...to understanding economic and financial processes. The Global Financial Crisis of 2008 and the Great Recession that followed challenged much conventional wisdom and academic orthodoxy with respect both to theory and policy. New economic thinking was needed and that need has been extended and amplified through the succeeding years. But: what constitutes 'new economic thinking?'
Three and only three passages containing the word:
Parenthetically, I do not consider addressing fraud to be regulation. Rampant fraud can significantly diminish the effectiveness of market competition, but fraud is theft and an issue of law enforcement…
Much, though not all, of what advocates of broadened oversight of finance are combating falls under the scope of fraud. Again, this is not the province of regulation but of enhanced law enforcement. Misrepresentation, the major source of consumer complaints, is fraud and should be readily addressed in more widespread enforcement of existing law…
The dot-com and housing bubbles bred much fraud, much of which, I suspect, to date, has gone undetected. We will never be able to fully prevent such wrongdoing. Its malignant roots are too deeply embedded in our nature. So is our inbred sense of justice in seeking to punish wrongdoers. But regulatory punishment of bubble malfeasance, beyond proven criminal fraud, which of course should be vigorously prosecuted, does little to restore our economy to where we would like it to be. Revenge may be soul satisfying, but it is rarely economically efficient…
Izabella Kaminska: Dark inventory, death of a city edition:
As we’ve argued before, the world is beset by a capital crisis not a debt crisis. There is too much capital and not enough productive use for it — at least not in western markets. At least nowhere near enough to guarantee the sort of returns “savers” have become accustomed to over the last few decades. The truth is that nowadays all savings come with risk. Yet most capital investors are simply not prepared to accept that. This is where the problem begins. For a long time, banking intermediaries took the risks on behalf of savers but, as we all know, this didn’t turn out so well for them in the end. Now that banks are being forced to de-risk, however, this poses a different problem for ‘sacred cow’ savers. They are now up in arms over low yields and no lending, demanding — ironically — that banks take more risk regardless of the lessons learned. Which, of course, is something of a double standard coming from savers, since they themselves are not prepared to take the risk either. And yet someone has to take the risk. The burden understandably falls on the government.
James Surowiecki: An Avoidable Crisis.
Christina Romer: What Do We Know About Fiscal Policy?
John McDermott: British Economic Policy: Less Plan B, More Plan A+1.
Izabella Kaminska: The German Bond Market Is All About ‘Buy and Hold’.
Joe Weisenthal: UPDATED: Wall Street Analysts Everywhere Are In Agreement: THE WORLD IS ENDING
Last week we looked at the right-wing critique of "activist" fiscal and monetary policies to deal with our current Lesser Depression. The week before that we looked at the Obama administration's initial round of policies through the eyes of our own Christina Romer--and the realization over the course of the Obama administration's first year that its policy moves had been insufficiently bold: constructive half measures, but half measures.
This week we go into the weeds of Washington DC, and try to figure out why the Obama administration and its congressional allies did not undertake a second round of expansionary policies in the period from late 2009 to, well, to today. Why was there no Plan B?
Readings in reverse chronological order from The New York Review of Books--plus my own Huffington Post review of Ron Suskind's interesting (albeit from my perspective badly flawed) Confidence Men.
Robert Johnson (October 13, 2011): Obama: A New Beginning?.
J. Bradford DeLong (September 25, 2011): Review of Ron Suskind's Confidence Men.
Elizabeth Drew (August 18, 2011): What Were They Thinking?.
Michael Tomasky (May 26, 2011): The Budget Battles on Which His Reelection Depends.
Jeff Madrick (April 28, 2011): The Wall Street Leviathan.
Elizabeth Drew (December 23, 2010): In the Bitter New Washington.
John Cassidy (December 9, 2010): The Economy: Why They Failed.
Paul Krugman and Robin Wells (October 14, 2010): The Way Out of the Slump
Narayana Kocherlakota:
Robert Lucas:
Econ 24-1: First Written Assignment:
Due via email to [email protected] by 5 pm on Thursday November 17:
The coming of our current Lesser Depression required four things:
A wave of increased savings hitting the United States and looking for safe assets in which to invest itself.
A collapse of lending standards in housing finance so that investments in mortgages that were in fact highly risky were sold as--and were believed to be--safe investments.
A failure of risk controls in high finance so that the highly-leveraged banks and shadow banks that were supposed to manage their own risks and distribute and diversify risks throughout the economy instead concentrated them--and were threatened with bankruptcy when the housing bubble collapsed.
An inability or unwillingness by the Federal Reserve to cut off the crisis in its early stages and fix it.
A mechanism that turned financial distress on Wall Street into a large-scale collapse in employment.
That's: "required five things…"
Suppose that you have to tell this story to somebody who is unfamiliar with any economics and with the history of the past five years. Write 400 words (i.e., between 300 and 500) explaining as best you can to this unfamiliar audience just how this all happened.
