Why Oh Why Donʼt I Understand Political

Economy?

J. Bradford DeLong

U.C. Berkeley

February 23, 2011

Three times in my life so far I have come to the conclusion that my understanding of the world is substantially wrong. The first came after NAFTA, when the flow of finance south seeking to build factories that now had guaranteed access to the largest consumer market in the world was overwhelmed by the flow of finance North seeking a friendly US jurisdiction, and the Mexican peso crisis was the result. The second was the fall and winter of 2008, when it became clear that large banks had no control either over their leverage or over their derivatives books and at the world central banks did not have the power in the will to maintain aggregate demand in the face of a large financial crisis.

The third is now.

Today, even though there is a nominal demand shortfall of 8% relative to the pre-recession trend, even though there are no signs of gathering inflation, even though unemployment rates in the North Atlantic are at least three percentage points higher than any credible estimate of the sustainable rate of unemployment, even though politicians who fail to successfully manage employment and production tend to lose their next election, the politicians of the North Atlantic are today all stumbling over

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one another to propose and perhaps enact policies to reduce production and employment in the short run.

Why?

It is not as though this is rocket science. The fundamental issues in macroeconomics were, I thought, settled back by 1829. Back then even John-Baptiste Say himself did not believe in Say's Law at business-cycle frequencies: he knew very well that a financial panic and an excess demand for financial assets could produce deficient demand for currently-produced commodities and for labor, and that while such a short run breakdown of Says Law might be temporary. It was still very destructive.

And once you have attained that insight the cures for the disease of the business cycle are obvious.

1. Don't go there in the first place. Avoid whatever it is--whether an external drain under the gold standard or a collapse of long-term wealth as in the end of the dot-com bubble or a panicked flight to safety as in 2007-2008--that creates the shortage of and excess demand for financial assets.

2. If you fail to avoid the problem, then have the government step in and spend on currently-produced goods and services in order to keep employment at its normal levels whenever the private sector cuts back on its spending.

3. If you fail to avoid the problem, then have the government create and provide the financial assets that the private sector wants to hold in order to get the private sector to resume its spending on currently-produced goods and services.

There are a great many subtleties in how a government should attempt to do (1), (2), and (3). Attempts to carry out one of the three may interfere with or make impossible attempts to carry out the other branches. If an inflationary spiral has embedded itself in an economy's expectations, it

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may be impossible for any of the three cures to work--but that is not our situation today. If the credit of the government is itself shaken, then intervention from some outside lender of last resort may be essential for either (2) or (3) to work--but that is not our situation today in the core economies of the North Atlantic.

Yet, today, somehow, all three of these cures are now off the table.

There is right now in the North Atlantic no likelihood of reforms of Wall Street and Canary Wharf to accomplish (1) and diminish the likelihood and severity of any future financial panic. There is no likelihood of government intervention to get the flow of risky finance through the banking system working at its normal pace.

There is right now in the North Atlantic no likelihood at all of (2): no political pressure to expand or even extend the anemic government-spending stimulus measures that have ben undertaken.

And there is right now in the North Atlantic little likelihood of (3): the European Central Bank is actively looking for ways to shrink the supply of the financial assets it provides to the private sector, and the Federal Reserve is under pressure to do the same--both because of a claimed fear that further expansionary asset provision policies run the risk of igniting unwarranted inflation.

Yet no likelihood of inflation that can be seen either in the tracks of price indexes or in the tracks of financial market readings of forecast expectations. And no approaching government debt crisis in the core economies can be seen in the tracks of government interest rates.

Nevertheless, you listen to the speeches of North Atlantic policymakers and you read the reports, and you hear Presidents say things like:

Just as people and companies have had to be cautious about spending, government should have to tighten its belt as well...

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And here we reach the limits of my mental horizons as a neoliberal, as a technocrat, as a mainstream neoclassical economist. Right now the global market economy is suffering a grand mal seizure of high unemployment and slack demand. We know the cures. Yet we are not attempting any of them.

February 23, 2011: 907 words

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