it’s pronounced lay-on-HOOF-udd – Page 2

The Puzzle of Profits

Part II of Capital begins with a puzzle: In markets, commodities are supposed to trade only for other commodities of equal value, yet somehow capitalists end up with more value than they start with.

In the world of simple exchange, money is just a convenience for enabling the exchange of commodities: C-M-C is easier to arrange than C-C. But profit-making business is different: the sequence there is M-C-M’. The capitalist enters the market and buys some commodities for a certain sum of money. Later, he sells some commodities, and has a larger sum of money. This increase — from M to M’ — is the whole point of being capitalist. But in a world of free market exchange, how can it exist?

Let’s put some obvious misunderstandings out of the way. There’s nothing mysterious about the fact that people can accomplish things with tools and previously acquired materials that they would be unable to with unaided labor. The problem is not that “capital,” in the sense of a stock of tools and materials, is productive in this sense. To the extent that what appears as “profit” in the national accounts is just the cost of replacing worn-out tools and materials, there’s no puzzle. [1]

The mystery is, how can someone enter the market with money and, after some series of exchanges, exit with more money? In the sequence M-C-M’, how can M’ be greater than M? How can the mere possession of money seemingly allow one to acquire more money, seemingly without end?

Before trying to understand Marx’s answer, let’s consider how non-Marxist economists answer this question.

1. Truck and barter. The most popular answer, among both classical and modern economists, is that the M-C-M’ sequence does not exist. All economic activity is aimed at consumption, market exchange is only intended to acquire specific use-values; when you think you see M-C-M you’re really looking at part of some C-M-C sequence(s). The classical economists are full of blunt statements that the only possible end of exchange is consumption. In today’s economics we find this assumption in the form of the “transversality condition” that says that wealth must go to zero as time goes to infinity. That’s right, it is an axiom in modern economics that accumulation cannot be a goal in itself. Or in the words of Simon Wren-Lewis (my new go-to source for the unexamined conventional wisdom of economists): “It would be stupid to accumulate infinite wealth.” Well OK then!

2. You earned it. Another answer is that the capitalist brings some additional unmeasured commodity to the production process. They are providing not just money M but also management ability, risk-bearing capacity, etc. In this view, if we correctly measured inputs, we would find that M’=M. In its most blatantly apologetic form this is effectively skewered by comrades Ackerman and Beggs in the current Jacobin. For unincorporated businesses, it is true, it is not straightforward to distinguish between profits proper and the wages of managerial labor, but that can’t account for profits in general, or for the skewed distribution of income across households. If anything, much of what is reported as managerial salaries should probably be called profits. This is a point made in different ways by Piketty and Saez and Dumenil and Levy; you can also find it offered as straightforward business advice.

3. It was the pictures that got small. The other main classical answer is that profit is the reward for “abstinence” (Senior) or “waiting” (Cassel). (I guess this is also the theory of Bohm-Bawerk and the other Austrians, but I admit I don’t know much about that stuff.) It appears today as a discount rate on future consumption. This invites the same question as the first answer: Is capitalist accumulation really motivated by future consumption? It also invites a second question: In what sense is a good tomorrow less valuable than the same good today? Is the utility derived from a glass of wine in 2013 really less than the utility derived from the same glass consumed in 2012,or 2010, or 1995? (So far this has not been my experience.) The logically consistent answer, if you want to defend profit as the return to waiting, is to say Yes. The capital owner’s pure time preference then represents an objective inferiority of output at a later date compared with the same output at an earlier date.

This is a logically consistent answer to the profits puzzle, and it could even be true with the right assumptions about the probability of an extinction-event asteroid impact/Khmer Rouge takeover/zombie apocalypse. With a sufficiently high estimate of the probability of some such contingency, M’ is really equal to M when discounted appropriately; capitalists aren’t really gaining anything when you take into account their odds of being eaten by zombies and/or suffocated by plastic bag, before they get to enjoy their profits. [2] But I don’t think anyone wants to really own this point of view — to hold it consistently you must believe that economic activity becomes objectively less able to satisfy human needs as time goes by. [3]

4. Oops, underpaid again. We can take the same “profit as reward for waiting” idea, but instead of seeing a pure time preference as consistent with rational behavior, as modern economists (somehow) do, instead interpret it like the classical economists (including Cassel, whose fascinating Nature and Necessity of Interest I just read), as a psychological or sociological phenomenon. Consumption in the future is objectively identical to the same consumption today, but people for some reason fail to assign it the same subjective value it the same. Either they suffer from a lack of “telescopic facility,” or, in Cassel’s (and Leijonhufvud’s) more sophisticated formulation, the discount rate is a reflection of the human life expectancy: People are not motivated to provide for their descendants beyond their children, and future generations are not around to bargain for themselves. Either way, the outcome is that exchange does not happen at value — production is systematically organized around a higher valuation of goods today than goods tomorrow, even though their actual capacity to provide for satisfaction of human needs is the same. Which implies that workers — who provide labor today for a good tomorrow — are systematically underpaid.

5. Property is theft. The last and simplest possibility is that profits are always just rents. Capitalists and workers start out as just “agents” with their respective “endowments.” By whatever accident of circumstances, the former just end up underpaying the latter. Maybe they are better informed.

We could develop all these points further — and will, I hope, in the future. But I want to move on to (my idea of) Marx’s answer to the puzzle.

One other thing to clear up first: profit versus interest. Both refer to money tomorrow you receive by virtue of possessing money today. The difference is that in the case of profit, you must purchase and sell commodities in between. What is the relationship between these two forms of income? For someone like Cassel, interest has priority; profit is a derived form combining interest with income from managerial skill and/or a rent. For Marx on the other hand, and also for Smith, Ricardo, etc., profit is the primitive and interest is the derived form; interest is redistribution of profits already earned in production. (Smith: “The interest of money is always a derivative revenue, which, if it is not paid from the profit which is made by the use of the money, must be paid from some other source of revenue.”) In other words, are profits an addition to interest, or is interest as a subtraction from profit? For Marx, the latter. The fundamental question is how money profits can arise through exchange of commodities. [4]

Marx gives his answer in chapter four: The capitalist purchases labor-power at its value, but gets the results of the labor expended by that labor-power. The latter exceeds the former. In other words, people are capable of producing more than it takes to reproduce themselves, and that increment is captured by the capitalist. In four hours, you can produce what you need to live on. The next four or six or eight or twelve hours, you are working for The Man.

This is the answer, as Marx gives it. Labor power is paid for at its value. But having purchased labor power, the capitalist now has access to living labor, which can produce more than the the cost of its own reproduction.

I think this is right. But it’s not really a satisfactory answer, is it? It’s formally correct. But what does it mean?

One way of fleshing it out is to ask: Why is it even possible that labor can produce more than the reproduction-costs of labor power? Think of Ricardo’s world. Profits are positive because we have not yet reached the steady state — there are still natural resources available whose more intensive use will yield a surplus beyond the cost of the labor and capital required to use them. The capitalist captures that surplus because capital has the short side of both markets — there is currently excess land going unutilized, and excess labor going unutilized. [5]

Another way: There is something in the production process other than exchange, but which is captured via exchange.

I want to think of it this way: Humanity does have the ability to increase social value of output, or in other words the aggregate capacity to satisfy human needs from nature does in general grow over time. This “growth” happens through our collective creative interchange with nature — it is about pushing into the unknown, a process of discovery — it is not captured beforehand in the market values of commodities.

