Tyler Cowan offers what he calls are the “the four basic truths of macroeconomics” in a recent column in Bloomberg. It may be paywalled, so I’ll quote liberally here.
His first point is that “a strong negative shock to demand — a sudden decline, in other words — usually leads to a loss of output and employment.” This is just the law of supply and demand, reworded to spin it a bit, and with some riders attached.
Put more clearly, the principle is this: in a market economy, a reduction in demand leads to a reduction in supply. It doesn’t matter whether the result is a ‘negative shock’ or simply a global disinterest in the product.
The rider in this proposition the the further assertion that this leads to unemployment. Let’s hear Cowan explain: “Nominal wages are sticky, for a complex mix of sociological reasons, and so employers do not always respond to lower demand with lower wages for workers. Instead they lay some people off, and that can lead to a recession.”
OK, first, lower wages can also lead to a recession, so the choice between ‘lower wages or lay people off’ is a false choice. Additionally, when people are laid off, it is not usually a result of high wages for other people, but because there is nothing for them to do.
Cowan calls this “one of the most important discoveries in history”. This may be true of the law of supply and demand, but not of his restatement. And the other half of this ‘most important discovery’ is that it applies only to market economies.
Market economies governed by the law of supply and demand are subject to market failures. One such failure is a drop in demand for a given product. All else being equal, this leads to a collapse of the economy. What saves the economy is intervention from outside the market. In a large company, for example, financial reserves may be brought in to develop a new product line. In a national or global economy, financial reserves may be brought in to build infrastructure, fight a war, or explore and discover.
Let’s move on to Cowan’s second point. It is this: “well-functioning central banks can offset such demand shocks to a considerable degree — or even prevent them from arising in the first place.“
This is Cowan’s version of the point I just made, but Cowan limits the sort of intervention needed to one conducted by central banks. It should be obvious, just on reflection of the point, that any intervention that replaces the loss of demand will apply equally well. Wealth does not exist only in central banks.
Cowan continues by narrowing the range of possibilities even further: “The bank can engage in complex financial transactions or simply print more currency to stabilize nominal demand and restore some measure of order.” Again, it should be clear by simple observation that there are many options in addition to ‘complex transactions’ or ‘printing money’.
This limited range of options is essential the set of constraints imposed in a set of responses known as ‘monetary policy’. The core idea of monetary policy is that economic fluctuations are addressed primarily by adjusting the money supply. But governments are more than merely central banks, and there is a range of options over and above monetary policy.
The obvious additional option, and the one we have actually taken, is to borrow money. Borrowing money isn’t the same as printing money, because the money still comes from somewhere – usually from places where it wasn’t being used to create demand, whether hidden in mattresses or stashed away in savings accounts. Another option is to tax this money – admittedly hard to do with cash stashed in the house somewhere, but much easier with unproductive wealth in futures markets or hidden in the Cayman Islands.
The other part of that strategy is, as I suggested above, giving people something else to do. During the pandemic, for example, no amount of money pumped into the economy is going to increase the demand for sit-down restaurants and seats in movie theatres. But there is an urgent and pressing need – one for which the market is not in a good position to address – in basic (but unprofitable) research in vaccines and personal protective equipment.
The second point was only one paragraph in Cowan’s article, not because there wasn’t a lot to say, but because there was a lot to keep hidden.
Let’s move on to his third point: “if central banks go crazy increasing the money supply, the result will be high price inflation.“ This is the law of supply and demand applied to money. Increase the supply of money, and its value decreases, meaning you need more to obtain the same goods and services. This phenomenon is called ‘inflation’.
This is a ceteris paribus clause, which means, ‘all else being equal’. But all else is never equal, and is is important, because there is an important corollary: if the demand for goods and services is greatly increased, the value of money decreases. This is the cause of some classic market failures. If, say, electricity becomes scarce, but demand is stable, the price will shoot through the roof, resulting (again) in inflation.
This is all the theoretical basis for monetary policy: keeping the value of money more or less in accord with variations in demand, growing the money supply as the economy grows, and shrinking it as the economy shrinks. This approach might work well on the upswing, but it has devastating consequences on the downswing. Just when the economy needs more investment to produce more jobs and more demand, money becomes tight, sending the economy into a downward spiral.
