Sunday, December 12, 2010

"Deficient Demand" and "Demand for Labor"

We can observe the unemployment rate is currently at a recent historical high in the U.S. We can also dig a little deeper into the employment numbers and discover that many are underemployed, meaning working at jobs for which they are overqualified; or, similarly, people are working less than they want to. Example: I would like to work 40 hours, but I can only find enough work to be employed for 20 hours. This is news to no one.

The question is, was, and will continue to be: why is unemployment high? David Andolfatto (see here: is asking if the deficient demand hypothesis is a reasonable explanation for high unemployment given some turnover statistics. It is a very interesting discussion. I want, though, to take this issue back to general principles and approach this logically.

Empirical fact 1: Unemployment is high. Note, as a supporting fact, that industrial capacity usage is still pretty low, but climbing: .

The deficient demand hypothesis suggests that firms are not employing people at as high a rate as before (demand for labor is low) because the firms themselves are facing low demand for their products (revenue is down). This has much intuitive appeal, I dare say. Sales are down, so why do I need to produce as much stuff? This squares with high unemployment and low capacity utilization.

But, which demand is deficient? Personal consumption (mostly households; this is the C in the GDP identity of GDP = C + I + G + (X-M)) has returned to its peak: Note that is in real terms. In nominal terms it's a little bit higher than its previous peak. Government (of course) consumption and investment expenditure is increasing: again, in real terms. The deficient demand appears to be in private investment: .

In other words, households and government are spending as much or more than before the recession, and definitely more than during, but investment remains far below recent history. Go back to 2003 and that's about where investment is. So clearly there is where the deficient demand is. Now, of this private investment, the item that has fallen off the most is housing. This again should be surprising to no one.

So let's say you are a company that sells construction materials. Clearly the demand for your products has fallen off, so you don't need as much labor and capital as when demand for your products was higher. Thus certain types of demand are deficient, but demand generally cannot be said to be deficient. As I have illustrated, spending is high from C and G.

What does this have to do with anything? Well, there is a strong correlation between lack of demand for new housing and lack of demand for housing construction workers. No amount of structural problems is required to explain that issue - in other words stuff like sticky wages aren't necessary here. Too many houses - that's the problem.

So the relevant question becomes manifold. First - specifically which industries are experiencing low demand? Second - why are those industries experiencing low demand? Those discussions are few and far between from what I can see.


  1. Isn't this is an excellent example of why non-Keynesians are against stimulus spending? An $800 billion stimulus package set into place 20 months ago did very little to lower unemployment and create jobs. Stimulus spending cannot repair non-general demand problems. We've now observed this, and so I hope Congress is paying attention so the same mistake is not repeated.

  2. You were going along pretty well I think til you came to your conclusion.....too many houses. We have millions of people homeless or shacked up with their parents now and we have too many houses? I dont think so. Housing is still too expensive for most so its likely the opposite. Yes we built a lot of houses,( people like McCain need 6 or 7 of them) but not enough AFFORDABLE houses. When prices are still out of reach for most Americans it is not an oversupply problem.

    I do think we need to do some fleshing out of the lack of demand and you seem to be getting at it some but I think consumption numbers dont truly reflect some things going on. Sales are down for the most part across the board which will lead to unemployment but I guess those of us with jobs are consuming just enough more ( I know I am) to make up for the losses from the laid off. So if what we are calling private investment is what is leading to the sales slow down then this can still be corrected by an increase in G or exports. Increasing exports doesnt happen overnight, especially when China, Korea and India can "cheap labor" us to oblivion.
    That leaves G, which can be increased today if desired. As your accounting identity shows you simply total up the spending from those four sources to get GDP. Its pretty simple. We dont have to wait for "I" to increase and just sit back while people stay unemployed and sales stay depressed, we can do something. Once we get some incomes flowing "I" will know where to put their efforts. "I" is usually a follower of consumer wants not a leader.

  3. Greg,

    So you see that housing prices are still high and conclude this is because of a shortage, relative to the demand schedule, of housing. Allow me to submit the alternative hypothesis: government intervention in the housing market has locked up the liquidation of houses that would cause housing prices to drop to market levels.