In a proper market, you cannot exchange a good in your possession for a good with a greater value, that is, with a greater capacity to satisfy human needs in general. (Your own particular needs, yes.) But you can, through creative activity, through a development of your own potential, increase the general level of satisfaction of human needs. The capitalist by buying labor power at its value, is able to capture this creative increment and call it their private property.

Our potential is realized through a creative interchange with nature. It’s not known in advance. What can we do, what can’t we do — we only learn by trying. We push against the world, and discover how the world pushes back, in so doing understand it better and find how it can be reshaped to better suit our needs. Individually or collectively, it’s a process of active discovery.

You as a person can exchange the various things you are in possession of, including your labor power, for other things of equal value. (Though for different use values, which are more desired by you.) But you will also discover, through a process of active learning and struggle, what you are capable of, what are the limits of your powers, what creative work you can do that you cannot fully conceive of now.

Through the process of education, you don’t just acquire something that you understood clearly at the outset. You transform yourself and learn things you didn’t even know you didn’t know. When you do creative work you don’t know what the finished product will be until you’ve finished it. I still — and I hope for the rest of my life — find myself reading economics and having those aha moments where you say, “oh that’s what this debate is all about, I never got it before!” And science and technology above all involve the discovery of new possibilities through a process of active pushing against the limits of our knowledge of the world.

The results of these active process of self-development and exploration form use-values, but they are not commodities. They were not produced for exchange. They were not even known of before they came into being. But while they are not themselves commodities, they are attached to commodities, they cannot be realized except through existing commodities. I may produce in myself, through this process of self-testing, a capacity for musical performance, let’s say. But I cannot realize this capacity without, at least, a sufficient claim on my own time, and probably also concrete use-values in the form of an instrument, an appropriate performance space, etc., and also some claim on the time of others. In this case one can imagine acquiring these things individually, but many — increasingly over time — processes of self-discovery are inherently collective. Science and technology especially. So specifically a discovery that allows cheaper production of an existing commodity, or the creation of a new commodity with new use-values, can only become become concrete in the hands of those who control the process of production of commodities. By purchasing labor power — in the market, at its value — capitalists gain control of the production process. They are thus able to claim the fruits of humanity’s collective self-discovery and interchange with nature as their own private property.

In some cases, this is quite literal. Recall Smith’s argument that one of the great advantages of the division of labor is that it allows specialized workers to discover improved ways of carrying out their tasks. “A great part of the machines made use of in those manufactures in which labour is most subdivided, were originally the inventions of common workmen, who, being each of them employed in some very simple operation, naturally turned their thoughts towards finding out easier and readier methods of performing it.” Who do you think gained the surplus from these inventions? This still happens. Read any good account of work under capitalism, like Barbara Garson’s classic books All the Livelong Day and The Electronic Sweatshop. You’ll find people actively struggling to do their jobs better — the customer service representative who wants to get the caller to the person who can actually solve their problem, the bookshelf installer who wants it to fit in the room just right. The results of these struggles are realized as profits for their employers. But these are exceptional. The normal case today is the large-scale collective process of discovery, which is then privately appropriated. Every new technology draws on a vast history of publicly-available scientific work — sometimes we see this directly as with biomedical research, but even when it’s not so obvious it’s still there. Every Hollywood movie draws on a vast collective project of storytelling, a general collective effort to imbue certain symbols with meaning. Again see this most directly in the movies that draw on folktales and other public-domain work, but it’s true generically.

It is this vast collective effort at transformation of nature and ourselves that allows the value of output to be greater than the value of what existed before it. Without it, we would eventually reach the classical steady state where the exercise of labor could produce no more than the value of the labor power that yielded it. So when Marx says the source of profits is the fact that labor can produce more than the value of labor power, lying behind this is the fact that, due to humanity’s collective creative efforts, we are continuing to find new ways to shape the world to our use.

Capital is coordination before it is tangible means of production. Initially (logically and historically) the capitalist simply occupies a strategic point in exchange between independent producers thanks to the possession of liquid wealth; but as the extension of the division of labor requires more detailed coordination between the separate producers, the capitalist takes over a more direct role in managing production itself. “That a capitalist should command on the field of production, is now as indispensable as that a general should command on the field of battle.”

There is another way of looking at this: in terms of the extension of cooperation and the division of labor, which is realized in and through capitalist production, but in principle is independent of it. I’ll take this up in a following post.

[1] Marx makes this point clearly in his critique of the Gotha program. Elimination of surplus as such cannot be a goal of socialism.

[2] It would seem that we have enough evidence to rule out a sufficiently high probability of world-ending catastrophe to explain observed interest rates, assuming the minimum possible return on accumulated wealth is zero. But of course in some conceivable circumstances it could be negative — that’s why I include the Khmer Rouge takeover, where your chance of summary execution is presumably positively related to your accumulated wealth. Also, maybe we have reason to think that catastrophe is more likely in the future than we would naively infer from the past. It would be funny if someone tried to explain interest rates in terms of the doomsday argument.

[3] There has been a lot of discussion of appropriate social discount rates in the context of climate change. But nobody in that debate, as far as I can tell, takes the logical next step of arguing that excessively high discount rates imply a comprehensive market failure, not just with respect to climate change. There is not a special social discount rate for climate, there is an appropriate social discount rate for all future costs and benefits. If market interest rates are not the right tool for weighing current costs against future benefits for climate, they are not the right guide for anything, including the market activities where they currently govern.

[4] Yes, interest exists independently of profits from production, and indeed is much older. Marx recognizes this. But capitalism is not generalized usury.

[5] And substitution between factors is impossible — Marx’s “iron law of proportions” — or at least limited.

Aggregate Demand and Modern Macro

Start with a point on language.

People often talk about aggregate demand as if it were a quantity. But this is not exactly right. There’s no number or set of numbers in the national accounts labeled “aggregate demand”. Rather, aggregate demand is a way of interpreting the numbers in the national accounts. (Admittedly, it’s the way of interpreting them that guided their creation in the first place). It’s a statement about a relationship between economic quantities. Specifically, it’s a statement that we should think about current income and current expenditure as mutually determining each other.

This way of thinking is logically incompatible with the way macroeconomics is taught in (almost) all graduate programs today, which is in terms of optimization under an intertemporal budget constraint. I’ll avoid semi-pejorative terms like mainstream and neoclassical, and instead follow Robert Gordon and call this approach modern macro.

In the Keynesian income-expenditure vision — which today survives only, as Leijonhufvud put it, “in the Hades of undergraduate instruction” — we think of economic actors as making decisions about current spending in terms of current receipts. If I earn $X, I will spend $Y; if I earn one dollar more, I’ll spend so many additional cents. We can add detail by breaking these income and expenditure flows in various ways — income from dividends vs. incomes from wages, income to someone at the top decile vs someone at the bottom, income to urban households vs income to rural ones; and expenditures on services, durable goods, taxes, etc., which generate income in their turn. This is the way macro forecasting models used by business and government were traditionally constructed, and may still be for all I know.

Again, these are relationships; they tell us that for any given level of aggregate money income, there is a corresponding level of aggregate expenditure. The level of income that is actually realized, is the one for which desired expenditure just equals income. And if someone for whatever reason adjusts their desired level of expenditure at that income, the realized level of income will change in the same direction, by a greater or lesser extent. (This is the multiplier.)

I should stress that while this way of thinking may imply or suggest concrete predictions, these are not themselves empirical claims, but logical relationships.