Not surprisingly, this is the policy Cowan suggests will be most effective. “If central banks simultaneously act to decrease the velocity of money,” he writes, “that is, if they take measures to reduce borrowing and lending, then price inflation will be limited accordingly.” Yes it would. At the cost of sending the economy into a tailspin.
But there’s room for a more positive message: inflation happens only if the supply of goods and services remains static. But if that supply increases, especially for new sorts of goods and services (to, say, build fibre networks, develop vaccine programs, explore space, develop alternative energy sources) then increased money supply does not increase inflation.
This is important because the greatest danger of inflation doesn’t come from governments printing money. For the most part, governments don’t print money; they borrow. No, the greatest danger lies in the fact that something like half of all global wealth is concentrated and hidden away in banks in Panama and the Caymans and Switzerland by the globally wealthy, and if this money is unleashed on the economy, the value of money will drop.
Finally, let’s look at Cowan’s fourth point: “non-monetary shocks, if they are large enough, can also create recessions or depressions.” For examples he gives us “the oil price shock of 1973, the current pandemic, or bad harvests in earlier agrarian societies.” What he should have said, in my opinion, is that “shocks can produce market failures”.
That is because the market generally, and monetary policy in particular, are not well-equipped to adjust to sudden systemic changes or disruptions to central aspects of the economy. Each of the three examples he gives impacted the market in a different way, but what they all have in common was that there was no market-based means to respond to them.
If we look at the pandemic, then what we saw was that, in addition to killing half a million Americans, the pandemic sharply reduced demand for public activities, thus eliminating the incomes of a wide swath of the population, including especially some of the most vulnerable and, at the same time, the most essential. If we did not address this by borrowing money and replacing that income, and also by developing alternative essential services, and also spending to combat the vaccine, then the economy would collapse.
If we look at the oil price shock of the 1970s, a completely different calculus was at play. The high cost of oil and gas resulted in widespread disruption because so much of the economy – from car production to drive-in theatres – depended on cheap and available fuel. The cost of a wide range of goods and services rose sharply. The short-term cause was the Arab oil embargo, and the crisis was effectively ended with the end of the embargo, which was the result of political agreements with the Arab states and an Israeli withdrawal in Egypt and disengagement with Syria. Longer term, the crisis resulted in increased (and often subsidized) exploration for oil elsewhere.
If we look at the collapse of harvests in agrarian economies, the cause and effect are pretty obvious, since the loss of food results in a loss of demand for pretty much everything else. The term ‘economic collapse’ becomes somewhat meaningless when everyone is starving. The response is found in one of the first of many accounts of socialism in the Bible (Genesis 42): store grain during the seven years of good times, and dispense it during the seven years of hard times. Today we know this as Keynesian economics.
So what sort of conclusions do we draw from all of this?
Well, the first thing I noticed about the article was that it mentioned Clubhouse right at the top, making it part of the non-market interventions being used by wealthier interests in order to stimulate demand for a product. I don’t know whether Cowan was paid for this, or for his appearance there, but I’m sure this reciprocity would not go unnoticed. The wealthy know all about non-market intervention, as use it liberally to tip the scales, drawing on their previously mention half of all wealth in the world.
Another is that in the discussion of economics and monetary policy, we never touch on the actual motivation for any of this, which is to increase human society and to alleviate suffering and hardship. When Cowan talks about, say, “the expected return of public investments,” he elides the point that a lot of government investment is made with no expectation of return – it is, indeed, the antithesis of market policy – because governments are addressing these very human needs. When you lose half a million people in a society, this is far more than an economic issue; it is a human tragedy.
That leads us to our final observation. Cowan says, as a result of these discoveries, that “the only thing worse than living with macroeconomics would be to try to live without it.”
I won’t deny the utility of macroeconomic theory (though I certainly have my doubts about unfettered market capitalism and the utility of monetary policy in a crisis). But it is also abundantly clear that tracking the flow of money, goods and services in an economy is only one small part of a much larger and more complex domain.
It’s like saying “the only thing worse for a human than living with the blood circulation system would be to try to live without it.” This is true – but it is far from the whole story. Focusing only on the blood supply leads to things like blood-letting as a part of medical theory. We need to look at many other things. We need to understand the human condition as a whole, not just as a set of numbers on a balance sheet.