Not all demand is created equal

January 30, 2013

Not all demand is created equal

by Raghuram Rajan

Raghuram RajanRaghuram Rajan, Professor of Finance at the University of Chicago Booth School of Business and the chief economic adviser in India’s finance ministry, served as the International Monetary Fund’s youngest-ever chief economist and was Chairman of India’s Committee on Financial Sector Reforms. He is the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.

TWO fundamental beliefs have driven economic policy around the world in recent years. The first is that the world suffers from a shortage of aggregate demand relative to supply; the second is that monetary and fiscal stimulus will close the gap.

Is it possible that the diagnosis is right, but that the remedy is wrong? That would explain why we have made little headway so far in restoring growth to pre-crisis levels. And it would also indicate that we must rethink our remedies.

High levels of involuntary unemployment throughout the advanced economies suggest that demand lags behind potential supply. While unemployment is significantly higher in sectors that were booming before the crisis, such as construction in the United States, it is more widespread, underpinning the view that greater demand is necessary to restore full employment.

Policymakers initially resorted to government spending and low interest rates to boost demand. As government debt has ballooned and policy interest rates have hit rock bottom, central banks have focused on increasingly innovative policy to boost demand. Yet growth continues to be painfully slow.

What if the problem is the assumption that all demand is created equal? Pre-crisis demand was boosted by massive amounts of borrowing.

When borrowing becomes easier, it is not the well-to-do, whose spending is not constrained by their incomes, who increase their consumption; rather, the increase comes from poorer and younger families whose needs and dreams far outpace their incomes.

Moreover, the goods that are easiest to buy are those that are easy to post as collateral — houses and cars, rather than perishables. And rising house prices in some regions make it easier to borrow even more to spend on other daily needs such as diapers and baby food.

While it catalyses a more generalised demand, it is not unreasonable to believe that much of debt-fuelled demand is more focused.

So, as lending dries up, borrowing households can no longer spend, and demand for certain goods changes disproportionately, especially in areas that boomed earlier.

Of course, the effects spread through the economy. But unemployment is most pronounced in the construction and automobile sectors, or in regions where house prices rose particularly rapidly.

A general stimulus to demand, such as a cut in payroll taxes, may be ineffective in restoring the economy to full employment. The general stimulus goes to everyone, not just the former borrowers.

Indeed, because the pattern of demand that is expressible has shifted with the change in access to borrowing, the pace at which the economy can grow without inflation may also fall.

Unlike a normal cyclical recession, in which demand falls across the board and recovery requires merely rehiring laid-off workers to resume their old jobs, economic recovery following a lending bust typically requires workers to move across industries and to new locations.

There is thus a subtle but important difference between my debt-driven demand view and the neo-Keynesian explanation that deleveraging (saving by chastened borrowers) or debt overhang (the inability of debt-laden borrowers to spend) is responsible for slow post-crisis growth.

The neo-Keynesian economist wants to boost demand generally. But if we believe that debt-driven demand is different, demand stimulus will at best be a palliative.

Writing down former borrowers’ debt may be slightly more effective in producing the old pattern of demand, but it will probably not restore it to the pre-crisis level.

The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand — to ease the way for construction workers and autoworkers to retrain for faster-growing industries.

The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit.

Supply-side adjustments take time, and, after five years of recession, economies have made some headway. But continued misdiagnosis will have lasting effects.

The advanced countries will spend decades working off high public-debt loads, while their central banks will have to unwind bloated balance sheets and back off from promises of support that markets have come to rely on.

Frighteningly, the new Japanese government is still trying to deal with the aftermath of the country’s two-decade-old property bust.

One can only hope that it will not indulge in more of the kind of spending that already has proven so ineffective — and that has left Japan with the highest debt burden in the Organisation for Economic Cooperation and Development.

Unfortunately, history provides little cause for optimism.– Project Syndicate

10 thoughts on “Not all demand is created equal

  1. Rajan ought to know that economists are unable to think outside the box, or their books and their flawed theories as they are victims of two hands juggling balls in the air. One on the one hand, and one of the other hand.Harry Truman once remarked : “Give me a one-handed economist! All my economists say, On the one hand on the other.”

    I like Lord Robbin’s definition of economics: “Economics is a social science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.” It is inexact science and human behaviour is unpredictable and often driven by instinct and animal spirits (Robert Schiller of Yale) rather than by pure logic, but economics as discipline is trying to be like physics. So far, it is failing to be one, rather miserably I think. –Din Merican

  2. If Friedman, Keynes, et. al. are empirical economist against ABCT, then history should provide reasons for optimism. The fact that history provides little cause for optimism is definitive no two demands are created equal or supply for that matter.

