BERKELEY – The central insight of macroeconomics is a fact that was known to John Stuart Mill in the first third of the nineteenth century: there can be a large gap between supply and demand for pretty much all currently produced goods and services and types of labor if there is an equally large excess demand for financial assets. And this fundamental fact is a source of big trouble.
A normal gap between supply and demand for some subset of currently produced commodities is not a serious problem, because it is balanced by excess demand for other currently produced commodities. As industries suffering from insufficient demand shed workers, industries benefiting from surplus demand hire them. The economy rapidly rebalances itself and thus returns to full employment – and does so with a configuration of employment and production that is better adapted to current consumer preferences.
By contrast, a gap between supply and demand when the corresponding excess demand is for financial assets is a recipe for economic meltdown. There is, after all, no easy way that unemployed workers can start producing the assets – money and bonds that not only are rated investment-grade, but really are – that financial markets are not adequately supplying. The flow of workers out of employment exceeds the flow back into employment. And, as employment and incomes drop, spending on currently produced commodities drops further, and the economy spirals down into depression.
Thus, the first principle of macroeconomic policy is that because only the government can create the investment-grade financial assets that are in short supply in a depression, it is the government’s task to do so. The government must ensure that the money supply matches the full-employment level of money demand, and that the supply of safe savings vehicles in which investors can park their wealth also meets demand.
How well have the world’s governments performed this task over the past three years?
In East Asia (minus Japan), governments appear to have been doing rather well. Shortage of demand for currently produced goods and services and mass unemployment no longer loom as the region’s biggest macroeconomic problems. Flooding their economies with liquidity, maintaining export-friendly exchange rates, and spending to employ workers directly and boost the supply of safe savings vehicles have made the Great Recession in East Asia less dire than it has been elsewhere.
In North America, governments appear to have muddled through. They have not provided enough bank guarantees, forced enough mortgage renegotiations, increased spending enough, or financed enough employment to rebalance financial markets, return asset prices to normal configurations, and facilitate a rapid return to full employment. But unemployment has not climbed far above 10%, either.
The most serious problems right now are in Europe. Uncertainty about how, exactly, the liabilities of highly leveraged banks and over-leveraged peripheral governments are to be guaranteed is shrinking the supply of safe savings vehicles at a time when macroeconomic rebalancing calls for it to be rising. And the rapid reductions in budget deficits that European governments are now pledged to undertake can only increase the likelihood of a full double-dip recession.
The broad pattern is clear: the more that governments have worried about enabling future moral hazard by excessive bailouts and sought to stem the rise in public debt, the worse their countries’ economies have performed. The more that they have focused on policies to put people back to work in the short run, the better their economies have done.
This pattern would not have surprised nineteenth-century economists like Mill or Walter Bagehot, who understood the financial-sector origins of industrial depression. But it does seem to surprise not only a great many observers today, but also a large number of policymakers.