Can a Keynesian "demand crisis" happen?

[Topazan]

I tried asking this on another site, but I didn't get a real answer, so I thought I'd try here.

Many of the posters he seem to adhere to the Austrian School of economics.  I'm aware that ABCT provides an alternate explanation for why recessions happen.  However, I haven't come across any reason in Austrian theory why the Keynesian narrative can't also happen.

Say's Law shows that over-supply of one good is balanced out by under-supply of another good.  This does not, however, mean that over-supply doesn't happen, or that it doesn't cause problems when it does.

I suppose the question comes down to:
1.  Can a shortage of a good occur because a large group of people irrationally decide to stop trading away that good?
2.  Can that good be money?

If not, to either of those questions, why not?

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[BoardGameCoin]

Yes to both. But ultimately the crisis resolves itself, either by adoption of some other form of money that has better liquidity or reaching a minimum level of consumption.

[Topazan]

So how do we tell the difference between a demand crisis and an Austrian-style malinvestment crisis?

If you're trying to say that a demand crisis is not a problem, that's not very convincing.  The decision to change the mainstream currency is pretty much out of the hands of the market, and even without legal barriers it would impose huge costs on businesses.  Letting consumption fall to its minimum level would be a huge step backward in material progress and imply a great deal of human suffering.

Where does the objection to the interventions proposed by monetarists or Keynesians come in if there's no fundamental disagreement about the possibility of a demand crisis?

[hugolp]

The answer is yes, but in a free market it wont produce a crisis because enterepreneurs will use the oportunity to fill the market with alternatives.

Its only in the regulated market that we live on that inefficiencies are kept around and produce long term harm.

The problem in reality between keynesianism and austrianism is the way each theory looks at an economic system. Austrians see the economy as an ecosystem, a mix of complex and changing parts with complex and changing interactions between them. On the contrary, keynesians have a macroeconomic outlook over the economy, where they see it as a whole, as a car that can only go faster or slower (or even backwards), but dont bother to look inside and how each different part coordinates with the other.

So in the keynesian model talking about coordination, about how different parts of the economy relate to each other, does not even make sense. Its all about total output, without looking about what type of output its being produced. For an austrian thats a completely insane oversimplification that can never capture how an economy works. Thats why it is so hard for a keynesian or basically any macroeconomic trained economist (most of them) to understand what an austrian is saying: what type of product? coordination between sectors? why are you looking at that, just look at total production! Its going down, we need to do something!!

When the austrian replies that the reason is because there is a realignement of sectors and therefore the temporal decrease in production is good because its a sign that in the furute the economy will start producing the type of products people need/want and not the old type of products people did not want (excess housing for example), macroeconomic trained economist dont understand. They just dont: why are you looking at different sectors, we only care about total output! And its going down!

And the discussion cycle goes on forever. Its up to you to decide if you think looking only at macroeconomic indicators is good enough to understand and make predictions about the economy, or if looking about how different parts of the economy interact with each other and the coordination they achieve is needed and will give you a better chance at understanding and predicting the economy.

[Topazan]

Thanks.

I understand the differences in philosophy between the two schools, and I understand that they each have their narrative for why recessions happen.

The problem I have is the two narratives do not seem mutually exclusive.  I don't see why the possibility of a malinvestment fueled misalignment of sectors rules out the possibility of a demand shortage brought on by an irrational change in consumption behavior, or vice-versa.  How do we know which one we're facing at any given time?

What "alternatives" do you mean?  Alternate currencies?  Does that really help if the shift in spending is from productive enterprise in general to stores of value in general?

[solex]

The problem I have is the two narratives do not seem mutually exclusive.  I don't see why the possibility of a malinvestment fueled misalignment of sectors rules out the possibility of a demand shortage brought on by an irrational change in consumption behavior, or vice-versa.  How do we know which one we're facing at any given time?

Surely, the principle that the market is always right must prevail, because it is made up of thousands, or millions, of human minds weighing decisions about investment, consumption or saving. While temporary misalignments will always occur, in the Austrian system these will be smaller in relative size and self-correct faster.

