Understanding the Lesser Depression
J. Bradford DeLong, U.C. Berkeley, August 2011
1.2 What Happened: A First Cut
Toward an Understanding of Macroeconomic Downturns
Jean-Baptiste Say and Thomas Robert Malthus: For most of human history before 1800 most people spent most of their time working to provide for their own households: gathering their own roots and berries, hunting their own meat, sewing their own furs, growing their own food, weaving and sewing their own clothes, building their own houses. Purchases and sales in the market were a relatively small part of total economic activity.
However, starting in the eighteenth century economic growth brought us to a place where—in northwestern Europe at least—most of what was produced was sold in the marketplace for money—and the money thus earned was used to buy other things in the marketplace, other things that other households had made.
This disturbed people. “What if it all went wrong?” they wondered. They understood how the markets made supply balance demand at an equilibrium price for any one particular commodity. But would the whole hang together as a system? “Could we wind up,” they wondered, “in a situation in which everybody—or a large number of people—are wasting their time making things nobody wants to buy? In which people who want to work can’t find useful employment because nobody will hire them because nobody trusts that they will be able to sell the things that their employees would make because nobody trusts that everybody will have jobs and thus have the income with which to buy?”
French economist Jean-Baptiste Say proposed an answer back in 1803. He said: “no.” Every seller, Say argued, was also a potential purchaser. Nobody would sell anything without intending to buy something with the money. And so purchasing power flows throughout the economy in a circular flow. Workers and property owners only sell and rent their hours and their resources to businesses because they then intend to spend the money they earn buying goods and services. The goods and services that they buy—well, those are the goods and services that the businesses make. So businesses sell final products to households and buy factor services from households, and households buy final products from and sell factor services to businesses.
Thus, Say claimed, the idea that there could be an economy-wide shortage of purchasing power was incoherent. It could be that there would be excess supply of some particular goods and services: perhaps exercise studios were expecting more people to sign up for yoga classes than actually do, and so there are yoga teachers without students and yoga mats without people sitting on them in the Lotus position. But the money people decided not to spend on yoga lessons they decided to spend on something else—espresso drinks, say—and there are long lines and harried, overworked baristas at coffee bars. The economic system would soon adjust to the excess supply in one industry and the excess demand in the other by moving capital and labor resources from industries where they are in surplus to industries where they are in shortage – in our example from the yoga studios to the coffee bars.
It would take something truly extraordinary, Say thought, to break the reliable operation of this circular flow principle—what economists came to call “Say’s Law”. As an economist of a younger generation, John Stuart Mill, put the argument:
There can never, it is said, be a want of buyers for all commodities [and labor]; 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...
The economist Thomas Robert Malthus protested that even though Say’s Law sounded good in theory, it failed the test of practice:
[T]he master manufacturers would have been in a state of the most extraordinary prosperity.... 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 understocked, and where high profits have been long pleading in vain for additional capital ? The 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...11
Indeed, Say’s claim that large macroeconomic downturns like the one we saw begin in 2007 did not pass the test of empirical reality. One such downturn took place in England in 1825-26 as a consequence of the collapse of the early 1820s canal boom. Say did indeed mark his beliefs to market—did recognize and analyze that somehow something going wrong in financial markets had produced a “general glut”, a large excess supply over demand for pretty much every commodity and also for workers willing to work.12 But Say did not then revisit his theory to figure out where he had gone wrong.
John Stuart Mill: It was John Stuart Mill who came up with what I believe is the best answer. In 1829 he wrote (although he did not publish it until 1844):
[Say’s Law] is evidently founded on the supposition of a state of barter; and, on that supposition, it is perfectly incontestable. When two persons perform an act of barter, each of them is at once a seller and a buyer.... If, however, we suppose that money is used, these propositions cease to be exactly true.... Although he who sells, really sells only to buy, he needs not buy at the same moment when he sells.... [When] there is a general anxiety to sell, and a general disinclination to buy, commodities of all kinds remain for a long time unsold, and those which find an immediate market, do so at a very low price.... In order to render the argument for the impossibility of an excess of all commodities applicable to the case in which a circulating medium is employed, money must itself be considered as a commodity. It must, undoubtedly, be admitted that there cannot be an excess of all other commodities, and an excess of money at the same time. But those who have, at periods such as we have described, affirmed that there was an excess of all commodities, never pretended that money was one of these commodities; they held that there was not an excess, but a deficiency of the circulating medium. What they called a general superabundance, was not a superabundance of commodities relatively to commodities, but a superabundance of all commodities relatively to money. 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...
Mill’s point is that people don’t just plan to buy currently-produced goods and services: they plan to buy currently-produced goods and services and financial assets. And people don’t just plan to spend their incomes: they plan to spend their incomes plus whatever resources they plan to get from selling their financial assets. If everybody (or even a critical mass) of people plan to spend less than their perfectly possible for there to be too little demand for currently-produced goods and services—for the current flow of aggregate demand for goods and services to be less than the cost of the goods and services currently being produced.
