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Karl Smith finds this peculiar comment in a Raghu Ragan FT article:

However, the past build-up of debt in now depressed areas may suggest that demand was too high relative to incomes. If so, demand, without the dangerous stimulant of borrowing, will stay weak. Policy should instead help workers move where there are suitable jobs – for instance, by helping them offload their homes and the associated debt without the stigma of default.

Smith can’t figure out what this means either. Here’s Karl’s interpretation:

So first, when we use demand in the macroeconomic sense, income is simply the equilibrium value of demand at a given price level. It makes no sense to say that demand is too high relative to income. We might mean that the local area was running a persistent current account deficit. So for example on total the people of Las Vegas were importing more than they were exporting. Las Vegas experienced perhaps the most severe crash of any major US metropolitan area. To undue this balance they need to run a current account surplus. That is they need to export more than they import.

Perhaps, but then his solution (people should work less in the region that has the CA deficit) would make no sense at all. I really don’t know what Rajan means here, if I had to guess I think he’d claim the people of the problem regions like Vegas and Spain were not producing too much in total, but rather were producing too much of one good (like houses) and too little of other goods. Then he might argue that in the short run it’s easier for the surplus labor to exit Vegas and Spain and work in a more prosperous area. That would be a defensible argument, but of course it would have nothing to do with “demand” having been too high relative to income. And even if output was too high in aggregate (say too many people had moved to Vegas), that would suggest both output and income were too high, not that demand was too high relative to income.

And as Karl points out, Rajan’s also confused about the re-allocation argument. Here’s Rajan:

This is probably the more pertinent case in several industrial countries, such as the US and Spain. Increasing employment in a sustainable way today could more than pay for itself if people who would otherwise drop out of the workforce earn incomes. The key question then is whether more government spending can make a real difference to the most severe employment problems. Here the case for a general stimulus becomes less compelling. In the US, demand is weakest in communities where a boom and bust in house prices has left an overhang of household debt. Lower local demand has hit employment in industries such as retail and restaurants. A general increase in government spending may be too blunt – greater demand in New York is not going to help families eat out in Las Vegas (and hence create more restaurant jobs there). Targeted household debt write-offs in Las Vegas could be a better use of stimulus dollars.

Notice the non-sequitur, from a lack of jobs to the claim that the “key question” is whether we need more government spending. If there’s not enough jobs (due to a demand shortfall) we need more monetary stimulus. That oversight is forgivable for Spain, as they lack their own currency. But the US? Why would we employ fiscal stimulus, when monetary stimulus doesn’t run up any debts? And the Vegas/New York comparison makes no sense. Both regions have high unemployment. But even if they didn’t, regional differences should play no role in aggregate demand policies. The Fed and the ECB can and should tailor their policy for the entire region. Obviously both the US and the eurozone have a demand shortfall. Recently the problem’s been getting slightly better in the US, and slightly worse in the eurozone. But both could use more monetary stimulus.

Indeed the US needs more monetary stimulus even if AD is currently right on target. How can that be? Because we are still doing fiscal stimulus, e.g. the payroll tax cut. So at a minimum you’d want to do more monetary stimulus until we reached a demand level where Congress felt it could remove fiscal stimulus. People used to sort of blanch when I talked about the Fed “sabotaging” fiscal stimulus, but Bernanke all but admitted that this is exactly what the Fed is currently doing:

1. Bernanke says the Fed can do more.

2. Bernanke says the Fed chooses not to do more, as they think the expected future path of AD is adequate.

3. Congress continues to hold down payroll taxes because they think the expected future path of AD (without fiscal stimulus) is not adequate.

That’s sabotage folks; there is no other word for it.

I apologize for the snarky post title. But think about how hard we work to get our undergrads to distinguish between shifts in demand and changes in quantity demanded. So it’s quite dismaying when a famous economist talks about too much “demand” in a context where he pretty clearly meant something entirely different. It’s hard to have an intelligent debate if each participant comes to the discussion with their own private language.

PS. It’s also possible Rajan meant “consumption” when he said “demand.” That would be a strange use of the term ‘demand,’ and of course the main problem in Vegas and Spain was too much investment, not too much consumption.

PPS. If anyone (including Rajan) can provide a sensible definition of what he meant by ‘demand’ then I’ll provide an abject apology.

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This entry was posted on May 25th, 2012 and is filed under Misc., Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