The intertemporal optimization approach followed in modern macro is based on a different set of logical relationships. In this framework, agents know their endowments and tastes (and everyone else’s, though usually in these models agents are assumed to be identical) and the available production technology in all future periods. So they know all possible mixes of consumption and leisure available to them over the entire future and the utility each provides. Based on this knowledge they pick, for all periods simultaneously (“on the 8th day of creation” — that’s Leijonhufvud again) the optimal path of labor, output and consumption.

I realize that to non-economists this looks very strange. I want to stress, I’m not giving a dismissive or hostile summary. To anyone who’s done economics graduate work in the last 15 or 20 years (a few heterodox enclaves excepted) constructing models like this is just what “doing macroeconomics” means.

(For a concrete example, a first-year grad textbook offers as one of its first exercises in thinking like an economist the question of why countries often run current account deficits in wartime. The answer is entirely in terms of why countries would choose to allocate a greater share of consumption to periods when there is war, and how interest rates adjust to make this happen. The possibility that war leads to higher incomes and expenditure, some of which inevitably falls on imported goods — the natural answer in the income-expenditure framework — is not even mentioned. Incidentally, as this example suggests, thinking in terms of intertemporal allocation is not always necessarily wrong.)

In these models, there is no special relationship between income and expenditure flows just because they happen to take place at the same time or in any particular order. The choice between jam today and jam tomorrow is no different from the choice between blackberry and lingonberry jam, and the checks you get from your current job and from the job you’ll hold ten years from now are no more different than the checks from two different jobs that you hold right now are. Over one year or 50, the problem is simply the best allocation of your total income over your possible consumption baskets — subject, of course, to various constraints which may make the optimal allocation unachievable.

My point here is not that modern models are unrealistic. I am perfectly happy to stipulate that the realism of assumptions doesn’t matter. Models are tools for logical analysis, not toy train sets — they don’t have to look like real economies to be useful.

(Although I do have to point out that modern macroeconomics models are often defended precisely on the grounds of microfoundations — i.e. more realistic assumptions. But it is simply not true that modern models are more “microfounded” than income-expenditure ones in any normal English sense. Microfoundations does not mean, as you might imagine, that a model has an explicit story about the individual agents in the economy and how they make choices — the old Keynesian models do at least as well as the modern ones by that standard. Rather, microfoundations means that the agents’ choices consist of optimizing some quantity under true — i.e. model consistent — expectations.)

But again, I come not to bury or dispraise modern models. My point is just that they are logically incompatible with the concept of aggregate demand. It’s not that modern macroeconomists believe that aggregate demand is unimportant, it’s that within their framework those words don’t mean anything. Carefully written macro papers don’t even footnote it as a minor factor that can be ignored. Even something anodyne like “demand might also play a role” would come across like the guy in that comic who asks the engineers if they’ve “considered logarithms” to help with cooling.

The atomic units of one vision are flows — that is, money per time period — between economic units. The atomic units of the other are prices and quantities of different goods. Any particular empirical question can be addressed within either vision. But they generate very different intuitions, and ideas of what questions are most important.

Still, it is true that the same concrete phenomena can be described in either language. The IS curve is the obvious example. In the Hades of the undergraduate classroom we get the old Keynesian story of changes in interest rate changing desired aggregate expenditure at each given income. While in the sunlit Arcadia of graduate classes, the same relationship between interest rates and current expenditure is derived explicitly from intertemporal optimization.

So what’s the problem, you say. If either language can be used to describe the same phenomena, why not use the same language as the vast majority of other economists?

This is a serious question, and those of us who want to do macro without DSGE models need a real answer for it. My answer is that default assumptions matter. Yes, with the right tweaks the two models can be brought to a middle ground, with roughly the same mix of effects from the current state and expected future states of the world. But even if you can get agreement on certain concrete predictions, you won’t agree on what parts of them depend on the hard core of your theory and what on more or less ad hoc auxiliary assumptions. So Occam’s Razor will cut in opposite directions — a change that simplifies the story from one perspective, is adding complexity from the other.

For example, from the income-expenditure perspective, saying that future interest rates will have a similar effect on current activity as current interest rates do, is a strong additional assumption. Whereas from the modern perspective, it’s saying that they don’t have similar effects that is the additional assumption that needs to be explained. Or again, taking an example with concrete applications to teaching, the most natural way to think about interest rates and exchange rates in the income-expenditure vision is in terms of how the the flow of foreign investment responds to interest rates differentials. Whereas in the modern perspective — which is now infiltrating even the underworld — the most natural way is in terms of rational agents’ optimal asset mix, taking into account the true expected values of future exchange rates and interest rates.

Or, what got me thinking about this in the first place. I’ve been reading a lot of empirical work on credit constraints and business investment in the Great Recession — I might do a post on it in the next week or so, though an academic style literature review seems a bit dull even for this blog — and three things have become clear.

First, the commitment to intertemporal optimization means that New Keynesians really need financial frictions. In a world where current output is an important factor in investment, where investment spending is linked to profit income, and where expectations are an independently adjusting variable, it’s no problem to have a slowdown in investment triggered by fall in demand in some other sector, by a fall in the profit share, or by beliefs about the future becoming more pessimistic. But in the modern consensus, the optimal capital stock is determined by the fundamental parameters of the model and known to all agents, so you need a more or less permanent fall in the return on investment, due presumably to some negative technological shock or bad government policy. Liberal economists hate this stuff, but in an important sense it’s just a logical application of the models they all teach. If in all your graduate classes you talk about investment and growth in terms of the technologically-determined marginal product of capital, you can hardly blame people when, faced with a slowdown in investment and growth, they figure that’s the first place to look. The alternative is some constraint that prevents firms from moving toward their desired capital stock, which really has to be a financial friction of some kind. For the older Keynesian perspective credit constraints are one possible reason among others for a non-supply-side determined fall in investment; for the modern perspective they’re the only game in town.

Second, the persistence of slumps is a problem for them in a way that it’s not in the income-expenditure approach. Like the previous point, this follows from the fundamental fact that in the modern approach, while there can be constraints that prevent desired expenditure from being achieved, there’s never causation from actual expenditure to desired expenditure. Businesses know, based on fundamentals, their optimal capital stock, and choose an investment path that gets them there while minimizing adjustment costs. Similarly, households know their lifetime income and utility-maximizing consumption path. Credit constraints may hold down investment or consumption in one period, but once they’re relaxed, desired expenditure will be as high or higher than before. So you need persistent constraints to explain persistently depressed spending. Whereas in the income-expenditure model there is no puzzle. Depressed investment in one period directly reduces investment demand in the next period, both by reducing capacity utilization and by reducing the flow of profit income. If your core vision of the economy is a market, optimizing the allocation of scare resources, then if that optimal allocation isn’t being achieved there must be some ongoing obstacle to trade. Whereas if you think of the economy in terms of income and expenditure flows, it seems perfectly natural that an interruption to some flow will will disrupt the pattern, and once the obstacle is removed the pattern will return to its only form only slowly if at all.

And third: Only conservative economists acknowledge this theoretical divide. You can find John Cochrane writing very clearly about alternative perspectives in macro. But saltwater economists — and the best ones are often the worst in this respect — are scrupulously atheoretical. I suspect this is because they know that if they wanted to describe their material in a more general way, they’d have to use the language of intertemporal optimization, and they are smart enough to know what a tar baby that is. So they become pure empiricists.

