Results for “aggregate demand wealth effect”

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Menzie Chinn discusses the evidence on sectoral shifts hypotheses.  See also the piece by Valletta and Cleary.

These are intriguing and useful studies but I don't think they get at the core of the matter, mostly because sectoral shifts and aggregate demand shocks are so closely intertwined in this recession.

Here's a very simple story.  The prices of homes and stocks fall, plus there is some panic, so people spend less.  On the surface, that's an AD story, following from an economy-wide negative wealth effect.  But it's also a sectoral shifts story, because people are not cutting spending proportionately on all items.  For instance luxury consumption and debt-financed consumption have been hit especially hard, not to mention real estate and financial services (for other reasons).  And since I do not expect a quick rebound of real estate or stock prices, this is more or less a permanent change in sectoral priorities.  Still, in the data the AD shock might well absorb most of the "credit" for what happened.

We're also seeing job losses in virtually every sector.  It's not for instance a "sectoral shift away from services and into matchstick production and tungsten."  It's a shift out of jobs which are revealed as unprofitable and a lot of people not knowing where the new jobs will be created.

If someone wants to insist that "this is really an AD shock, not a sectoral shift," I'm not so keen on fighting to keep one term over the other.  I would insist, however, on an issue of substance, namely that not all AD shocks are alike.  If we are going to switch terminology, it could be said that this is a real AD shock and not just a nominal AD shock.  (Though there have been nominal AD shocks too.)  A nominal AD shock can be offset more easily by goosing up some mix of M and V and restoring the previous level of nominal demand.  If you want an example of a nominal AD shock, imagine a more neutral change in monetary variables and indeed those have happened in the postwar era.  Or read David Hume's parable of the money under the pillow.  In those cases you don't need to make people feel wealthier in real terms, you just need to get the flow of spending up again.  Today, part of the problem is that people feel less wealthy in real terms and that influences the content of their spending and investment decisions.

When a real AD shock comes, policy still should be expansionary in response, but there is an important difference.  In absolute terms, nominal expansion won't much help the labor market, which still has to reallocate workers from some sectors to others, given the collapse in asset prices and expectations.

You'll see indirect recognition of this from many current Keynesian writers, when they talk of the jobless recovery or fear that the economy will fall back next year after the stimulus money runs out.  In general I agree with those points.  Yet these writers are less willing to consider the implied conclusion that a bigger stimulus won't much help — and may hurt — the longer-run adjustments which are required.  Boosting MV will restore employment only to a very limited extent.  It's still the case that recovery will require a great deal of sectoral readjustment and that will take a good bit of time.

Arnold Kling comments as well.  And again.

Let's say government can spend $100 billion today or spend the present expected value of $100 billion, stretched out over time so it is a commitment in perpetuity.  Both spending programs are financed by bonds.  So that's the same net present value of spending and the same method of finance.

The Keynesian boost to aggregate demand arises because people consider the resulting bonds to be "net wealth" even when they are not, in the sense outlined by Robert Barro (1974).  People are tricked by the government's fiscal policy, but of course the extent, timing, and nature of the trickery is hard to predict.

Is it easier to trick people "a lot all at once" or "a little bit by bit over time"?  It depends.  If you try to trick them slowly over time, temporal learning and adaptive expectations may work against the policymaker.  But if you try to trick people a lot all at once, the trick may rise over their threshold of attention, perhaps because of media coverage.  We don't know which "trick" to aggregate demand will be greater, the temporary boost to spending or the permanent boost.

One way to get a clear answer — in favor of Krugman's hypothesis that the temporary spending is more potent — is to assume that bonds as net wealth fails for a policy rule but not for a single period policy surprise (the temporary boost in spending).  In contrast, the traditional Keynesian view is to think that bonds are also net wealth in the medium run and perhaps the long run too and then we are back to not knowing whether the permanent or temporary spending boost does more for aggregate demand.  Or you might think, as I have suggested, that whether bonds are viewed as net wealth in the short run will depend on the size of the spending boost.  Many different assumptions are possible and thus many different results are possible.

Alternatively, you might compare $100 billion today (and no more) to $100 billion each year, every year.  You could call that "temporary" vs. "permanent" although I suspect the dominant effects will fall out of "small" vs. "large."

