Results for “aggregate demand wealth effect”
23 found

In the medium-run, supply- and demand-side stagnation stories are very similar

Paul Krugman argues the contrary here.  But let’s say there was a supply slowdown starting in 1999 or so, as reflected in wage and jobs data, masked a bit by the real estate bubble of 2004-2006 and with some of the productivity figures inflated for domestic purposes due to outsourcing.

If there is less produced, there are eventually perceived negative wealth effects.  What happens to demand?  It goes down, in this case with a lag because of credit.  Yes, it is a big mistake to assume Say’s Law always holds but it is an even bigger mistake to think it never holds.  Supply slowdowns are bad for demand, and they likely are bad for credit creation too, which hurts demand further yet.

There is no contradiction in a model where both aggregate demand and aggregate supply curves shift in unfavorable directions!  And in the medium run, each of these shifts pushes the other curve around too.

Let’s not forget that economies have real wage and price stickiness in addition to nominal stickiness.  That is another channel through which negative supply shocks can hurt aggregate demand and throw people out of work.

Krugman is worried about policy implications:

If labor force growth and productivity growth are falling, the indicated response is (a) see if there are ways to increase efficiency and (b) if there aren’t, live within your reduced means. A growth slowdown from the supply side is, roughly speaking, a reason to look favorably on structural reform and austerity.

But if we have a persistent shortfall in demand, what we need is measures to boost spending — higher inflation, maybe sustained spending on public works (and less concern about debt because interest rates will be low for a long time).

It’s not either/or.  Circa 2008-2009, we should have had a higher inflation or ngdp target.  We could do structural reform too, whatever you might think that means, obviously opinions will differ.  We could build productive infrastructure, boosting both supply and demand, and with little risk of default on the debt.  And yes, we might wish to cut some other government expenditures in the process (farm subsidies anyone?), with looser money to pick up the slack.  What we shouldn’t do is all that Keynesian ditch digging.  Even if you agree with the argument for it (and I don’t), it so hurts the reputation of legitimate government investment that we shouldn’t be going near it.  There are many, many other better things to do, including giving our government a reputation for careful project selection looking forward.

Simple textbook economics indicates that the AD-AS distinction makes the most sense in the short run.  Of course hysteresis is a mechanism by which low AD can over time translate into low AS as well, but the causation runs both ways, don’t forget that.

We are not as wealthy as we thought we were, and its consequences

Erzo G.J. Luttmer has an interesting new paper and model (pdf):

When consumers realize they are not as wealthy as they thought they were, they reduce consumption and save more. This lowers the real interest rate, making the development of new projects more profitable. The price of new projects rises relative to the price of consumption. The Stolper-Samuelson theorem therefore implies an increase in managerial wages, and a decline in worker wages. If the economy operates in a region where the supply of worker labor is sufficiently elastic, this can lead to a significant reduction in the employment of workers, while managers are reallocated towards developing new projects.

You should not believe in this to the exclusion of traditional aggregate demand channels, but still it is an interesting way to visualize some supplemental effects.  Note that workers who are quite good at building new projects will earn premia, while others, in the declining sectors, are losing their jobs.  That is not so different from the world we live in.

For the pointer I thank Paddy Carter.

Declines in demand and how to disaggregate them

Let’s say that housing and equity values fall and suddenly people realize they are less wealthy for the foreseeable future.  The downward shift of demand will bundle together a few factors:

1. A general decline in spending.

2. A disproportionate and permanent demand decline for the more income- and wealth-elastic goods, a category which includes many consumer durables and also luxury goods.  (Kling on Leamer discusses relevant issues.)

3. A disproportionate and temporary demand decline for consumer durables, which will largely be reversed once inventories wear out or maybe when credit constraints are eased.

Those are sometimes more useful distinctions than “AD” vs. “sectoral shocks,” because AD shifts consist of a few distinct elements.

If you see #1 as especially important, you will be relatively optimistic about monetary and fiscal stimulus.  If you see #2 as especially important, you will be relatively pessimistic.  You can call #2 an “AD shift” if you wish, but reflation won’t for the most part bring those jobs back.  People need to be actually wealthier again, in real terms, for those spending patterns to reemerge in a sustainable way.  Stimulus proponents regularly conflate #1 and #2 and cite “declines in demand” as automatic evidence for #1 when they might instead reflect #2.

If you see #3 as especially important, and see capital markets as imperfect in times of crisis, you will consider policies such as the GM bailout to be more effective than fiscal stimulus in its ramp-up forms.

Sectoral shift advocates like to think in terms of #2, but if #3 lurks the shifts view can imply a case for some real economy interventions.  I read Arnold Kling as wanting to dance with #2 but keep his distance from #3.  But if permanent sectoral shifts are important, might not the temporary shifts (we saw the same whipsaw patterns in international trade) be very important too?  Can we embrace #2 without also leaning into #3?

I wish to ask this comparative question without having to also rehearse all of the ideological reasons for and against real economy bailouts.  It gets at why the GM bailout has gone better than the fiscal stimulus, a view which you can hold whether you favor both or oppose both.

