While I’m usually a stickler for the minutiae — I always have something critical to say —, I enjoyed Raghuram Rajan’s piece for Project Syndicate: “Why Stimulus Has Failed.” Don’t get me wrong, much of this post is a criticism, but compared to some of Rajan’s other essays (such as his May–June piece for Foreign Affairs) this one I mostly agree with. In fact, he makes several points that should be made more often, and this post also serves as an expansion of the territory already covered by Rajan. Specifically, when he writes that not “all demand is created equal,” we should also be clear to specify that not all demand-side policy is created equal — not that this means that such demand side policy is what the division of labor needs. In this respect, my concern is giving opposing theories a fair platform.

Rajan’s point that not all demand is made the same is crucial. While I think the case could be made less ambiguously, his differentiation of different sources of demand partly hints at the Austrian concept of the structure of production. He does this by referring, although maybe not in these words, to the fact that most demand is derived from the demand for consumer goods. That is, the demand for intermediate products depends on demand for consumer goods, even if the former may represent a bigger chunk of effective demand than the latter (at least, if you’re a Hayekian — Hayek, in Prices and Production, estimated that 75 percent of economic goods are factors of production). Changes in the pattern of demand for consumer goods call for changes in the allocation of producers’ goods, and the Great Recession does represent a significant change in demand.

This is similar, and in fact related to, a point that I make often and repeatedly: there is no demand without supply, and vice versa. What I mean is this, if a firm reduces its flow of output this means that it’s also reducing its demand for inputs, whether labor or capital. An economy characterized by structural problems, or a misallocation of resources, is going to engender dramatic fluctuations in demand if the transition to the new structure of production is rigid, as they always are when the cumulative malinvestments of the boom period are suddenly revealed (and the problems are structure-wide). This understanding makes it less paradoxical to talk about “industrial fluctuations,” implying fluctuations in output (a supply-side issue), and powerful downward changes in aggregate demand. It also makes it clear that “supply-side” changes occur one-in-the-same with “demand-side” changes: an increase in output is going to call for an increase in inputs. Likewise, “demand-side” alterations will have “supply-side” consequences: an increase in demand for product ‘x’ will probably lead to an increase in the production of product ‘x’ and all those products that go into the production of ‘x.’

Where Rajan’s analysis gets weaker is in discounting the value of any “demand-side” “stimulus.” I’m sure he wouldn’t disagree, for instance, with the probable desirability of changes in the money stock in response to changes in the demand for money — even if one rather let the market do this than some quasi- or full government agency. By extension, he also misses the crucial facet of a desirable recovery in aggregate demand. More than how this demand arises, what matters is that money prices are allowed to form constrained by consumer preferences, especially for the factors of production. A subsidization of demand — either through government expenditure or monetary stimulus — will have adverse effects if they lead to prices that don’t correspond to consumer preferences. For example, capital can be misallocated if the price of product ‘x’ is inflated by subsidized demand, drawing resources to this line of production that aren’t warranted by actual consumer preferences. More generally, different interventions can skew the process of profit and loss in such a way that this is no longer an effective harmonizer of interests.

But, most economists recognize this. Nowadays, “demand-side” policies are oftentimes advocated on the basis that they’re neutral with regards to the allocation of resources. Here, neutrality refers to the notion that a policy allows resources to be allocated in accordance with consumer preferences (not that the effects of the policy will be neutral, or irrelevant, per sé). Monetary policy is the clearest example. In fact, if one adopts an interpretation of Keynesian monetary policy that follows that of Leijonhufvud and Clower, then the goal of monetary policy is to manipulate the rate of interest to reflect society’s time preference. The same is true of monetary policy that seeks to respond to changes in velocity: the idea is to allow the market to allocate resources based on unaltered profit and loss. Now, none of this means that we should accept these recommendations as being neutral — I, in the case of most monetary policy, certainly reject this premise! —, but we should at least recognize that this is what these theorists have in mind.

It’s true that there is a large cluster of economists that belong to the group that Rajan’s criticism more directly applies. Ironic given him being a libertarian, I think Scott Sumner belongs to this camp. It may be because he doesn’t recognize the possibility of resource misallocation (instead, everything seems to fall on “NGDP expectations,” which are apparently the cause rather than being caused), but the notion that the housing crisis could have been avoided (once all that investment had taken place) seems utterly naïve to me. More obvious than Sumner, though, are all those who support direct government spending and income redistribution. But, the most powerful argument against these economists isn’t just one that stresses structural issues, but one that proves the relevance of structural issues in a world of large excess capacity (the most common quip against Hayekian business cycle theory).

Lastly, I’m not as comfortable with Rajan’s comments on debt. We shouldn’t oppose debt for the sake of opposing debt. What matters when we talk about debt is whether that debt is sustainable. This includes not only if the debtor can guarantee a sufficient stream of future income, but whether that stream of future income is itself sustainable. I agree that certain assets can be more sensitive to changes in the rate of interest than others, housing being one of them, but the long-term solution isn’t to limit debt creation. Rather, the solution is to reform the financial system. One cosmetic change would be to rethink how to approach macro- and microprudential regulations. There’s evidence that the Basel rules as they existed prior to 2007–08 made it so that mortgage related lending was less expensive than other kinds of lending, including to businesses (because of how the risk buckets that decided capital reserve standards were organized). These kinds of regulations make some assets more interest rate sensitive than others, which ends up distorting the allocation of credit. In short, we should be talking about debt, but it’s worth being specific.

Overall, Rajan’s piece is persuasive. But, where he gets his own theory right, I don’t think he adequately deals with the criticisms of others. He forgets about the “demand-siders” who have already internalized his lesson, and his article is not entirely adequate to deal with some of the objections of “demand-siders” who question the relevance of an economics of scarcity during a period of putative surplus. Nevertheless, his argument is one that all should take seriously, and that it can be made better doesn’t mean that one shouldn’t seriously consider it and attempt to fill in the blanks on one’s own.