What will drive future growth?

Simon Johnson asks:

…if finance doesn’t drive growth, what will…?

You'll
also read many commentators breaking national income into its components of C,
I, G, and X-M (consumption, investment, government spending, and net exports) and asking where the growth will "come from" to "drive"
the recovery.  Of course national income accounting is an identity, so this cannot be a nonsensical question.  Yet when the word "drive" is used, we are smuggling in a causal category.  There is no guarantee that any particular decomposition of the national income identities the relevant causal components for what will "drive" recovery.  How would it sound if you aggregated national income by zip code or county (or household) and asked where the boost to drive recovery would come from?  Such an approach might not be on the right conceptual track.

You'll also see discussions of how exports or real estate construction usually precede a more general recovery.  There is then a fear of when or how those trends will come about.  But again, are those the causal factors for thinking about economic recovery?  It was Chinese demand for exports which pulled Japan out of its lost decade but overall I am less convinced of the causal role of exports per se.  Healthy exports are often a symptom of good outcomes, not a cause.

Slipping back and forth between national income identities and causal relationships was one of the big problems in Keynes's General Theory.  I worry that we still see this tendency in macroeconomic thinking.

There are two key questions I ask in a downturn: what will boost aggregate demand? and what will cause a better matching of the particular components of C and I?

The answer to the first is usually "nominal money."  The answer to the second is trickier and harder to encapsulate in a few letters (C, I, G, X-M) or in the mention of an economic sector or two.

A third question might be: which factors are hindering confidence and thus recovery?  Sometimes the answer to this question works through the channel of monetary velocity and the relaxation of "wait and see" investment strategies.

None of these questions deny the relevance of aggregate demand macroeconomics.  But also none of these questions focus our attention on the C, I, G and X-M aggregates per se, except of course for nominal money.

These questions offer a framework for thinking about fiscal policy.  By mobilizing new M into a more rapid V, fiscal policy can boost aggregate demand.  And maybe you like how the money is being spent by the public sector (that's a separate debate).  But unless the new flow of spending is permanent, or can be turned off in a very smooth fashion, it creates temporary bubbly-like conditions in the recipient sectors and that is cause for concern.  You get a better matching of C and I in the short run, but maybe not a better matching for the longer run.

Comments

I read this sort of stuff and wonder: do any of the leading economists of the day have any background in the natural or engineering sciences? Or even logic?

"...if finance doesn’t drive growth, what will...?"

Drugs?

The solution to our economy? Get more letters!

What gets a healthy economy at this point forward is transportation efficiency, add a T.

Great post, Tyler. In my brief teaching stint, I tried to make this point (about tautologies versus causality) by "proving" that if equipment depreciation went up, so would GDP. (You can rewrite gross investment as net investment + depreciation, with GDP on the other side of the equation.)

Kudos to jimi!

The expansion will be driven by HOPE and CHANGE.

Finance (financial services industries) cannot drive (economic) growth. That is precluded by new (idiotic) credit card regulations and the new (destructive) regulatory structures proposed. The financials' problems are more than executive pay, bonuses, ACORN-paid pitchfork-wielding patriots, Credit Default Swaps or toxic loans.

Banks and thrifts are over-regulated and suffer from severely restricted margins, which cannot compensate capital for the multitude of risks incurred.

The Obama regime is strenuously adding to these weaknesses. We're screwed!

Is it a coincidence that much of Hayek's post-1936 work focused on the fallacy of mistaking tautologies & identifies for causal explanations (see Hayek's "Economics and Knowledge", 1936/1937, or Hayek's _The Pure Theory of Capital_)?

Hayek was getting tautologies and God-like "directly intuited" aggregates and their magical relations from both Keynes and from the the socialist equilibrium folks (Lange, Taylor, Dickinson, Lerner, etc.).

Tyler writes:

"Slipping back and forth between national income identities and causal relationships was one of the big problems in Keynes's General Theory."

It depends on whether by "growth" one means increasing demand to close the output gap, in which case thinking of aggregate demand components of C, I, G and NX is appropriate. Or does one mean long-run growth; i.e., increasing potential output due to technological progress and capital deepening, in which case one would want to think about how, and in what sectors, this will occur.

A tech bubble drove growth in the 90's; a real estate bubble drove growth in the naughties; a government bubble looks likely to drive growth in the tens, albeit no more sustainably than its predecessors.

The government bubble attempts to offset private deleveraging with government leverage, basically denying that the sum of the two remains unsustainably high. By definition, we won't return to sustainable growth until total leverage reaches a sustainable level, which is when we'll see the economy's true bottom. From that bottom, true growth can flow.

Biology will drive future growth. We are in the equivalent of the seventies in terms of the computer revolution, in the nanobio revolution. Things are about to get interesting.

On the contrary, such an event would create massive demand for things that are both capital intensive and very scarce: sustainable energy economy capital.

This sounds like a variation of the broken window fallacy. Doubling the price of energy creates growth, because it stimulates the demand for new energy, causing massive capital investment?

Why not just destroy the oil infrastructure then? We'd be rich. While we're at it, let's destroy the extant fleet of automobiles, which will stimulate huge demand for new ones. They'll be better than the old ones, and more fuel efficient too. Win-win.

Next, we tear down all the existing commercial real estate. It will do wonders for the construction industry.

I don't think Tyler's point is quite right.

That Y = C+I+G+X-M is an identity is true but Y was decomposed into these parts because they allow causal inference. That is, the indenitity didn't just come from the ether as the definition of as the definition of aggregate output.

There is GDP, and then we say can we break GDP down into parts that tend to move together and tend to have the same drivers. This gives us Consumption which is driven by household wealth and interest rates. Investment which is driven by interest rates and profit. Government which is drive by policy. Net exports which are driven by exchange rates and growth abroad. Abroad meaning: countries whose policy we cannot directly control.

More over, just saying, increases in the money supply drive increases in nominal demand doesn't tell us a whole lot about the recovery. How does money do this? How broad a definition of money do you need? Does credit count?

These questions are especially relevant now when the money multiplier is falling.

So I think sector decomposition has a lot going for it. Its a useful tool for thinking about the recovery. In particular we might think about the fact that rising balance sheets have driven rising consumption and now falling balance sheets are creating falling consumption.

Through what channel is increasing the money supply going to work in these conditions. Are we thinking about interest rates so low consumption will return despite bad balance sheets? Are we thinking about interest rates so low that investment is spurred despite low capacity utilization? Are we thinking about interest rates so low that the dollar is devalued and net exports rise?

Given that we have zero overnight rate this matters for the rates we would target next.

Comments for this post are closed