The Keynesian principle that elements of an economy can be controlled (e.g. interest rates) is assuming that a few people (e.g. a central bank committee) can be wiser than the market. Time and again this is proven false, and it is governmental interventions that makes misalignments much larger and longer-lived than they would in a free market. Consider China's centrally planned empty cities as an extreme example.

[hugolp]

Thanks.

I understand the differences in philosophy between the two schools, and I understand that they each have their narrative for why recessions happen.

The problem I have is the two narratives do not seem mutually exclusive.  I don't see why the possibility of a malinvestment fueled misalignment of sectors rules out the possibility of a demand shortage brought on by an irrational change in consumption behavior, or vice-versa.  How do we know which one we're facing at any given time?

Define "irrational change in comsumption behavior".

If Im understanding it correctly, let me advance you that from an austrian perspective "irrational change in consumption behavior" is not possible because, for austrians, consumers are kings and the objective of an economic system is to produce and supply what the consumer needs and/or wants. So when there is a mismatch between what consumers demand and what the production system is offering the "fault" is always on the production system, that needs to re-organize. What is the point on having a production system that produces stuff people dont need/want?

What "alternatives" do you mean?  Alternate currencies?  Does that really help if the shift in spending is from productive enterprise in general to stores of value in general?

Any kind of alternative, it depends on each particular change on consumer demand.

If the problem is happening in the currency market, then alternative currencies can be an option, yes.

[oleganza]

1.  Can a shortage of a good occur because a large group of people irrationally decide to stop trading away that good?
2.  Can that good be money?

Yes. E.g. when people buy old famous paintings on auctions: the amount of works is limited, demand is huge and the painting is not sold again for unknown amount of time. And when it is being sold again, new price may have no relation to initial price.

Money can be that good if there are 10 units remaining and they have value in the eyes of collectors. But the more identical units you have, the more "liquidity" they will have. That is, the bigger chance you have to buy it for some price simply because more than a handful of persons will be holding these units and some of holders will be more willing to sell at some price point.

After all, even if you end up in a situation where all coins are collectibles and nobody is willing to sell them, who is suffering from that? Obviously, everybody who sold their coins are better of (they got something more valuable for them, e.g. USD, or food or whatever). Those who purchased coins and do not want to sell, are also happy owners of coins. If they don't like them anymore - they can always sell to other crazy collectors.

In other words, there is nothing "bad for society" in a free voluntary trade. On each side of trade everyone gets what they want.

[shawshankinmate37927]

1.  Can a shortage of a good occur because a large group of people irrationally decide to stop trading away that good?
2.  Can that good be money?

If not, to either of those questions, why not?

1.  No, not in a free market.  Technically, a shortage is simply a matter of the price not being able to rise to match increased demand.  Disparity between supply and demand occurs when prices are fixed either too high and overvalued, leading to a surplus, or too low and undervalued, leading to a shortage.  When the price of a good is allowed to rise or fall freely, there are no shortages or surpluses, and suppliers will not "decide to stop trading away that good".  For example, in the US after Hurricane Sandy there were reports of gasoline shortages and long lines waiting for hours forming at gas stations.  This happened because it was illegal to raise gas prices to account for the increased demand.

2.  Yes, money is a good/service with supply and demand.

[hazek]

1.  Can a shortage of a good occur because a large group of people irrationally decide to stop trading away that good?

What's the point of holding such a good? To brag to your friends how much it's worth? Of course not. The point is to eventually consume this wealth so trading can't really stop.

[sunnankar]

I understand the differences in philosophy between the two schools, and I understand that they each have their narrative for why recessions happen.

Based on the language in your posts it sure does not seem like you understand the philosophical underpinnings of the Austrian school. Have you even read a single page in Human Action? How about Man, Economy and State?

1.  Can a shortage of a good occur because a large group of people irrationally decide to stop trading away that good?

What's the point of holding such a good? To brag to your friends how much it's worth? Of course not. The point is to eventually consume this wealth so trading can't really stop.