In Leon Fink’s wonderful history of the New York health care workers’ union 1199, Upheaval in the Quiet Zone, he talks about how the union’s early leaders and activists were disproportionately drawn from Communist Party members and sympathizers, and other leftists. Like other communist-led unions, 1199 was kicked out of the CIO in the 1940s, but unlike most of the others, it didn’t fade into obscurity. Originally a drugstore-employees union, it led the new wave of organizing of health care and public employees in the 1960s. Fink attributes a large part of its unusual commitment to organizing non-white and female workers, in an explicitly civil-rights framework, and its unusual lack of corruption and venality, to the continued solidarity of the generation of the 1930s. Their shared political commitments were a powerful source of coordination and discipline. But, says Fink, it was impossible for them to pass these commitments on to the next generation. Yes, in 1199, unlike most other unions, individual leftists were not purged; but there was still no organized left, either within the union or in connection to a broader movement. So there was no way for the first generation to reproduce themselves, and as they retired 1199 became exposed to the same pressures that produced conservative, self-serving leadership in so many other unions.

I feel there’s something similar going on in economics. There are plenty of people at mainstream departments with a basically Keynesian vision of the economy. But they write and, especially, teach in a language that is basically alien to that vision. They’re not reproducing the capacity for their own thought. They’re running a kind of intellectual extractive industry, mining older traditions for insights but doing nothing to maintain them.

I had this conversation with a friend at a top department the other day:

me: http://noahpinionblog.blogspot.com/2013/03/the-swamp-of-dsge-despair.html

what do you think? is this kind of critique valid/useful?

11:17 AM him: its totally true

11:18 AM and you wouldn’t know what was getting baked into the cake unless you were trained in the literature

I only started understanding the New Keynsian models a little while ago

and just had the lazy “they are too complicated” criticism

11:19 AM now I understand that they are stupidly too complicated (as Noah’s post points out)

11:20 AM me: so what is one supposed to do?

if this is the state of macro

him: i dunno. I think participating in this literature is a fucking horror show

me: but you don’t like heterodox people either, so….?

11:21 AM him: maybe become a historian

or figure out some simple variant of the DSGEmodels that you can make your point and publish empirical stuff

This is where so many smart people I know end up. You have to use mainstream models — you can’t move the profession or help shape policy (or get a good job) otherwise. But on many questions, using those models means, at best, contorting your argument into a forced and unnatural framework, with arbitrary-seeming assumptions doing a lot of the work; at worst it means wading head-deep into an intellectual swamp. So you do some mix of what my friend suggests here: find a version of the modern framework that is loose enough to cram your ideas into without too much buckling; or give up on telling a coherent story about the world and become a pure empiricist. (Or give up on economics.) But either way, your insights about the world have to come from somewhere else. And that’s the problem, because insight isn’t cheap. The line I hear so often — let’s master mainstream methods so we can better promote our ideas — assumes you’ve already got all your ideas, so the only work left is publicity.

If we want to take questions of aggregate demand and everything that goes with it — booms, crises, slumps — seriously, then we need a theoretical framework in which those questions arise naturally.

[*] Keynes’ original term was “effective demand.” The two are interchangeable today. But it’s interesting to read the original passages in the GT. While they are confusingly written, there’s no question that Keynes’ meant “effective” in the sense of “being in effect.” That is, of many possible levels of demand possible in an economy, which do we actually see? This is different from the way the term is usually understood, as “having effect,” that is, backed with money. Demand backed with money is, of course, simply demand.

UPDATE: The Cochrane post linked above is really good, very worth reading. It gives more of the specific flavor of these models than I do. He writes: In Old Keynesian models,

consumption depends on today’s income through the “marginal propensity to consume” mpc.

Modern new-Keynesian models are utterly different from this traditional view. Lots of people, especially in policy, commentary, and blogging circles, like to wave their hands over the equations of new Keynesian models and claim they provide formal cover for traditional old-Keynesian intuition, with all the optimization, budget constraints, and market clearing conditions that the old-Keynesian analysis never really got right taken care of. A quick look at our equations and the underlying logic shows that this is absolutely not the case.

Consider how lowering interest rates is supposed to help. In the old Keynesian model, investment I = I(r) responds to lower interest rates, output and income Y = C + I + G, so rising investment raises income, which raises consumption in (4), which raises income some more, and so on. By contrast, the simple new-Keynesian model needs no investment, and interest rates simply rearrange consumption demand over time.

Similarly, consider how raising government spending is supposed to help. In the old Keynesian model, raising G in Y = C + I + G raises Y, which raises consumption C by (4), which raises Y some more, and so on. In the new-Keynesian model, the big multiplier comes because raising government spending raises inflation, which lowers interest rates, and once again brings consumption forward in time.

Note, for example, that in a standard New Keynesian model, expected future interest rates enter into current consumption exactly as the present interest rate does. This will obviously shape people’s intuitions about things like the effectiveness of forward guidance by the Fed.

UPDATE 2: As usual, this blog is just an updated, but otherwise much inferior, version of What Leijonhufvud Said. From his 2006 essay The Uses of the Past:

We should expect to find an ahistorical attitude among a group of scientists busily soling puzzles within an agreed-upon paradigm… Preoccupation with the past is then a diversion or a luxury. When things are going well it is full steam ahead! …. As long as “normal” progress continues to be made in the established directions, there is no need to reexamine the past…

Things begin to look different if and when the workable vein runs out or, to change the metaphor, when the road that took you to the “frontier of the field” ends in a swamp or in a blind alley. A lot of them do. Our fads run out and we get stuck. Reactions to finding yourself in a cul-de-sac differ. Tenured professors might be content to accommodate themselves to it, spend their time tidying up the place, putting in modern conveniences… Braver souls will want out and see a tremendous leap of the creative imagination as the only way out — a prescription, however, that will leave ordinary mortals just climbing the walls. Another way to go is to backtrack. Back there, in the past, there were forks in the road and it is possible, even probable, that some roads were more promising than the one that looked most promising at the time…

This is exactly the spirit in which I’m trying to rehabilitate postwar income-expenditure Keynesianism. The whole essay is very worth reading, if you’re interest at all in the history of economic thought.

Reviving the Knife-Edge: Aggregate Demand in the Long Run

The second issue of the new Review of Keynesian Economics is out, this one focused on growth. [1] There’s a bunch of interesting contributions, but I especially like the piece by Steve Fazzari, Pietro Ferri, Edward Greenberg and Anna Maria Variato, on growth and aggregate demand.

The starting point is the familiar puzzle that we have a clear short-run story in which changes in output [2] on the scale of the business cycle are determined by aggregate demand — that is, by changes in desired expenditure relative to income. But we don’t have a story about what role, if any, aggregate demand plays in the longer run.

The dominant answer — unquestioned in the mainstream [3], but also widespread among heterodox writers — is, it doesn’t. Economic growth is supposed to depend on a different set of factors — technological change, population growth and capital accumulation — than those that influence demand in the short run. But it’s not obvious how you get from the short-run to the long — what mechanism, if any, that ensures that the various demand-driven fluctuations will converge to the long-run path dictated by these “fundamentals”?