Note there also (at least) two versions of the sectoral shift view and probably both are operating.  The first cites #2.  The second claims some other big change is happening, such as the move to an internet-based economy.  If both are happening at the same time, along with some #1 and some #3, that probably makes the recalculation problem especially difficult.

I see another real shock as having been tossed into the mix, namely that liquidity constraints have forced many firms to identify and fire the zero and near-zero marginal productivity workers.

There’s also the epistemic problem of whether we have #2 or #3 and whether we trust politics to tell the difference.

The Germans had lots of #3 (temporary whacks to their export industries) and treated them as such, whether consciously or not, and with good success.  Arguably Singapore falls into that camp as well.  The U.S. faces more serious identification problems, whether at the level of policy or private sector adjustment.  We have not been able to formulate policy simply by assuming that we face a lot of #3.

I would have more trust in current applied policy macroeconomics if we could think through more clearly the relative importances of #1, 2, and 3.  And when I hear the phrase “aggregate demand,” immediately I wonder whether it all will be treated in aggregate fashion; too often it is.

Is current unemployment all about aggregate demand?

Christie Romer basically says yes, Arnold Kling dissents.

I don't expect Romer to turn a speech into an academic debate and in this sense I don't fault her.  Nonetheless I did not find her account very persuasive.

I would start with the fact that output has bounced back more robustly than employment has.  AD theories per se do not explain that differential.  One simple possibility is that better management and better measurement have allowed us to identify (and fire) hundreds of thousands of low-wage people who just weren't producing much of value.  That's a real shock, even if it does not qualify as a sectoral shift in the traditional sense.

It's also the case that the rate of new job creation has been especially low.  Yet the nominal wages on those jobs-to-be are not constrained by previous contracts or agreements.  Tell stories as you may, but it's hard for me to see that as exclusively an AD problem.

I wonder what is the behavioral postulate for how long all these unemployed workers are all staring jobs in the face yet persistently stubborn about their appropriate nominal wage.  I'm all for behavioral economics, but I don't buy the necessary story here.

I don't want to oversell the minimum wage hike + unemployment compensation extension + means-testing hypothesis here, but surely it deserves a mention as one relevant factor.  Those are real factors too.

I also see that wages, and the job market, are more flexible today than in a long time, with so much service sector employment, so much flex-time and part-time, and such a low rate of unionization.  In most AD theories that implies the job market bounces back relatively quickly yet that is not what we observe.

A separate question is what Romer believes the major AD shock to have been.  She clearly repudiates the Scott Sumner story that monetary policy was too tight.  Is it all from the collapsed bubble in the housing market?  Keep in mind those are paper values and that the real services from the country's housing stock haven't declined.  Again, you can tell behavioral stories about the asymmetric perception of losses vs. future gains (for many people, buying a future home is now much cheaper, though perhaps they don't notice the positive wealth effect), but is that going to drive the whole cycle?

To be sure, AD is a major factor in this recession but it is not the entire story by any means.  In major recessions usually it is AD and AS forces together.

Most of all, the Romer essay convinces me that current economic policymakers — not to mention many bloggers — should not be so certain they understand what is going on.

Addendum: I sometimes have the feeling that commentators on the left reject the "real shocks" hypothesis because they think it implies government can't do much to make things better.  That doesn't follow.  Most of what government does, for better or worse, is an attempt to solve a real rather than a nominal problem.  It might imply "intervention is less effective" but it also (possibly) can imply "intervention is more necessary."

Does crypto add to the money supply?

That is a reader request from Jerry Kate:

Is crypto effectively adding to M2 or M3 money supply and hence inflationary (outside the control and models of central banks), or is the velocity of crypto so low that it acts (like stocks) as a store of value having no impact on inflation? Will the answer to the prior question change if the market cap of crypto doubles or if crypto is tweaked to add velocity, or incorporated into the banking system to generate multiplier effects? Should central banks be worried?

I think you could ask this question of monetary economists, and get “confirmed” answers, yet the answers would disagree with each other.  My views are as follows:

1. If crypto prices are bubbles, they will encourage more spending and thus they would be inflationary, though only mildly so.  And that process could not continue for very long.  In the old school “Gurley and Shaw” sense, crypto is a kind of outside money and net wealth, and so spending will rise.

2. Alternatively, let’s say crypto assets have use cases that justify the current prices, but those use cases are not yet actively in use at this moment.  The crypto assets are then mildly inflationary now, but an offsetting deflationary impetus will kick in once those use cases arrive and lower the prices of goods and services in the marketplace.

3. Or, let’s say crypto prices are not bubbly, and are justified by current uses.  You then have a more or less offsetting boost in both aggregate demand and aggregate supply.

4. An additional question is whether the velocity of (traditional) money is higher or lower in the crypto sector.  I don’t know the answer to that question.  It is a possible effect, though probably not a major one.  If crypto soaks up money in a kind of “segregated from the real economy” shell game, it can be mildly deflationary.