Well, not completely. Every individual has subjective valuation differences for why they would hold a money good. The price of doing so is expressed as an interest rate which acts as a price signal to the market to regulate production over time.

[granolageek]

1.  No, not in a free market.  Technically, a shortage is simply a matter of the price not being able to rise to match increased demand.  Disparity between supply and demand occurs when prices are fixed either too high and overvalued, leading to a surplus, or too low and undervalued, leading to a shortage.  When the price of a good is allowed to rise or fall freely, there are no shortages or surpluses, and suppliers will not "decide to stop trading away that good".  For example, in the US after Hurricane Sandy there were reports of gasoline shortages and long lines waiting for hours forming at gas stations.  This happened because it was illegal to raise gas prices to account for the increased demand.

You just exposed what I regard as a big Austrian irrationality. In your second sentence you said a shortage could only result from increased demand [in a distorted market], and then you gave Hurricane Sandy as an example.

It destroys your claim. The problem was completely due to a drastic decrease in supply. Demand was probably down, given the number of people who had evacuated and/or lost their cars in the storm.

[shawshankinmate37927]

1.  No, not in a free market.  Technically, a shortage is simply a matter of the price not being able to rise to match increased demand.  Disparity between supply and demand occurs when prices are fixed either too high and overvalued, leading to a surplus, or too low and undervalued, leading to a shortage.  When the price of a good is allowed to rise or fall freely, there are no shortages or surpluses, and suppliers will not "decide to stop trading away that good".  For example, in the US after Hurricane Sandy there were reports of gasoline shortages and long lines waiting for hours forming at gas stations.  This happened because it was illegal to raise gas prices to account for the increased demand.

You just exposed what I regard as a big Austrian irrationality. In your second sentence you said a shortage could only result from increased demand [in a distorted market], and then you gave Hurricane Sandy as an example.

It destroys your claim. The problem was completely due to a drastic decrease in supply. Demand was probably down, given the number of people who had evacuated and/or lost their cars in the storm.

It's not the increase in demand or a decrease in supply (or even a combination of both) that leads to a shortage.  It's an inability or unwillingness to raise prices that causes shortages.  After Hurricane Sandy, if the free market was allowed to function and gas prices had been allowed to rise, suppliers would have found a way to bring more gasoline to the area in order to capitalize on the higher prices.  As the supply increased and more gas was made available to meet the demand, prices would begin to drop.

[Topazan]

Define "irrational change in comsumption behavior".

If Im understanding it correctly, let me advance you that from an austrian perspective "irrational change in consumption behavior" is not possible because, for austrians, consumers are kings and the objective of an economic system is to produce and supply what the consumer needs and/or wants. So when there is a mismatch between what consumers demand and what the production system is offering the "fault" is always on the production system, that needs to re-organize. What is the point on having a production system that produces stuff people dont need/want?

Good point.  Perhaps I should have said "spontaneous change in consumption behavior."  The idea that a large number of people will be seized by the urge to hold liquid assets rather than spend or invest them.

After all, even if you end up in a situation where all coins are collectibles and nobody is willing to sell them, who is suffering from that?

People who have invested with the expectation that they'd be able to make some money?  You can say that the problem is that they made a bad investment, bit what if consumer preference is inherently unpredictable?  How do you maintain the capital needed to meet that preference if it isn't consistent?  (Just playing devil's advocate here.)

What's the point of holding such a good? To brag to your friends how much it's worth? Of course not. The point is to eventually consume this wealth so trading can't really stop.

People do hold on to things though, even if according to your principle they shouldn't.

Based on the language in your posts it sure does not seem like you understand the philosophical underpinnings of the Austrian school. Have you even read a single page in Human Action? How about Man, Economy and State?

I must admit I'm not as well read on Austrian theory as I'd like to be.  I only understand the philosophical difference on a very basic level.  I will keep your suggestions in mind as I work my way down my reading list, thanks.