Christina Romer's takes, at three different moments:
Christina Romer (February 27, 2009): "The Case for Fiscal Stimulus" http://t.co/Ci6N1Z3W
Christina Romer (September 24, 2009): "Back from the Brink" http://t.co/WPdhXbd3
Christina Romer (September 1, 2010): "Not My Father's Recession" http://t.co/4jACyXth
Vincent Reinhart (2011). "A Year of Living Dangerously: The Management of the Financial Crisis in 2008." Journal of Economic Perspectives, 25(1): 71–90. http://tinyurl.com/d201109b
Frederic S. Mishkin (2011). "Over the Cliff: From the Subprime to the Global Financial Crisis." Journal of Economic Perspectives, 25(1): 49–70. http://tinyurl.com/d201109c
Robert E. Hall (2010). "Why Does the Economy Fall to Pieces after a Financial Crisis?" Journal of Economic Perspectives, 24(4): 3–20. http://tinyurl.com/dl201109d
Since we did not (in my mind, at least) spend enough time on Gorton and Cecchetti last class, I want to repeat those two readings:
Gary Gorton (2010), "Questions and Answers About the Financial Crisis" http://tinyurl.com/d201109d
Stephen G. Cecchetti (2009). "Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis." Journal of Economic Perspectives, 23(1): 51–75.http://tinyurl.com/d201109a
And add, as well:
Frederic S. Mishkin (2011). "Over the Cliff: From the Subprime to the Global Financial Crisis." Journal of Economic Perspectives, 25(1): 49–70.http://tinyurl.com/d201109c
Complaint: SEC vs. Citigroup: http://delong.typepad.com/20100909-complaint-sec-v.-citit.pdf
Memorandum in Response: SEC vs. Citigroup: http://delong.typepad.com/20100909-sec-v-citigroup.pdf
Vincent Reinhart (2011). "A Year of Living Dangerously: The Management of the Financial Crisis in 2008." Journal of Economic Perspectives, 25(1): 71–90.http://tinyurl.com/d201109b
Gary Gorton and Andrew Metrick (2010), "Regulating the Shadow Banking System" http://tinyurl.com/dl201109e
G. Phillip Rutledge (2005), "A Brief Guide to Financial Derivatives" http://tinyurl.com/dl201109f
Rene Stultz (2004), "Should We Fear Derivatives?" http://tinyurl.com/dl201109g
Gary Gorton (2010), "Questions and Answers About the Financial Crisis" http://tinyurl.com/d201109d
Stephen G. Cecchetti (2009). "Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis." Journal of Economic Perspectives, 23(1): 51–75.http://tinyurl.com/d201109a
Vincent Reinhart (2011). "A Year of Living Dangerously: The Management of the Financial Crisis in 2008." Journal of Economic Perspectives, 25(1): 71–90.http://tinyurl.com/d201109b
Frederic S. Mishkin (2011). "Over the Cliff: From the Subprime to the Global Financial Crisis." Journal of Economic Perspectives, 25(1): 49–70.http://tinyurl.com/d201109c
Gary Gorton and Andrew Metrick (2010), "Regulating the Shadow Banking System" http://tinyurl.com/dl201109e
*J. Bradford DeLong, U.C. Berkeley, September 2011
The Housing Boom
But the collapse of the Great Moderation was still in the future as the U.S. and the world economy recovered from the relatively small recession and downturn in the early 2000s that had followed the collapse of the late-1990s dot-com boom. The recovery of the 2000s did have a somewhat odd shape that puzzled and worried many economists, who wrote papers about and tried to puzzle out the logic of two phenomena, the global savings glut and the housing boom.
Figure 6 shows the relative intensity of two different flows of investment spending in the U.S. economy since 1995. The blue line tracks business investment in machines—producer durable equipment (and software) divided by the Congressional Budget Office’s estimate of the economy’s productive potential. The dot-com boom in information technology and telecommunications is clearly visible in Figure 6: investment in PDE rises from 5.5% of potential GDP in 1995 to a peak of more than 8% of potential GDP in 2000. It then fell back, not because the technologies of the internet, of modern computers, and of modern telecommunications were disappointing but rather because it proved unexpectedly difficult to make profitable businesses out of them. Nevertheless, investment in PDE as a share of potential GDP recovered to its 2000 level by the mid-2000s—and is closing on on its year-2000 level today.
As equipment investment fell, however, the question arose: what would be the next leading sector to soak up American labor and capital that had been rendered unemployed in the recession that started in 2001? It was not plausible that there would be a second information technology boom so close on the heels of the first, and biotechnology was too new and unbaked for it to develop the kind of mass demand that would power a boom on the scale needed to matter for the American economy as a whole.
The answer was housing. Investment in residential construction rose from 5% of potential GDP in the second half of the 1990s to a peak of more than 6% of potential GDP by 2006, and the number of houses on which construction was started in America rose from its usual pace of perhaps 1.5 million a year to a peak of more than 2.2 million by 2006.
