Persistent Global Demand Shortfall: Some Theory
In much of the world, there is insufficient demand to fully employ the valuable services of available humans and machines. This characterization of the global economy has been true for the past seven years. It seems likely to be true for years to come.
As of 2007, many, if not most, macroeconomists would have thought that this kind of persistent demand shortfall was an impossibility. (I was certainly one of those macroeconomists.) Indeed, many, if not most, still do so.
Why do so many macroeconomists dismiss the possibility of a persistent demand shortfall? There is a widespread belief in the power of markets. It is generally agreed (although not by all) that prices and wages don’t adjust instantaneously. It is also widely felt (although, again, not by all) that, over an eight year period, Adam Smith’s invisible hand should work: prices and wages should be able to adjust sufficiently to clear markets.
But let’s try to be slightly more precise than this vaguely optimistic reference to an invisible hand. Suppose households and businesses believe that there is a material risk that the market real interest rate (r) is currently, and will remain persistently, higher than the market-clearing real interest rate (r*). Then, the demand shortfall will only disappear if market forces prove households and businesses wrong by pushing r and r* together.
What would this invisible hand have to do? The real interest rate (r) is the nominal interest rate, less expected inflation. But (just suppose!) central banks can’t or won’t lower the nominal interest rate. So, to eliminate the demand shortfall, inflation expectations have to rise - even though central banks loudly proclaim that they are fully committed to not allowing that increase to take place. I don’t see how the invisible hand of the free market is supposed to accomplish this increase in inflation expectations.
More empirically, we have not seen inflation expectations rise over the past few years. The basic mechanism that’s supposed to lead markets to clear does not seem to be working. (Indeed, I would argue that we’ve seen a decline in inflation expectations - not a rise.)
This situation - in which r is expected to remain above r* for many years to come - is my interpretation of the term “secular stagnation” that Larry Summers has done so much to bring into the policy conversation. And, as I suggest above, I believe that it can only be cured through policy choices, not through the invisible hand of the free market.
For those who are interested: See here, here, here, here, and here for some of the more technical expositions that inform my above description of highly persistent (although not necessarily permanent) demand shortfalls.
In the next post, I discuss some lessons from the persistent global demand shortfall of the 1930s.
Rochester, NY, January 8, 2016
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