5. Jerry also asks about “incorporating crypto into the banking system.”  That could mean a number of things.  Under one scenario, stable coins are told to become banks and then they are regulated like banks.  It would then be like having more money market funds, and that could be broadly inflationary on a modest, one-time basis, though of course you would have to compare the effects of those money market funds to the “wild west crypto effects” they were displacing.

Any other views or scenarios to consider?  Overall I don’t see this as a significant effect in quantitative terms, but it is nonetheless worth thinking through the logic of the question.

Tim Duy on desperately searching for a new strategy

I liked this recent Tim Duy post, the one that is everyone is talking about.  Do read the whole thing, but here is the closing bit:

We don’t have answers for these communities. Rural and semi-rural economic development is hard. Those regions have received only negative shocks for decades; the positive shocks have accrued to the urban regions. Of course, Trump doesn’t have any answers either. But he at least pretends to care.

Just pretending to care is important. At a minimum, the electoral map makes it important.

These issues apply to more than rural and semi-rural areas. Trump’s message – that firms need to consider something more than bottom line – resonates in middle and upper-middle class households as well. They know that their grip on their economic life is tenuous, that they are the future “low-skilled” workers. And they know they will be thrown under the bus for the greater good just like “low-skilled” workers before them.

The dry statistics on trade aren’t working to counter Trump. They make for good policy at one level and terrible policy (and politics) at another. The aggregate gains are irrelevant to someone suffering a personal loss. Critics need to find an effective response to Trump. I don’t think we have it yet. And here is the hardest part: My sense is that Democrats will respond by offering a bigger safety net. But people don’t want a welfare check. They want a job. And this is what Trump, wrongly or rightly, offers.

In part this is a question about helping these communities but if you read the whole post it is also about checking or preventing Trump and Trumpism.  My main disagreement is simply with the view that a solution is difficult.  It is not, rather most people are unwilling to accept the solutions on the table.  In fact I have a more or less bulletproof two-part remedy.  I’ll phrase it in backward-looking terms, but it is not hard to divine the forward-looking implications, noting that in the short term we have the president-elect we have no matter what.  Here goes:

1. In 2012, have five percent of Democratic voters switch their support to Mitt Romney, so that Romney is elected.  You don’t have to think Romney would be a better president than Obama has been, but a Romney election almost certainly would have forestalled the rise of Trump.  The worse you think Trump is, the more you should support this kind of “change we can believe in.”

If you don’t favor this retrospective change, you’re not very pragmatic (or you might really like Trump), perhaps preferring to consume your own expressive views than to improve the world.  That’s a common enough preference, and maybe it is even morally OK, but let’s recognize it for what it is: a deliberate lack of interest in solving the major problem before us, instead preferring to focus on your own feelings.  It’s not that different than the wealthy wishing to keep their tax cuts.  And if your response is something like “But the Republicans started this whole mess, why should I reward them?”, well, that is yet another sign you are far from the pragmatic, reality-oriented perspective.  At the very least, you should be regretting that you did not vote for Romney.  Unless of course you did.

A complement to this strategy, looking forward, is to have the Democrats run more conservative candidates, including those with a more conservative cultural garb.  They still can support a social safety net.  And, my friend, if you are tempted to suggest that Hillary Clinton was such a candidate, you need to attend Ross Douthat University for remedial lessons.

Another way to put this point is that Democrats (and some others) need to become more like the more sophisticated libertarians, namely to realize you won’t win but need to settle for what you can get.  At least increase your “p” that is the case, as the European left is finally starting to do.  I know that comes hard, but again our country is at stake.  And there is a lesson for libertarians too, more or less in the same direction, namely that potential backlash to libertarian ideas is stronger than we had thought, even for those with a fairly weak libertarian bent, and thus there is less absolute scope for their realization.  Sad!

Many progressives and libertarians have one thing in common, namely assuming that human affairs can be more governed by reason than ever will be the case.

2. Support a voluntary temperance movement for zero alcohol, zero drugs.  No exceptions.  Make these commodities less socially available, less widely advertised, less diverse in supply, and less glamorized on television and in the movies.  Take away the demand, and along the way praise Islam and Mormonism for their stances on this.

That’s so simple, isn’t it?  No one argues that the Rust Belt communities and the like are unacceptably “income poor” by global standards, rather they have wrenching social problems.  A temperance movement, insofar as it succeeds, would eliminate a significant share of those tragedies.  It would mean less alcoholism, fewer opioid addictions, less crime and spouse beating, and so on.  Consider the impact of this on America’s inner cities as well.  It’s hard to estimate how many of the problem users would stop if say 70 percent of America went “cold turkey,” but surely we should give this a try.  For instance, even less educated Americans smoke at much lower rates than they used to.

Do you really care about suffering Americans?  The answer is staring you right in the face, but are you brave enough, altruistic enough, and contrary enough to embrace it?  Again, you might like your evening glass of wine, or joint, but that is also like the wealthy seeking to keep their tax cuts.  It really is the same logic, like it or not.

