Why does Aggregate Demand Collapse?

The Great Depression of 1929, and now the Great Recession following the Global Financial Crisis, poses several puzzles for economists. One is them is the sudden and severe drop in aggregate demand. This leads firms to curtail production, and therefore reduces demand for factors of production, most importantly labor. Why does aggregate demand fall, and why do not the price adjustment mechanisms restore equilibrium? The outstanding contribution of Atif Mian and Amir Sufi in House of Debt (see my Review & Summary) is to explain both why aggregate demand fell and also why the standard price adjustment mechanisms fail to restore equilibrium. The correct explanations have eluded famous economists like Keynes, Friedman, Lucas and many others . Only after understanding the reason for the shortfall in aggregate demand does it become possible to prescribe a remedy.

(see also discussion following repost on RWER Blog)



Keynes noted that Aggregate Demand fell in wake of the financial crisis and suggested that fiscal and monetary policy might restore it. It is the shortfall of aggregate demand which leads to unemployment. Standard macroeconomics then and now does not allow for a long run and persistent shortfall in aggregate demand. Theoretically, prices should fall in response, which would stimulate the demand. Increased demand would lead to increased production and ultimately restore full employment equilibrium. The Great Depression made it clear to all that this mechanism did not work as expected. The Great Recession following the Global Financial Crisis has reinforced this lesson. Unemployment persists at high levels, even though there had been no change in the productive capacity of the economy. Why did not the self regulating market restore equilibrium? A similar and related puzzle was the failure of demand and supply in the labor market. High unemployment should have led to falling wages, which should have eliminated unemployment. Again this was not observed to happen. Why?

Keynes did not really have an answer to this puzzle – he argued that wages and prices were fixed in nominal terms and could not move downwards, for unknown reasons. Therefore prices and wages could not adjust to bring about equilibrium. This was factually wrong. There was deflation — fall in wages and prices – of about 30% in the course of the Great Depression. Nonetheless, this did not wipe out unemployment, and it did not stimulate aggregate demand. CORRECTION (by Paul Davidson) Fixed prices is a common mis-interpretation of Keynes, who actually said that bargains between capitalist and laborers involved nominal wages, not real wages. A simultaneous fall in wages and prices would leave real wages unchanged and fail to equilibriate supply and demand in the labor market. In any case, the mechanism under discussion by Mian and Sufi is DIFFERENT from the Keynesian mechanism for prolonged unemployment.

The answer provided by Mian and Sufi requires looking at dis-aggregated demand – which is perhaps why the explanation was missed by economists who shared the views of Lucas (2004) that: “Of the tendencies that are harmful to sound economics, the most poisonous is to focus on questions of distribution.” As shown by Mian and Sufi, understanding effects of distribution is one of the keys to understanding the GFC. Lack of understanding of distributional effects led Lucas to make the embarrassing claim that “the central problem of depression-prevention has been solved” just before the GFC. Mian and Sufi bring a lot of empirical evidence to show that the financial crisis wiped out the assets of a class of consumers who have a very high marginal propensity to consume. These were the “borrowers” – obviously a less wealthy class than the lenders. In order to rebuild savings to desired levels, this class cut back heavily on consumption leading to a sharp decline in aggregate demand. In contrast to the “borrowers”, lenders have very low marginal propensity to consume. A drastic drop in their wealth does not impact on aggregate demand.

The difference is illustrated by the dotcom bubble, which was of similar magnitude to the property price bubble. The bursting of the bubble inflicted heavy losses, but only on the wealthy investors in dotcom stocks. This loss of wealth did not impact much on the aggregate demand, since the wealthy have low marginal propensity to consume. Thus there were minimal consequences to the economy as a whole. On the other hand, the bursting of the real estate price bubble wiped out the assets of the middle class which has a much higher marginal propensity to consume. This class which ordinarily consumes heavily started to save to build up their savings back to desired levels. Their cutback on demand caused a severe drop in aggregate demand which led to cutbacks in production and consequent unemployment.

Mian and Sufi argue that bailing out the mortgagors would have prevented the recession by providing relief to the classes who spend the most. Then the sharp downfall in aggregate demand and the resulting unemployment could have been avoided. Due to political reasons, this sensible solution was not adopted. Instead, relief was given to the bankers who had caused the recession – this is like applying the medicine to the weapon which caused the wound, instead of applying it to the wound. The relief packages of trillions of dollars for bankrupt financial institutions did not address the root of the problem. Thus they were unable to prevent the recession which followed, and continues to this day. This is because it remains true that about 20% of the current mortgages are “under water” – the value of the house is less than the mortgage debt. The millions of distressed homeowners have cut back on spending, which is the root cause of the recession.

The reason that price adjustment mechanisms fail to work to restore equilibrium is because of the heavy debt burden of these homeowners. As in the Great Depression, businesses cut down on production and reduced prices, as required by the adjustment mechanism. However, maintaining profitability required reducing wages at the same time. These cutbacks led to decreased employment and decreased incomes for the employed, reducing the ability of workers to pay back their debts. The debt burden, fixed in nominal terms, increased as a result of this process of deflation of prices and wages. Instead of stimulating aggregate demand, deflation led to a reduction in aggregate demand, which led to further decreases in production, prices and wages. This vicious cycle was termed the debt-deflation cycle by Irving Fisher; as he put it in 1933, “I have . . . a strong conviction that these two economic maladies, the debt disease and the price-level disease, are, in the great booms and depressions, more important causes than all others put together.” Thus excessive debt is the solution to the second puzzle of why the price adjustment mechanisms fail to work.

This analysis remains critically important today. Mian and Sufi point out that although monetary and fiscal policy as prescribed by Keynes are useful, they represent highly inefficient solutions, since they do not go to the root cause of the problem. In fact, monetary policy, in the form of quantitative easing, is completely ineffective, as they demonstrate. Fiscal policy works only to the extent that it reaches the distressed class of mortgage holders, and others with high propensity to consume. Targeted relief to homeowners can do wonders, and there are effective proposals on board, but they have been blocked by political resistance. Among the enablers of this political resistance are false economic theories which are strongly advocated and propagated. Thus learning and propagating the correct theories is a useful methodology for resistance against the power of the top 0.1%.