How uncertainty reduces investment
In this environment, an increase in uncertainty--a mean-preserving spreading-out of ex ante investment project return distributions--causes a greater share of investment projects to fail to make the 1/β guaranteed gross-rate-of-return hurdle. So production of investment goods falls...
...and production of consumption goods rises, as labor is redirected.
There is no employment-reducing fall that I can see in aggregate supply in response to an increase in uncertainty. Yes, there is a structural readjustment as investment-goods industries shed labor and consumption-goods industries gain labor. But this is no more a fall in aggregate supply that leaves an extra 5% of the labor force with nothing productive to do than there was a fall in aggregate supply earlier, when perceived uncertainty fell and labor moved into investment-goods production--remember, back when financial engineering guaranteed by S&P and Moody's offered a way to create more of the AAA assets that the representative worker wanted to hold. There is a fall in aggregate supply in the sense that the value added by investment projects falls--but that fall shouldn't have implications for employment.
I think Brad is assuming I've fallen into the "Paul Krugman is right and Austrian Business Cycle theory is wrong" trap, but it's a different story. I have in mind a model of costly-to-reverse investment where many entrepreneurs decide to wait. It's also the case that producing consumption goods can be risky, even non-durable consumption goods: look at the decline in the number of luxury food items in a Whole Foods over the last few years. Brad may not be convinced, but there's no logical problem in the story.
Here is one of the empirical pieces on how uncertainty reduces investment and yes RW this is also a negative supply shock, as it makes extant resources less productive, at least for the time being. Here are more papers in the area. Here is one recent relevant model or see the papers of Robert Pindyck. Again, I don't wish to push "uncertainty" as the only story, it's rather the simplest means of seeing that it's not all just about weak aggregate demand.
Scott Sumner likes to scream from the rooftops about how Bernanke has forgotten his previous work on monetary economics. I like to note that there is more than one -- indeed more than two -- Ben Bernankes. He wrote his MIT dissertation on uncertainty and irreversible investment. One of the Ben Bernankes I follow is in part a real business cycle theorist.
Brad also writes:
...the cost of borrowing for the government has fallen--the market value troday of future cash tax flow earmarked for debt repayment has gone way, way up--therefore we should dedicate more future cash flow to debt repayment by borrowing more. There is no "but even." Expansionary fiscal policy is a good idea.
I'll blog more on that soon, in a separate post. For the time being I'll repeat my point that the monetary authority moves last anyway, so it's ultimately a matter of monetary rather than fiscal policy, whether we like that fact or not.