Larry Summers’ Inverse Say’s Law sheds light on lack of Effective Demand…

By way of Mark Thoma, there is a new video of Larry Summers talking about Inverse Say’s Law. It is a wonderful video and one that could wake up the economics profession about Effective Demand. His views will not only challenge Fresh Water economists, but also Salt Water economists. (His talk starts at 9-minute mark.)

His idea of Inverse Say’s Law is that “lack of demand creates overtime lack of supply”. He is describing the situation when weak Effective Demand leads to higher unemployment and lower utilization of capital capacity. He is describing the work that I have been doing for over a year. He is describing what Keynes wrote in Chapter 3 of General Theory about Effective Demand.

Update for statement made during talk: “This might have been a theoretical notion some years ago… it is an empirical fact today.”

Most economists know that weak demand is a problem, but Mr. Summers is opening the door to the theory behind it. Like he says at the beginning of his talk, he will present 3 ideas that were not part of the economics tool kit, so to speak, 7 years ago. And I have been writing for over a year that Effective Demand is now low enough that it is having a noticeable effect on the traditional calculation of potential output and the natural rate of unemployment.

He talks about the $800 billion lost in potential. I have written before here on Angry Bear that this money has gone from the hands of labor consumers to the hands of capital income.

He says that going forward, the US will “suffer a demand constraint and to have its level of output and employment constrained by demand, rather than supply”. He is saying what I have been saying that weak Effective Demand means that potential output has fallen and that the natural rate of unemployment has risen, beyond what most economists perceive.

There are still some issues that will come to light about effective demand. For example, Christine Lagarde at the IMF is warning about low inflation. My veiw is that inflation will stay low in the US as long as effective demand stays low in terms of low labor share. I hear everyday that inflation will perk up again. I do not think it will. I am watching labor share. I still do not see it rising. Even if labor share does rise, you have to watch consumption by capital income to see if labor income will rise faster than capital consumption falls.

He goes on to imply that monetary policy is constrained by demand. This is old news to me. I have a model to show this, but I wonder what model he is using.

He concludes his talk with these words…

“Let us hope, that the focus of our macroeconomic policy discussion over the next 5 years shifts to a dominant emphasis on the crucial priority of generating sufficient demand to restore rapid and reasonable growth.”

In the answer portion of the video, he mentions how current monetary policy can bring back the asset bubble environment before the crisis. He mentions how low interest rates with low inflation have an unstable impact on asset prices. He says that it is better to raise demand, which points at consumption by the general population.

“It seems to me that a strategy of focusing dominantly on reducing real interest rates is a strategy of bringing back 2005…. it seems to me that the safer strategy is one that goes directly at demand at a given level of real interest rates.”

He kind of says what I have been saying. Yet I frame it specifically in terms of labor share, even though Mr. Summers does refer later in the video to the “inclusiveness” of growth.  He is referring to the general population, who as I see it depend upon  a reasonable labor share of income to be considered “included”.

As long as the Fed rate stays low in an environment that prefers non-productive investment by the wealthy over productive investment in the face of weak effective demand by labor, I am not in favor of easy monetary policy. However, if the Fed was to direct their funds at productive community investment with a complementary policy to raise labor share, then I would be in favor of easy monetary policy. As it is, the current policy does more long-term damage to the economy than good. He might call that damage financial instability, but he must recognize that the damage could go much deeper than that… Social instability.

This is a great day in economics to hear Larry Summers forming a debate around effective demand.