    That is because resources’ demand and supply need to be manipulated (managed being a friendlier term) for better of political alliance and national security. Of late, platinum is ‘synthetic’ by the world of alchemists who advance that discovery some 15 years ahead of forecast. The same happened to Nano tech in 2000 by so-called accidental discover. Now what if alchemists suddenly Eureka synthetic rare earth? …………its coming, rest assure else how would Obama be setting tax brackets for low mpg vehicles? Think about it..who will be a perils’ end.

  3. Din,
    Margaret Thatcher joked about getting rid of economists……Guess what! Kenneth Jeyaratnam is an economist.
    Ken is a double first at Cambridge.–Din Merican

  4. An addendum:

    The complication of Demand and Supply is extended by WTO/GATT into the rights to demand not meeting the rights to withhold supply. Recent cases of pressing demand for rare earth by Japan and the US; supply withheld by PRC for security and environment reasons. In reality, the real reasons could be strategic bargaining chip for higher value technology PRC is in dire need e.g. proprietary horizontal shale oil extraction method………so the PRC will have to invent its own but how much shale oil does PRC has compare to the US?

    Near home we have no regards for environment and people’s life. While others say NIMBY we say with open arms DIMBY (…do in my back yard.
    Remember Say’s Law of the Market which was later refuted by John Maynard Keynes in his General Theory.–Din Merican

  5. “Who the Hell Cleared This?”
    — Forbes columnist regarding the evidence unleashed in the following investigation
    that has already been presented to the Pentagon, CIA, and Congress
    from discussion with Jim Rickards,who blogs at blogspot dot sg

    Financial Pearl Harbor’ is a Real Threat Warns a Pentagon Adviser

    Roubini’s devastating diagnosis –
    “In the long term, I think that the fundamentals of the U.S. are a lot stronger than other advanced countries. In the short run I think we will have another year of very anemic economic growth. Next year we will have barely 1.7% including a modest amount of fiscal drag and lots of tail risk could make it worse in the U.S–bigger fiscal cliff, the eurozone crisis, a Chinese hard landing, maybe tensions will raise oil prices in the Middle East–so the downside scenario is actually having a meaningful probability.””

    But more succinct summaries of Kyle Bass’s argument that Japan will set off the global dominos within 12 to 18 months,now that PM Abe is busy setting a higher inflation target

    Roubini’s devastating diagnosis – Freeland File

    Roubini should know that in the long term we are all dead.–Din Merican

  6. Industrial Democracy:

    Keynes vs Say had been the debate about industrial democracy in Thatcher’s era where union elements were influencing supply and demand through collective bargaining. Coal was demanded. Supply were plentifully imported but port union interrupted logistics. That era also saw Canadian postal workers strike against their union leader’s arrest. To overcome automotive workers’ union demand, big guns in US auto industry started spreading plants across few states as each state has their own laws. What a waste to shift production to other states just to sit out the union of one state. Hyundai workers also staged strike and stalled shipment. With parts supply disrupted, demand for Hyundai labels abroad shifted. Such is the manipulation of supply that demand simply shifted to hold Hyundai ransom. In the 80s, the Dutch public transported also strike but services was normal; just that fares were uncollected for about 2 months because the people supported the strike and the G gave in to union.

    Moral of the story:
    Bersih 3.0 was supported by the masses so G should give in to a peaceful strike against growing non-performance of people’s mandate.
    Selangorians are going first to the polls to endorse Khalid Ibrahim’s performance score card.
    Selangor has been CEPAT, BERSIH dan AMANAH. No reason the incumbent state government should not win BIG despite hike in phantom voters.

  7. Looes74 & Dato, now we know why Kenneth lost his deposit in the last “by-erection” (I might remind you that i frequently failed my spelling tests!!!)

  8. Kenneth Jeyeratnam should not have got himself in a by-election (at Punggol East) in the first place as it was already an election where the electorate were already pissed mad with the betrayal by a key establishment figure ie Mr Palmer and his assistant…. And when they got mad with Palmer, they also got mad with the rich and haves and Kenneth Jeyeratnam, although the son of an opposition icon Joshua B Jeyeratnam, was seen as well-heeled…. so somehow the Workers Party come into enjoying the rub-offs….

    Having said that, Ken Jeyeratnam is good asset for Singapore, and would definitely be a good opposition MP putting the others on their toes… this KJ is unlike the KJ we have, Ken has gone through baptism of fire and humiliation…. our KJ has to go to an army training to get a taste of crawling on the ground…

  9. Howdy! I know this is somewhat off topic but I was wondering if you knew where I could locate a captcha
    plugin for my comment form? I’m using the same blog platform as yours and I’m having problems finding one?

    Thanks a lot!

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.