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Hoisted from the Archives: Macroeconomics Is Not Hard

Gene Callahan reminds me that this is pretty good, and I should promote it more:

Is Macroeconomics Hard?: "Math is hard," said Malibu Barbie, famously--and a ton of criticism came down on her for the implicit message that her auditors should go off and do other, easier, things instead and leave the math to the trained professionals. Is macroeconomics hard in this sense? I confess that I do not think so. I think that macro is pretty easy...[1]

Let's go back in time almost two centuries, to the days when--first after the end of the Napoleonic Wars and then in 1825-6--the nascent intellectual community of economists confronted the question of whether the circular flow of economic activity as mediated by the market system could break down and the economy become afflicted by a "general glut" of commodities.

There was no question that there could be a "glut" of particular commodities. An example may make this clear:

Suppose--this is Berkeley, after all--that households decide that they want to spend less than they have been spending on electricity to power large-screen video and audio entertainment systems and more on yoga lessons to seek inner peace. The immediate consequence--within the "market day," as late-nineteenth century British economist Alfred Marshall would have put it--of this shift in preferences is excess demand for yoga instructors and excess supply of electric power. Prices of electricity (and of large-screen TVs, and of audio systems) fall as unsold inventories pile up in stores and as generators spin down and stand idle. Yoga instructors, by contrast, find themselves overscheduled, working ten-hour days, and stressed out--and find the prices they can charge for their lessons going through the roof. Workers in electric power distribution and in video and audio production and sales find that they must either accept lower wages or find themselves out on the street without jobs.

Over time the market system provides individuals with changing incentives that resolve the excess-supply excess-demand disequilibrium and restore the economy to equilibrium balance. Seeing the fortunes to be earned by teaching yoga, more young people learn to properly regulate their svadisthana chakra and teach others to do so. Seeing unemployment and stagnant wages in electrical engineering, fewer people major in EECS. The supply of yoga instructors grows. The supply of electrical engineers shrinks. Wages of yoga instructors fall back towards normal. Wages of electrical engineers rise. And balanced equilibrium is restored.

Thus we understand how there can be a glut of a particular commodity--in this case, electric power. And we understand that it is matched by an excess demand for another commodity--in this case, yoga instructor services to properly align your svadisthana chakra.

But can there be a general glut, a glut of everything?

Some economists early in the nineteenth century said yes--and that the economy was experiencing one, and that the fact that such "general gluts" could manifest themselves was a problem with the market system that economists needed to figure out how to solve. Thomas Robert Malthus was the most prominent of those who protested. He agreed that the then-fashionable economic theory said that a glut in one market had to be balanced by a surplus of excess demand in another. But, he said, so much the worse for economic theory:

Malthus on Ricardo: [A]ccording to [Ricardo's]... theory of profits... the master manufacturers would have been in a state of the most extraordinary prosperity, and the rapid accumulation of their capitals would soon have employed all the workmen that could have been found. But, instead of this, we hear of glutted markets, falling prices, and cotton goods selling at Kamschatka lower than the costs of production. It may be said, perhaps, that the cotton trade happens to be glutted; and it is a tenet of the new doctrine on profits and demand, that if one trade be overstocked with capital, it is a certain sign that some other trade is understocked. But where, I would ask, is there any considerable trade that is confessedly under-stocked, and where high profits have been long pleading in vain for additional capital? The [Napoleonic] war has now been at an end above four years; and though the removal of capital generally occasions some partial loss, yet it is seldom long in taking place, if it be tempted to remove by great demand and high profits; but if it be only discouraged from proceeding in its accustomed course by falling profits, while the profits in all other trades, owing to general low prices, are falling at the same time, though not perhaps precisely in the same degree, it is highly probable that its motions will be slow and hesitating...

Jean-Baptiste Say defended the theory. He wrote to Malthus claiming that theory was sound, and that the idea of a "general glut" was logically inconceivable:

Letters to Mr. Malthus: I shall not attempt, Sir, to add... in pointing out the just and ingenious observations in your book; the undertaking would be too laborious.... [And] I should be sorry to annoy either you or the public with dull and unprofitable disputes. But, I regret to say, that I find in your doctrines some fundamental principles which... would occasion a retrograde movement in a science of which your extensive information and great talents are so well calculated to assist the progress.... What is the cause of the general glut of all the markets in the world, to which merchandize is incessantly carried to be sold at a loss?... Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own. To the proprietor of the mines whence this money is obtained, it is a production with which he purchases such commodities as he may have occasion for.... From these premises I had drawn a conclusion... “that if certain goods remain unsold, it is because other goods are not produced; and that it is production alone which opens markets to produce.”... [W]henever there is a glut, a superabundance, [an excess supply] of several sorts of merchandize, it is because other articles [in excess demand] are not produced in sufficient quantities... if those who produce the latter could provide more... the former would then find the vent which they required.... You, on the contrary, assert that there may be a superabundance of goods of all sorts at once; and you adduce several facts in favour of your opinion. M. Sismondi had already opposed my doctrine...