Why did housing construction boom? Because people in the mid-2000s were willing to pay a lot more for houses. Figure 8 plots real housing pries—the FHFA’s housing price index divided by the Consumer Price Index. Before 2000 the real price of housing showed little variation on a country-wide scale. Prices in 1979 were perhaps 15% above what they had been in 1975 and would be in 1984. Prices in 1990 were perhaps 6% above what they would be in 1995. And by the peak of the dot-com boom in 2000 prices were perhaps 9% above what they had been in 1995.
But housing prices country-wide exploded in the 2000s. Why?
*J. Bradford DeLong, U.C. Berkeley, September 2011
Accounting for the Great Moderation
Why was the civilian adult employment-to-population ratio so close to its ten-year trailing moving average during the Great Moderation? It was not that there was anything odd or unusual about employment as a measure: other attempts to estimate macroeconomic business-cycle volatility found equally-strong evidence of an equally-large Great Moderation as well.
There were in the mid-2000s three lines of argument for why the Great Moderation had taken hold starting in the mid 1980s.
The first line of argument was that America’s central bank, the Federal Reserve, had finally learned how to do its job well. Under this interpretation, before the mid-1980s Federal Reserve policymakers, because of a combination of short-sightedness, committee group dynamics, and political pressure, oscillated between periods in which it pursued full employment without looking down the road at the effect of its policies on inflation, and periods in which it fought inflation and tried to create excess supply to break cycles of inflationary expectations with little regard for the effects of its policies on employment and capacity utilization. But, on this interpretation, after the Volcker disinflation of the early 1980s the Federal Reserve began to get it right. It now looked forward into the future, and made monetary policy with its eyes not on what inflation and unemployment were now but with its eyes on what inflation and unemployment were likely to be two or more years into the future.
On this interpretation, the Great Moderation was likely to be a permanent result of institutional learning and also of effective institutional independence. After the 1970s both members of congress and presidents concluded that applying pressure to the Federal Reserve was likely to be a political and policy loser, and that the best strategy was simply to repeat that the Federal Reserve was a trusted independent agency charged with making monetary policy judgments. Thus political pressure that may have previously resulted in the stop-go cycles of the late 1960s, 1970s, and early 1980s was removed. In addition, the volatility of the 1970s taught every potential member of the Federal Open Market Committee the importance of taking a relatively long view. And a couple of strong and dominant chairs in the mold of William McChesney Martin in the 1950s and 1960s—Paul Volcker and Alan Greenspan—could both take the long view and enforce their vision of the long view on the FOMC and on the Federal Reserve Board.
There was, however, a second line of argument. It was that the Great Moderation was less the product of better government regulation of the economy by the central bank and more the product of financial deregulation and the growth of more sophisticated financial markets. More sophisticated financial markets allowed both households and businesses to properly smooth spending—to react to an economic downturn not by slashing their consumption and investment spending but by either drawing down financial assets that they had built up during a previous boom or to borrow against earnings that they would make in a future boom. In the pre-1980s world in which the ability of financial institutions to take risks was constrained borrowing and investing were significantly harder. But, this line of argument went, the shift away from tight New Deal financial regulation to a greater tolerance for experimentation and innovation had paid dividends in a substantially reduced size of the business cycle.
The third line of argument was simply that the Great Moderation was due to the absence of major disturbing shocks. Between 1965 and 1980, the argument went, the world economy had been buffetted by an unusually large number of disasters. First came the inflation of the Vietnam War and President Lyndon Johnson’s failure to raise taxes to finance the war, then came the breakdown of the Bretton Woods system of international finance, third came Richard Nixon’s desperate drive for a more inflationary monetary policy to increase his chances for reelection in 1972, which was then followed by the Yom Kippur Arab-Israeli war and the tripling of world oil prices, that was then followed by a sharp slowdown in global productivity growth (the causes of which remain mysterious, shock number six in 1979 with the Iranian Revolution and an additional tripling of world oil prices, and the series of shocks was topped off with number seven with the Latin American debt crisis of the early 1980s.
Staring in 1983, no such similar shocks hit the global economy. Thus, this line of argument went, naturally there was a “Great Moderation”. It would, advocates of this line of explanation argued, come to an end when a substantial shock once again hit the global economy.
At the time, before 2007, of these potential explanations the third seemed the weakest. The second seemed plausible as a partial explanation, but in all likelihood too small to account for the entire magnitude of the Great Moderation. That left the first: skilled monetary management by a federal reserve that understood what it was doing under the wise leadership of the Maestro, Alan Greenspan.
Events since the summer of 2007 have decisively disproved explanations (1) and (2). The Federal Reserve—and other central banks, and legislators, and executive branch officials—have been well behind the curve in their stabilization policy maneuvers since the magnitude of leveraged money-center bank exposure to the losses in low-quality mortgage investments became apparent. Financial deregulation ddi not help but rather poured gasoline on the flames, in the sense that a more tightly regulated financial system would have had much more trouble suffering the total collapse of risk management standards that took place in the 2000s. That leaves explanation (3): for nearly two decades the world economy was very fortunate.
