Tuesday, May 1, 2012

From the comments, on downturns, fiscal policy, and multiple equilibria

We were less wealthy than we thought we were.

Call me an AD-denier, but I still think the basic issue here is that you can’t consume more than you produce. Production exists to satisfy demand, but at the same time demand is limited by production. We had a long boom built on the notion we could boost demand and thus supply and thus demand again in a virtuous cycle, and now we are seeing the cycle work in reverse as demand/supply seek their natural levels.

One way to justify this model is in terms of multiple equilibria, and that we have been walking (bouncing our heads?) back down the escalator. Arguably for the United States this downward bouncing is over. Along the way we are sending signals about the quality of our institutions and thus shaping the course of the future.

In this model there is still a useful role for fiscal policy. For one thing, fiscal policy can smooth that ride down the escalator, by spreading the losses out over time, at the cost of future debt of course. This may be needed if only to make the political economy of decline less bitter; see Spain and Greece. Nonetheless fiscal policy cannot make up for the output losses at will. We are not standing in an IS-LM diagram where the difference between “what we have” and “what we could have” is thwarted only by some supposed Austerians who won’t shift the proper curve and yet somehow have taken over some of the biggest spending social democratic, insider-leaning governments in world history. The IS-LM approach fits in nicely with the view that policy improvement is all about yakking about the obstructionists. Instead, policy is also about rebuilding trust, not just maintaining ngdp on a decent keel. Read more......

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