    Now, regarding the cheap labor story. The countries you enumerate provide cheap labor, true; but only for low value-added products and services. High value-added manufacturing and service provision resides in America. The value-added to GDP of manufacturing peaked right before the bust, and it is still pretty high. Labor is at an all-time low, but it is not clear why that is. I know many manufacturers would desperately like to hire middle-skilled people, but such people are not available.

    G has been increased, and continues to be increased, a great deal. What has been the effect? Nothing good as far as I can see. It, in fact, is not at all simple. This story didn't work for the Great Depression, and it isn't working now. Moreover, GDP is not a desirable metric on its own. It is a measure of the flow of expenditure. Has nothing to do with stock.

    I is the flow of expenditure that adds to the stock, and this is the key part of the puzzle. The annual flow is small, relative to C, but C gets used up straight away (within 3 years, for counting purposes). I has an average life much longer than 3 years. How long do office buildings stand, after all?

    So looking at annual GDP grossly underestimates the importance of I to the economy. In fact, one might say that I is the whole train engine. Everything else is a car being pulled along.

    I does not follow C. Without I, there is no C. If you do not produce, you do not consume. This is true if you're Robinson Crusoe, or if you're a member of a vast exchange economy.

  4. Well remove G and see where GDP goes (and incomes too, after all incomes = spending..... no spending no incomes). I agree that GDP is not the best metric however it IS the metric we have been using for a long time, you cant change the rules now.

    I isnt a stock either, its a component of GDP as your own formula shows. It is a subflow of the larger flow GDP and ALL flows can accumulate stocks. GDP adds up to national incomes (flows) which ALL national saving (a flow) is out of which results in the accumulation of "savings" (a stock) So as you see, investment leads to savings. There is no rational reason to break I out of GDP it is a component of GDP. GDP is the flow that all stocks emerge from.

    ALL economic activity is a function of someones present or future consumption. I either produce to consume myself or I produce surplus for others to consume or I produce extra to save and consume later. If there is no consumption there is no reason to produce. Kill consumption and you kill an economy. By adding in money the raison de etre becomes "selling" that which you dont produce for your self or saving to sell later.

  5. Greg,

    I don't really follow paras 2 and 3. I will respond to the idea that removing G from GDP reduces it. This is, of course, mechanically so. But it misses the point entirely that I'm trying to make.

    GDP is an accounting identity. You tally up all the stuff that goes in, and a number comes out the other end of the sausage machine. This has nothing whatever to do with whether or not any value was created by the input.

    Are you familiar with the concept of accounting value added v. economic value added? That is the main issue that I'm getting at here. G is a big number, sure; but is it value added to the economy? How would you know? In other words, do the inputs going to the government return a higher rate of return than the opportunity cost?

    P.S. I didn't say I isn't flow. In fact, I said it is a flow. It is a flow that adds to permanent (moreso than consumption anyway) stock. That's the key.

  6. You tried to talk about I in your previous post as if it were separate from GDP You said;

    "So looking at annual GDP grossly underestimates the importance of I to the economy. In fact, one might say that I is the whole train engine."

    This makes no sense. I is a component of GDP. GDP CANT grossly underestimate the role of I....... it INCLUDES the role of I. "I's" proportion of GDP is completely up to "I". If it is underrepresented or underestimated it is all the fault of I itself.

    "G is a big number, sure; but is it value added to the economy? How would you know? In other words, do the inputs going to the government return a higher rate of return than the opportunity cost?"

    How do we 'know' what value anything adds to the economy? The point is that all G results in income to someone as does all other spending. This income is then saved or further spent. The further spending is the source of sales for other businesses and gives them signals as to how to adjust their production (how they should invest their income from sales).

    We cannot save our way out of a recession. Spending is what leads to production and new employment. No spending no production.

    I thought my third paragraph was clear. It is a rebuttal to your;

    "Without I, there is no C. If you do not produce, you do not consume. This is true if you're Robinson Crusoe, or if you're a member of a vast exchange economy."