The latter, permanent boost to spending will give a bigger boost to aggregate demand overall (unless again you neuter it by applying Ricardian Equivalence to the rule but not the single period policy).  It also will lead to more crowding out.  Do note that in the early periods of this policy taxes need not rise by $100 billion for each year but rather the early installments can be paid off over time.

It is less clear whether the permanent spending boost leads to a bigger AD shift only for today.  It will if you apply the same degree of bonds as net wealth to the rule and single period policy, and if you think that the later periods of government spending will add net value, thus creating positive feedback through the long-run wealth effect.

It is also unclear if the larger, permanent spending boost creates more "stimulus per dollar" (as opposed to more stimulus in the aggregate or more stimulus for the single period).  That will depend on whether we are in the range where the stimulus has increasing returns to scale (maybe a certain critical mass is needed, as I believe Mark Thoma has suggested), constant returns to scale, or diminishing or even negative returns to scale, because of eventual crowding out. 

Overall the Keynesian effects can mean either the permanent or the temporary spending boost has a bigger effect and there are also a number of ways of defining what a "bigger effect" might mean.  This analysis has more variations than does the Poisoned Pawn Sicilian.

It is a common shibboleth that saved funds mean a decline in aggregate demand but this doesn't have to be true.  Savings often fund investment, which boosts aggregate demand and creates jobs.

Admittedly, savings don't fund investment when the banking system is malfunctioning.  Or it may take so long to translate savings into investment that incomes are falling in the meantime and S and I follow them on the way down (Keynes's scenario).  Still, you shouldn't assume that savings translate into a collapse of aggregate demand.

Michael Mandel adds:

I believe that Obama’s $300 billion tax cut is essential to
‘recapitalize’ the American consumer, just like the banks are being
recapitalized.

With that as background, consider the tax cuts in Obama's stimulus plan.  If the money is spent, you get a boost to aggregate demand.  That was the goal.  If the money is not spent, it is a wash.  The government borrows for people (at a low rate) and people save it.  Since savings has gone up, the borrowing is sustainable and it doesn't even have to crowd out additional government spending, if that is what you want. 

Furthermore these people would have done some borrowing anyway, so their ability to implicitly borrow at a lower interest rate creates a small, positive wealth effect.  The savings also means you have supplied those people with some form of implicit insurance, and at very low risk of moral hazard.

I wouldn't expect a whole lot of recovery from these scenarios, but there's nothing problematic about having some tax cuts in the stimulus package.  If you're looking for another opinion, here is Joseph Stiglitz.

1. We have zombie banks.

2. There is considerable regulatory uncertainty in banking and finance.

3. There is a negative wealth effect from lower home and asset prices.

4. There is a big sectoral shift out of real estate, luxury goods, and debt-financed consumption.

5. Some of the automakers are finally meeting their end, or would meet their end without government aid.

6. Fear and uncertainty are high, in part because they should be high and in part because Bush and Paulson spooked everyone.

7. International factors are strongly negative.

8. There is a decline in aggregate demand, resulting from some mix of 1-7.

I have two simple points,  First, a large fiscal stimulus addresses factor #8 but fares poorly in alleviating the other problems.  Of course it may give a band-aid for #5 or #6 and you can tell other stories but we are in a multi-factor depression.

Second, forecasting will prove very difficult.  These factors interacted with each other in a unique manner on the way down and they may well interact in an unpredictable manner on the way back up, whenever that comes.  Just for a start, who has a good model of #1, #2, or #6?  Right now we're seeing a lot of good faith efforts to develop forecasts, but I say don't believe any of them, whether they support your point of view or not.

Paul Krugman describes and writes:

Here’s how I see it: the opponents of a strong stimulus plan don’t
really have an alternative to offer. They don’t even have a really
coherent critique; as Brad DeLong points out,
if you believe that a surge in private spending would raise employment
– and even the critics agree on that – it’s very hard to explain why a
surge of public spending wouldn’t have the same effect.

The critics are instead mainly engaged in a series of minor complaints, aka niggles; FDR didn’t do so well, the statistical evidence ain’t so great, you can’t trust government, etc., etc..

My view is the disaggregated one that sometimes private spending can stimulate employment and sometimes it cannot. Private spending has the greatest chance of stimulating employment when a) market psychology is on its side, and b) the financial system is relatively well-functioning.  Neither is the case right now. 

