This lecture discusses what I think of as the Leijonhufvud interpretation of macroeconomics as an attempt to characterize an economy that is far from classical equilibrium.How do we reconcile macroeconomics, which uses ratios, with microeconomics, which does not?

Macroeconomics often deals in ratios. For example, the simple Keynesian multiplier equation is:

Y = A/(1-c)

where Y is total national income, A is “autonomous” demand (including investment) and c is the marginal propensity to consume.

From a microeconomic perspective, making predictions using simple ratios is typically wrong. For example, if you think that the ratio of food production to land is fixed, you will predict that soon we will see people starving. In the 1970’s, environmentalists made many incorrect predictions based on this sort of ratio analysis. They saw “limits to growth” based on fixed quantities of natural resources.

Simple ratios do not take into account prices, adaptation, and technological change. If a natural resource becomes scarce, its price will rise, and the economy will adapt. Over time, entrepreneurs are developing new recipes that use resources (including labor) more efficiently.

One of the problems that I have with the quantity theory of money is that it is a ratio-based theory. If the quantity of money were to gradually become scarce, would people not be able to create money substitutes? In practice, that sort of thing does happen, which is why velocity is not a constant. Of course, if you print money fast enough, I do believe that you can reach the point where substitution effects are relatively minor, and you will see strong correlations between the money supply and the price level.

Axel Leijonhufvud (henceforth AL) suggests that when the economy is close to equilibrium (“inside the corridor,” he might say), trade and employment can be maintained by small price adjustments and simple adaptations by consumers and producers. However, outside the corridor, the standard adaptive mechanisms do not work sufficiently well to maintain full employment.

In this interview (from 2002), AL says,

When I talked about situations where the system is not recovering rapidly by itself due to effective demand failures, there are basically two of them that we can find in [Keynes’] General Theory. First, a fresh act of saving is not an effective demand for future goods. Second, the wishes of the unemployed for consumer goods do not constitute an effective demand. But there is a third effective demand failure that can be very important. This is when the financial system is in a state where for most entrepreneurs it is not possible to exert an effective demand for today’s factors of production by offering future goods. That is, it is not possible to make a deal by saying: ‘I have this investment project that will pay off in the future and I want to trade that prospect for the factors of production today necessary to produce those future goods’. And that’s where we end up if the financial system is totally clogged up with bad loans. That has been and still is the Japanese situation.

The first type of effective demand failure is a shortage of “animal spirits.” No matter how much people want to save, entrepreneurs don’t have projects that they want to pursue. The result is that instead of an increase in investment, we see a decline in output.

The second type of effective demand failure is what I think of as the standard multiplier effect. When people lose their jobs, they cut back on consumption.

The third type of effective demand failure is a credit crunch. Entrepreneurs want to engage in projects with reasonable risk-return trade-offs, but banks are busy shoring up their own balance sheets.

I think that in the United States today, we do not have a shortage of “animal spirits.” We have a credit crunch. But we have something else, not included in AL’s list. We have savers suddenly wanting a lower ratio of risky assets to risk-free assets. This is somewhat akin to Keynes’ liquidity preference. It reinforces the credit crunch.

However, the main issue for this lecture is the “corridor” theory. Think of the economy as a kite. Under normal circumstances, it flutters around but stays aloft. However, a sudden, sharp change in the wind might send it into a tree or hurtling into the ground.

I am not sure we know how to distinguish wind shifts that the kite can withstand from wind shifts that will bring it hurtling down. A housing crash, particularly when so many decisions had been made under the assumption that house prices would never fall, might constitute such a major wind shift. But was it really such an enormous wind shift? If you had known that a large correction in home prices was in store, would you have predicted such a large overall macroeconomic impact? Why was the popping of the housing bubble more of a wind shift than the popping of the dotcom bubble?

I am not sure that we know how to pull the kite out of a dive. Pulling out of the dive means continuing to make appropriate adjustments to relative shifts in supply and demand while somehow stopping or offsetting adjustments that are counterproductive, such as multiplier effects. There is a widespread view that printing money and/or increasing the Federal deficit are policies that can do this. However, it is always worth stopping to think about whether that view is correct. What I think of as the Japan problem (and what many of us fear is taking place in the U.S.) is one where policy works to inhibit necessary adjustments.

Another aspect of the “corridor” theory or the kite theory is the role of beliefs. When people believe they are wealthy, in some sense this causes them to be wealthy. As long as none of Bernard Madoff’s investors knew that he was running a Ponzi scheme, they were able to treat their funds with him as real wealth. Until the respective bubbles burst, the owners of dotcom stocks and of mortgage-backed securities could treat those assets as real wealth.

One way to look at fiscal stimulus is that its effectiveness depends on beliefs. Think of deficit spending as a Madoff scheme. As long as people view their holdings of our government bonds as real wealth, a larger deficit will be stimulative. If instead people were to see government bonds as deferred taxes, the stimulative effect would be less. If investors were to come to believe that the U.S. is a banana republic, the stimulus effect would be nonexistent, or even negative.

With the “corridor” theory, one can say that when the economy is inside the corridor, you should forget about macroeconomics. Normal adjustment mechanisms, including responses to relative prices, take care of solving economic problems. However, when the economy gets pushed outside the corridor, normal adjustment mechanisms are ineffective or even counterproductive. At that point, one can describe the economy in terms of ratios, such as the Keynesian multiplier. If such multipliers are to be trusted, then fiscal and monetary stimulus can offset some of the otherwise counterproductive adjustments.

Previous lecture here