This is the question posed by Fazzari et al., building on Roy Harrod’s famous 1939 article. As Harrod noted, there are two relations between investment and output: investment influences output as a source of demand in the short run, and in the longer run higher output induces investment in order to maintain a stable capital-output ratio. More investment boosts growth, for the first channel, the multiplier; growth induces investment, through the second, the accelerator. With appropriate assumptions you can figure out what combinations of growth and investment satisfy both conditions. Harrod called the corresponding growth paths the “warranted” rate of growth. The problem is, as Harrod discovered, these combinations are dynamically unstable — if growth strays just a bit above the warranted level, it will accelerate without limit; if falls a little below the warranted rate, it will keep falling til output is zero

This is Harrod’s famous “knife-edge.” It’s been almost entirely displaced from the mainstream by Solow type growth models. Solow argued that the dynamic instability of Harrod’s model was due to the assumption of a fixed target capital-output ratio, and that the instability goes away if capital and labor are smoothly substitutible. In fact, Harrod makes no such assumption — his 1939 article explicitly considers the possibility that capitalists might target different capital-output ratios based on factors like interest rates. More generally, Solow didn’t resolve the problem of how short-run demand dynamics converge to the long-run supply-determined growth path, he just assumed it away.

The old textbook solution was price flexibility. Demand constraints are supposed to only exist because prices are slow to adjust, so given enough time for prices to reach market-clearing levels, aggregate demand should cease to exist. The obvious problem with this, as Keynes already observed, is that while flexible prices may help to restore equilibrium in individual markets, they operate in the wrong direction for output as a whole. A severe demand shortfall tends to produce deflation, which further reduces demand for goods and services; similarly, excessive demand leads to inflation, which tends — though less certainly — to further increase demand. As Leijonhufvud notes, it’s a weird irony that sticky wages and/or prices are held to be the condition of effective demand failures, when the biggest demand failure of them all, the Depression, saw the sharpest falls in both wages and prices on record.

The idea that if it just runs its course, deflation — via the real balance effect or some such — will eventually restore full employment is too much even for most economists to swallow. So the new consensus replaces price level adjustment with central bank following a policy rule. In textbooks, this is glossed as just hastening an adjustment that would have happened on its own via the price level, but that’s obviously backward. When an economy actually does develop high inflation or deflation, central banks consider their jobs more urgent, not less so. It’s worth pausing a moment to think about this. While the central bank policy rule is blandly presented as just another equation in a macroeconomic model, the implications are actually quite radical. Making monetary policy the sole mechanism by which the economy converges to full employment (or the NAIRU) implicitly concedes that on its own, the capitalist economy is fundamentally unstable.

While the question of how, or whether, aggregate demand dynamics converge to a long-run growth path has been ignored or papered over by the mainstream, it gets plenty of attention from heterodox macro. Even in this one issue of ROKE, there are several articles that engage with it in one way or another. The usual answer, among those who do at least ask the question, is that the knife-edge result must be wrong, and indicates some flaw in the way Harrod posed the problem. After all, in real-world capitalist economies, output appears only moderately unstable. Many different adjustments have been proposed to his model to make demand converge to a stable path.

Fazzari et al.’s answer to the puzzle, which I personally find persuasive, is that demand dynamics really are that unstable — that taken on their own the positive feedbacks between income, expenditure and investment would cause output to spiral toward infinity or fall to zero. The reasons this doesn’t happen is because of the ceiling imposed by supply constraints and the the floor set by autonomous expenditure (government spending, long-term investment, exports, etc.). But in general, the level of output is set by expenditure, and there is no reason to expect desired expenditure to converge to exactly full utilization of the economy’s resources. When rising demand hits supply constraints, it can’t settle at full employment, since in general full employment is only reached on the (unfulfillable) expectation of more-than-full employment.

Upward demand instability can drive demand to a level that fully employs labor resources. But the full employment path is not stable. … The system bounces off the ceiling onto an unstable declining growth path.

I won’t go through the math, which in any case isn’t complicated — is trivial, even, by the standards of “real” economics papers. The key assumptions are just a sufficiently strong link between income and consumption, and a target capital output ratio, which investment is set to maintain. These two assumptions together define the multiplier-accelerator model; because Fazzari et al explicitly incorporate short-term expectations, they need a third assumption, that unexpected changes in output growth cause expectations of future growth to adjust in the same direction — in other words, if growth is higher than expected this period, people adjust their estimates of next period’s growth upward. These three assumptions, regardless of specific parameter values, are enough to yield dynamic instability, where any deviation from the unique stable growth path tends to amplify over time.

The formal model here is not new. What’s more unusual is Fazzari et al.’s suggestion that this really is how capitalist economies behave. The great majority of the time, output is governed only by aggregate demand, and demand is either accelerating or decelerating. Only the existence of expenditure not linked to market income prevents output from falling to zero in recessions; supply constraints — the productive capacity of the economy — matters only occasionally, at the peaks of businesses cycles.

Still, one might say that if business-cycle peaks are growing along a supply-determined path, then isn’t the New Consensus right to say that the long run trajectory of the economy is governed only by the supply side, technology and all that? Well, maybe — but even if so,this would still be a useful contribution in giving a more realistic account of how short-term fluctuations add up to long-run path. It’s important here that the vision is not of fluctuations around the full-employment level of output, as in the mainstream, but at levels more or less below it, as in the older Keynesian vision. (DeLong at least has expressed doubts about whether the old Keynsians might not have been right on this point.) Moreover, there’s no guarantee that actual output will spend a fixed proportion of time at potential, or reach it at all. It’s perfectly possible for the inherent instability of the demand process to produce a downturn before supply constraints are ever reached. Financial instability can also lead to a recession before supply constraints are reached (altho more often, I think, the role of financial instability is to amplify a downturn that is triggered by something else.)

So: why do I like this paper so much?

First, most obviously, because I think it’s right. I think the vision of cycles and crises as endogenous to the growth process, indeed constitutive of it, is a better, more productive way to think about the evolution of output than a stable equilibrium growth path occasionally disturbed by exogenous shocks. The idea of accelerating demand growth that sooner or later hits supply constraints in a more or less violent crisis, is just how the macroeconomy looks. Consider the most obvious example, unemployment:

What we don’t see here, is a stable path with normally distributed disturbances around it. Rather, we see unemployment falling steadily in expansions and then abruptly reversing to large rises in recessions. To monetarists, the fact that short-run output changes are distributed bimodally, with the economy almost always in a clear expansion or clear recession with nothing in between, is a sign that the business cycle must be the Fed’s fault. To me, it’s more natural to think that the nonexistence of “mini-recessions” is telling us something about the dynamics of the economic process itself — that capitalist growth, like love,

is a growing, or full constant light,
And his first minute, after noon, is night.

Second, I like the argument that output is demand-constrained at almost all times. There is no equilibrium between “aggregate supply” and “aggregate demand”; rather, under normal conditions the supply side doesn’t play any role at all. Except for World War II, basically, supply constraints only come into play momentarily at the top of expansions, and not in the form of some kind of equilibration via prices, but as a more or less violent external interruption in the dynamics of aggregate demand. It is more or less always true, that if you ask why is output higher than it was last period, the answer is that someone decided to increase their expenditure.

Third, I like that the article is picking up the conversation from the postwar Keynesians like Harrod, Kaldor and Hicks, and more recent structural-Keynesian approaches. The fundamental units of the argument are the aggregate behavior of firms and households, without the usual crippling insistence on reducing everything to a problem of intertemporal optimization. (The question of microfoundations gets a one-sentence footnote, which is about what it deserves.) Without getting into these methodological debates here, I think this kind of structuralist approach is one of the most productive ways forward for positive macroeconomic theory. Admittedly, almost all the other papers in this issue of ROKE are coming from more or less the same place, but I single out Fazzari for praise here because he’s a legitimate big-name economist — his best known work was coauthored with Glenn Hubbard. (Yes, that Glenn Hubbard.)