From another direction, here are comments from Paul Krugman.  I agree with most of what he says, though I would stress the points above.

Paul Krugman on Brexit and falling investment

I think there is a pretty simple story here.  Brexit increases uncertainty, both in the mean-preserving sense, and in the “very bad outcomes are now more likely” sense, and that lowers investment.  That in turns shifts back the aggregate demand and aggregate supply curves, and a recession may result.  Less than a year ago, MIT economist Olivier Blanchard published a major paper on capital inflows being expansionary, and now of course we are seeing the reverse.  Toss in some negative wealth effects for further transmission.  I was at an event in The City a few days ago where the anecdotal data about postponed or cancelled deals seemed pretty overwhelming, and this is consistent with what one reads in the papers as well, not to mention with basic economic theory.  It is true of course that we don’t know how large these effects will be, but the more purely British measures of equity value are still down quite a bit.

Krugman is usually an exponent of the “don’t make things too complicated” approach, but here in this blog post he wants to…make things too complicated:

Second, doesn’t this argument imply a later investment boom once the uncertainty is resolved in either direction? That is, once Prime Minster Farage and President Le Pen have engineered the demise of the EU, there’s no reason to wait, and all the pent-up investment comes roaring back, right? But I haven’t heard anyone arguing that the contractionary effect of Brexit will be followed by a compensating boom once things settle down.

Third, doesn’t this argument suggest essentially the same effects from any policy negotiation whose end result isn’t known? Why don’t we say that the possibilities of TPP or TTIP are contractionary, because firms have an incentive to postpone investment decisions until they know whether these agreements actually happen? Somehow, though I’ve never heard anyone argue for the depressing effects of pending trade liberalization.

It is true investment might bounce back if Brexit were essentially undone, but that is hardly an argument for Brexit.  The UK economy is about 85 percent services, those are currently “passported” into the rest of the EU, and it is very very hard to negotiate a new free trade agreement for services in anything like a timely manner, even when passions are not inflamed and there are no considerations of punishing other possible EU-defecting countries.  So if you read someone writing “…after Brexit, the UK will face an average tariff rate of only xxx…” that is a sign they are not thinking hard enough about how trade agreements for services really work.

(Note also the subtle point that when financial and business services are being sold, the difference between “FDI falling” and “trade and exports falling” is quite a subtle one.  Most of all, the traders of these services are investing in ongoing relationships.  The decline of trade and the decline of investment are two ways of talking about the same contractionary process, it is not as if FDI falls, the exchange rate falls, and then trade then rises to pick up the slack, at least not in the UK-EU context.  What is happening is that a negative shock to both trade and investment is coming up front, and then the British pound falls; the second-order response to that currency decline won’t undo the initial problem.)

On whether the same macroeconomic logic applies to other trade agreements, many investors may be playing “wait and see” before doing more FDI in say Vietnam.  But still the very prospect of TPP in the meantime should not be lowering the chance of such investment in Vietnam because TPP represents some chance of a positive-sum advance.  The potential loser is more plausibly China, and one does read about this effect.  Investors may be less likely to set up plants in China because they are waiting on news about the options in lower-cost Vietnam.  Of course given the relative sizes of China and Vietnam, this is unlikely to be a very large effect, but it does exist and it is already discussed.  In contrast to that example, the EU is by far the biggest trading and FDI partner for the United Kingdom, and the prospective trade change is negative-sum rather than positive-sum.

What is most striking about Krugman’s post is how many Krugmanisms are completely absent from it.  I mean recent Krugmanisms, this isn’t some kind of 1990s nostalgia (not today at least).  Here are a few Krugmanisms which appear to be missing in action:

1. The EU is quite indecisive, it just kicks the can down the road and doesn’t resolve much uncertainty.  Why not expect the same when dealing with the uncertainty from Brexit?

2. Just apply the AD-AS model quite simply, and follow it where it leads you.

3. How about increasing returns to scale?  A lot of the UK exports to the EU are finance and business services, both areas which are plausibly based on clustering and scale economies.  An initial whack to a clustered IRS sector can have quite significant long-run consequences, even if some or maybe even all of the initial penalty is reversed.  This is part of what Krugman won a Nobel Prize for, admittedly I am hearkening back to the 90s and indeed 80s here but Krugman has cited this argument many times much more recently.  This is also another reason why higher trade won’t make up for the investment shortfall, because the investment shortfall stifles the prospects for future high value-added trade.

4. The gravity equation.  The pound has depreciated, but the EU is the UK’s natural trading partner, for reasons of distance, and the UK is unlikely to make up the difference by exporting more to the rest of the world.  Export adjustment from currency depreciation won’t in general neutralize the impact of investment-destroying and EU-trade-destroying policy changes.

