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Low Aggregate Demand Matters

October 7, 2011

Most conservative economists have a clear understanding of the problems associated with too much spending, but some have trouble seeing the problems with too little spending. It seems like there is a dichotomy: when spending is too high, the problem is too much money. “Inflation is always and everywhere a monetary phenomenon”, as the saying goes. The problem of low spending is blamed on low interest rates, high consumer debt, high tax rates, structural shifts, and financial crises. People are willing to bend over backwards to avoid flipping Friedman’s statement. If central banks can err by having too much money, surely they can err by having too little. The price mechanism is an incredible social institution for allocating resources, but it is not indestructible. Unpredictable monetary policy can throw sand in its gears, whether that policy is too expansionary or contractionary.

The first of the two core Keynesian insights is that prices are sticky. Price changes have real costs and they occur slowly and unevenly. Because different classes of goods respond to monetary shocks at different speeds, monetary shocks affect relative prices as well as the overall price level. Slow adjusting prices, like wages, are too low in inflationary times and too high under deflation. The relative price of quickly changing prices, such as commodities, are too high under inflation and too low under deflation. The more liquid and well connected to financial markets a good is, the faster the price shifts. For example, the price of oil, corn, and shares of stock are highly reactive to even slight macroeconomic disturbances. Rarely traded and emotionally charged prices, such as wages and house prices, tend to move slowly, especially downward. Additionally, because money is injected into the economy through the banking sector, instead of increasing everyone’s holdings of money simultaneously, it tends to increase the price of capital first before spreading out to other sectors. Both inflation and deflation can be quite damaging to relative price signals.

The second major Keynesian insight is that one person’s spending is another person’s income. When you buy bread, it is your consumption spending, and the baker’s income. In turn, he uses it to buy other things, providing income to others. The baker faces a dilemma when faced with decreased demand for bread. If the reduced demand is based on a relative shift in demand, such as people deciding to eat other things, he should cut production, fire workers, and scale down his operation. If the demand change is because of an aggregate reduction in demand, he can simply lower his prices and the wages he pays. His real income will stay the same, since other produces are also reducing their prices, and his workers will not quit (unless there are sticky wages) since they will not be able to find better jobs elsewhere. The whole process reverses for an increase in spending. If everyone in the economy spends more, that has no impact on the amount of scarce resources they have at their disposal. Prices will have to increase to equilibrate the system. On the other hand, if people spend more on one good and less on others, resources can shift from producing one thing to producing the other. Entrepreneurs have a really hard time telling these two types of shocks apart.

On the flip side, consumers have trouble telling the difference between a permanent income shock stemming from a decrease in demand for their skills and a temporary income shock stemming from a deflationary monetary shock. If the baker as an entrepreneur, cannot tell between a relative reduction in demand for bread and an aggregate demand drop, the baker as a household cannot tell if he will be permanently poorer due to lower returns on his services or temporarily poorer until prices of the goods he buys drop. If you believe in the permanent income hypothesis, this distinction makes a huge difference. People whose permanent income has dropped will cut back relatively more on superior goods, whereas people whose income has temporarily decreased will draw down their capital. As the recession drags on, consumers have no idea how long it will last, and thus how big a shock to their permanent income it will cause. Without income level targetting, no one has a clear idea what level of income to expect. Income shocks, whether permanent or temporary, can impact households and firms by affecting their ability to repay fixed loans. If someone must repay a fixed nominal amount, inflation will reduce (and deflation will increase) the real value of the repayment. If loans are not repaid, firms and households must endure the very real costs of bankruptcy. Banks facing high default rates may go bankrupt, furthering the deflationary shock through the “Debt-Deflation” channel.

Possibly the most harmful consequence of contractionary monetary policy is that it undermines faith in the free market and opens the door to all sorts of crazy and harmful government policies. Congress, powerless to increase spending directly, has dumped untold billions into “jobs”, which is just a euphemism for industrial planning and pork. We don’t live in a world where we can cooly choose between various policy outcomes in inflation and then pick the size and type of government programs. Politicans react to populist anger and will do something, anything, if things go wrong. The best possible argument for the free market is that it works. Take that away, and people turn to all sorts of other nonsense.

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