Mill’s insight is crucial. Let us see if we can make it clearer:
Consider a normal—microeconomic—shift in demand: Americans decide that they want to spend somewhat less on manufactured goods and somewhat more on consumer services. Suppose, say, they plan to spend less money buying espresso machines and plan to spend more buying yoga lessons, so trading caffeine for inner peace.
Assembly-line workers and businesses that make espresso machines then find that they have made more machines than they can sell. Some manufacturers cut wages and so their workers see their incomes fall. Some cut back on hours and employment and their workers find themselves unemployed.
By contrast, yoga instructors find demand for what they do booming. They work extra hours. Exercise centers raise their prices. Wages and prices fall in manufacturing. Wages and prices rise in the service sector. Deficient demand for manufactured goods and assembly-line workers comes with excess demand for consumer services and service-sector workers. Manufacturing firms close and service-sector firms open. Workers who lose their jobs in manufacturing retrain in order to demonstrate how to do the Downward-Facing Dog.
In a short time the economy adjusts.
Labor exits the manufactured goods and enters the service industry. The economy rebalances with fewer assembly-line workers and more workers in the service sector, the structure of production has shifted to accommodate the shift in demand, and the excess unemployment above normal disappears.
But now consider, instead, what happens when the excess demand in the system is not for something like yoga lessons—currently-produced goods and services—but instead for something like money—financial assets.
Households decide that they want to spend somewhat less on manufactures and to hold more cash in their wallets instead. Instead of spending normally, everybody decides to keep at least one $20 in reserve at all times. Those with less than $20 simply stop spending on manufactures—until somebody buys some of what they have made and they have more than $20 in their pockets. What happens next? Well, what happens in manufacturing is the same thing that happened when there was a shift in demand from manufacturing to services. Manufacturers find that they have made more goods than they can sell. Some firms cut their prices and wages and their assembly-line workers see their incomes fall. Some cut back on hours and employment. Inventories of unsold manufactured goods pile up. Entrepreneurs looking at their growing piles of unsold inventory cut back on hours and production even more.
But there is a big difference: there is no countervailing increase in spending, employment, and hours in the service sector.
Things then snowball. The unemployed assembly-line workers now have no incomes. They cannot afford to buy as much food or as many services or, indeed, as many manufactured goods as they had before. Inventories of unsold goods keep rising, and so employers cut back production and employment even more. Thus there is a second-round fall in demand which renders even more people unemployed—and not just assembly-line workers this time. And then there is a third round. And so on...
Moreover, everybody sees rising unemployment and falling incomes around them. Can you imagine a better signal to make you decide to try to hold onto more cash? Instead of cutting back on spending on coffee when you have less than $20 in your pocket, people start cutting back on all spending when they have less than $40 in their pocket. And the more the prices at which you can sell your goods falls and the higher unemployment climbs, the more desperate people are to pile up more cash in their wallets.
In a normal market adjustment—a fall in the demand for manufactures and a rise in the demand for services—the workers laid off from the shrinking sector (for example manufacturing: espresso machines) would rapidly be hired into the expanding sector (for example the service sector: yoga lessons). But this is not a normal market adjustment: this is macroeconomics, depression economics.
How far down does production and employment decline when the economy gets itself into a recession economics state? How high does unemployment rise? Well, employers keep cutting back employment—and thus keep cutting back their workers’ incomes—until they are no longer producing more than they can sell and inventories are stable rather than rising. And households keep trying to build up their cash balances until their incomes have fallen so low that they do not think that they dare economize on their spending any further to try to boost their holdings of liquid cash money. There the economy will sit, with spending, production, and employment depressed because at that level and at that level only planned spending is equal to income—until something happens to induce households and businesses to attempt on net to sell financial assets and spend more than their incomes on currently-produced goods and services which will induce businesses in aggregate to start hiring more workers again.13
That, in a nutshell, is what happened in 2007-2009—and in 1825, and in 2001, and in 1991, and in 1979-82, and so forth.
Note that, in Mill’s theory, downturns can have different causes. Any of a number of things can cause a sudden excess demand for financial assets. It can spring from a withdrawal of public subsidies from risky investments in railroads (as happened in 1873), it can spring from worries about minting silver coins that induce people to ship their gold overseas which under a gold standard reduces the money stock (as happened in 1893), it can spring from high interest rates abroad that under a gold standard induce money stock-shrinking gold exports (as happened in 1907), it can spring from a Federal Reserve that raises interest rates to fight inflation (as happened in 1979-1982), it can spring from a recognition that a good deal of the financial assets that people had thought their high-tech investments consisted of simply were not there because it would be very difficult to profit from internet technologies (as happened in 2001), or from a host of other causes.
What was the cause this time of this sudden excess demand for financial assets, which carried with it deficient demand for currently-produced goods and services, deficient demand for labor, large-scale extra firings all across the economy, and a persistent shortfall below its normal pace in hiring since? Why was the decline in the employment-to-population ratio so large? Why hasn’t it recovered since?
Those are all good questions, but they are not for this background chapter.