5. What about the multiplier?  Isn’t the multiplier HUUGE in economies at the zero bound?  And isn’t that the UK?  And Cameron already has announced, plausibly in my view, that the UK won’t be meeting its forthcoming revenue targets.  Won’t that result in a form of additional austerity sooner or later?  With yet further multiplier-based negative macroeconomic consequences?

Where is the multiplier?  I want my Paul Krugman back!

Going broader lens here, and moving away from Krugman, what I notice is many of the less academic Keynesians becoming less and less comfortable making arguments about deficient or contracting investment.  C + I + G + X is ever so slowly morphing into C + G + X, at least in popular discourse.  That is odd, because Keynes himself was most concerned with the instability of investment.  It seems that these days however to worry about investment is to sympathize with capitalists, and perhaps to even wish to keep more resources in their hands.

I want my investment back!  It is no accident that Keynes’s solution was to nationalize investment, not to redistribute away from capital per se.  But nationalizing investment isn’t very popular these days, and so the vitality of capitalism and capitalists once again becomes — or should become — an important issue.

My macroeconomic framework, circa 2015

A while ago Scott Sumner laid out at least part of his framework, I thought I should lay out some key parts of mine.  Here goes:

1. In world history, 99% of all business cycles are real business cycles.  No criticism of RBC can change this fact.  Furthermore the propagation mechanism for a “Keynesian business cycle” (arguably a misleading phrase) also relies on RBC theory.

2. In the more recent segment of world history, a lot of cycles have been caused by negative nominal shocks.  I consider the Christina and David Romer “shock identification” paper (pdf, and note the name order) to be one of the very best pieces of research in all of macroeconomics.  Sometimes central banks tighten when they shouldn’t, and this leads to a recession, due mainly to nominal wage stickiness.

3. Workers are laid off because employers are often (not always) afraid to cut their nominal wages, for fear of busting workplace morale, or in Europe often for legal and union-related reasons.

4. Overall I favor a nominal gdp rule for monetary policy.  But most of its gains would come in a few key historical episodes, such as 1929-1932, or 2008-2009.  In most periods I don’t think we know what the correct monetary policy should be, nor do we know that it matters.  Still, that uncertainty does not militate against an ngdp rule.

5. Once workers are unemployed, nominal wage stickiness is no longer the main reason why they stay unemployed.  In fact nominal wage stickiness is largely taken out of the equation because there is no preexisting nominal wage contract for these workers.  There may, however, be some residual stickiness due to irrational reservation wages, also known as voluntary unemployment due to stupidity.  (You will find a different perspective in Scott’s musical chairs model, which I may cover more soon.)

5b. Monetary stimulus to be effective needs to be applied very early in the job destruction process of a recession.  It is much harder to put the pieces back together again, so urgency is of the essence.

6. The successful reemployment of workers depends upon a matching problem, a’la Pissarides, Mortensen, and others.  Yet this matching problem is poorly understood, and it can involve a mix of nominal and real imperfections.  Sometimes it is solved more quickly than expected, such as in the recent UK experience, and other times more slowly than expected, as in current Spain.  Most of the claims you will read about this reemployment of workers are wrong, enslaved to ideology or dogmatism, or at the very least unjustified.  Hardly anyone wants to admit this.

7. Really bad recessions involve deficient aggregate demand, negative shocks to intermediation, some chronic supply-side problems, negative wealth effects, and increases in the risk premium, all together.  It is hard to find a quick fix.  Furthermore models where AS and AD curves are independent and separable are often misleading, despite their analytic convenience.

8. Given that weak AD is only one of the problems in a bad downturn, and that confidence, risk, and supply side problems matter too, the best question to ask about fiscal policy is how well the money is being spent.  The “jack up AD no matter” approach is, in the final political equilibrium, not doing good fiscal policy any favors.

9. You should neither rule out nor overstate the relevance of Hayek and Minsky.  Their views have much in common, despite the difference in ideological mood affiliation and who — government or the market — gets blamed for the downturn.  For really bad recessions, usually both institutions are complicit to say the least.

10. All propositions about real interest rates are wrong.

There is more, but I’ll stop there for now.

Does it reflate economies if all nations increase their exports?

The Germans lecture the periphery to engage in structural reform and increase their exports.  A variety of IS-LM Keynesians strike back and note that not all nations can increase their net exports, therefore it is a kind of zero-sum game which won’t boost aggregate demand overall.  This is sometimes followed by blaming the Germans for soaking up aggregate demand from other parts of the world.

But that Keynesian counter is a mistake, perhaps brought on by the IS-LM model and its impoverished treatment of banking and credit.

Let’s say all nations could indeed increase their gross exports, although of course the sum of net exports could not go up.  The first effect is that small- and medium-sized enterprises would be more profitable in the currently troubled economies.  They would receive more credit and the broader monetary aggregates would go up in those countries, reflating their economies.  (Price level integration is not so tight in these cases, furthermore much of the reflation could operate through q’s rather than p’s.)  It sometimes feels like the IS-LM users have a mercantilist gold standard model, where the commodity base money can only be shuffled around in zero-sum fashion and not much more can happen in a positive direction.