Well, not completely. Every individual has subjective valuation differences for why they would hold a money good. The price of doing so is expressed as an interest rate which acts as a price signal to the market to regulate production over time.

Isn't that only the case if the money's lent out?

@shawshankinmate37927- Your basic point seems to be that prices can adjust to a point where markets reach equilibrium.  I believed that for a long time, but I have doubts now.  It's been pointed out to me that in the real world, prices don't change that easily.  It's not just the government that controls them, either.  Individuals are resistant to reductions in their income as well.  It is rational for them to be.

For instance, if I'm an employee, it would be an unwise decision to agree to let my boss lower my salary at will.  There are costs involved in changing jobs if he lowers it below the worth of my labor, so that would allow him to consistently underpay me.  It makes far more sense to lock a certain salary in contractually, even though this means some of the workers need to be laid off when the money available to pay them goes down.


Thanks, guys.  What you're saying makes sense, but so far I haven't experienced that "Aha! That's why it can't happen." moment.

[Realpra]

I suppose the question comes down to:
1.  Can a shortage of a good occur because a large group of people irrationally decide to stop trading away that good?
2.  Can that good be money?

If not, to either of those questions, why not?

Tulips in Holland once rose to crazy heights as a speculative good - of course the bubble crashed because it was effing tulips.

Keynesian economics would explain that as a deflationary spiral and Austrian economics as simply a stupid investment of time and energy.

Such a thing as "deflationary spiral crisis" does not exist. It makes no sense.
So:
1. No, a lasting shortage sustained only by hoarding can NOT happen.
2. No, if the shortage comes from speculation purely it will not last and it is not good money.

[hugolp]

Define "irrational change in comsumption behavior".

If Im understanding it correctly, let me advance you that from an austrian perspective "irrational change in consumption behavior" is not possible because, for austrians, consumers are kings and the objective of an economic system is to produce and supply what the consumer needs and/or wants. So when there is a mismatch between what consumers demand and what the production system is offering the "fault" is always on the production system, that needs to re-organize. What is the point on having a production system that produces stuff people dont need/want?

Good point.  Perhaps I should have said "spontaneous change in consumption behavior."  The idea that a large number of people will be seized by the urge to hold liquid assets rather than spend or invest them.

Ok, basically what you are asking me is about the keynesian story about people putting their savings in the mattress when there is a crisis, what keynesians call the paradox of thrift. Hayek wrote about it in his article "The 'Paradox' of savings", but I dont think you can find it for free on the Internet.

First, this does not address the situation proposed in the keynesian paradox of thrift but it is worth noting that an increase on the demand for more liquid assets is not necessarely bad. Let me give you a simple example: Imagine there are a bunch of people stranded in an island. They collect, hunt and fish to provide food for themselves. They have specicialized a bit and some people have been able to not work on getting food but on getting other materials and producing stuff like better housing. They keep food for 3 days always stored just in case. Suddenly, they see a big storm coming, and they decide to stop any other activity and get everybody on getting food. They also ration the food and start increasing the amount of food stored. From a macroeconomic point of view, consumption has gone down, investment has gone down, in general economic activity is down, and savings are up. A keynesian would say it is a crisis and you need to stimulate consumption. But the reality is that there is a very valid reason for what people are doing, and increasing consumption would deplete the food storage and could get the people killed if the storm last for long. This simple example is just to explain that there might be valid causes for a temporal shifts in the demand for liquid assets.

But the paradox of thrift is about people increase savings during a crisis, not at any other moment. Keynes argued that it was a paradox because acording to neo-clasical economics the self-interest of individuals would always produce the best overall result. In a crisis, the uncertainty increases and therefore most individuals have an increased taste for more liquid assets and less for risky investments. The result of decreased consumption and increased savings would depress the economy even more, producing more uncertainty, which in turn would make more people look for liquid assets, ... and starting a self-reinforced cycle into depression. To break this cycle it is necessary that an authoritarian institution acts decisevely against what individuals want to do and start increasing consumption to break the cycle. Again, the issue with this story is that it only looks at macroeconomic indicators. The answer I already gave it to you earlier (it is worth noting that, because of its macroeconomic nature, this explanation completely overlooks the problems that caused the crisis in the first place, for example, it overlooks an excess investment in certain sectors like housing during the last bubble):

what type of product? coordination between sectors? why are you looking at that, just look at total production! Its going down, we need to do something!!

