gluts

While I am on the subject of Classical economics [see my post of the ‘Two Economies’], I think it’s useful to dredge up the way in which those folks would have looked at our current situation. Prior to modern economics there was no concept of a ‘recession’ and a ‘recovery’. Instead observers back in the years before the late 1800’s would have referred to there being a ‘glut’ of unsold goods and underused resources.

This is actually a very useful way to understand what happens in a recession.

In a nutshell a recession is marked by a decline in demand. Supply stays the same for a while until businesses adjust to the new lower level of activity. Even then a large amount of the economy’s productive assets remain either under-utilized or totally idle. To a casual observer this appears as an abundance of resources on the one hand and growing poverty on the other. This combination can be disconcerting.

So a typical question for the likes of Smith or Ricardo would have been: how come a ‘glut’ of resources can co-exist along side extreme poverty and a lack of job? Hence their interest in revealing the mechanism that was supposed to prevent this oddity. It was their observation of ‘gluts’ that provided one of the motives behind the development of economic theory as we now know it.

And it remains confusing today.

Anyone walking around New York City would be struck by the empty stores and ‘for rent’ signs. This is a ‘glut’ of unused real estate. Similarly states like Florida are full of empty homes – there is a ‘glut’ of housing. In the midwest there is a ‘glut’ of auto making factories sitting idle. And so on.

The problem is that demand has collapsed. It isn’t that ‘no one’ is spending. It is that not enough people are spending, or that people are not spending enough to use all that capacity.

Every time a business reduces its work force or closes a factory, and every time a small business closes up shop and the store sits empty, we add to our unused capacity. These unused assets represent the amount below potential that the economy is operating. They also represent the hill we have to climb in order to get back to full capacity. It is only once we have returned there that it makes sense to start adding new factories and build new stores.

The modern – Keynesian – remedy to this collapse in demand is to have the government spend: that way some of those stores and factories remain used, and, importantly, some of those workers remain employed. and so the ‘glut’ is kept from growing.

The conventional thought is that a collapse in demand stems from a ‘shock’ that hits the economy from outside – an increase in oil prices; the impact of 9/11; or an error on the part of the central bank in monetary policy. Shocks are not supposed to come from inside the system.

This is the great divide between orthodox economics and Keynsian economics. Keynes suggested that shocks could be internal, and that ‘gluts’ were a periodic feature of a capitalist economy. Orthodox economists reject this idea: to them markets are always perfect and thus any perturbation must come from outside, by definition.

This is why there is such a fissure within economics. To orthodox economists – I call them the ‘magic market’ people – markets can do no wrong and should therefore be left to fix any wobbles that occur. To Keynesians markets are inherently flawed and need help to get back on track.

The ‘help’ that Keynesians suggest is that the government should reduce those ‘gluts’ by offsetting the drop in private sector demand.

That’s what we’ve been doing in our current ‘glut’. And it’s working. Which implies a major re-think for orthodox economic theory and the ‘market magic’ people.

About time.