Aggregate Demand Dominance: The Equilibrium Error

My previous posting ends asking the question whether consumers are getting shafted (by the illogic of the LRAS “curve”) from an economic system that largely refuses to recognize aggregate demand even exists.  But considering that I have already found supply-side concepts warping more accurate Keynesian models, I will attempt to correct another.

I will begin with Paul Krugman’s model:

Suppose aggregate demand falls for some reason, say a global financial crisis. Then what the textbook says happens is illustrated by the red arrows. First the economy contracts, then, over time, it expands again as prices fall.

Oddly enough, looking at the data from the 2007-2009 contraction tells a slightly different story.  One issue is that while many charts show the brief American experience with deflation occurred in 2009…

 Historical Data Chart

…in reality the deflation occurred immediately after the price of crude oil crashed in July 2008 until the end of the year:


                                                                                                                 Annual    Dec-   Avg-
Year   Jan.     Feb.     Mar.     Apr.     May      June     July     Aug.     Sep.     Oct.     Nov.     Dec.    Avg.      Dec    Avg
2008  211.080  211.693  213.528  214.823  216.632  218.815  219.964  219.086  218.783  216.573  212.425  210.228  215.303    0.1   3.8
2009  211.143  212.193  212.709  213.240  213.856  215.693  215.351  215.834  215.969  216.177  216.330  215.949  214.537    2.7  -0.4

Why the disparity?  Strangely, it is a wrong mathematical assumption.  Because inflation rarely falls since the U.S. was taken off the domestic gold standard in 1933 (thank God); inflation tables measure monthly price changes compared to the same month a year prior rather than taking the monthly change in CPI and annualizing it.  The method is adequate for increasing CPI, but is off by several months when deflation is concerned.

Officially, the Great Recession began in December 2007, so I begin with GDP loss:

 Historical Data Chart

CPI according to the BLS was 210.036 in December 2007, at the start of the recession.  The data shows a loss of $394.6 billion during the 2008 deflationary period ending New Years 2009, $217.7 billion lost during the 2009 inflationary period ending with the beginning of 2009 Q3, and $639.2 billion lost peak-to-trough.  The deflationary period ended with a CPI of 210.228 and CPI stood at 215.693 at the end of the inflationary period of the recession.  Looking at the supply-and-demand model again…

…how does one reach AD2/LRAS considering prices rose 2.69% during the economic contraction (and prices have not declined since the end of 2008)?

Equilibrium—the Wrong Assumption

The title says it all.  Much of the economics field (including microeconomics in its entirety) makes the assumption that aggregate demand always meets aggregate supply to determine the price and output level—that supply and demand moves into equilibrium.  I believe I just demonstrated it does not.  I would create a new graph to show this effect, but this software rejects anything that I create that isn’t text-based, so I will have to describe what happens with Krugman’s diagram as a model.

During the Great Recession, the AD1 to AD2 shift occurred only until the close of 2008, before output slid to the left (and upward) along AD2 until “stabilizing” at the end of 2009 Q2.  For equilibrium to be reestablished, SRAS would have to shift leftwards as well, but why would it?  Some factories and farms shut down and some business fail outright, but that only presents an opportunity to other, better run businesses (i.e.: Best Buy surged after the liquidation of Circuit City).  Workers are out of a job, but that only increases the labor pool available to businesses.  I doubt the SRAS curve is affected at all—if output decreases, so do costs.  Nor is disequilibrium impossible—the output demanded is above the SRAS curve, at a price level greater than the equilibrium point. 

This leads to a simple question: what do the two price levels signify in this eventuality?  I would wager the price level on the aggregate demand curve is consumer prices and the price level on the aggregate supply curve is producer prices.  Consumer prices are self-explanatory, while producer prices are buildings, maintenance, energy, legal, and most importantly, labor costs.

