Scarcity and Unemployment

A key principle of macroeconomics is scarcity. There are not enough resources, including labor, to produce all goods and services in quantities sufficient for everyone to achieve their goals. While it is possible to over produce one or a few goods, perhaps even to the point where those particular goods are no longer scarce, what that overproduction means is that resources are devoted to expanding production to a point where those goods are worth less than their opportunity cost. The opportunity cost is the value of the other goods that could have been produced instead. Overproduction of some goods means underproduction of other goods. In a world of scarcity, a general glut of goods must be due to a coordination failure.

Arnold Kling fails to grasp this important principle of macroeconomics. He argues that a general glut of goods is not necessarily due to an excess demand for money. He instead sticks with his "recalculation" story. That story combines a common place and correct idea with a novel and absurd idea.

The common place idea is structural unemployment. Some parts of the economy shrink and others grow. People lose jobs in the shrinking sectors of the economy and obtain new jobs in the growing sectors of the economy. Because of a mismatch of skills, this process can be painful and gradual. Those who lose their jobs in shrinking sectors may remain unemployed for a substantial period of time before they are employed in the growing sectors of the economy.

A situation of structural unemployment involves matching shortages and surpluses in product markets. For example, if the demand for new homes falls 50 percent and new homes make up 10 percent of the economy, then the demand for other products in the economy should grow more than otherwise. To offset those shrinking sectors, the real volume of demand for the other products of the economy should grow approximately 5 percent. With growing productive capacity due to a growing labor force, saving, investment and capital accumulation, and improved technology, the real volume of demand in the rest of the economy should be growing a bit more than 8 percent.

If, on the other hand, the demand for other goods and services grows less than 8%, which would include zero or else the demand for other products shrink as well, then the problem isn't "structural." That is, the problem isn't simply difficulties in shifting labor from where it is needed less to where it is needed more.

Kling's innovation is to claim that some industries are shrinking because people don't want the products any more, and nothing is growing because people don't know what they want instead. It is necessary to recalculate and discover what people want to buy. Certainly, this view has a certain appeal. If those spending less on houses had wanted to spend on something else instead, the demands for those goods would have risen.

The problem with this argument is that it ignores scarcity. There are not enough resources (including labor) to produce all good in quantities sufficient for everyone to achieve their goals. There are any number of goods, currently being produced, that could be produced in larger quantities and help people achieve their goals. Resources would be needed to produce those goods and services.

To say that houses are over produced is to mean that the value of the additional homes is less than their opportunity costs. The opportunity cost is the value of the other goods that could have been produced with the resources. The reason to reduce the production of houses is to free up labor and other resources to expand the production of those other goods that are the opportunity cost of producing the houses.

But clearly, individuals who don't want to buy houses can instead just hold money. And that is the problem. When people choose to hold more money than the existing quantity, then total spending in the economy falls. It is still true that scarcity exists and that the reason to reduce the production of homes is that the resources could be used to produce other more valuable goods, but nominal expenditures on those other goods doesn't increase.

What happens? It depends on monetary institutions.

Suppose the monetary institution is a 100 percent reserve gold standard, and people decide that they don't want to purchase new houses, and instead want to hold more gold rather than spend on some other good or service. People are laid off from the housing industry. There is no increase in demand for any other good, other than gold mining. So, it is necessary for the unemployed workers to just wait until someone comes up with a new product that tickles the fancy of the former home buyers. Right?

WRONG!

What happens is that the surplus of labor and other resources results in lower resource prices, including wages. This reduces the costs of producing various products, and so, firms expand output of those goods and lower their prices enough so that people will purchase the additional output.

While the lower prices appear to make it possible for people to be able to buy more products, the lower wages and other resource prices means that money incomes are lower as well. However, the real value of the gold has increased. Everyone who holds money earns a real capital gain. Now, if the former home buyers still have no desire to buy anything, they just have higher real money balances. But other people, who also hold money, earn a real capital gain. And some of them could use more consumer goods and services. And they buy more of them.

The real volume of expenditures on various goods (and perhaps, to some degree housing) rises enough to match the productive capacity of the economy. By far, the most likely scenario is that the real demand for houses is lower and the demand for other goods rise. There is still a need to redeploy resources from the housing industry to other industries. However, there is no need to wait for somone to find some product that appeals to those who don't want to buy houses and instead want to hold money. The level of prices (and wages) fall enough that the real quantity of money rises enough that some of those holding money expand their expenditures on goods and services. Other people holding money who do want more of the existing goods buy them.