As the young John Stuart Mill put it, the core of the argument of Say, Ricard, and their school was that:

There can never, it is said, be a want of buyers for all commodities; because whoever offers a commodity for sale, desires to obtain a commodity in exchange for it, and is therefore a buyer by the mere fact of his being a seller. The sellers and the buyers, for all commodities taken together, must, by the metaphysical necessity of the case, be an exact equipoise to each other; and if there be more sellers than buyers of one thing, there must be more buyers than sellers for another...

Thus a general glut was as impossible as a square circle or a solid gas.

Yet Say changed his mind. By 1829, in his analysis of the British financial panic and recession of 1825-6, Jean-Baptiste Say was writing that there could indeed be such a thing as a general glut of commodities after all: "every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared..."

The general glut, Say wrote in 1829, had been triggered by a panicked financial flight to quality which had led the Bank of England to shrink its liabilities:

The Bank [of England], legally obliged to redeem its banknotes in specie... [t]o limit its losses... forced the return of its banknotes, and ceased to put new notes into circulation. It was then obliged to cease to discount commercial bills. Provincial banks were in consequence obliged to follow the same course, and commerce found itself deprived at a stroke of the advances on which it had counted, be it to create new businesses, or to give a lease of life to the old. As the bills that businessmen had discounted came to maturity, they were obliged to meet them, and finding no more advances from the bankers, each was forced to use up all the resources at his disposal. They sold goods for half what they had cost. Business assets could not be sold at any price. As every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared among merchants and among bankers, who having placed more bills in circulation than their personal wealth could cover, could no longer find guarantees to cover their issues beyond the undertakings of individuals, many of whom had themselves become bankrupt...

What was going on?

The answer was nailed by John Stuart Mill in that same year.

Mill's explanation: there was indeed a "general glut" of newly-produced commodities for sale and of workers to hire. But it was also the case that the excess supply of goods, services, and labor was balanced by an excess demand elsewhere in the economy. The excess demand was an excess demand not for any newly-produced commodity, but instead an excess demand for financial assets, for "money":

Although he who sells, really sells only to buy, he needs not buy at the same moment when he sells... there may be, at some given time, a very general inclination to sell with as little delay as possible, accompanied with an equally general inclination to defer all purchases as long as possible.... In order to render the argument for the impossibility of an excess of all commodities applicable... money must itself be considered as a commodity....

Those who have... affirmed that there was an excess of all commodities, never pretended that money was one of these commodities.... What it amounted to was, that persons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute....

The result is, that all commodities fall in price, or become unsaleable.... [A]s there may be a temporary excess of any one article considered separately, so may there of commodities generally, not in consequence of over-production, but of a want of commercial confidence...

How, exactly, should economists characterize the excess demand in financial markets? Where was it, exactly? That became a subject of running dispute, and the dispute has been running for more than 150 years, with different economists placing the cause of the "general glut" that was excess supply of newly-produced goods and of labor at the door of different parts of the financial system.

The contestants are:

Fisher-Friedman: monetarism: a depression is the result of an excess demand for money--for those liquid assets generally accepted as means of payment that people hold in their portfolios to grease their market transactions. You fix a depression by having the central bank boost the money stock. Eliminating the excess demand for money also brings the goods and labor markets into balance and out of excess supply.

Wicksell-Keynes (Keynes of the Treatise on Money, that is): a depression happens when there is an excess demand for bonds--for ways of moving purchasing power from the present into the future. The workings of the banking system lead the market rate of interest to be above the natural rate of interest which balances the supply of funds saved and the demand for funds to finance business investment. You fix a depression by either reducing the market rate of interest (via expansionary monetary policy) or raising the natural rate of interest (via expansionary fiscal policy) in order to bring them back into equality. Then, with no more excess demand for bonds, the goods and labor markets will also be back in balance and out of excess supply.

Bagehot-Minsky-Kindleberger: a depression happens because of a panic and a flight to quality, as everybody tries to sell their risky assets and cuts back on their spending in order to try to shift their portfolio in the direction of safe, high-quality assets--which, of course, everybody cannot all do at the same time. The excess demand is an excess demand for high-quality AAA assets in particular, not of money (although outside money and some inside money are AAA assets) and not of bonds (some of which are AAA assets, but not all). You fix a depression by restoring market confidence and so shrinking demand for AAA assets and by increasing the supply of AAA assets. Eliminating the excess demand for high-quality assets is eliminated will bring the goods and labor markets out of excess supply and back into balance.

From the perspective of this Malthus-Say-Mill framework Keynes's General Theory is a not entirely consistent mixture of (1), (2), and (3)...