But when Alan Greenspan retired after 17 years as head of the Federal Reserve in 2005 and the Federal Reserve Bank of Kansas City devoted its annual August conference in Jackson Hole, Wyoming to an assessment of his tenure, (3) was very much a minority opinion. The main debate was between the proponents of (1)—more skillful policy—and (2)—deeper, less tightly regulated, and more sophisticated financial markets. Only three economists at the conference strongly argued that the Great Moderation was the result of luck, and luck that might well not last: James Stock, Mark Watson, and Raghuran Rajan.
*J. Bradford DeLong, U.C. Berkeley, September 2011
The Employment-to-Population Ratio
Here in Figure 1 is a time-series chart of the single key quantity you need to study to understand business cycles: the civilian adult employment-to-population ratio.
Every month the Bureau of Labor Statistics (BLS) of the U.S. Department of Labor sends its interviewers around the country to conduct the Current Population Survey (CPS). They ask a random sample of civilian American adults questions. One of the questions is: “last week, did you do any work for pay or profit?”1 The proportion of American adults who answer “yes” to our first CPS question—“did you do any work for pay or profit?”—is the civilian adult employment-to-population ratio: the fraction of American adults who say that they have jobs.
The first thing that catches my eye in the chart is the high-frequency annual wiggle pattern. Almost every single year the share of American adults with jobs reaches a peak in the early summer, declines in the late-summer vacation season, climbs to a lesser peak in the fall before Christmas, and then collapses in the winter to rise again in the spring and the early summer. More people want to work in the (early) summer and fall. Some businesses—construction in the northeast and midwest comes to mind—cannot effectively function in winter. Other businesses see sharp increases in the demands for what they make and sell as the Christmas rush approaches.
Once you seasonally smooth the data to eliminate the spring and fall bulges and the winter slump in unemployment, the course of the employment-to-population ratio over the past fifty years shows:
We would like a view of the data that filters out (1) (or as much as possible of (1)) and that let's us look at (2) or (3) by themselves. And we would like to construct such a filter in a relatively automatic way, rather than asserting what the long run trend is and so baking our conclusions into our assumptions. We want to allow the data to speak. We do not want to torture the data until we confess.
A natural first way to cut the data (to me at least) is to detrend the seasonally-adjusted adult employment-to-population ratio data by a ten-year trailing moving average. Why trailing? So we can look at the present through our filter. Why ten? Because we have ten fingers? Why a moving average? Because we have seen enough moving averages over our lifetimes that we have a sense of how they behave--a sense we do not have for other trendier, fancier statistical detrending filters.
Filtering the employment-to-population ratio through this ten-year trailing moving average filter produces Figure 4. And let us process the data one more step. Johann Carl Friedrich Gauss said that when you are analyzing variability, you should measure it by squaring deviations from the average and then averaging those squared deviations. That produces Figure 5.
Figure 5 tells us that when you measure trends with a trailing ten-year moving average and look at the employment-to-population ratio, four features over the past third of a century jump out at you:
And note that we have not quite succeeded in our task of filtering out movements of type (1). In Figure 5 the late 1980s look like a volatile time. It is certainly true that the employment-to-population ratio in the late 1980s was indeed far away from its ten-year moving average. But this was not because of any depression or recession. And this was not because employment was in any sense artificially elevated because of a high-pressure inflationary economy. Instead, the employment-to-population ratio in the late 1980s was far above its ten-year trailing moving average because (a) the moving average was still depressed below normal levels by the downturn of the early 1980s, and (b) the late 1980s were the high-water mark of the feminist revolution as female labor force participation increased at its fastest pace.
This shows that our automatic statistical procedure has not succeeded in completely purging our data series of movements of type (1): long-run changes in Americans desires and opportunities to work. But we would not expect any automatic, mechanical procedure to do a perfect job of filtering out such phenomena, would we?
The Great Moderation and the Global Savings Glut:
The Housing Boom:
Economists Try to Understand the Economy: Paul Krugman:
Economists Try to Understand the Economy: J. Bradford DeLong:
Most Fridays 4:10-5:45, Evans Hall 597. Alas, this is a freshman
J. Bradford DeLong [email protected] 925.708.0467.
These freshman seminars are supposed to meet for about 12 hours--50 minutes a week for fourteen weeks. I find that 90 minutes works a lot better than 50, so I propose that we meet most Fridays--a total of fifteen hours plus an end-of-semester lunch.
Proposed topics:
Economists are, overwhelmingly, what one of my teachers, the late Rüdiger Dornbusch, used to call "goldsmiths": they start with a few organizing principles--principles of human psychology and motivation and of market structure--and work them with precision, deducing theoretical corollaries and consequences that can then be used to analyze the actually existing real world out there. We could do that in this freshman seminar, but then we would be simply repeating Economics 1: that would largely waste your time.
Moreover, there is a danger in attempting to be a goldsmith if you are not a very good one. You then become what Rüdi would scornfully call a "plumber": somebody who was obsessed with constructing an elaborate Rube Goldberg-like device without a clear vision of what it would be good for and would find at the end that he had constructed something that gave absolutely no insight into what was going on in the real world.
