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Tyler Cowen: Your Inner Keynesian Is Missing...

Tyler Cowen's inner Keynesian to the white courtesy phone please...

Tyler appears to be confused. Or maybe I am hopelessly confused. He writes:

Is there a general glut?: Consider a simple model, in which uncertainty goes up, first because of the U.S. financial crisis, now because of Greece and the Euro and the open questions about Spain and how well Europe can cooperate.  I'm not saying that's the only or even the prime cause of what's going on, it's simply an illustrative story. With higher uncertainty, investors pull back, wait, and exercise option value. Aggregate supply declines, as does employment. As a result, aggregate demand declines too, and that includes real aggregate demand, not just nominal aggregate demand.  Until the underlying uncertainty is resolved, the economy remains in the doldrums...

And this I don't understand: what is this "aggregate supply declines"? How? Where?

Suppose we have a risk neutral representative worker with a rate of time preference β and an endowment of L hours of labor, which she can either use to produce consumption goods or investment goods with a linear technology. Suppose further you have a representative financier with no endowment, who must borrow from the representative worker and who invests in risky investment projects which have an ex-ante return distribution that is public knowledge but whose actual outcome is private information to the financier.

In this situation, financiers will strike wage bargains with workers--they can't credibly promise to give them a share of the investment project outcome--and will make debt constracts with households--they can't credibly promist to give them an equity share. Since the financiers have no endowment, they will be unable to post bonds. Hence households will be willing to fund only those investment projects that are certain to return at least 1/β. That much labor will be devoted to making investment goods, and the rest of labor will be devoted to making consumption goods.

In this environment, an increase in uncertainty--a mean-preserving spreading-out of ex ante investment project return distributions--causes a greater share of investment projects to fail to make the 1/β guaranteed gross-rate-of-return hurdle. So production of investment goods falls...

...and production of consumption goods rises, as labor is redirected.

There is no employment-reducing fall that I can see in aggregate supply in response to an increase in uncertainty. Yes, there is a structural readjustment as investment-goods industries shed labor and consumption-goods industries gain labor. But this is no more a fall in aggregate supply that leaves an extra 5% of the labor force with nothing productive to do than there was a fall in aggregate supply earlier, when perceived uncertainty fell and labor moved into investment-goods production--remember, back when financial engineering guaranteed by S&P and Moody's offered a way to create more of the AAA assets that the representative worker wanted to hold. There is a fall in aggregate supply in the sense that the value added by investment projects falls--but that fall shouldn't have implications for employment.

Now it is certainly true that the rise in uncertainty is a bad thing.[1] The market failure in the model is the inability of financiers to credibly reveal their private information about the outcome of investment projects. And this market failure means that the society underinvests in the future. And the rise in uncertainty makes this market failure worse, and reduces welfare because it increases the wedge between how much the economy is investing and how much it, in first best, should be. Real output--the sum of the wages of workers and the profits of financiers--does fall.

But "aggregate supply declines" when uncertainty rises? Aggregate supply as measured by the number of workers who ought to be doing things that add value doesn't decline. Aggregate supply stays the same--and aggregate demand should shift away from risky investment goods and toward consumption goods. But somehow it doesn't. Instead, it declines.

And, indeed, Tyler goes on:

Note that there is still a case for fiscal policy, based on the idea of intertemporal substitution.  With some labor unemployed, a sufficiently finely targeted fiscal policy can build a new road at lower social cost than before, by drawing upon unemployed resources...

It's not just that a greater amount of government investment meets the benefit-cost test when the government can borrow at...


The U.S. Treasury can borrow for thirty years, taking all CPI risk onto its own books, and pay only 1.83% per year in interest?



It's not just that a greater amount of government investment meets the benefit-cost test when the government can borrow at 1.83% in inflation-proof bonds for thirty years, a whole bunch of tax postponements do as well. And so do a whole bunch of expanded social welfare programs. And so do a whole bunch of government issues of debt which are then invested in risky private ventures.

So I don't see how Tyler then gets to:

But even if that fiscal policy is a good idea...

Where does the "but even" come from? I see no "but even" earlier in the market: the cost of borrowing for the government has fallen--the market value troday of future cash tax flow earmarked for debt repayment has gone way, way up--therefore we should dedicate more future cash flow to debt repayment by borrowing more. There is no "but even." Expansionary fiscal policy is a good idea,

And I don't see how Tyler gets to:

[expansionary fiscal and monetary policy] won't drive recovery, at least not for plausible values of the multiplier.... We still have to wait for the uncertainty to be cleared up...

But what the rise in uncertainty means is that we don't, right now, want to finance investment-goods production through the private-markets securitization channel. The rise in uncertainty doesn't mean that we have to have an extra 5 percent of our labor force sitting idle because there is nothing socially productive that they can do.

[1] Note that in this model irrational exuberance--workers who believe that investment projects are guaranteed to meet the 1/β gross-rate-of-return hurdle when they are not--is a good thing in moderation: as long as the true expected return on the marginal funded project is greater than 1/β and as long as we don't care very much about zero-sum transfers from workers to financiers. And shady financial engineering that leads to a moderate amount of irrational exuberance is a good thing. But I digress...