When the austrian replies that the reason is because there is a realignement of sectors and therefore the temporal decrease in production is good because its a sign that in the furute the economy will start producing the type of products people need/want and not the old type of products people did not want (excess housing for example), macroeconomic trained economist dont understand. They just dont: why are you looking at different sectors, we only care about total output! And its going down!

So if you do not look at the relation between sectors and how the decrease in agregate production output is a result of a process of shifting the types of production, and only care about keeping an arbitrary amount of growth in the production output, then the keynesian explanation makes sense. The problem is that looking only at macroeconomic aggregates only and therefore arriving to the conclussion that keeping an arbitrary amount of growth in the total output is what the economy should be doing, you miss what it is really happening in the economy and what the economy should be really doing, providing to the people what they need/want.

But what about the unemployed? We let them rot? No, but if we want to help them we need to know how to create employment, and for that we need to understand what really caused the crisis and the real mechanism that will solve it. And answering to your question: So why do economic recession last so long? Is it because everybody starts hiding money under the matress as Keynes said? No, the reality is that people hardly hide money in the matress during crisis, more like are really struggling to get along. The lack of liquidity during the Great Depression or during the years after the 2008 crash is real, but it does not come from people saving more as Keynes argued, it comes mainly from banks having to cut their lending activities due to being completely overextended. And because the banking system is a government created oligopolly around the central bank and its monopollistic currency, competition can not fill the void propperly. Its not coincidence that during the Great Depression there was a big increase in the use of alternative currencies. Banks are broke and the transmission from savings into investment (what banks do) is broken, cutting any opportunity of recovery.

Keynesians argue that the solution should be the central bank saving them, and in extreme cases use the taxpayer directly. Austrians argue that they should go into bankruptcy to liquidate the bad debt and have new management re-build the sector with what can be savaged. You will discover that a lot of keynesian phalacies at the end what acomplish is shift the blame from the banks to the people and the mesures proposed under the excuse of helping the people in reality are geared towards helping the banking system.

[shawshankinmate37927]

@shawshankinmate37927- Your basic point seems to be that prices can adjust to a point where markets reach equilibrium.  I believed that for a long time, but I have doubts now.  It's been pointed out to me that in the real world, prices don't change that easily.  It's not just the government that controls them, either.  Individuals are resistant to reductions in their income as well.  It is rational for them to be.

For instance, if I'm an employee, it would be an unwise decision to agree to let my boss lower my salary at will.  There are costs involved in changing jobs if he lowers it below the worth of my labor, so that would allow him to consistently underpay me.  It makes far more sense to lock a certain salary in contractually, even though this means some of the workers need to be laid off when the money available to pay them goes down.

I would actually state the point I'm trying to make just a little differently.  Instead of saying that "prices can adjust to a point of equilibrium", I would say "Prices should be adjusted to the point of equilibrium, otherwise there will be shortages or surpluses."  Equilibrium is where the price should be and a shortage is the result of a price being set below that point.  

Yes, you're right--sometimes prices don't change easily--and that is the problem.  The first question in your original post was: "Can a shortage of a good occur because a large group of people irrationally decide to stop trading away that good?"  I'm just trying to point out that if enough people decided to start hoarding a good it would raise the point of equilibrium, but there would be no shortage as long as the price was adjusted to that new point of equilibrium.  Shortages are a result of inability or unwillingness to raise prices, not refusing to sell.  Raise prices and you'll get more sellers (and fewer buyers).  Raise prices too high and you'll have a surplus--too many sellers and not enough buyers.