Returning again to Krugman’s chart…

..real GDP in 2009 Q3 lay somewhere to the left of equilibrium with SRAS along the AD2 curve.  More disturbingly, I doubt the American economy had reached equilibrium after the 2001 recession, which would only exacerbate the effects of what is essentially an AD-AS price level gap.  To reach equilibrium and rectify this destructive situation, consumer prices would have to drop while wages would have to rise.  This decidedly isn’t likely to happen willingly on the part of producers:

So now we have two new analyses, by Hobijn and Daly at a Boston Fed conference, and in the IMF’s new World Economic Outlook, both of which strongly suggest that the issue isn’t structural unemployment, it’s low responsiveness of inflation to unemployment when inflation is low to begin with.

Three points here:

1. This does say that there is little risk of accelerating inflation. Indeed, Hobijn and Daly suggest that there’s a “pent-up demand for wage cuts” that will probably push inflation lower even if the economy is recovering.

“Pent-up demand for wage cuts.”  Four years into this “recovery,” consumers reeling from wage losses while corporate entities rack up immense profit levels (a probable byproduct of the AD-AS price level gap); with aggregate demand increasing only due to population growth (which is slowing down), American producers are pushing for deflation.  If my theory is correct and SRAS in reality appears like this


Aggregate supply is quite obviously finite: factories and farms can produce only so much per day.  The aggregate supply curve, which mathematically must run infinitely in the positive direction, turns vertical to reflect the reality that prices rise much faster than marginal output when total output begins to abut the maximum capacity of the current economy’s infrastructure.  However, this is also clearly only an issue in the short-term, because increasing factory and farm capacity (not to mention constructing more factories and farms) is very much an option over a longer time horizon.  In sum, short-term supply becoming a set value reflects the fact that economies have capacity constraints.

…the only way the AD-AS price level gap will be bridged is when the economy passes potential output.  When this price signal to expand SRAS is mistaken for runaway inflation after years of plodding population-based AD increases (assuming we don’t suffer the Japanese fate), the Fed will crush the real recovery before it even begins. 

Let’s be clear—the statement “pent-up demand for wage cuts” is absolute insanity.  Businesses have so bought into the “job-creator” mythos that managers and owners believe anything that would improve their lot on the micro level obviously translates into the macro level.  In reality, demanding wage cuts is step one toward an American turn toward freeterism.

Destructive Deflation or the Dispossessed of Disinflation Devastation?

I descend into alliterative anger partly to rail against this:

What is most alarming is that things keep getting worse for subsequent generations. Today, more than 20 years after Japan’s bubble burst, youth unemployment is higher than ever. Only half of working 15-to-24-year-olds have regular jobs, and another 10 percent are unemployed. The rest are “nonregulars.” Somewhat akin to temp positions in the U.S., Japan’s nonregular jobs pay half as much as regular jobs, offer few benefits, and can be eliminated on a whim—which they often are. The portion of young Japanese working as nonregulars exploded in the mid-1990s and has marched upward ever since.

After years of profit pressure, Japanese companies have all but stopped hiring regular employees, and most young job-seekers must choose between an unstable job and no job at all. The companies claim they are just reacting to the weak economy: sinking profits call for cost control, and nonregulars are both cheap to employ and easy to fire.

Just reading the title of Ethan Devine’s article in April’s Atlantic Monthly, The Slacker Trap (simply calling it The Trap would have been more appropriate), raised a righteous indignation inside of me.  Not once in an article about the Japanese economy’s effects did Devine write the word “deflation” or “disinflation,” which in my mind made his piece completely worthless.  Now that I have posited the existence of an AD-AS price level gap (the sequence that created the situation in the U.S. was similar in 1989 Japan), reading that companies are crying about cost control (I can’t avoid alliteration apparently) almost leads me to dismissively say “you made your bed, now lie in in it.”

I say almost because the U.S. has a long freeter trap history of its own:

If any young man is about to commence the world,” a reform-minded New York journalist wrote in 1838, “we say to him, publicly and privately, Go to the West.” Today, Horace Greeley’s advice comes down to us as “Go West, young man” and has been mythologized into a slogan of Manifest Destiny. But at the time Greeley wasn’t expressing any messianic desire to tame a savage continent. Rather, he was alarmed by how terrible economic conditions had become in New York.