Note that under standard theory neither monetary nor fiscal policy will set right the basic problems from negative real shocks and indeed the U.S. economy is undergoing a series of massive sectoral shifts.  That includes a move out of construction, a move out of finance, a move out of debt-financed consumption, a move out of luxury goods, the collapse of GM, and a move out of industries which cannot compete with the internet (newspapers, Borders, etc.)

I’ve never seen a stimulus proponent deny this point about real shocks but I don’t see them emphasizing it either.  It should be the starting point for any analysis of fiscal policy but so far it is being swept under the proverbial rug.

Maybe a big enough push to aggregate demand could stimulate useful, productive employment (as opposed to merely boosting measured gdp) right now, but since the
U.S. savings rate must rise sooner or later, that would only mean a
steeper decline for aggregate demand some time in the future.  My discount rate isn’t that high.

The alternative to a huge fiscal stimulus is simple: enough pro-active fiscal policy to ensure that cuts in state and local spending do not bring additional contractionary pressure to bear on the economy.  Otherwise bear the costs of the ongoing sectoral shifts and allow consumption to decline as indeed it must sooner or later.  Aggregate demand macroeconomics really does matter, but it is easier to do badly from negative shocks than it is to engineer good results from expansionary shocks. 

Those looking for other policy alternatives might consider Robert Lucas’s recent suggestions for monetary policy or cuts in the payroll tax, although I am myself not quite (yet?) on either bandwagon (though I think they are better plans than massive fiscal stimulus).

By the way, FDR didn’t do so well, the statistical evidence ain’t so great, and you can’t trust government, etc.  But those are only my minor complaints.

The bottom line remains this: we are being asked to spend ???? hundreds of billion dollars when a) the evidence for fiscal policy is inconclusive, and b) when you consider how real shocks fit into aggregate demand analysis, the theory isn’t there either.

Addendum: Here is a post by Krugman on the "hangover theory."  The answer to Krugman’s #1 is a combination of (perceived) wealth effects, downward nominal and real rigidities, and, during the boom workers at least thought they knew what they should be doing but now they do not.  The coordination problem on the upswing is not symmetric with the coordination problem on the downswing.  In any case it is correct that real sectoral shift theories do not explain all facets of a recession or depression; it is incorrect to conclude that therefore, in light of sectoral shocks, fiscal policy will be effective.

If every American saved the rebate and invested it in equities, we might be (ever so slightly) better off.  Government can borrow at a low interest rate for us.  Of course we’re being told to spend the money.

Most fundamentally, more aggregate demand is not the answer because insufficient aggregate demand was not the problem in the first place.  Just as a social framing effect (and lots of fraud) led subprime loans to be perceived as
"not very risky," right now social framing effects — call them collective fear — are causing lower asset prices, some degree of
credit constipation, and higher risk premia.  The economy is undergoing a sectoral shift toward less risky assets and that can bring an economic downturn.  The shift itself is costly, it brings thorny coordination problems (e.g., sudden insolvencies, overturning of credit expectations), and lower-yielding assets also mean less wealth.  Lack of liquidity simply is not the fundamental problem. 

Arguably there is a secondary negative aggregate demand shock at work, mostly because asset prices are lower from the sectoral shift.  Monetary policy should offset this secondary effect, to keep things from getting worse, but still monetary policy won’t and indeed can’t set things right again.   

More speculatively, you might argue that boosting aggregate demand may convince people to postpone their adjustments to the sectoral shift, thereby making the coordination problems last longer.  Maybe, but I won’t push that on you for lack of evidence.  Another speculative argument is that boosting aggregate demand can push us all back into optimistic expectations but that is unlikely. 

The bottom line: Our expectations from the Fed or a stimulus plan should be very modest, even if the boosts to aggregate demand are done perfectly.

Here is part of Anderson’s argument:

Let’s consider first Hayek’s claim that prices in free market capitalism do not give people what they morally deserve. Hayek’s deepest economic insight was that the basic function of free market prices is informational. Free market prices send signals to producers as to where their products are most in demand (and to consumers as to the opportunity costs of their options). They reflect the sum total of the inherently dispersed information about the supply and demand of millions of distinct individuals for each product. Free market prices give us our only access to this information, and then only in aggregate form. This is why centralized economic planning is doomed to failure: there is no way to collect individualized supply and demand information in a single mind or planning agency, to use as a basis for setting prices. Free markets alone can effectively respond to this information.

