declines in demand and how to disaggregate them
Let’s say that housing and equity values fall and suddenly people realize they are less wealthy for the foreseeable future. The downward shift of demand will bundle together a few factors:
1. A general decline in spending.
2. A disproportionate and permanent demand decline for the more income- and wealth-elastic goods, a category which includes many consumer durables and also luxury goods. (Kling on Leamer discusses relevant issues.)
3. A disproportionate and temporary demand decline for consumer durables, which will largely be reversed once inventories wear out or maybe when credit constraints are eased.
Those are sometimes more useful distinctions than “AD” vs. “sectoral shocks,” because AD shifts consist of a few distinct elements.
If you see #1 as especially important, you will be relatively optimistic about monetary and fiscal stimulus. If you see #2 as especially important, you will be relatively pessimistic. You can call #2 an “AD shift” if you wish, but reflation won’t for the most part bring those jobs back. People need to be actually wealthier again, in real terms, for those spending patterns to reemerge in a sustainable way. Stimulus proponents regularly conflate #1 and #2 and cite “declines in demand” as automatic evidence for #1 when they might instead reflect #2.
If you see #3 as especially important, and see capital markets as imperfect in times of crisis, you will consider policies such as the GM bailout to be more effective than fiscal stimulus in its ramp-up forms.
Sectoral shift advocates like to think in terms of #2, but if #3 lurks the shifts view can imply a case for some real economy interventions. I read Arnold Kling as wanting to dance with #2 but keep his distance from #3. But if permanent sectoral shifts are important, might not the temporary shifts (we saw the same whipsaw patterns in international trade) be very important too? Can we embrace #2 without also leaning into #3?
I wish to ask this comparative question without having to also rehearse all of the ideological reasons for and against real economy bailouts. It gets at why the GM bailout has gone better than the fiscal stimulus, a view which you can hold whether you favor both or oppose both.
Note there also (at least) two versions of the sectoral shift view and probably both are operating. The first cites #2. The second claims some other big change is happening, such as the move to an internet-based economy. If both are happening at the same time, along with some #1 and some #3, that probably makes the recalculation problem especially difficult.
I see another real shock as having been tossed into the mix, namely that liquidity constraints have forced many firms to identify and fire the zero and near-zero marginal productivity workers.
There’s also the epistemic problem of whether we have #2 or #3 and whether we trust politics to tell the difference.
The Germans had lots of #3 (temporary whacks to their export industries) and treated them as such, whether consciously or not, and with good success. Arguably Singapore falls into that camp as well. The U.S. faces more serious identification problems, whether at the level of policy or private sector adjustment. We have not been able to formulate policy simply by assuming that we face a lot of #3.
I would have more trust in current applied policy macroeconomics if we could think through more clearly the relative importances of #1, 2, and 3. And when I hear the phrase “aggregate demand,” immediately I wonder whether it all will be treated in aggregate fashion; too often it is.
Here is a post by Matt Yglesias, my version goes like this:
1. If there is something akin to a liquidity trap, one can expect that a broader aggregate such as M2 has collapsed. Accelerating the velocity of currency (say through a negative nominal interest rate, enforced through money stamping) may be a highly imperfect substitute for all the lost credit. (Not all AD is created equal.) Currency is usually small relative to M2, it is sector-specific, and the demand for currency can be slow to respond to relative prices.
2. If currency disappeared, how might negative nominal interest rates come about? The market won’t do it automatically. Let’s say we start with zero price inflation and the real rate of return goes negative. Competitive banks won’t impose negative nominal rates, rather the equilibrium is that they stop further real investments and pay zero on the balances. One constraint is that some form of withdrawals may always be possible, the more important constraint is simply that “storing balances” costs almost nothing at the margin and so competition will bring a zero rather than negative nominal return, adjusting for costs of transacting of course.
3. There is another way to get negative nominal interest. We could imagine a government-engineered reserve requirement, the shutting down of competing networks for trading reserves, and then the government raises the tax on those reserves to bring about negative nominal interest rates. This can be done with or without the existence of zero-interest-bearing currency. (Converting large quantities of reserves to currency, by the way, might be quite costly, given costs of transport and storage.)
4. Conclusion: getting rid of zero-interest-bearing currency doesn’t provide a new weapon against a liquidity trap. Tsiang (JMCB, 1974), by the way, went to an extreme and argued that getting rid of zero-interest-currency meant you were in a liquidity trap all the time, because arguably the money-bonds distinction disappears. I don’t agree, but the presumption lies in that direction.
5. Most generally, the problem in liquidity trap scenarios is that the economy is making an attempt to move from riskier assets to safer assets, and in the face of that attempted adjustment economic expansion is unlikely, no matter what the policy response. Changing one of the properties of one of the safest assets (i.e., allowing currency to bear interest) probably won’t make the reequilibration process much easier if at all. In broad outlines it will be pretty much the same.