Fourth, I like the paper’s notion of economies having different regimes, some of persistently excess demand, some persistent demand shortfalls. When I was talking about this paper with Arjun the other day he asked, very sensibly, what’s the relevance to our current situation. My first response was not much, it’s more theoretical. But it occurs to me now that the mainstream model (often implicit) of fluctuations around a supply-determined growth path is actually quite important to liberal ideas about fiscal policy. The idea that a deep recession now will be balanced by a big boom sometime in the future underwrites the idea that short-run stimulus should be combined with a commitment to long-run austerity. If, on the other hand, you think that the fundamental parameters of an economy can lead to demand either falling persistently behind, or running persistently ahead, of supply constraints, then you are more likely to think that a deep recession is a sign that fiscal policy is secularly too tight (or investment secularly too low, etc.) So the current relevance of the Fazzari paper is that if you prefer their vision to the mainstream’s, you are more likely to see the need for bigger deficits today as evidence of a need for bigger deficits forever.

Finally, on a more meta level, I share the implicit vision of capitalism not as a single system in (or perhaps out of) equilibrium, but involving a number of independent processes which sometimes happen to behave consistently with each other and sometimes don’t. In the Harrod story, it’s demand-driven output and the productive capacity of the economy, and population growth in particular; one could tell the same story about trade flows and financial flows, or about fixed costs and the degree of monopoly (as Bruce Wilder and I were discussing in comments). Or perhaps borrowing and interest rates. In all cases these are two distinct causal systems, which interact in various ways but are not automatically balanced by any kind of price or equivalent mechanism. The different systems may happen to move together in a way that facilitates smooth growth; or they may move inconsistently, which will bring various buffers into play and, when these are exhausted, lead to some kind of crisis whose resolution lies outside the model.

A few points, not so much of criticism, as suggestions for further development.

First, a minor point — the assumption that expectations adjust in the same direction as errors is a bit trickier than they acknowledge. I think it’s entirely reasonable here, but it’s clearly not always valid and the domain over which it applies isn’t obvious. If for instance the evolution of output is believed to follow a process like yt = c + alpha t + et, then unusually high growth in one period would lead to expectations of lower growth in the next period, not higher as Fazzari et al assume. And of course to the extent that such expectations would tend to stabilize the path of output, they would be self-fulfilling. (In other words, widespread belief in the mainstream view of growth will actually make the mainstream view more true — though evidently not true enough.) As I say, I don’t think it’s a problem here, but the existence of both kinds of expectations is important. The classic historical example is the gold standard: Before WWI, when there was a strong expectation that the gold link would be maintained, a fall in a country’s currency would lead to expectations of subsequent appreciation, which produced a capital inflow that in fact led to the appreciation; whereas after the war, when devaluations seemed more likely, speculative capital flows tended to be destabilizing.

Two more substantive points concern supply constraints. I think it’s a strength, not a weakness of the paper that it doesn’t try to represent supply constraints in any systematic way, but just leaves them exogenous. Models are tools for logical argument, not toy train sets; the goal is to clarify a particular set of causal relationships, not to construct a miniature replica of the whole economy. Still, there are a couple issues around the relationship between rising demand and supply constraints that one would like to develop further.

First, what concretely happens when aggregate expenditure exceeds supply? It’s not enough to just say “it can’t,” in part because expenditure is in dollar terms while supply constraints represent real physical or sociological limits. As Fazzari et al. acknowledge, we need some Marx with our Keynes here — we need to bring in falling profits as a key channel by which supply constraints bind. [4] As potential output is approached, there’s an increase in the share claimed by inelastically-supplied factors, especially labor, and a fall in the share going to capital. This is the classic Marxian cyclical profit squeeze, though in recent cycles it may be the rents claimed by suppliers of oil and “land” in general, as opposed to wages, that is doing much of the squeezing. But in any case, a natural next step for this work would be to give a more concrete account of the mechanisms by which supply constraints bind. This will also help clarify why the transitions from expansion to recession are so much more abrupt than the transitions the other way. (Just as there are no mini-recessions, neither are there anti-crises.) The pure demand story explains why output cannot rise stably on the full employment trajectory, but must either rise faster or else fall; but on its own it’s essentially symmetrical and can’t explain why recessions are so much steeper and shorter than expansions. Minsky-type dynamics, where a fall in output means financial commitments cannot be met, must also play a role here.

Second, how does demand-driven evolution of output affect growth of supply? They write,

while in our simple model the supply-side path is assumed exogenous, it is easy to posit realistic economic channels through which the actual demand-determined performance of the economy away from full employment affects conditions of supply. The quantity and productivity of labor and capital at occasional business-cycle peaks will likely depend on the demand-determined performance of the economy in the normal case in which the system is below full employment.

I think this is right, and a very important point to develop. There is increasing recognition in the mainstream of the importance of hysteresis — the negative effects on economic potential of prolonged unemployment. There’s little or no discussion of anti-hysteresis — the possibility that inflationary booms have long-term positive effects on aggregate supply. But I think it would be easy to defend the argument that a disproportionate share of innovation, new investment and laborforce broadening happens in periods when demand is persistently pushing against potential. In either case, the conventional relationship between demand and supply is reversed — in a world where (anti-)hysteresis is important, “excessive” demand may lead to only temporarily higher inflation but permanently higher employment and output, and conversely.

Finally, obsessive that I am, I’d like to link this argument to Leijonhufvud’s notion of a “corridor of stability” in capitalist economies, which — though Leijonhufvud isn’t cited — this article could be seen as a natural development of. His corridor is different from this one, though — it refers to the relative stability of growth between crises. The key factor in maintaining that stability is the weakness of the link between income and expenditure as long as changes in income remain small. Within some limits, changes in the income of households and firms do not cause them to revise their beliefs about future income (expectations are normally fairly inelastic), and can be buffered by stocks of liquid assets and the credit system. Only when income diverges too far from its prior trajectory do expectations change — often discontinuously — and, if the divergence is downward, do credit constraints being to bind. If it weren’t for these stabilizing factors, capitalist growth would always, and not just occasionally, take the form of explosive bubbles.

Combining Leijonhufvud and Fazzari et al., we could envision the capitalist growth path passing through concentric bands of stability and instability. The innermost band is Leijonhufvud’s corridor, where the income-expenditure link is weak. Outside of that is the band of Harrodian instability, where expectations are adjusting and credit constraints bind. That normal limits of that band are set, at least over most of the postwar era, by active stabilization measures by the state, meaning in recent decades monetary policy. (The signature of this is that recoveries from recessions are very rapid.) Beyond this is the broader zone of instability described by the Fazzari paper — though keeping the 1930s in mind, we might emphasize the zero lower bound on gross investment a bit more, and autonomous spending less, in setting the floor of this band. And beyond that must be a final zone of instability where the system blows itself to pieces.

Bottom line: If heterodox macroeconomic theory is going to move away from pure critique (and it really needs to) and focus on developing a positive alternative to the mainstream, articles like this are a very good start.

[1] It’s unfortunate that no effort has been made to make ROKE content available online. Since neither of the universities I’m affiliated with has a subscription yet, it’s literally impossible for me — and presumably you — to see most of the articles. I imagine this is a common problem for new journals. When I raised this issue with one of the editors, and asked if they’d considered an open-access model, he dismissed the idea and suggested I buy a subscription — hey, it’s only $80 for students. I admit this annoyed me some. Isn’t it self-defeating to go to the effort of starting a new journal and solicit lots of great work for it, and then shrug off responsibility for ensuring that people can actually read it?