I agree with you, that it's not just politicians that prevent adjustments in price.  Market participants could also just be too stubborn to adjust prices.  Home owners will sometimes put their house on the market and don't understand why they haven't been able to sell it after a year or so.  The answer is simple.  The price is too high.  Drop the price enough and it will sell.  Lower it too far and you'll get swamped with offers.

This is a one and a half minute video that does a good job of illustrating shortages and surpluses with supply/demand curves:
http://www.youtube.com/watch?v=Ffcd6Wdkn5w&feature=player_embedded#!

When it comes to being compensated by their employer, most people's pay is actually being reduced over time in real terms.  They just don't realize it because they tend to measure their pay in nominal terms using a fiat currency that loses value over time.  They see their cost of living steadily rising and assume that's just the natural order of things.  However, in a free market where goods and services are priced in an honest currency, that can't be debased, prices would be steadily falling over time, and it would be easier to accept a reduction in pay in that type of environment.  You would still be able to enjoy a better standard of living as long as your pay was declining at a slower rate than the steadily falling consumer prices in the economy.

[johnyj]

I think OP's thinking have some valid concern

Imagine some time in the future, someone want to move billions of dollar worth of bitcoin into another place in the world, but then he has to convert bitcoins to that country's currency, without a very liquid exchange market, this conversion will crash the btc price very hard so that eventually he could lose half of the original value

[johnyj]

Ok, basically what you are asking me is about the keynesian story about people putting their savings in the mattress when there is a crisis, what keynesians call the paradox of thrift. Hayek wrote about it in his article "The 'Paradox' of savings", but I dont think you can find it for free on the Internet.

So if you do not look at the relation between sectors and how the decrease in agregate production output is a result of a process of shifting the types of production, and only care about keeping an arbitrary amount of growth in the production output, then the keynesian explanation makes sense. The problem is that looking only at macroeconomic aggregates only and therefore arriving to the conclussion that keeping an arbitrary amount of growth in the total output is what the economy should be doing, you miss what it is really happening in the economy and what the economy should be really doing, providing to the people what they need/want.

But what about the unemployed? We let them rot? No, but if we want to help them we need to know how to create employment, and for that we need to understand what really caused the crisis and the real mechanism that will solve it. And answering to your question: So why do economic recession last so long? Is it because everybody starts hiding money under the matress as Keynes said? No, the reality is that people hardly hide money in the matress during crisis, more like are really struggling to get along. The lack of liquidity during the Great Depression or during the years after the 2008 crash is real, but it does not come from people saving more as Keynes argued, it comes mainly from banks having to cut their lending activities due to being completely overextended. And because the banking system is a government created oligopolly around the central bank and its monopollistic currency, competition can not fill the void propperly. Its not coincidence that during the Great Depression there was a big increase in the use of alternative currencies. Banks are broke and the transmission from savings into investment (what banks do) is broken, cutting any opportunity of recovery.

Great post!

I think the fact that banks could not loan out money in a recession is not only caused by the credit crisis in the banking system, it is also affected by the general atmosphere in investment world. Few companies dare to invest when they can easily forecast the majority of people's spending is going down for the forseeable future, due to their saving action.

Until people feel safe after they have accumulated enough saving, things will not improve, and the stimulus from either FED or Government will just give them enough money to save until they feel safe. Suppose the normal transaction need for money is 1 trillion, then the panic saving could easily eat up 10 trillion without any significant spending improvement. And when the sentiment changed eventually, all these saved money will pour out quickly and cause heavy inflation. Sentiment plays a very important role here, the psychology effect of a financial crisis is not very easy to disappear in 3-5 years

I regard Keynesian economics as painkiller, it does not really cure the internal structure problem but it stopped the financial panic and buy people some peace to deal with the real problem at a later time. Interestingly more and more modern medicine are taking this approach. The internal problems are quite complex and have various historical reason, it typically takes a long time to solve by themselves

[pretendo]

Only thing you have to know : Say's Law