Kelly writes

First, it is tempting, but probably mistaken, to assume the Great Recession came along and knocked the U.S. off an otherwise sustainable growth track. It wasn’t an external shock, but internal weakness, that led to the economy’s collapse.

One worrying aspect of GDP growth prior to 2007 was that it came even as real household incomes stagnated. Assuming that boom-era growth rates were sustainable, and not fueled by a surge in house prices and a credit boom that simply pulled forward demand from the future, is a huge leap in logic.

This, I believe, misunderstands the concept of aggregate demand.

Regular demand measures how much of something people are willing to buy given its price in terms of other stuff. That other stuff is competing goods, their labor, their assets, etc.

Aggregate Demand measure the total amount people want to buy given the price index. But, the price index is the cost of all goods in terms of money. This is explicitly a nominal measure.

For real demand of something to be too low, the real demand of something else would have to be too high.

Said another way the recession makes no sense as a response to a country that is fundamentally overextended. That’s because the US economy isn’t overworked, its underworked.

In 2007 138 Million Americans were working and producing stuff. US industrial capacity was running at around 80%. Office vacancy rates were running at about 12%. And, the US was producing around 11 million motor vehicles a year.

By 2009 – at the bottom of the recession – 129 million Americans were working. Industrial capacity was running at 67%. Office vacancies were running at 18% and the US was producing around 5 million motor vehicles a year.

So in those two years 9 million people stopped going to work. 13% of our factories and utilities shutdown. 6% of our offices were emptied out. And, our car companies churned out fewer than half as many vehicles.

There is no sense to the idea that if we were over-extended and had bought too much that what we should do in response is work and create less.

If you think about how a nation as whole gets over-extended it makes perfect sense how this would work. If the US as a whole were living beyond its means that means that we were borrowing money from abroad.

Suppose that suddenly came to a stop. China or whomever else decided they no longer wanted to fund profligate American consumption. The Chinese would dump US assets, the value of the US dollar would fall and the value of the Chinese Yuan would rise.

The price of Chinese goods in America would rise causing American consumption to fall. We would have to buy less foreign goods. At, the same time price of American goods in China would collapse and the Chinese would buy more American goods.

The net result would be that demand for American goods would rise and with it American employment. However, the consumption of foreign goods by Americans would fall.

In the end Americans would be working more and consuming less. Which is precisely what should happen if you have over-extended yourself. You should cut back on your own consumption and do more work.

However, that is not what is happening now. Americans are doing less work. This is in part because far from contracting the credit they are extending to America, foreigners have been more than willing to increase lending to America and the US dollar rose during the crisis rather than falling.

What’s happened instead is nominal shock. The circulation of money within the United States ground to a halt because of difficulties at the institutions responsible for turning savings into borrowing, banks. This causes savings to pile up while borrowing goes undone.

The result is that the economic wheel slows down. We have at once people consuming less and producing less. We have an economy where there is simply less exchange going on. It’s a less economy, economy and that’s reflected in the collapse of nominal GDP.  What the Fed needs to do is to get our economy back; to get the dollar value of total exchange back to where it was before.