What Causes Gluts and How Can They be Cured?

In Britain in 1818, a large decline in agricultural prices led to the severe depression of 1819, and the high levels of unemployment that followed led to general social unrest:

In August of that year, thousands of workers had demonstrated in the streets of Manchester. The British government had called out the armed forces and the demonstrators were brutally suppressed. Ten demonstrators were killed and many hundreds were severely injured in what came to be known as the “Peterloo Massacre.” This occurred just one year before the publication of the first edition of Malthus’s Principles. Malthus was extremely aware that depressions not only could but did happen in a capitalist economy; he was also well aware of the potential revolutionary danger of such labor uprisings. His single most important goal in writing the Principles was to promote an understanding of these crises, or gluts, and to propose policies to mitigate them. [History of Economic Thought, by E.K. Hunt]

Malthus answer was to explain how it was possible for the demand for goods and services to be less than the amount of goods and services produced – so his was a theory of deficient demand – and when that happened, goods would pile up in the marketplace and a general glut would ensue.

But why did this happen? Why did goods pile up in the marketplace and simply rot away (creatively) while so many people struggled to meet the necessities of life? His solution was to realize that the costs of production (i.e. the natural value of the goods) had to be equal to the income of the various classes in society, i.e. that the value of production had to equal wages plus interest plus profits (notice that rents are missing – more on that below).

He argued that labor is hired only if it produces a value greater than it is paid, so labor income alone won’t be enough to consume all that is produced. That leaves Capitalists and landlords to make up the difference.

Capitalists’ main desire was to accumulate capital, and to do that they needed to save. But the problem was that this led to a tendency for capitalists to save too much, more than there were profitable opportunities. Hence, some of the saving sat idle – imagine pieces of gold sitting in a safe somewhere doing nothing instead of being employed productively supporting new investments – and this led to deficient (or, as he called it, ineffectual) demand. [For classical economists, this couldn’t happen since the interest rate would adjust so as to draw all of the idle gold out of the safes and into profitable investment. Adam Smith argued that, “Whatever a person saves from his revenue he adds to his capital, and either employs it himself in maintaining an additional number of productive hands, or enables some other person to do so, by lending it to him for an interest, that is, for a share of the profits. . . . What is annually saved is as regularly consumed as what is annually spent, and nearly in the same time too; but it is consumed by a different set of people.” Of course both Say and Ricardo took this position as well, and later classical made clear how movements in the rate of interest would ensure that saving equals investment. Keynes response that money demand being greater than money supply in a temporary equilibrium would allow a general gut of goods even with Say’s law in place is a subject for another day.]

So capitalists did not consume enough. How to solve this? By moving income to landlords. Landlords could depend upon income from rent, and because of that, they consumed all that they earned – more rent would come in the next time period so they spent lavishly on “personal services”, there was no need to save. Importantly, this was unproductive consumption – landlords took from output but added noting to it – and hence they could be depended upon to make up the slack in demand if income could be shifted in their direction. Their was no danger than this class would save too much.

Here, then, was the solution. An important policy question of the day was whether the corn laws – tariffs on cheaper grain from France and other countries – were helpful or not. Malthus answer was that they helped. By raising the price of corn (i.e. grains), rents would increase and this would shift income to landlords. They would then buy up all the extra goods the capitalists had left idle by saving too much and the problem would be solved.

One question, though, is why Malthus didn’t advocate a transfer of income from capitalists who saved too much to workers who didn’t save anything. Why wouldn’t that have taken care of the problem?:

The only way to assure adequate effectual demand, then, was through some redistributional device, such as the corn laws, that would permit the landlords to receive more rent and thereby, through their own expenditures and those of their servants, to contribute more to aggregate demand without contributing to further increased production. Once again the economic welfare of all society depended on promoting the interests of the landlords. …

One final question remains: How did Malthus argue against a redistribution that would increase wages in order to increase aggregate demand? From his Essay on the Principle of Population, one might suppose that he would have argued that no social benefit would come of this because increases in the number of workers would simply push the workers back to the subsistence level. But as we have seen, in his theory of gluts Malthus abandoned his population theory, at least in the short run. Or, again from the Essay, one might suppose that he would argue that the increase in wages “would make every man fancy himself comparatively rich” and thereby create “a strong and immediate check to productive industry.” Although there were hints of the latter argument in the Principles, Malthus’s primary case against increased wages was contained in the following passage:

