Revenge of the Aggregates

7 October 2008 at 2:59 pm 2 comments

| Peter Klein |

I first studied macroeconomics back in the dark days before the microfoundations revolution had filtered down into the undergraduate curriculum. We learned Y = C + I + G and that was about it. Fluctuations in aggregate demand cause fluctuations in aggregate output, Hayek be damned. Relative price changes — between markets at the same place in the time-structure of production, or between higher- and lower-order sectors — were completely ignored.

Supposedly mainstream macroeconomics has moved beyond this crude level of aggregation. But you’d never know if from the discussions of the last few weeks. “Banks” aren’t “lending” enough. “Businesses” and “consumers” can’t get “loans.” “Firms” have too many “bad assets” on their books. The key question, though, is which ones? Which banks aren’t lending to which customers? Which firms have made poor investments? Newsflash: a loan isn’t a loan isn’t a loan. I hate to break it to the Chattering Class, but not every borrower should get a loan. The relevant question, in analyzing the current mess, is which loans aren’t being made, to whom, and why? The critical issues revolve around the composition of lending, not the aggregate amount. Focusing on total lending, total liquidity, average equity prices, and the like merely obscures the key questions about how resources are being allocated across sectors, firms, and individuals, whether bad investments are being liquidated, and so on.

I like the way Michael Rozeff puts it here and here:

The Fed’s latest move is to lend directly to business firms by buying the commercial paper that they are unable to roll over except by paying higher interest rates.

Thus does the Fed bypass any market discipline and subvert the market for commercial paper, a major once-free and no longer free market for capital of maturity 1 year or less (usually 6-9 months.)

This move is inflationary. But since it props up (finances) companies that should not be getting capital at the rates it will charge them, it distorts business activity. I think it prolongs the depression because it prevents capital from flowing to entrepreneurs who may expand employment and gives it to those who apparently cannot.


Everywhere I read in the press that the Fed is “injecting” the sluggish or moribund credit markets with a “much needed dose” of confidence and liquidity. Some sort of credit B-12 cocktail from the 60s.

This level of thought is totally false. The Fed is supplanting capital market discipline and preventing the higher rates of interest that would bring forth more capital and also careful capital that seeks the economy’s better opportunities.

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2 Comments Add your own

  • 1. spostrel  |  8 October 2008 at 6:31 pm

    I had proposed a six-month offer to insure commercial paper from highly-rated non-financial companies rather than direct purchases of all CP by the Fed, but the logic is probably similar. Lots of companies whose default risks ex-panic really haven’t gone up and that use the CP market for working capital are going to have trouble conducting routine business when they can’t roll over their paper. They’ll probably survive, but a contractionary spiral will be set off as they cut back on their payroll and input purchases in order to de-lever themselves. The country would survive such a spiral, but it would be a lot more costly than avoiding it in the first place.

    There is no way to avoid the second-best problems in the financial markets caused by the previous role of the Fed, the regulators, Fannie and Freddie, FDIC, etc. Most of the bailout strikes me as a terrible idea; this Fed intervention seems more reasonable (even though I like my insurance proposal better).

  • 2. claudio mendes  |  14 October 2008 at 1:18 pm

    please i want know the influence of austrian ecnomics on edmund phelps thanks and best regards

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