[2] It’s not a straightforward question what exactly is growing in economic growth. When I talk about demand dynamics, I prefer to use the generic term “activity,” as proxied by a variety of measures like GDP, employment, capacity utilization, etc. (This is also how NBER business-cycle dating works.) But here I’ll follow Fazzari et al. and talk about output, presumably the stuff measured by GDP.

[3] See for instance this post from David Altig at the Atlanta Fed, from just yesterday:

Forecasters, no matter where they think that potential GDP line might be, all believe actual GDP will eventually move back to it. “Output gaps”—the shaded area representing the cumulative miss of actual GDP relative to its potential—simply won’t last forever. And if that means GDP growth has to accelerate in the future (as it does when GDP today is below its potential)—well, that’s just the way it is.

Here we have the consensus with no hedging. Everyone knows that long-run growth is independent of aggregate demand, so slower growth today means faster growth tomorrow. That’s “nature,” that’s just the way it is.

[4] This fits with the story in Capitalism Since 1945, still perhaps the first book I would recommend to anyone trying to understand the evolution of modern economies. From the book:

The basic idea of overaccumulation is that capitalism sometimes generates a higher rate of accumulation than can be sustained, and thus the rate of accumulation has eventually to fall. Towards the end of the postwar boom, an imbalance between accumulation and the labor supply led to increasingly severe labor shortage. … Real wages were pulled up and older machines rendered unprofitable, allowing a faster transfer of workers to new machines. This could in principle have occurred smoothly: as profitability slid down, accumulation could have declined gently to a sustainable rate. but the capitalist system has no mechanism guaranteeing a smooth transition in such circumstances. In the late sixties the initial effect of overaccumulation was a period of feverish growth with rapidly rising wages and prices and an enthusiasm for get-rich-quick schemes. These temporarily masked, but could not suppress, the deterioration in profitability. Confidence was undermined, investment collapsed and a spectacular crash occurred. Overaccumulation gave rise, not to a mild decline in the profit rate, but to a classic capitalist crisis.

I think the Marxist framework here, with its focus on profit rates, complements rather than contradicts the Keynesian frame of Fazzari et al. and its focus on demand. In particular, the concrete mechanisms by which supply constraints operate are much clearer here.

Credit Cards and the Corridor

I don’t know if most people realize how much credit card debt fell during and after the Great Recession. It fell by a lot! Credit card debt outstanding today is about $180 billion, or 21 percent, lower than it was at the end of 2007. This is a 50 percent larger fall than in mortgage debt in percentage terms — though the fall in mortgages is of course much bigger in absolute dollars.

This fall in credit card debt is entirely explained by the drop in the number of credit card accounts, from about 500 million to 380 million. The average balance on open credit card accounts is about the same today as it was when the recession began.

The obvious question is, is this fall in consumer credit due to supply, or demand? Are banks less willing to lend, or are households less eager to borrow?

Here’s some interesting data that helps shed light on this question, from the Fed’s most recent Quarterly Report on Household Credit and Finance.

The red line shows the number of credit card accounts closed over the preceding 12 months, while the blue line shows the number opened. So the gap between the blue and red lines equals the change in the number of accounts. The spike in the red line is mostly write-offs, or defaults. I’ll return to those in a subsequent post; for now let’s look at the blue and green lines. The green line shows the number of inquiries, that is, applications for new cards by consumers. The blue line, again, shows the number issued. As we can see, the number of new accounts tracks the number of inquiries almost exactly. [1] What do we conclude from this? That the fall in the rate at which new credit cards are issued is entirely a matter of reduced demand, not supply. And given that balances on outstanding credit cards have not fallen, it’s hard to avoid the conclusion that banks’ reduced willingness to lend played little or no role in the fall in consumer credit.

Of course one figure isn’t dispositive, and mortgage debt is much more important quantitatively than credit card debt. But Dean Baker has been making a similar argument about mortgages for several years now:

the ratio of applications to [home] sales has not risen notably in this slump, indicating that the inability of potential homebuyers to get mortgages has not been a big factor in the housing downturn.

As a matter of fact, after reading that post (or one of Dean’s many others making the same point), I tried to construct a similar ratio for credit cards, but I wasn’t able to find the data. I didn’t realize then that the Fed publishes it regularly in the household credit report.

Needless to say, the ratio of applications to contracts is hardly the last word on this question, and needless to say there are plenty of more sophisticated attempts out there to disentangle the roles of supply and demand in the fall in borrowing. Rather than get into the data issues in more detail right now, I want to talk about what is at stake. Does it matter whether a fall in borrowing is more driven by the supply of credit or the demand for it? I think it does, both for theory and for policy.

One important question, of course, is the historical one: Did the financial crisis straightforwardly cause the recession by cutting off the supply of credit for nonfinancial borrowers, or were other factors more important? I admit to being agnostic on this question — I do think that credit constraints were dragging down fixed investment in the year or so before the recession officially began, but I’m not sure how important this was quantitatively. But setting aside the historical question, we also need to ask, is the availability of credit the binding constraint on real activity today?

For monetarists and New Keynesians, the answer has to be Yes almost by definition. Here’s DeLong:

There is indeed a “fundamental” configuration of asset prices–one that produces full employment, the optimal level of investment given the time preference of economic agents and the expected future growth of the economy, and the optimal division of investment between safe, moderately risky, and blue-sky projects.

However, right now the private market cannot deliver this “fundamental” configuration of asset prices. The aftermath of the financial crisis has left us without sufficient trusted financial intermediaries … no private-sector agent can create the safe securities that patient and prudent investors wish to hold. The overleverage left in the aftermath of the financial crisis has left a good many investors and financial intermediaries petrified of losing all their money and being forced to exit the game–hence the risk tolerance of the private sector is depressed far below levels that are appropriate given the fundamentals… Until this overleverage is worked off, the private marketplace left to its own will deliver a price of safe assets far above fundamentals … and a level of investment and thus of employment far below the economy’s sustainable and optimal equilibrium.

In such a situation, by issuing safe assets–and thus raising their supply–the government pushes the price of safe assets down and thus closer to its proper fundamental equilibrium value.

In other words, there is a unique, stable, optimal equilibrium for the macroeconomy. All agents know their expected lifetime income and preferred expenditures in that equilibrium. The only reason we are not there, is if some market fails to clear. If there is a shortfall of demand for currently produced output, then there must be excess demand for some asset the private sector cannot produce. In the monetarist version of the story, that asset is money. [2] In DeLong’s version, it’s “safe assets” more generally. But the logic is the same.

This is why DeLong is so confident that continued zero interest rates and QE must work — that it is literally impossible for output to remain below potential if the Fed follows its stated policy for the next three years. If the only reason for the economy to be off its unique, optimal growth path is excess demand for safe assets, then a sufficient increase in the supply of safe assets has to be able to get us back onto it.

But is this right?

Note that in the passage above, DeLong refers to a depressed “level of investment and thus of employment.” That’s how we’re accustomed to think about demand shortfalls, and most of the time it’s a reasonable shorthand — investment (business and residential) generally does drive fluctuations in demand. But it’s not so clear that this is true of the current situation. Here, check this out:

We’re looking at output relative to potential for GDP and its components; I’ve defined potential as 2.5 percent real annual growth from the 2007Q4 peak. [3] What we see here is investment and consumption both fell during the recession proper, but since 2010, investment has recovered strongly and is almost back to trend. The continued output gap is mainly accounted for by the failure of consumption to show any signs of returning to trend — if anything, consumption growth has decelerated further in the recovery.