Suppose instead the nominal quantity of money is increased to match the additional demand for money. Those who don't want to buy houses and just don't want to buy anything else, hold more money. The quantity of money is increased enough to offset the increase in the demand for money and keep money expenditures growing with the productive capacity of the economy.

How is the quantity of money increased? Suppose it increases by helicopter drop. New money is printed and dropped out of helicopters. People pick up the money. Those people who have nothing they want to spend money on, presumably just hold the additional money. (I suppose they rake up whatever appears in their yard because some good may appear at some unknown future time that they will want.) However, all of those people who are currently holding money, not because they don't want additional goods and services, but instead only because they prefer holding the money, spend at least some of the additional money on whatever it is that they want.

Given a sufficient increase in the quantity of money, the demand for the scarce goods that those picking up the money want will increase enough so that total spending matches productive capacity. Perhaps some of those picking up money buy houses, but the likely result is that there will still be less spending on houses and more on other things. There remains a need to redeploy resources away from houses and towards other goods.

In the real world, the closest thing to a helicopter drop of money is a tax cut financed by money creation. The government cuts taxes and instead borrows money by selling bonds. The central bank buys the bonds with new money created out of thin air. Again, those people who used to buy houses and were holding more money because they could think of nothing else to do with it, presumably just hold on to the additional money they receive. However, other people, who are holding money despite valuing the additional goods they might buy, spend the additional money on whatever goods they want the most. Perhaps some of them spend more on houses. Given sufficiently large tax cuts funded by money creation, total spending will rise enough to match the productive capacity of the economy. The most likely scenario will be that fewer houses are demanded and more other goods are demanded. There remains a need to redeploy resources, including labor, from the production of houses to other goods.

Suppose that instead of these schemes of creating "outside" money and giving it away, instead, money is "inside" and lent into existence. Those who used to buy houses and instead hold money because they have nothing else they want to buy are clearly saving. By holding money, they are choosing to lend additional funds to the banking system. The demand to hold inside money represents increased lending to the issuing banks--either private banks or the central bank. The money issuer (or issuers) then expand the quantity of money enough to match that increase in demand to hold money. With inside money, new money is issued by lending. This could be in the form of loans, but it can also occur through the purchase of already existing bonds.

As the money issuers expands loans (or purchases bonds,) they lower interest rates. The lower interest rates provides an incentive to reduce saving and so, increase consumption, or else expand investment. Further, the reduced interest rates that the money issuer or issuers can earn also reduces the interest rates they can pay on the money. This reduces the benefit from holding money, and so results in some of those holding money spending it on consumer goods or capital goods.

Superficially, the increase in the quantity of inside money requires an increase in debt. And it certainly requires that the money issuers hold more debt. However, it is entirely possible for the money issuers to expand their market share in the credit market, so that while the quantity of money expands, total lending actually shrinks. How can spending on goods and services expand, even if total lending shrinks? All that is necessary is that some of those who would have lent by holding existing bonds instead sell them and spend on consumer good or capital goods.

Interestingly, because money issuers pay lower interest rates than they charge, it is possible that the decrease in interest rates could go so far as to make the interest rates "paid" on money negative. This is interesting, because those who spend less on housing and then just hold money because they have nothing better to do with it, may have to pay.

The changes in interest rates motivate people who have use for additional goods ands services to purchase them. To some degree, this will be people borrowing money that they must pay back later, but it also could involve people spending more out of current income on consumer good and services or capital goods. And it can involve people selling off previously accumulated assets to fund purchases of consumer goods and services or capital goods. (And, yes, the zero nominal bound on interest rates can cause problems with a pure inside monetary system.)

The resolution of monetary disequilibrium, either through a lower price level and increased real balances, or an increase in the nominal quantity of money, results in increased real expenditures on scarce goods and services. Resources are shifted from the production of goods that people don't want to the production of goods that people do want. As long as there are scarce goods, as long as there are some people who want to purchase consumer good and services or capital goods, the correction of monetary disequilibrium will result in increased production of those goods. There is no need for the particular individuals who chose to reduce spending and accumulated money balances to choose to spend on anything in particular. The process that corrects monetary disequilibrium, whether a lower price level, helicopter drops, or reduced interest rates, results in increased expenditures on goods and services by other people.

The notion that it is necessary to wait until some new good is found that will appeal to those demanding fewer existing goods, and that production should or must be reduced until such products are found is an error. It is an error that ignores the fundamental reality of scarcity.