Demand Crisis, Structural Crisis, or Both?

Paul Krugman seems to believe that something like the bubble economy we enjoyed until it burst in 2008 could be had again if only our leaders were sufficiently bold.

Paul Krugman asserts flatly that, “The slump in the United States and other advanced economies is the result of a failure of demand — period, end of story. All attempts to claim that it is somehow structural, or maybe the result of reduced incentives to produce, have collapsed at first contact with the evidence.”

I continue to be skeptical of this claim,  seeing much of the decreased demand as evidence of a structural problem. In my view, the shock to the financial system and the resulting global recession sped up a long-term trend of shedding jobs in favor of technology and outsourcing. Joseph Stiglitz, for example, argues that attempts to stimulate the economy actually further accelerates this phenomenology because, “In a globalized economy, the money is looking for the best place to go. And where is it finding it? In the emerging markets. ”

Regardless, Krugman fears that the demand failure caused by a liquidity trap is causing structural problems.

But there is a real concern that if the slump goes on long enough, it can turn into a supply-side problem, because investment will be depressed, reducing future capacity, and because workers who have been unemployed for a long time become unemployable. This is the issue of hysteria ”hysteresis”.

And if you look at manufacturing capacity, in particular, you can already see that starting to happen.

[…]

[T]here was a mini-version of the current decline in manufacturing capacity after the 2001 recession: capacity basically stopped growing in the face of a protracted weak economy. But this time around, with manufacturers operating way below capacity with little prospect of needing more capacity any time soon, they’re both scrapping equipment and failing to expand. The result is that when we finally do have a real recovery, we’ll run up against capacity constraints much sooner than we would have if there had been no Lesser Depression.

Arguably the same thing is happening in other sectors of the economy, as the long-term unemployed begin to become unemployable, as the long shortfall in residential construction leads to rising rents (and a small uptick in core inflation) even though demand remains deeply depressed.

Hysteresis can mean that the costs of failing to pursue expansionary policies are much greater than even the direct effects on employment. And it can also mean, especially in the face of very low interest rates, that austerity policies are actually self-destructive even in purely fiscal terms: by reducing the economy’s future potential, they reduce future revenues, and can make the debt position worse in the long run.

I’m skeptical of this, too.

First, there’s a pretty good chance that the long-term unemployed are actually already unemployable. Jobs that have gone away because they’re now being done by robots, software, or people in the developing world aren’t coming back no matter how much we prime the pump. Nor am I sure why we’d invest public funds in building more housing when prices for existing housing stocks are dropping and millions of Americans are underwater and unable to sell.

Second and relatedly, it would indeed be a major cause for concern in manufacturers were selling off equipment and facilities that would otherwise be useful for scrap. Presumably, though, they’re either scrapping equipment that’s outdated and uncompetitive or selling it off to others who will put it to more productive use. After all, why would they buy it, otherwise?

Krugman seems to believe that something like the bubble economy we enjoyed until it burst in 2008 could be had again if only our leaders were sufficiently bold. While I agree with some of his prescriptions–a time of near-zero interest rates and high unemployment is a great opportunity to make massive investments in the national infrastructure–I’m afraid that his premise is flawed.

FILED UNDER: General,
James Joyner
About James Joyner
James Joyner is Professor and Department Head of Security Studies at Marine Corps University's Command and Staff College and a nonresident senior fellow at the Scowcroft Center for Strategy and Security at the Atlantic Council. He's a former Army officer and Desert Storm vet. Views expressed here are his own. Follow James on Twitter @DrJJoyner.

Comments

  1. Krugman seems to believe that something like the bubble economy we enjoyed until it burst in 2008 could be had again if only our leaders were sufficiently bold.

    Bubbles burst. Or doesn’t Krugman realize this?

    The key isn’t to create another bubble economy, it’s to create the economic conditions that make sustained growth possible.

  2. Jay says:

    I’ve said before that NY Times-Krugman is different than scholar-Krugman. His op-eds are meant for a certain audience that does not mind his straw man arguments. My question is, what does the scholar say about hysteresis.

  3. Hey Norm says:

    “…Jobs that have gone away because they’re now being done by robots, software, or people in the developing world aren’t coming back no matter how much we prime the pump…”

    Yeah…I don’t know about this. We are poised to hire as just as soon as there is adequate DEMAND (which does appear to be growing). I don’t think we are that unique.
    Yes there needs to be economic conditions that make sustained growth possible…but the primary element of those conditions is DEMAND.
    I know there are plenty of fantasies about the supply-side wet-dream of no taxes and no regulations…but, as Krugman correctly points out, that doesn’t pass the giggle test after 30 years of low taxes and de-regulation. Even in Perry’s Texas the job creation is not as great as before Perry, and is largly dependent on government spending. (plus he instituted a “pole-tax” on strippers – sacrilege!!!)
    We need to spend while the spending is good…with near-zero interest rates, scads of available labor, and a super-competitive bid environment…then once the engine is running on it’s own we can address the debt. Slashing a million government jobs…teachers, cops, firefighters, dpw workers…over the last year or so is stalling the engine. we’re creating private sector jobs. we need to stop bleeding public sector jobs. I know this is the recovery the so-called republicans want…but like almost all of their ideas it’s not working as advertised.
    We need to save money when times are good, and spend it to get through the tough times. Republicans have gotten us off that track. They squandered money when times were good, and now they want to get all austerity on us when times are as lean as they have been since the depression. This is just stupid on the face of it. The simple-minded Teavangelicals aren’t helping. We need to get back on the right track now.

