Home > Economics > Britain is not your standard AD story – a follow up

Britain is not your standard AD story – a follow up

So, I thought I would pen (or, rather, dictate as I am using the latest Dragon NaturallySpeaking voice recognition software, which is excellent by the way) a quick follow up to an email I sent to Tyler Cowen, which he then posted (with my permission) on Marginal Revolution.

First, I would like to make clear I am not ‘pro-austerity’ - not in the UK and certainly not in Europe. But we control our own monetary policy here and that makes all the difference. If you have a problem with the level of aggregate demand in the UK, please take it up with Mervyn King, or with our monetary policy objective which is much more heavily biased towards stable prices than full employment.

Second, there are an enormous number of people in the world who are suffering right now due to deficient aggregate demand. I am one of those people who has a problem with Mervyn King and our monetary policy objective. More aggregate demand, please.

However, I am becoming steadily less convinced that this is the whole story, at least for the UK. Back in November, Karl Smith made the clearest statement I have ever read of the New Keynesian explanation of a recession:

I can’t hammer this home enough. A recession is not when something bad happens. A recession is not when people are poor.

A recession is when markets fail to clear. We have workers without factories and factories without workers. We have cars without drivers and drivers without cars. We have homes without families and families without their own home.

Prices clear markets. If there is a recession, something is wrong with prices.

Right now, unemployment remains at over 8% in the UK while real wages are lower than they were 7 years ago and are continuing to fall. Yes, you read that correctly. Which immediately leads one to ask: on this explanation of a recession as expounded by Karl, how much further do real wages have to fall to eliminate disequilibrium unemployment?

I am not a political person, I’m trying to ask an intellectual question here. As an interested observer of (and, I stress, not remotely an expert on) the economy, I am finding the aggregate demand narrative an increasingly unsatisfying explanation of all that is happening in the British economy. Supply-side suffering is suffering too, and I think we need to take very seriously the chance that it is happening.

 

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  1. May 15, 2012 at 1:29 am

    Great post — Thanks for the insights.

    Quoting Smith: “A recession is when markets fail to clear….Prices clear markets. If there is a recession, something is wrong with prices.” Insightful and well stated.

    But it is also true that (working from this premise) if there is a recession, something is wrong with the market. For example, jobs can be had in Singapore or Texas, but if the home you own in Nevada is under water and you can neither sell, nor refinance and rent it out, nor mail back the key and get enough credit (or keep your credit rating high enough) to move and buy or rent a new place in Texas or Singapore. Where are you? Totally stuck.

    So this is an example of one of many structural problems that are BOTH market and price driven and that keep prices and markets from meeting in some reasonable middle ground. Drill down into the detail of each possible transaction in all the markets that affect all of these choices and solutions slip away as quickly and inexorably as the tide goes out — at least when individual, corporate and governmental players lack the political or moral will, the courage, the common sense, and the knowledge to change the many things that probably need to be changed.

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