Preferable, Rüdi thought, to be what he called a "pig": to leap into a subject with vigor and wallow in it until you emerged with a defensible and coherent point of view, even though it did not proceed with goldsmith-like precision from a few organizing principles of human motivation and market structure.
We are going to be pigs--and, for Rüdi, to be called a pig was to be given a compliment.
So let's look first at some data about the recent history and current state of the economy--at the Lesser Depression in which we are enmeshed--and then look at some old-fashioned economists' attempts to think about and understand economic situations like the one we seem to find ourselves in today:
Things to Notice:
Things to notice:
J. Bradford DeLong, U.C. Berkeley, August 2011
What should you takeaway from this background chapter? I hope you take four things away from it.
First, I hope you have learned that our market system irregularly but semi-periodically fails in a disturbing and substantial way: it pukes up large numbers of workers—two or three or five percent of the adult population—into excess unemployment, out of which they are only gradually and slowly absorbed. Workers who in normal times have no trouble finding and keeping jobs paying the prevailing wages find themselves unemployed in large numbers, and can stay unemployed for a long time.
Second, economists disagree about the closets and nature of these downturns. There are four groups of economists who I believe are largely if not completely wrong: those who think downturns are on inevitable and unavoidable consequence of previous expectational errors, those who think that if only we got rid of government intervention in financial markets such downturns would cease, those who see their cause in workers’ desires to take a “great vacation”, and those who see their cause in a “great forgetting” of how to make things. I think these four groups simply have not done their homework. They have thus fallen victim to what Joseph Schumpeter liked to call the “Ricardian Vice”. The question of why people would not do their homework would be a difficult one, were not for the fact that this is something that you promised have been doing for sentry witness the name Ricardian vice.
Third, these downturns have their origin in any of a number of different causes all of which however have one thing in common call they all in do's and excess demand for financial assets, and the flip side of this excess demand for financial assets is deficient demand for currently produced goods and services, is a general glut.
Fourth, and excess demand for financial assets is an animal of a different kind then a normal excess demand for a currently produced good or service. The market economy is good at dealing with an excess demand for a currently produced good or service like yoga lessons and its flipside of excess supply of another currently produced good or service like espresso machines. The market can move labor, capital, and resources from the one to the other relatively smoothly. By contrast, and excess demand for financial assets causes large-scale unemployment among those who used to make currently produced good and services, with no countervailing pressure in the system to rapidly absorbed the unemployed into making or doing anything else.
J. Bradford DeLong, U.C. Berkeley, August 2011
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.
**J. Bradford DeLong, U. C. Berkeley, August 2011
Economists' Wrong Explanations
Economists have a number of theories of why the downturn that started the Lesser Depression was so large and why the recovery from it has been so slow—indeed, to date nonexistent. Some of these theories, those put forward by economists whom Rüdiger Dornbusch would classify as “plumbers”, are simply wrong. We can dispose of them quickly.
A Great Forgetting?: A first group, headed by Arizona State University’s Edward Prescott, has argued for decades that business cycles are the result of—and are socially optimal responses to—uncertainty and stochastic variation in the rate of technological change.
It is certainly the case that good news about technology can produce a boom, with rapidly growing output and employment and productivity above trend: recall the second half of the 1990s. And it is certainly the case that bad news about resource availability can produce a downturn: that was certainly part of 1973-1975 and 1979-1982, and perhaps the larger part of 1973-1975.
But technology does not regress: we do not forget how to make and do things, and thus Prescott’s attempt to attribute a sharp downturn in employment and production to some change in economically-applicable technology—to a “great forgetting”—seems doomed to failure. Indeed, in our Lesser Depression the argument seems to go the wrong way: it is not that the productivity of American workers today is lower than in the past or lower than expected back in 2006, it is rather higher.
A Great Vacation?: A second group, of which the most vocal member is the University of Chicago’s Casey Mulligan, claims that downturns come when workers lose their taste for employment, and that you can tell that this is so by looking at the “Douglas formula” relating movements in labor productivity relative to trend to movements in employment relative to trend.
Indeed, as of the second quarter of 2011 labor productivity was 5% above its 2003-2007 trend, which Mulligan claims reflects a decline in desired work hours by American workers of 15%—much more than the decline in work hours actually seen in the Lesser Depression. According to Mulligan’s theory, the entire fall in the employment-to-population ratio is simply the result of American workers’ sudden desire to work less: to take a great vacation—itself induced, he claims, by the fact that if you have no job the Obama Administration will pressure your lender to reduce the principal amount you owe on your mortgage. The big problem with Mulligan’s story is that people did not quit their jobs in unusual numbers in 2008 and 2009: instead, they were fired.
Firings went up, quits went down, and more important new hires went down as firms that would otherwise have expanded found that they did not have the customers to justify expanding employment. Mulligan never asked the very first reality-check question: does my theory of why fewer people are at work today fit with the process of how the decline in employment actually took place? The answer is that it does not.