Note that these financial market excess demands can have any of a wide variety of causes: episodes of irrational panic, the restoration of realistic expectations after a period of irrational exuberance, bad news about future profits and technology, bad news about the solvency of government or of private corporations, bad government policy that inappropriately shrinks asset stocks, et cetera. Nevertheless, in this Malthus-Say-Mill framework it seems as if there is always or almost always something that the government can do to affect asset supplies and demands that promises a welfare improvement over, say, waiting for prolonged nominal deflation to raise the real stock of liquid money, of bonds, or of high-quality AAA assets. Monetary policy open market operations swap AAA bonds for money. Quantitative easing that raises expected inflation diminishes demand for money and for AAA assets by taxing them. Non-standard monetary policy interventions swap risky bonds for AAA bonds or money. Fiscal policy affects both demand for goods and labor and the supply of AAA assets--as long as fiscal policy does not crack the status of government debt as AAA and diminish rather than increasing the supply of AAA assets. Government guarantees transform risky bonds into AAA assets. Et cetera...

And then there are, of course, those who never read their John Stuart Mill of 1829, and who never noticed that Jean-Baptiste Say in 1829 had retracted his 1803 claim that a general glut is impossible. They continue claim that a depression is not an economic disequilibrium that can be cured by proper government policy at all--but rather an economic equilibrium that can only be made even less pleasant by government intervention. Think of Karl Marx, Friedrich Hayek, Ludwig von Mises, Andrew Mellon, Robert Lucas, et cetera.

This fraction maintains that in a depression there is no excess supply of goods and labor in any meaningful sense. But, instead, they say:

  1. goods and labor markets are in balance--no government policy to raise employment and production is welfare-increasing--it is just that technological regress has lowered the productivity of labor, and employment is low because real wages are low and workers would rather be unemployed; or

  2. goods and labor markets are in balance---no government policy to raise employment and production is welfare-increasing--it is just that workers have an increased taste for leisure that has raised their reservation wage, and employment is low because real wages are high and businesses would rather not hire; or

  3. goods and labor markets are in balance---no government policy to raise employment and production is welfare-increasing--it is just that previous overinvestment has given us a capital stock that is too large and misallocated, and employment is low because workers cannot quickly be redeployed into jobs in the consumption goods sector; or

  4. goods and labor markets are in balance---no government policy to raise employment and production is welfare-increasing--it is just that workers have mistaken nominal shocks for real shocks, and think that real wages are lower than they are because they misperceive the price level.

It is pretty clear to me at least that they are all wrong.

Indeed, John Stuart Mill and Jean-Baptiste Say back in 1829 had pretty clear and convincing arguments that this no-disequilibrium fraction is wrong.

And Mill's and Say's arguments have not become less clear and convincing in the past 180 years.

I like this Malthus-Say-Mill framework. I think that this framework allows me to at least characterize every position on our current macroeconomic dilemmas that I have heard--like, for example, that the advocates of austerity are convinced that further debt issue by the U.S. government will crack the U.S. Treasury bond's status as a safe asset and thus increase, not decrease, the excess demand for AAA assets and increase, not decrease, the excess supply of recently-produced commodities and labor.

And it is not rocket science.

But it is, however, cutting-edge economics--cutting edge for 1829, that is.

[1] People who, along with me, took Olivier Blanchard's Economics 2410b course in spring 1983 will note how closely this tracks what Olivier was trying to teach us in the three classes--the week and a half--he spent on Lloyd Metzler's "Wealth, Savings, and the Rate of Interest." (The only distinction Metzler is missing that I think is needed is the distinction between safe and risky bonds.) And, of course, Edmond Malinvaud's Theory of Unemployment Reconsidered...

And Gene Callahan writes:

Crash Landing: Macroeconomic History: An interesting post by Brad DeLong here. The first item in it that is too little noted is that JB Say changed his mind about general gluts:

'Yet Say changed his mind. By 1829, in his analysis of the British financial panic and recession of 1825-6, Jean-Baptiste Say was writing that there could indeed be such a thing as a general glut of commodities after all: "every type of merchandise had sunk below its costs of production, a multitude of workers were without work. Many bankruptcies were declared..."'

That's correct. In the Malthus-Say debate, Say conceded to Malthus. Which makes a comment like this one interesting: "Say emerged victoriously from his polemics with Malthus and Sismondi."

Well, except in his own eyes!

Secondly, DeLong clarifies something that only became apparent to me last year: the deepest divide in macro is between those who believe that general overproduction is possible and those who think that only sectoral imbalances can occur. The list of adherents to the latter view is interesting here: "Think of Karl Marx, Friedrich Hayek, Ludwig von Mises, Andrew Mellon, Robert Lucas, et cetera."

That's right: Marx.

The problem with Marx's business cycle theory is that he never wrote it down in a tight, coherent, consistent form. The closest he comes is in Theories of Surplus Value, XVII--and it is not very close. it is clear to me that Marx claims that the commercial crisis takes a monetary form--an excess demand for money and a general glut of currently-produced goods and services--but that it does not have a monetary essence, and thus it is fruitless to attempt to resolve the crisis by printing money. Why he thinks it fruitless escapes me: he claims that the crisis is a manifestation of the fact that capitalism divorces use value from exchange value and turns the social institutions we have created into alien powers that dominate and oppress us, but that does not elucidate it to me.