Economic Policy for the Pandemic III What About Aggregate Demand ?

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Robert Waldmann
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Unemployment has shot up in many countries especially including the USA. Is it time for aggregate demand stimulus ? One interesting thing (noted by Krugman in his newsletter which should still be a blog) is that Keynesians (including Krugman) are not treating everything as a nail, because all they have is a hammer. He (and others) haven’t just reflexively said stimulate until the unemployment rate is normal. This might be a bit of boasting about not making a stupid mistake, because the straw Keynesian demanding full employment now would be very dumb. Much (but not all) of the high unemployment is socially desirable. It is the result of the technology shock that, right now, the provision of services to customers carries the unusual cost of sharing Covid 19. So baristi and waiters should stop working. Their sitting at home is not a waste of productive capacity — it is an efficient response to the pandemic.

But note the parenthetical “(but not all)”. I will argue that it is also true that, in addition to the efficient unemployment caused to reduce contagion, there is also inefficient unemployment due to low aggregate demand. This means that stimulus makes sense. This includes cutting interest rates back to zero again and also broad fiscal stimulus including the $1200 which many of you may have received today. The reason is that the loss of income from currently socially undesirable work (tending bar and waiting tables and such) causes a larger decline in total production through the good old Keynesian multiplier. That additional decline is inefficient and can be prevented with monetary and fiscal aggregate demand stimulus.

This is so obvious that it is even obvious to Donald Trump. Or rather this is a point where Trump, Pelosi and Krugman agree so it must be obvious. I am going to play with some counter-intuition explaining how it can be non obvious to someone who knows a little general equilibrium theory but missed developments in the field since 1950 (I am thinking of fresh water macroeconomists who have been very quiet lately).

I realize that this post makes an obvious point in a boring technicl way so I put all the rest of it after the jump.

An aside, the Real Business Cycle view that reduced employment is an efficient response to a shock is less obviously wrong than usual. I am sure that there is additional inefficient unemployment now, but one doesn’t have to be crazy to say someething like 13% unemployment is efficient right now. Also note that Keynesians have no problem recognizing that reduced output and employment can sometimes be efficient.

Now I am going to present a model in which there is a reduction of hours worked and production and everything is Pareto efficient, then explain how it differs from the real world. A sufficient (and generically necessary) condition for Pareto efficiency is that there are complete contingent claims markets. This means that for any state of nature, there is an asset which pays 1 unit of numeraire good in that state. In particular, it means that people can buy Covid 19 insurance which pays if there is a Covid 19 epidemic (note the assumption that agents with rational expctations already knew in 2019 (and in 1920) that Covid 19 was possible — complete contingent claims markets imply that people have always known that a Covid 19 epidemic was possible). People whose work involves face to face contact with customers and whose work is not absolutely necessary (baristi and waiters) would buy that insurance. Now they would be sitting at home ordering things to spend the payment from the insurance company. This means that in the efficient model, there is some demand for goods which did not occur (until maybe today) in the USA.

The sudden poverty of people who used to be employed and aren’t now because their work is socially inefficient during a pandemic is a result of, among other things, incomplete markets.

But I still haven’t gotten to lower than Pareto efficient aggregate demand. The reason is that another feature of the Arrow Debreu general equilibrium model (with a Pareto efficient outcome) is that people are always free to borrow. Also they always pay their debts. This means that temporarily low income has a small effect on consumption as people smooth consumption by borrowing against future earnings.

In the real world many people can’t do this. Basically people who have positive financial wealth can spend it down, but there are many people who have zero wealth, would like to borrow, and no one will lend to them. This means a sharp decline in their income has a larger effect on their consumption than it would in the model where there are no financial frictions.

So far I have just argued for unemployment insurance (basically providing the missing asset and it has to be a universal program because of adverse selection). But I also support broader stimulus (the $1200 for everyone not just $600 per week extra for the unemployed, the Federal Funds target rate cut to 0-0.25% — all the usual stimulus). To get to a case for broad stimulus, I need some way for aggregate demand to be lower than is socially desirable.

Here I’m afraid I come back to nominal rigidities. Prices are set in advance. A firm surprised by low demand has low marginal cost and wishes it had advertized a lower price. This is ugly (no one likes Calvo alarm clocks) but necessary to fit the facts and, by now, generally accepted among macro economists.

The long story with credit rationing causing a secondary decline in employment which is not efficient is just a long story for the Keynesian multiplier. As usual, the fancy new theory just says the old paleoKeynesian story which doesn’t even sound like economic theory any more was right all along.

It is interesting that Keynesians can recognize efficient output decline when they see it and that Republicans can see the case for aggregate demand stimulus whenever no Democrat is in the White House.

However this post is not interesting. Sorry.