Most important of all, however, is the question of how the unemployed feel about their status. In Mulligan’s theory they are happy not to have jobs: they could get jobs at the prevailing wage that others are getting, and have decided not to. But few of America’s unemployed today are at all happy with their situation.
A Great Europeanization?: A third group, headed by the University of Chicago’s Robert Lucas believes that the failure of the employment-to-population ratio to recover to normal levels is due to fear of the policies of President Barack Obama. Lucas believes that “[o]ur economy has got a remarkable ability to return to its long term growth trend... quick[ly]: two or three, four years...” But things were not back to normal by 2009, or 2010, or 2011. Lucas’s conclusion? This: 
Liquidity is no longer the problem.... Yet business investment remains very low.... [T]he problem is government is doing too much.... Likelihood of much higher taxes, focused on the “rich”. Medical legislation that promises large increase in role of government. Financial legislation that assigns vast, poorly-defined responsibilities to Fed, others. Are these conditions that foster a revival in business investment, consumer spending?
But the answer appears to be “yes, it is”.
Business spending on equipment and software has recovered very well from its downturn, and is in no wise dragging the economy down by doing worse than average. It is other components of spending—housing construction, government employment, consumer spending by middle-class households now far underwater with their home mortgages—that has failed to recover. The claim that business fear of Obama’s policies is at the root of slow recovery does not seem to pass its first consistency checks with the data.
Paul Krugman observes that much of Lucas’s confidence in his Obama-centric explanation comes from yet another failure of Lucas to mark his beliefs to reality. Obama’s policies have attempted (so far without any notable success) to move the structure and function of the American government closer to those seen in more social democratic western Europe. And it is an item of conservative faith that in western European countries red tape strangles employment and enterprise. A case for such an argument could have been made from the mid-1980s—but not before—until the end of the 1990s—but not since.
Government Guarantees: Yet a fourth group believes that excessively-generous government loan guarantees induced too many working-class households who could not afford to carry mortgages to buy houses and thus too many American construction workers to build too many houses. Since the market system cannot easily deploy the construction workers elsewhere—they are, when not engaged in building houses, zero marginal product workers—we are doomed to suffer depression until the overhang of excess houses constructed during the 2000s housing bubble is worked off.
The problem here is once again a failure to mark the theory to market. During the boom of the 2000s America built perhaps five million houses above trend and financed them with mortgages on which perhaps $100,000 per mortgage will never be paid back. That is a total economic loss to investors in the housing sector due to overconstruction of $500 billion dollars. But the world economy had, in 2007, $80 trillion total of financial wealth. How can a $500 billion loss bring an $80 trillion wealth economy into a depression? That question is never answered.
Moreover, the claim that we have to wait until the overhang of bad capital investment produced by the housing bubble is worked-off would lead us to predict that the U.S. economy would by now be in a healthy boom, because the overhang of housing construction has been worked off. As Figure 11 shows, the housing boom that led to above-trend housing construction has been followed by a housing bust of below-trend housing construction: we now have perhaps one million fewer houses than a simple extrapolation of pre-bubble trends would predict. When people become tired of living in their sisters’ or their in-laws’ basements and resume normal housing purchase patterns we will find that we have not an overhang but a shortage of housing investment.
I believe that all four of these theories illustrate one of the great vices of economics—what Joseph Schumpeter in called “the Ricardian vice”.8 People have started from what they take to be obvious principles of human psychology and markets—that people seeking their own welfare trading in markets will create an efficient system of production in the case of the “great forgetting” and the “great vacation” explanations, that high taxes and tight regulations can impoverish an economy in the “great Europeanization” explanation, and that government guarantees in finance induce “heads we win—tails the government behaves” behavior by lenders—and reasoned to what they take to be logical conclusions without ever doing the elementary sanity or reality checks. The fact that this goldsmith-like reasoning can go so awry in the hands of those who are not very skillful at it or not terribly grounded in reality was the reason that Rüdiger Dornbusch scorned those economists whom he called “plumbers”.
You need to be aware that these theories are out there. And you need to be able to rebut them. But once you are aware of them and do know how to rebut them, do not let them trouble you further.
Let us turn, instead, to attempts to understand the origins and persistence of our Lesser Depression that have promise.
**J. Bradford DeLong, U. C. Berkeley, August 2011
The Lesser Depression
The third notable thing about Figure 3 is our current downturn, our Lesser Depression. It is itself unique for three reasons: the size of the downturn, the fact that this time the market economy was not shocked into a downturn by something governments did but rather did it to itself, and the failure—so far—of there to be any meaningful recovery from the downturn.
The Largest: First, as a share of the country’s population and labor force, our current Lesser Depression is by far the largest such downturn we have seen since World War II or indeed since the Great Depression of the 1930s itself (which was a much larger relative macroeconomic disaster than the one we are suffering through now). Our Lesser Depression starts with a large, sudden collapse in the adult civilian employment-to-population rate of a magnitude nearly twice as large as the largest previous such post-World War II downturn—the three percentage point of the civilian adult population decline in the Carter-Reagan-Volcker downturn of 1979-1982.