Second, the higher (gross) exports and higher quantity of trade overall would produce positive wealth effects.  This too would reflate economies through a variety of well-known mechanisms, including but not restricted to the easing of collateral constraints.

In other words, it can help reflate all or most of the economies if they increase their gross exports, even though net exports are a zero-sum magnitude.

This interpretation of the meaning of zero-sum net exports is one of the most common economic mistakes you will hear from serious economists in the blogosphere, and yet it is often presented dogmatically or dismissively in a single sentence, without much consideration of more complex or more realistic scenarios.

*House of Debt*

That is the new book by Atif Mian and Amir Sufi and the subtitle is How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again.  As the title suggests, the argument focuses on household debt and also its subsequent effects on aggregate demand.  Here is one bit:

From 2006 to 2009, large net-worth-decline counties cut back on consumption by almost 20 percent.  This was massive.  To put it into perspective, the total decline in spending for the U.S. economy was about 5 percent during these same years.  The decline in spending in these counties was four times the aggregate decline.   In contrast, small net-worth-decline counties spent almost the exact same amount in 2006 as in 2009.

There is much in this book of interest, but the problem is on the theoretical side.  High debt means higher payments to banks and other intermediaries, and so that money need not disappear from the stream of aggregate demand.  Investment is AD too, and more generally AD theories based on short-term changes in the distribution of wealth have not generally succeeded in the past (with apologies to Michael Kalecki).  It is true that wealth redistribution will induce sectoral reallocations, perhaps significant ones, but then a debt-collapse theory requires a lot of the predictions of sectoral shift theories.  At least for the recent crisis that is not obviously going to do the trick, even if sectoral shifts have been underrated by a lot of Keynesian commentators.

I would sooner start the foundations with multiple equilibria and then add on the Swedish and also Hayekian notion of intertemporal equilibrium, period analysis, and satisfied plans, or lack thereof.  Excess household debt then can slot into that argument neatly, and without putting so much burden on wealth redistribution and sectoral shifts per se.

In any case this is a book worth reading and pondering.  You can follow Sufi on Twitter here.

Would abolishing cash help cure AD problems?

Miles asks about this on Twitter.  Earlier in the year, Matt wrote:

Stop for a moment and ask yourself why the interest rate can’t be reduced much below 1 percent. The trouble is cash. At any given time, relatively little paper currency circulates in the United States. Instead, most of the American money supply consists of bank accounts and other electronic stores of value. People prefer to keep money in bank accounts because it’s convenient and because you get interest on it. If the rates were driven below zero—in effect a tax on holding cash in the bank—people would just withdraw money and store it in shoeboxes instead. But what if you couldn’t withdraw cash? What if all transactions were electronic, so the only way to avoid keeping money in a negative-rate account was to go out and buy something with the money? Well, then, we would have solved our depression problem. Too much unemployment? Lower interest rates below zero, Americans will start spending and investing again, the economic will grow, and unemployment will go back down to its “natural rate.”

Ryan Avent comments.  A few points from me:

1. Even pure cash can be taxed, if we are willing to go the goofy route.  A stochastic declaration of “counterfeit,” based on serial numbers and scans, is one way to go.

2. Technologically speaking, it is possible to run virtually all transactions without cash, or it will be quite soon.  That said, for this to work as stated, you would need to run all transactions without cash or the option of cash.  How many millions of Americans do not even have bank accounts much less smart phones?  This is more likely to work in Singapore or Denmark, at least for the foreseeable future.

3. You could have currency or some currency equivalent continue to exist in the black market economy, with penalties for ordinary citizens caught holding currency.  (Which would probably not be popular on Fox News, and furthermore in Tennessee imagine all that talk of Book of Revelation, “Mark of the Beast,” etc.)  Even so, you still end up with a currency-bonds margin and most likely with lower nominal interest rates in that equilibrium; if the law taxes currency holdings there is less need for equilibrium to require a high nominal interest rate.  I am not sure why this should be so desirable for monetary policy.

Furthermore, under some views, this proposal would in essence put monetary policy in the hands of the drug trade.  Cracking down on drug lords, or easing up on them, would become major monetary policy instruments, at least if you take the Fama-Sumner view that currency has special potency over the price level.

4. I do not myself believe that currency per se has such extreme power over aggregate demand, at least not in such a credit-intensive economy as ours.  That means this proposal doesn’t get at the heart of the AD problem, which is closely linked to credit creation.  But if you disagree with me on this one, you end up back at #3.

5. What do we really know about money demand anyway?  Cooley and Leroy (1981) is still worth reading.  Under one plausible view, you get sustainable increases in velocity, aggregate demand and investment when people feel safer and wealthier, not when you tax them more.  It’s fine to say “we don’t know,” but I get nervous when macro stabilization policy is relying so directly and so relentlessly on money demand effects.

6. I don’t see how this proposal could work unless it is applied globally, which seems implausible.  If your dollars are being taxed some extra amount, just put them in a foreign bank to earn zero or do some kind of funny quasi-repurchase agreement, with a foreign bank, to avoid having formal ownership of the dollars on the days of the tax.

