Econ 101: How Does it all End?

With new and expensive government programs being announced almost daily, I sense a little fatigue already about how much the government is doing. The housing plan in particular seems to be raising questions about moral hazard and how much the public should insure private risk. On OPBs "Think Out Loud" this morning I heard the opinion that hosing prices should be left to fall without intervention and this would help lower income people afford a home.

The problem with this argument is that if the housing market continues to fall and households net wealth continues to drop and banks continue to hoard capital, demand, which is already plunging, will continue to fall, businesses will fail and these lower income people are not going to have jobs to make them able to buy the houses.

But it does lead to a good question (that I was asked the last time I was on Think Out Loud and did a poor job of answering): if the government did nothing in terms of fiscal stimulus, housing market interventions, etc., how would the downward spiral end?

Well the classic Keynesian story is one of depreciation: over time households and firms who have resisted investment due to belt tightening find that their stuff is starting to wear out. For business this is their productive capital - the machines they use to make stuff to sell, and for households these are consumer durables - cars, washers and dryers, refrigerators and the like. Thus after some time people are forced to start to make these investments again and this starts to turn the tide. Add to this the fact that while households can economize, there is generally a minimal level of consumption that they need, so decreases in demand by households can only fall so far. But this can take a long, long time...

It should be noted (and Krugman has a nice piece on this) that the more typical (post-Keynesian) business cycle theory tells a story of recovery that is based on falling prices which makes the money supply too large and forces down interest rates and spurs on more investment and output. However, we are in a situation currently where the interest rate is a low as it can go and it is not spurring on this new investment. Essentially the aggregate demand curve is near vertical so this mechanism is no longer working.