It is indeed most important to observe that no power of consumption on the part of the labouring classes can ever . . . alone furnish an encouragement to the employment of capital. No one will ever employ capital merely for the sake of the demand occasioned by those who work for him. Unless they produce an excess of value above what they consume … it is quite obvious that his capital will not be employed in maintaining them…. As a great increase of consumption among the working classes must greatly increase the cost of production, it must lower profits, and diminish or destroy the motive to accumulate. [History of Economic Thought, by E.K. Hunt]

Another way to say this is that rent adds to effective demand without increasing costs of production (which are comprised of wages, interest, and profits). Rent is a residual based upon the difference between the actual price and the costs of production. If you transfer income to laborers rather than landlords, costs of production would go up and that would undercut the competitive position of Britain on world markets.

Robert Frank, however, argues this isn’t so. Transferring money from the rich to the poor can, in fact, increase aggregate (effectual) demand, and it won’t lead to “a strong and immediate check to productive industry” as supply-siders claim:

Why Wait to Repeal Tax Cuts for the Rich?, by Robert Frank, Economic View, NY Times: On the campaign trail, Barack Obama said he wanted to eliminate the Bush tax cuts for top earners upon taking office in January. Now he seems to favor letting those cuts expire as scheduled, at the end of 2010.

His apparent concern is that raising anyoneâs taxes immediately might worsen the economic crisis. …

Of course, the governmentâs first priority must be to stimulate spending as quickly as possible, deficits be damned. But itâs important to get the biggest possible stimulus for any given deficit. To that end, it would make sense for Mr. Obama to stick with his original timetable. Eliminating the Bush tax cuts right away would make it possible to generate a much larger immediate increase in total spending.

Higher tax rates for top earners wouldnât appreciably reduce their spending. A robust finding in behavioral research is that people are extremely reluctant to accept cutbacks in their standard of living.

With few exceptions, high-income taxpayers earn substantially more during their lifetimes than they spend, generally bequeathing the surplus to heirs or charities. If these taxpayers faced slightly higher rates, they would have ample resources to maintain their current lifestyles, so most would keep spending as before. The only consequence would be that, years from now, they would leave smaller bequests.

The added revenue from eliminating the Bush tax cuts would pay for larger temporary tax cuts for low- and middle-income families than the permanent ones now planned. And because these families spend most or all of their post-tax income, the immediate effect would be an increase in total spending roughly equal to the additional revenue from repealing the cuts. …

In short, weâd get a lot more stimulus for any given budget deficit if we scrapped the Bush tax cuts immediately and steered the resulting revenue to people who would spend it.

Those who oppose repealing the cuts will offer the same argument they used to promote them during Mr. Bushâs first term…

In a nutshell, the claim is that low tax rates for top earners prompt small businesses to create jobs. Although this idea went largely unchallenged during the presidential campaign, it flies in the face of everything we know about the economic logic of hiring decisions.

It rests implicitly on the premise that business owners will hire new workers whenever they can afford to do so. What matters, however, is not whether owners can afford to hire, but whether hiring will increase their profit.

If the goods produced by additional workers can be sold for at least enough to cover their salaries, hiring makes economic sense, no matter how poor a business owner might be. But if additional workers wonât produce enough to cover their salaries, hiring is a losing move… The after-tax personal incomes of business owners are irrelevant in hiring decisions. …

In any event, the most important barrier to current hiring is … that not enough people want to buy what companies are selling. To eliminate this demand deficit as quickly as possible, the Bush tax cuts on top earners should be repealed right away, freeing money for more effective use.

Although the first concern of the new administration must be to get the economy back on its feet, economic justice was a central theme of Mr. Obamaâs campaign. …

The Bush tax cuts widened income inequality and drove deficits to record levels. … Economic fairness and economic growth are sometimes conflicting goals. But not here. Repealing the Bush tax cuts immediately is not just the fairest policy option but is also the most efficient.

We use new, and hopefully better tools of analysis, but very few, if any, of our political and economic debates are truly new.

Originally published at the Economist’s View and reproduced here with the author’s permission.