    Robinson Crusoe or anyone else is a consumer at their most basic level. We consume food, we consume materials to build shelter etc etc.

    Again, all economic activity, at its root, is either for personal consumption or later consumption by self or someone else. No one has ever produced stuff that wasnt intended for consumption. Even art is intellectually consumed. Using something is consuming it.

    In a monetary economy things are produced to be sold. Either now or later.

  7. I'd like to engage you prof in a thought experiment.

    This is off the topic of this post but maybe you can address it in another post. You as a finance professor probably should think about this. Here's the experiment;

    The Tea Party succeeds in convincing a split in our nation and forms a "new" country in the southern part of our country. You are the finance minister, Treasury chair...whatever you want to call it. You are placed in charge of determining how your new country will pay for things.

    How will you set things up?

    Address these questions (or if you think they are the wrong questions explain why);

    What will be your currency?

    How will it be created?

    Will it have an exchange rate fixed to a commodity (gold?) or be free floating?

    What will you do with your new citizens "old" US$ ?

    How will you control inflation?

    Ive addressed this issue in my own blog in a satirical fashion but I did address some legitimate issues that are seemingly ignored by many who like to talk money in the blogosphere.

    Of course the point of this thought experiment is to ask "What is money?"

    I know you'll give it a good shot.

  8. Greg,

    I will surely address your thought experiment in a future post.

    To respond to the prior comment, maybe I can clear up some vagueness on my part. What I'm saying is when you tally up the flow of I in any given year, that number underestimates the importance of investment to an economy. This is not an accounting perspective, so much as it is an economics one. The I every year goes to maintaining or building the structure that allows us to produce stuff to consume. So the annual flow is not a good, or even close to good, representation of the relative importance of investment.

    I see you still follow the Keynesian line of "spending our way out of a recession." This is only mechanically true. What's lacking is real private investment. Businesses won't invest until they think the return will exceed the costs. Right now there is too much uncertainty to make a trustworthy calculation on this issue.

    I also see there's a definitional problem. When you say "consume materials to build a house" this is investment. It does "use up" materials in a sense, but the result is not like eating food. So while both activities might "use up" materials, one of them is much more long-lived than the other, and that is an important difference.

  9. Jeff

    Your using I in a very narrow way it seems. I is also salaries for new hires, I is not just new buildings or infrastructure. I is any new injection of funds that generates economic activity. It can be a horizontal transaction completely within the private sector where a private bank issue a new loan to fund a start up or it can be a vertical transaction where NEW money is created form the govt sector. Both are part of I and they have different affects on the private sector balance sheets.

    You call it the Keynesian line in a dismissive fashion but its more than that.... its a reality that Keynes fleshed out. Its how monetized economies grow. MY income is the result of someone elses spending. It can be NO OTHER WAY. If the country stopped spending on finance departments you would not have your current job. Now, this does NOT mean we should simply spend all we want on everything we want. No Keynesain economist has EVER advocated as such ( but they often get painted as such by their critics). Tell me another way for people to have incomes without someone spending? I dont understand what you mena by mechanically true? You are right that we are lacking private investment, but wrong that the govt is making private investment more expensive. Look at interest rates.

    What businesses are lacking is the confidence that they will have customers. You cant sell something without buyers and everyone sees less buyers not more.

    We are a strange lot, we homoeconomicus, thinking that if we cut peoples jobs (therby making fewer customers) we can make it better for businesses to expand and attract customers. The lunacy of it is staggering to me.

    Austrians like to say they are simply using logic and even argue that there is a logic to our economy if we stay out of the way. Ive heard them argue that the current mass unemployment is just our economies way of making us pay for the credit fueled over consumption of the last 10 years. What they are in affect saying is that the economies logic is to make people pay for their credit binge by....... NOT. WORKING. Thats a very interesting way to make someone pay back something. How about making them work HARDER.

  10. Greg,

    You raise many issues in your last post. I think that it requires a new blog post of its own.