It’s a short step from this core insight about prices to their failure to track any coherent notion of moral desert. Claims of desert are essentially backward-looking. They aim to reward people for virtuous conduct that they undertook in the past. Free market prices are essentially forward-looking. Current prices send signals to producers as to where the demand is now, not where the demand was when individual producers decided on their production plans. Capitalism is an inherently dynamic economic system. It responds rapidly to changes in tastes, to new sources of supply, to new substitutes for old products. This is one of capitalism’s great virtues. But this responsiveness leads to volatile prices. Consequently, capitalism is constantly pulling the rug out from underneath even the most thoughtful, foresightful, and prudent production plans of individual agents. However virtuous they were, by whatever standard of virtue one can name, individuals cannot count on their virtue being rewarded in the free market. For the function of the market isn’t to reward people for past good behavior. It’s to direct them toward producing for current demand, regardless of what they did in the past.

Now, I am torn between "strict philosopher" and "common sense morality" views.  In the former, I am a metaphysical determinist who doesn’t think much of desert arguments — whether pro-market or not — in any context. 

But for purposes of argumentation, let’s put on the common sense hat.  I then think that most voluntary transactions — at least in democratic market economies — are in fact reasonably just.  The biggest problem is fraud — Enron and the like — and that cannot be blamed on Hayek.  The share price of Enron — when it counted as the seventh largest firm in terms of capitalization — was a Hayekian obscenity if judged as an information aggregator.  The problem was that prices were tricked by inflated earnings estimates and did not perform their Hayekian duties properly. 

Another fairness problem is that some people are born into terrible neighborhoods and face unfair odds in life.  But the information aggregation function of prices is again far from the leading culprit in those cases.  In fact price floors and ceilings usually make poverty worse and less fair.

The complex concept of merit encompasses many values.  One of those values — but not the only one — is how much other people are willing to pay for what you have to offer.  Let’s start with that as a workable concept, and modify it whenever deviations will serve the general welfare.  Nozick goes wrong in thinking that no other notion of merit can override a prescription for laissez-faire, but consenting acts between capitalist adults should serve as the proper default.  If I buy a wonderful stinky cheese for $10, barring fraud, most likely all is well in the moral universe in this case.

Now the critiques are well-known.  Marginal products are determined in a broader social and economic context, plus the distribution of wealth may be unfair.  But the American public comes close to having the correct view here.  On one hand, it is widely recognized that taxation to finance public goods, including some degree of social insurance, is morally legitimate.  At the same time, people are seen as deserving what they earn, again fraud aside.  We ought to think twice before treating earned incomes as a "social pie" purely up for grabs.

But those judgments are piecemeal rather than foundationalist.  Few people agree with Robert Nozick in treating property rights as absolute.  More generally, we cannot justify all distributions, prices, and incomes from some set of first principles.  Rather we start with what we have and go from there.  And then the $10 for the cheese does in fact represent justice.  Furthermore we can believe this while admitting that the child born in the South Bronx does not receive a fair shake.

Anderson also confuses the manner in which prices are forward-looking.  A measured price for a consummated transaction reflects supply and demand from the past.  To the extent that a person’s merit was reflected by what she can get others to pay, this is OK.  There is no contradiction between backward-looking and forward-looking perspectives.  It remains true that such prices will not reflect, say, the purity of a person’s heart.  But this point stands without worrying about time frames.  Anderson writes as if "information aggregation" is some independent, ex ante functional purpose which causes prices to move in morally undesirable directions.  In reality information aggregation is an ex post property of a competitive bidding process, it does not on its own drive prices away from some pre-existing benchmark of moral merit.

Some of Anderson’s statements are hard to parse:

"the function of the market isn’t to reward people for past good behavior. It’s to direct them toward producing for current demand, regardless of what they did in the past."

OK, but past rewards will have come from efficacious past behavior in satisfying consumer demands.

Anderson also argues that even a productive and meritorious person cannot insure adequately against all possible future disasters.  It is well-known that markets do not produce many kinds of long-term insurance and indeed this remains a puzzle.  But here a dose of more Hayek — not less – would seem to be in order. 

The bottom line: A coherent notion of moral merit includes more than just your ability to serve others through the marketplace.  So market returns won’t coincide with personal merit, even putting aside the dilemmas of determinism.  But voluntary transactions — in many settings — provide a rough but non-absolute starting point for what is fair.  And if we are looking for causes of unfairness, the Hayekian informational role of prices is simply not a major culprit.