, minimizes inflation, and promotes price stability.” – FAIL (See output gap and oil prices)

    Employment is not mentioned specifically in this act. Instead you need to revert back to the Employment Act of 1946. And in that act the Fed is not mentioned at all.

  4. 4 Frank Restly September 29, 2012 at 4:05 pm

    “Lately, some smart economists (Eli Dourado backed up by Larry White, George Selgin, and Tyler Cowen) have been questioning whether it is plausible, four years after the US economy was hit with a severe negative shock to aggregate demand, and about three and a half years since aggregate demand stopped falling (nominal GDP subsequently growing at about a 4% annual rate), that the reason for persistent high unemployment and anemic growth in real output is that nominal aggregate demand has been growing too slowly.”

    Ahem, anemic growth in real (inflation adjusted) output occurs when demand exceeds supply.

    Also, personal consumption expenditures now 71% of GDP. What exactly are these guys hoping for – 100%???

    I am not an economist but I play one on CNBC.

  5. 5 Diego Espinosa September 29, 2012 at 6:26 pm

    Inflation is at a “historically low level?”

  6. 6 Lorenzo from Oz September 29, 2012 at 6:46 pm

    Jorg Bibow’s paper on the actions of the Bundesbank into knocking Germany onto a lower growth path during the 1990s provide further support for what you have to say. I discuss the paper here:

    http://skepticlawyer.com.au/2012/09/19/they-did-it-again/

  7. 7 David Glasner October 5, 2012 at 9:31 am

    Marcus, Yes, it’s almost like a kind of oriental fatalism

    Becky, You are right on the level of the individual, but we have a systemic problem that can’t be overcome by individual action. It requires a (monetary) policy response.

    Frank, Thanks for the references. Good luck in your acting career!

    Diego, Yes, that’s what it look likes to me.

    Lorenzo, Thanks for the reference.

  8. 8 Taz von Gleichen October 7, 2012 at 10:04 am

    After creating all that money something should happen. The reality is that inflation is robbing us from our savings. Prices have increased tremendesly. You can easily tell that by going to the grocery store. Simply everything around us has increased. The only thing that doesn’t increase are our wages. The current financial system fiat money is ROBBING us.


  1. 1 Browsing Catharsis – 09.30.12 « Increasing Marginal Utility Trackback on September 30, 2012 at 5:02 am

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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