  4. Dave Schuler says:

    The “output gap” is defined as the difference between potential output or GDP and actual output or GDP. The theory behind Keynesian stimulus is that when actual output falls, producing an output gap, government deficit spending can intervene to partially or completely fill the gap. There are competing, reasonable views of this.

    One view, that held by both Drs. Krugman and Stiglitz, appears to be that the Keynesian model is correct and applicable to our circumstances today. If that view is correct, failing to fill the output gap with government spending is foolish, criminal even.

    Another view is that consumers and producers respond to the additional government spending in such a way that the boost predicted by Keynes doesn’t happen. In researching this view the buzz words to look for are “Ricardian equivalence”. Under this theory the additional spending is feckless—it’s bound to be ineffective.

    A third view is that Keynesian stimulus may well be effective under some conditions but not in the aftermath of a bubble because there is no output gap. The economy is already operating at its full potential, its potential just isn’t high enough to put the unemployed back to work.

    There is a variant approach to Keynesian stimulus, originally proposed by Paul Samuelson and recently suggested by Robert Shiller, that doesn’t require deficits. It relies on marginal outputs and productivity, i.e. you do less of things that are less effective in producing more growth and more of things that produce more. IMO this makes pretty good sense under any circumstances.

    I believe that we have both a cyclical and a structural problem, our policy responses to both have largely been targeted at re-inflating the bubble and, consequently, have been worse than useless. We’re filling whatever output gap there is with spending on healthcare, education, the financial sector, and so on that produce fewer jobs per dollar expended than was the case in the sectors that have contracted.

    I believe that our problems go back decades, that even under optimal conditions it’s going to take a while to unwind them and we’re desperately trying to prevent that from happening. That’s not much solace to people who are out of jobs now.

  5. john personna says:

    I think it’s reasonable to assume it’s not all one thing (structural) or the other (cyclical). With stimulus I think it’s reasonable to assume that there is some distance between success (100% employment) and failure (an unemployment spiral).

    As I’ve observed in the past, we split the difference on solutions. We did “half a Krugman” of stimulus.

    That may not have been terrible, because somewhere between success and failure, it may have halted the decline. As an example, the housing stimulus may have been stupid, but it’s actually helped us all that house prices aren’t down another 10 or 12 percent.

    But sadly that leaves us with this muddy mix (arguable mix) of structural and cyclical problems, increased government debt, and no real plan in sight.

    The default plan is austerity, which bodes for a 10 year slog of a “recovery,’ and one in which many of the long term unemployed exhaust their personal savings. What we do then might be the biggest hanging question. If a wave of 60-somethings hit reduced employment options even as benefits are pushed out to the 70’s … what do we do?

  6. john personna says:

    (A year ago pessimists predicted a full-on decline in housing prices after the stimulus expired, but instead we’ve had relative stability. A success?)

  7. Dave Schuler says:

    @john personna:

    ? Real housing prices continue to decline, albeit at a slower rate than previously.

  8. john personna says:

    @Dave Schuler:

    Case Shiller: Home Prices increased in June

    Admittedly it comes down to chart-reading. No one knows the future, but as I say above, I read that chart as “relative stability.”

  9. Dave Schuler says:

    Case-Shiller is not seasonally adjusted and it reflects nominal prices. In real terms, housing prices are still going down.

  10. john personna says:

    @Dave Schuler:

    I think you might be splitting hairs. Especially when we are contrasting to the old prediction that once stimulus expired “prices would keep on dropping.” We are no where near the old shape of decline.

  11. john personna says:

    Interesting prescription from Roubini, an eight point plan:

    First, we must accept that austerity measures, necessary to avoid a fiscal train wreck, have recessionary effects on output. So, if countries in the eurozone’s periphery are forced to undertake fiscal austerity, countries able to provide short-term stimulus should do so and postpone their own austerity efforts. These countries include the United States, the United Kingdom, Germany, the core of the eurozone, and Japan. Infrastructure banks that finance needed public infrastructure should be created as well.

    Down at number seven we have:

    Seventh, the reasons for advanced economies’ high unemployment and anemic growth are structural, including the rise of competitive emerging markets. The appropriate response to such massive changes is not protectionism. Instead, the advanced economies need a medium-term plan to restore competitiveness and jobs via massive new investments in high-quality education, job training and human-capital improvements, infrastructure, and alternative/renewable energy. Only such a program can provide workers in advanced economies with the tools needed to compete globally.

    That one rings a bit hollow to me. Education is out there. While it can help the individual, it’s a different question whether it can help a 5% or 10% share of the population to find or change to better jobs in the short term.