Market-Generated: Second, the Carter-Reagan downturn and the other largest post-World War downturns were in large part caused by government shocks to the market economy. The Carter-Reagan-Volcker downturn was the result of two large and obvious shocks to the market economy administered by governments: the Iranian Revolution of 1979 and the Saudi Arabian acquiescence in the tripling of world oil prices triggered by the conquest of power in Iran by Ayatollah Khomeini and his allies, and Federal Reserve Chair Paul Volcker’s decision that it was time to bring on an economic downturn and depress the employment-to-population ratio by creating a liquidity squeeze of high interest rates by shrinking the money supply in order to reduce inflation by demonstrating that the Federal Reserve would not keep money cheap enough to make it profitable for private businesses to keep borrowing and spending no matter what. By contrast, the 2007-9 downturn saw no correspondingly-large external shock administered to the market economy by the world’s governments as its cause: no large-scale removal of oil rigs from production, no liquidity squeezes by central banks nothing—this time the market economy did it to itself all by itself.

The Flatline: Third, the downturn of the Lesser Depression has, so far, been followed not by recovery but rather by flatline. The civilian adult employment-to-population ratio in late 2011 is what it was in late 2009. Recovery as measured by the course of the civilian adult employment to population ratio has not just been slower than the downturn: recovery has, so far, been nonexistent.
The civilian adult employment-to-population ratio as of August 2011 is lower than it has been at any moment between today and 1983, back when American feminism was only half-formed. So far, at least, there is not even a hope that its end is in sight. As of this writing in August 2011 economic forecasters are by and large predicting that the employment-to-population as of the end of 2012 is more likely than not to be not lower but rather a little bit higher than it is today.
This failure of recovery is worth underscoring. In 1973-1975 the adult civilian employment-to-population ratio fell by about two-fifths as much as it fell in 2007-2009. In 1979-1982 it fell by about three-fifths as much. But after both of those downturn episodes recovery came swiftly and recovery was rapid: the employment-to-population ratio rose almost but not quite as steeply as it had previously risen, giving the track of the employment-to-population ratio on the graph the appearance of a “V”. That has not been the case in this Lesser Depression: so far, at least, this episode looks more like an “L”.
**J. Bradford DeLong, U. C. Berkeley, August 2011
The Lesser Depression
Some call it the “Great Recession”. I call it the “Lesser Depression”. It is the worse episode of macroeconomic distress that the U.S. has seen since the Great Depression itself—although it does remain and will almost surely conclude as far smaller than the Great Depression of the 1930s. It is the largest episode of prolonged high unemployment since World War II. And it is what the American economy is going through right now.
If economics is of any use at all, it should be able to help us understand our current Lesser Depression—to give good and convincing answers to the four obvious questions:
How to Do Economics: Goldsmiths, Plumbers, and Pigs
Before we start to tackle these questions, however, comes a digression on the method of economics as an intellectual discipline.
There are, broadly, three ways to do the intellectual discipline of economics. My old teacher the late Rüdiger Dornbusch gave names to the practitioners of these three intellectual styles.1 He called them “goldsmiths”, “plumbers”, and “pigs”.
Goldsmiths: Goldsmiths start with a few organizing principles—principles of human psychology and motivation and of market structure. They would then work them with precision, deducing theoretical corollaries and consequences to create a finely-crafted, detailed, and beautiful intellectual structure They would then apply that structure to understanding the world. I could follow this style, but then this book would be very much like a Principles of Economics textbook, and there are enough Principles of Economics textbooks in the world already—I am aiming to write something different that will, I hope, be more useful.
Plumbers: Moreover, there is a danger in attempting to be a goldsmith. You might turn out to be a plumber instead. Suppose that you start with your few organizing principles of human psychology and motivation and of market structure, but you get them wrong. Or suppose that you get your organizing principles right but try to apply them to situations that they do not really apply to. Then when you reach the end of your intellectual journey you will discover that you have constructed an elaborate Rube Goldberg-like device that gives no insight into what is going on in the real world.
Pigs: Better, Rüdi thought, to be what he called a “pig”: to leap into a subject with vigor, and then to wallow in the subject until you emerged with a defensible and coherent point of view, even though you did not proceed with goldsmith-like precision from a few organizing principles of human motivation and market structure to their logically-entailed conclusions. When Rüdiger Dornbusch called my other teacher Lawrence Summers “a fearful pig”, he was paying him a high compliment.
We are going to be pigs. We are going to look first at some data about the recent history and current state of the economy—at the Lesser Depression in which we are enmeshed—then we are going to look at some old-fashioned economists' attempts to think about and understand economic situations like the one we seem to find ourselves in today, and last we are going to wallow in the subject and so attempt to assess, explore, and develop the different hypotheses about what is going on that economists have set out.
Let us start wallowing.
Yes, I know that this is about four times as much as freshmen in a freshman seminar can be expected to absorb. But where to cut?