On net, it is an interesting idea, but I wouldn’t actually do it.

Addendum: Scott Sumner comments (I don’t myself think the monetary base is so special, and if pre-2008 wasn’t a problem, that is why).

Bubbles and economic potential and potential gdp

Here is a Krugman post on the question, here are earlier posts from Sumner and Yglesias.  I will put my remarks under the fold…This topic is easiest to understand if you sub out the United States and sub in Greece.  There is no AD boost that can (anytime soon, without a lot of extra growth kicking in), restore Greece to its previous output peak and its previously expected performance-to-come.  Circa 2006, Greece was in an unsustainable position, if for no other reason the market didn’t understand the correct risk premium for Greece.  Once the correct risk premium is applied, Greek output falls and furthermore numerous (related) bad events kick in and also a whole set of previous plans are shown to be unsustainable (and no this doesn’t have to be an Austrian argument!).  The gap between Greece’s current path, and the path previously envisioned for Greece is thus:

a. part AD gap which can be fixed by AD policy

b. part a difference in risk premia, and for Greece the old risk premium, when the country borrowed at very low rates, was wrong and is gone more or less forever.  The concomitant financial and fiscal stability is gone too.

c. part a difference in enthusiasm in supply, based on the differences between earlier expectations that “get rich quick” really does apply to Greece, and the current more pessimistic expectation that “get rich quick” is now unlikely, and thus “smaller-scale, scrabble-around projects just to make ends meet” are the order of the day.  DeLong gets at some of this here.

Greece does have to rebuild a) — don’t get sucked into aggregate demand denialism! — but it also has to rebuild b) and c) and perhaps other factors too.  This follows rather directly from — dare I breathe the words? — the synthetic real business cycle/neo Keynesian models which form the backbone of contemporary macroeconomics and which Krugman apparently still doesn’t wish to recognize.  (To various commentators and other bloggers: when I write macro on this blog I usually take knowledge of these models for granted; if you don’t know those models that is fine, call me arcane, but it doesn’t mean I am the one who is wrong.)   Krugman runs through a bunch of weak arguments and responses, and counters them well enough, but he doesn’t see or consider the baseline response that would follow from standard contemporary macro, with the possible exception of his brief parenthetical phrase about credit conditions.

Turning for a moment to broader points, the astute reader will note that in this framework the current sluggishness of recovery need not be evidence for Old Keynesianism.  An ineffective response to fiscal policy does not per se have to mean we just didn’t do enough fiscal policy.  And so on.  Maybe yes, maybe no, but all of a sudden there is a lot more room for agnosticism about macroeconomics and more broadly there is more room for epistemic modesty.

Contra Tim Duy, you can hold this mixed view without wanting to see the Fed raise interest rates.  Just avoid the AD denialism.

Krugman defines “potential GDP is a measure of how much the economy can produce” but keep in mind that this quite possibly won’t be a unique number.  With what risk premium?  With what enthusiasm of supply?  See my Risk and Business Cycles for an extended discussion and also numerous citations.

It’s also worth noting that while gdp is a useful “we can all agree upon what to measure” kind of concept, its real meaning is conceptually fairly slippery and “potential gdp” is not likely to be better pinned down at its foundations.  Let’s not reify that concept above and beyond what it is worth.

In any case, we can be agnostic about the size of the potential gdp gap with regard to the United States today and indeed my original post very carefully used a question mark in its title.  But there is no incoherence to assert that part of the apparent gap is due to the real side.  The new learning about America is not about the correct risk premium for our debt (not yet at least), but about our financial fragility, how well our politics responds to crises, some worrying long-term trends in the labor market, possible misreadings of the productivity numbers, and a few other real factors.  It really is possible that previous investment plans were based on expectations of the real economy that were wrong and unsustainable and now have been (partially?) corrected, with negative growth penalties looking forward.

Stephen Williamson offers very detailed comment, noting also that the recession started well over four years ago, which gives plenty of time for nominal resets, and we’ve seen no downward cascading spiral, so maybe there is a non-AD problem with getting back on track at the preferred rate.  He also eschews AD denialism.  Today Krugman has a brief note along the lines that the views of his opponents on these questions are “even worse than your first impression” but that is best thought of as a) his occasional churlishness, and that b) his writings on this topic do not, at least not to date, reflect a very thorough knowledge of the relevant literature(s).

Unoriginal, but simple, true, important, and neglected

Jesús Fernández-Villaverde, Pablo Guerrón-Quintanaz, and Juan F. Rubio-Ramírez report:

This paper examines how supply-side policies may play a role in fi…ghting a low aggregate demand that traps an economy at the zero lower bound (ZLB) of nominal interest rates. Future increases in productivity or reductions in mark-ups triggered by supply-side policies generate a wealth effect that pulls current consumption and output up. Since the economy is at the ZLB, increases in the interest rates do not undo this wealth effect, as we will have in the case outside the ZLB. We illustrate this mechanism with a simple two-period New Keynesian model. We discuss possible objections to this set of policies and the relation of supply-side policies with more conventional monetary and fi…scal policies.