The Panic of 1837—American history’s worst financial calamity until the Great Depression—had put one-third of the city’s labor force out of work. Greeley ran poor relief in one of the city’s wards, but available funds were meager and people were dying from lack of food and shelter. An angry mob became so enraged by the high price of bread that it rioted and looted the city’s flour merchants. Witnessing all this suffering and rage, Greeley concluded that the best solution would be for new entrants to the workforce to move someplace—anyplace—else. “Fly, scatter through the country, go to the Great West,” Greeley wrote. “Anything rather than remain here.”

This piece, Timothy Noah’s contribution to next month’s Washington Monthly, struck me with the statement “people were dying from lack of food and shelter.”  After President Andrew Jackson killed the Second Bank of the United States and precipitated the Panic of 1837 with the Specie Circular, an extremely ill-advised turn to hard-money policy the previous year, the U.S. government responded by doing…essentially nothing.  If the AD-AS price level gap is a reality, the gap is either filled with safety net programs or people die.  The tremendous increase in federal food-stamp participation between January 20, 2001 and January 20, 2009 leads me to believe the AD-AS price level gap is real and been afflicting the American populace for more than a decade.

I would leave my rant there and smooth down my hackles when more mathematical buffoonery runs into me:

In the past, migration served to reduce inequality among states by matching workers more efficiently to the country’s best available jobs. The creation of a single automobile plant—Ford’s River Rouge complex, completed in 1928—boosted Michigan’s population by creating more than 100,000 well-paying jobs. (One of those migrants, the future United Auto Workers President Walter Reuther, made a beeline from West Virginia on hearing Ford was paying tool and die makers the equivalent, in 2013 dollars, of $16.50 an hour.) Today, the reverse appears to be happening. While migration goes down, the richest states are getting richer.

Connecticut, for example, had in 1980 a per capita income that was 21 percent above the national average. By 2011, that disparity rose to 39 percent above average. Over the same interval, New York State’s per capita income rose from 8 percent to 23 percent above average, while Massachusetts went from 6 percent to 29 percent above average.

Today, the state with the highest median household income is Maryland. If you want to do like Willie Sutton and go where the money is, migrate to Maryland, because median income there is about $70,000, or roughly 40 percent above the national median. Pack up the truck, we’re moving to Maryland! Except we aren’t. About 8,000 more people moved out of Maryland last year than moved in from other states. Indeed, Maryland experienced negative net domestic migration in every year of the past decade except two.

So, what Noah is saying is per capita income increases with net emigration in the above states.  Is this surprising?  The fact that there are states with rising household income coupled with net emigration likely indicates that the denominator is getting smaller, not the numerator increasing.  Not to mention this is specifically household income.  Households include children living at home, so perhaps Friendly’s jobs in Connecticut and Massachusetts are more likely to be filled by people living at home with their gainfully employed parents than those working at Whataburger in Texas?

So where have people been moving to, if not to where the money is? Generally to southern Sun Belt states, where average wages not only are lower than in the places they left behind but are also growing more slowly. So, for example, when people moved from Connecticut to Texas in 1980, they moved to a place where per capita income was 17 percent lower. By 2011, when people made the same migration from Connecticut to Texas, they wound up in a place where per capita income was 31 percent lower. And yet they kept coming.

Maybe you’re thinking that states with lower wages have a higher volume of jobs. Pay people less and you can hire more of them, right? But in fact, most Americans moving across state lines are relocating to places where they’re no more likely to find employment. As the Atlantic’s Jordan Weissman pointed out in December 2012, of the ten states with the highest rates of in-migration, more than half had unemployment rates equal to or higher than the national average.

I guess Americans just have to get used to the phrase “pent-up demand for wage cuts.”  I’m beginning to think current American wage policy is far worse than the gold standard (don’t mistake this for support for gold and silver insanity).  Speaking of which…


2 thoughts on “Aggregate Demand Dominance: The Equilibrium Error

  1. I got lost after the title. I think you were talking about the Chinese buying to many pancakes from Sock Puppets?

  2. Pingback: Unacknowledged Damage | In The Corner, Mumbling and Drooling

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