F4-5:30, Evans Hall 597. J. Bradford DeLong [email protected] 925.708.0467
Aug. 26: Panics: Kindleberger, Manias, Panics, and Crashes
Sep. 2: Bubbles: Galbraith, The Great Crash
Sep. 9: NO CLASS
Sep. 16: General Gluts: Bagehot, Lombard Street http://tinyurl.com/dl20110612b; Minsky, "The Financial Instability Hypothesis" http://tinyurl.com/dl20110612f.
Sep. 23: NO CLASS
Sep. 30: The Great Moderation: Greenspan, The Age of Turbulence; Bernanke, "The Great Moderation" http://tinyurl.com/dl20110612g; Blinder and Reis, "Economic Performance in the Greenspan Era: The Evolution of Events and Ideas" http://tinyurl.com/dl20110612j; Rajan, "Financial Markets, Fragility, and Central Banking" http://tinyurl.com/dl20110612i plus discussions at http://www.kansascityfed.org/publicat/sympos/2005/pdf/GD5_2005.pdf http://www.kansascityfed.org/publicat/sympos/2005/pdf/Shin2005.pdf and http://www.kansascityfed.org/publicat/sympos/2005/pdf/Kohn2005.pdf
Oct 7: Mortgages and Derivatives: Nocera and MacLean, All the Devils Are Here
Oct.14: NO CLASS
Oct. 21: Bank Runs: Gorton, Slapped by the Invisible Hand; Shleifer and Vishny, "Fire Sales in Finance and Macroeconomics"
Oct. 28: The Financial Collapse: Paulson, On the Brink; Cecchetti, "Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis"
Nov. 4: The Recession: Robert Hall, "Why Does the Economy Fall to Pieces After a Financial Crisis?"; Mill, "Of the Influence of Consumption on Production" http://tinyurl.com/dl20110612a; Krugman, selections from The Conscience of a Liberal http://krugman.blogs.nytimes.edu
Nov. 11: NO CLASS
Nov. 18: Policies: Suskind, Confidence Men; Viner, "Mr. Keynes on the Causes of Unemployment" http://tinyurl.com/dl20110612e
Nov. 25: NO CLASS
Dec. 2: Politics and Sovereigns: Reinhart and Rogoff, This Time It's Different
Dec. 9: Lunch
Bloggingheads.tv - Non-Free Ice Cream Edition:
http://bloggingheads.tv/diavlogs/37836>
Keynesian:
Monetarist:
Note that neither of these theories seems to have an obvious central role for financial markets--financial markets feed each of these models an interest rate--the long-term risky real interest rate r in the Keynesian model, and the short-term safe nominal interest rate i in the monetarist model.
Which of these theories is correct? Both--they are both (nearly) tautologies...
Which of these theories is most useful in understanding the coming of the Great Recession Little Depression of 2007-2012? Neither--for all the action goes on behind the scenes, in the determination of I0 and r in the Keynesian model and in the determination of v0, vi, M, and in the monetarist model.
How, then, should we analyze the coming of the Great Recession Little Depression of 2007-2012 at a freshman seminar level?
Aug. 26: The housing bubble: Reading: Nocera and MacLean, All the Devils Are Here.
Sep. 2: Historical perspective: Reading: Kindleberger, Manias, Panics, and Crashes.
Sep. 9: NO CLASS
Sep. 16: Recessions and depressions: Mill, "Essay II: Of the Influence of Consumption on Production" http://tinyurl.com/dl20110612a; Keynes, "The General Theory of Employment" http://tinyurl.com/dl20110612c; Hicks, "Mr. Keynes and the 'Classics': A Suggested Interpretation" http://tinyurl.com/dl20110612d; Jacob Viner, "Mr. Keynes on the Causes of Unemployment" http://tinyurl.com/dl20110612e.
Sep. 23: Panics and recessions: Bagehot, Lombard Street http://tinyurl.com/dl20110612b; Minsky, "The Financial Instability Hypothesis" http://tinyurl.com/dl20110612f.
Sep. 30: The great moderation: Bernanke, "The Great Moderation" http://tinyurl.com/dl20110612g; Blinder and Reis, "Economic Performance in the Greenspan Era: The Evolution of Events and Ideas" http://tinyurl.com/dl20110612j; Rajan, "Financial Markets, Fragility, and Central Banking" http://tinyurl.com/dl20110612i plus discussions at http://www.kansascityfed.org/publicat/sympos/2005/pdf/GD5_2005.pdf http://www.kansascityfed.org/publicat/sympos/2005/pdf/Shin2005.pdf and http://www.kansascityfed.org/publicat/sympos/2005/pdf/Kohn2005.pdf
Oct. 7: The financial collapse:
Oct. 14: The downturn:
Oct. 21: Government policies:
Oct. 28: Politics:
Nov. 4: Sovereigns and their debts:
Nov. 11: NO CLASS
Nov. 18: Recoveries?:
Nov. 25: NO CLASS
Dec. 1: Possible futures: Reinhart and Rogoff, This Time It's Different
Test
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