Yes, there exists a model where the productivity shock has negative consequences, but don’t let “them” talk you into believing that model is relevant for today’s world.

Capital depreciation as stimulus?

Let’s say the U.S. becomes another Japan or for that matter let’s say Japan has become Japan.  Still, we all know that capital depreciates.  That raises the return on replenishing and rebuilding the capital stock.  Even though wealth is falling, it raises the marginal rate of return on investment.  Which in turn should spur aggregate demand and also credit creation.  At some point you have to get the roof fixed.  If alien invasion can work, what about a slower rotting away of the same output?

That’s a slow, ugly and painful way to end a downturn, but the deeper question is whether it will work at all.  It doesn’t seem to have worked in Japan and they’ve had enough time for a lot of capital to rot away. This paper measures depreciation rates (for America) and estimates that physical capital, without repair, has an average survival time of thirteen to sixteen years.

Why has it not worked in Japan?  I see (at least) two options:

1. The boost to aggregate demand has to be based on sustainable increases in real wealth, rather than deteriorations in wealth.  Maybe so, but then monetary and fiscal policy won’t work either, or more accurately the fiscal policy will work only if the resulting outputs are fairly valuable.  Keynesian pyramids won’t do the trick.  Of course, people who stress “the broken window fallacy” will likely side with this response.

2. As the capital stock depreciates, it is repaired slowly but steadily, enough to keep the MP of K from rising very much and thus there is enough capital replacement to thwart recovery.  (People who stress “the broken window fallacy fallacy” may prefer this option!)  That sounds plausible, but if I think about it long enough my worries multiply.

The argument implies that the real problem is low and enduring real rates of return, and not simply that a monetary trick is distorting those rates of return.  The marginal real rate of return keeps on creeping up and the decisions of investors keep on pushing it back down, but only so much; apparently the economy wants to stay in this low output, low rate of return corridor.  That’s closer to a TGS story than to a “we can fix this with AD” story.  (Alternatively, do you wish to argue that there is a collective action problem with the slow accretion of the “investment of repair” and that we should tax it and save it all up for one big bang of recovery?  I can see the model but does anyone actually believe this?)

Does the argument imply a funny non-linearity?  It implies that, say, a stimulus of $2 trillion will be more than twice as effective as a stimulus of $1 trillion.  Bombs falling are better than slow rot, and so on.  That could be true, but I see a lot of hand-waving on the issue.  It would seem to boil down to psychology and multiple equilibria (“the confidence fairy”?) and thus I am suspicious of very definite predictions along this particular dimension.  Of course, sometimes bombs really wreck a place; ever been to Bosnia?

It is worth pondering our views on capital depreciation and whether they are consistent with our other beliefs about macroeconomics and also about Japan and why it has remained in its downturn so long.

By the way, measured private investment has not really risen since 1998.

Another look at why both AD and AS matter

Often I read blog posts by other economists, using the AD-AS model.  The implicit assumption is that there is either too little AD, or too little AS, but the two problems do not and indeed cannot exist together.  If the economy is well-described by these two curves, that is indeed the implication: if AD is shifted in too far to the left, how can there be too little AS?

I suggest a slightly more complex model.  During the financial crisis the American economy took a big AD hit due to debt overhang, falling asset prices, unemployment, imperfect monetary policy, credit contraction, and several other factors.  After the peak of the crisis there were massive layoffs, largely because of these AD problems, toss in an increase in the risk premium and perhaps higher fixed costs of employing people.  A lot of the labor market problems from this hit still have not been cleaned up, and furthermore with lower net wealth many of these jobs are never coming back, with or without monetary stimulus.

Now fast forward.  These days, the layoffs are no longer so frantic, but the rate of new job creation is slow.  Some of the unemployed (not all) could find new work by moving to North Dakota or Australian mining communities, but few of them will do so, mostly for the obvious reasons.  They are waiting for good, new jobs in areas they are willing to live in.  But slow underlying rates of innovation mean slow job creation and so many of these unemployed continue to wait.  It also means a very low quit rate, which we have observed too, because employed workers can’t so easily step into new jobs.

The economy still has a problem with weak AD.  The economy also has an ongoing problem from weak AS.  Both are true, though you won’t see this if you think those two AD and AS curves sum up the whole picture.  Again, it is about the disaggregated aggregate demand.

Thinking even a little bit hard about the derivation of the AD curve (especially in “p space” rather than “p dot space”) should cure one of the tendency to take these models too literally.  Note also that most AD-As models are not integrated with growth theory, though the Modern Principles text with Alex is a big exception here.

Here is further simple proof, using seasonal data, that both blades of the scissors matter.  Via Matt Yglesias, here is a iscussion of how productivity growth in the recovery — if you could call it that — is lagging behind other U.S. business cycles.

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