Monday, September 6, 2010

The alternative to Keynesian stimulus

If prices or wages are "sticky," then following a drop in demand, you get excess supply.  Excess supply manifests itself  in the labor market as unemployment, and in the housing market as unsold inventory (currently over a year's worth).

There are two competing solutions to the problem:  (i) stimulus, which increases demand
Over the last 18 months, the administration has rolled out just about every program it could think of to prop up the ailing housing market, using tax credits, mortgage modification programs, low interest rates, government-backed loans and other assistance intended to keep values up and delinquent borrowers out of foreclosure. The goal was to stabilize the market until a resurgent economy created new households that demanded places to live.

or (ii) wait for wages or prices to fall:
As the economy again sputters and potential buyers flee — July housing sales sank 26 percent from July 2009 — there is a growing sense of exhaustion with government intervention. Some economists and analysts are now urging a dose of shock therapy that would greatly shift the benefits to future homeowners: Let the housing market crash.

When prices are lower, these experts argue, buyers will pour in, creating the elusive stability the government has spent billions upon billions trying to achieve.

A prices fall, quantity demanded increases, and quantity supplied decreases, until there is no more excess supply.


  1. The neat thing about #2 is that if you don't try to goose demand it will happen faster.

    The bad thing about #1 is you cannot raise demand indefinitely and by artificially holding prices up higher, you will only accumulate more bad investments that need to be liquidated when the fall eventually happens.

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