  12. marcus nunes says:

    “I continue to be skeptical of this claim, seeing much of the decreased demand as evidence of a structural problem”.
    Not really. Krugman messed things up when he went all out to “peddle” his “liquidity trap” view.
    And the breadth and depth of the “great recession/depression” is the direct result of monetary policy errors.
    http://thefaintofheart.wordpress.com/2011/09/18/john-taylor-defends-a-troublesome-target/

  13. john personna says:

    @marcus nunes:

    Are you sure it’s best to answer an “it’s all one thing” argument, with another?

  14. marcus nunes says:

    @john personna:
    jp It´s not “another all one thing”. It´s mostly AD shortfall, but the longer you let it linger, the more “structural” it´s likely to become.

  15. legion says:

    @Dave Schuler:

    The theory behind Keynesian stimulus is that when actual output falls, producing an output gap, government deficit spending can intervene to partially or completely fill the gap.

    This is correct, but I think the problem is that some people interpret this to imply that gov’t spending somehow _fixes the problem_. That is not the case. The best a boost in gov’t spending can do is _stabilize_ GDP _until_ the crisis is resolved. I think a boost (i.e., a significantly larger stimulus package) would help the average American, but it’s the whole solution by any means.

  16. legion says:

    Well, here’s my pet theory, FWIW… Historically, people have generally made money by making/selling things. If you had a lot of excess cash (a lot), you could make money by lending it, but that still generally resulted in other people using that money to make & sell things. But since the financial deregulation of the 90s, people have found that you can make money by simply trading pieces of paper back & forth (CDOs, anyone?).
    This had certain advantages (to the money-makers) in that:
    a) there’s a much quicker turnaround than building a new plant or developing a new product;
    b) there’s a lot less risk than traditional investment, because both
    c) if all the big-money players are running the same game, you can keep inflating things for a long time – until the lack underlying physical value becomes too obvious to ignore (again, CDOs), and
    d) by this time, you’ve got enough cash to buy your way out of actually being blamed (“too big to fail”).

    Technically, I suppose this could be called a structural problem, but it still results in a demand crisis, because you’ve concentrated an enormous amount of wealth in the hands of a lot fewer people, and as I keep saying: You can’t get money from people that don’t have any.

  17. MBunge says:

    @Dave Schuler: “I believe that our problems go back decades, that even under optimal conditions it’s going to take a while to unwind them and we’re desperately trying to prevent that from happening.”

    This. Krugman basically believes our current economic structure is great but it’s just been managed by morons and fools. While the latter may be true, I’m not sold on the former.

    Mike

  18. Rob in CT says:

    The appropriate response to such massive changes is not protectionism. Instead, the advanced economies need a medium-term plan to restore competitiveness and jobs via massive new investments in high-quality education, job training and human-capital improvements, infrastructure, and alternative/renewable energy.

    I used to believe this. Part of me still does. But part of me (increasingly insistent) agrees with john: it rings hollow.

  19. Ben Wolf says:

    Neither Krugman nor Stiglitz are correct. We have a demand problem as Krugman states, but he misses why demand destruction has left a trillion dollar hole in the American economy.

    We’re in a balance-sheet recession, where the private sector is so heavily indebted it is forced to net save in order to service it. Steve Keen lays in out at DebtDeflation, saving me the trouble:

    The latest Flow of Funds release by the US Federal Reserve shows that the private sector is continuing to delever. However there are nuances in this process that to some extent explain why a recovery appeared feasible for a while.

    The aggregate data is unambiguous: the US economy is delevering in a way that it hasn’t done since the Great Depression, from debt levels that are the highest in its history. The aggregate private debt to GDP ratio is now 267%,  versus the peak level of 298% achieved back in February 2009–an absolute fall of 31 points and a percentage fall of 10.3% from the peak.

    The aggregate level of private debt now towers over the economy, putting into sharp relief the obsession that politicians of all persuasions have had with the public debt. Rather like Nero fiddling as Rome burnt, politicians have focused on the lesser problem while the major one grew out of control. Now they are obsessing about a rise in the public debt, when in a very large measure that is occurring in response to the private sector’s deleveraging.
    If they had paid attention to the level of private debt in the first place, then we wouldn’t be facing exploding public debt today.

    http://www.debtdeflation.com/blogs/2010/09/20/deleveraging-with-a-twist/

  20. Rob in CT says:

    So what’s the appropriate policy response, Ben?

  21. Ben Wolf says:

    @Rob in CT: Anything which helps the private sector deleverage faster. Suspend payroll taxes entirely. Direct government acquisition of underwater mortgages and large principle reductions. A new WPA offering jobs at roughly $8-$9 per hour to help them generate income and transition back to the private sector as they renew skills lost by three years of unemployment. Those are short-term fixes with direct and measureable economic benefits: the more quickly they reduce their debt, the sooner they start spending and government can reduce expenditures.

    Over the long-term serious reforms are going to be needed. We can never again allow the massive credit bubble which formed over the 90’s and 2000’s to develop again, which means pushing back against thirty years of government policies moving national income toward profits and away from wages. It also means thinking about government deficits and surpluses in a radically different way.