You can’t explain low household consumption demand in terms of a shortage of safe assets. The safest, most liquid asset available to households is bank deposits, and the supply of these is perfectly elastic. I should note that it is possible (though not necessarily correct) to explain falling consumption this way for the early 1930s, when people were trying to withdraw their savings from banks and convert them into cash. The private sector cannot print bills or mint coins. But classical bank runs are no longer a thing; people are not trying to literally hoard cash; it is impossible that a lack of safe savings vehicles for households is what’s holding down consumption today.

So if we are going to explain the continued consumption shortfall in DeLong’s preferred terms, households must be credit-constrained. It is not plausible that households are restricting consumption in order to bid up the price of some money-like asset in fixed supply. But it is plausible that the lack of trusted financial intermediaries makes investors less willing to hold households’ debt, and that this is limiting some households’ ability to borrow and thus their consumption. In that case, it could be that increasing the supply of safe assets will provide enough of a cushion that investors are again willing to hold risky assets like household debt, and this will allow households to return to their optimal consumption path. That’s the only way DeLong’s story works.

It’s plausible, yes; but is it true? The credit card data is evidence that, no, it is not. If you believe the evidence of that first figure, the fall in consumer borrowing is driven by demand, not supply; continued weakness in consumption is not the result of unwillingness of investors to hold household debt due to excess demand for safe assets. If you believe the figure, investors are no less willing to hold consumer debt than they were before the recession; it’s households that are less willing to borrow.

Again, one figure isn’t dispositive. But what I really want to establish is the logical point: The shortage-of-safe-assets explanation of the continued output gap, and the corollary belief in the efficacy of monetary policy, only makes sense if the weakness in nonfinancial units’ expenditure is due to continued tightness of credit constraints. So every additional piece of evidence that low consumption (and investment, though again investment is not especially low) is not due to credit constraints, is another nail in the coffin of the shortage-of-safe-assets story.

So what’s the alternative? Well, that’s beyond the scope of this post. But basically, it’s this. Rather than assume there is a unique, stable, optimal equilibrium, we say that the macroeconomy has multiple equilibria and/or divergent adjustment dynamics. More specifically, we emphasize the positive feedback between current income and expenditure. For small deviations in income, people and businesses don’t adjust their expenditure, but use credit and and/or liquid assets to maintain it at its normal level. But for large deviations, this buffering no longer takes place, both because of financing constraints and because true lifetime income is uncertain, so people’s beliefs about it change in response to changes in current income.

In other word’s Axel Leijonhufvud’s “corridor of stability”. Within certain bounds (the corridor), the economy experiences stabilizing feedback, based on relative prices; beyond them, it experiences destabilizing feedback based on the income-expenditure link. Within these bounds, the multiplier is weak; outside them, it is “strong enough for effects of shocks to be endogenously amplified. Within the corridor, the prescription is in favor of ‘monetarist,’ outside in favor of ‘fiscalist’, policy prescriptions.”

I’m going to break that thought off here. The important point for now is that if you think that the continued depressed level of real economic activity is due to excess demand for safe assets, you really need evidence that the expenditure of households and businesses is limited by the unwillingness of investors to hold their liabilities, i.e. that they face credit constraints. And this credit card data is one more piece of evidence that they don’t. Which, among other things, makes it less likely that central bank interventions to remove risk from the balance sheets of the financial system will meaningfully boost output and employment.

[1] For some reason, inquiries are given over the past six months while the other two series are given over the past year. This implies that about half of all inquiries result in a new account being opened. The important point for our purposes is that this fraction did not change at all during the financial crisis and recession.

[2] To be fair, you can also find this story in the General Theory — “unemployment develops because people want the moon,” etc. But it’s not the only story you can find there. And, I would argue, Keynes really intends this as a story of how downturns begin, and not why they persist.

[3] Yes, it would be more “correct” to use the BEA’s measure of potential output. But the results would be qualitatively very similar, and I don’t think there’s nearly enough precision in measures of potential output to make the few tenths of a point difference meaningful.

LATE UPDATE: Here is a similar graph for the previous recession & recovery.

IMF: Abolish the Debt!

Not exactly; you have to read between the lines a little.

People are talking about this new thing from the IMF, reviving the 1930s-era “Chicago plan” for 100% reserve banking. Red meat for the end-the-Fed crowd. The paper shares a coauthor, Michael Kumhof, with that other notable recent piece of IMF rabble-rousing, on how inequality is responsible for financial crises. Anyway, the Chicago plan. It was the brainchild of ~~Herbert Simon~~ Henry Simons and Irving Fisher:

The key feature of this plan was that it called for the separation of the monetary and credit functions of the banking system, first by requiring 100% backing of deposits by government-issued money, and second by ensuring that the financing of new bank credit can only take place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks, but not through the creation of new deposits, ex nihilo, by banks.

Fisher (1936) claimed four major advantages for this plan. First, preventing banks from creating their own funds during credit booms, and then destroying these funds during subsequent contractions, would allow for a much better control of credit cycles, which were perceived to be the major source of business cycle fluctuations. Second, 100% reserve backing would completely eliminate bank runs. Third, allowing the government to issue money directly at zero interest, rather than borrowing that same money from banks at interest, would lead to a reduction in the interest burden on government finances and to a dramatic reduction of (net) government debt, given that irredeemable government-issued money represents equity in the commonwealth rather than debt. Fourth, given that money creation would no longer require the simultaneous creation of mostly private debts on bank balance sheets, the economy could see a dramatic reduction not only of government debt but also of private debt levels.

Kumhof and his coauthor Jaromir Benes run through how such a thing would be implemented today, and then estimate its effects on output and prices in a DSGE model. (I don’t care about that second part.) My opinion: I don’t think this makes sense practically as a practical policy proposal or strategically as a political focal point. But it’s not crazy. I think it’s a useful thought experiment to clarify what we do and don’t need banks for, and I’m glad that some people around Occupy seem to be noticing and talking about it.

Though Kumhof and Benes don’t quite say so, this proposal should really be understood as addressing two distinct and separate problems:

1. Stabilization via monetary policy is constrained by the fact that its traditional tools have less purchase on private credit creation than they are imagined to or they used to, and not just at the ZLB. (As discussed repeatedly on this blog, e.g. these posts and this one.) So if the state wants to continue relying on monetary policy as its main countercyclical tool, we need to think about institutional changes that would strengthen the transmission mechanism.

2. If government liabilities are more liquid than the liabilities of even the biggest banks, as they certainly seem to be, then the banking system plays no function with respect to federal borrowing. The banks that hold federal debt are providing “anti-intermediation” — they are replacing more liquid assets with less liquid ones. In this sense, whatever income banks get from holding federal debt and providing means of payment are pure rents – it would be more efficient for federal liabilities to serve as means of payment directly.

The Chicago plan is the stone that is supposed to kill both these birds. I think it misses both, but in an intellectually productive way. In other words, it’s fun to think about.

The goal of the plan is to, in effect, collapse the categories of inside money, outside money and government debt by eliminating the first and turning the third into the second. Equivalently, it’s an attempt to legislate the economy into functioning the way monetarists (and some MMTers) say it already does, with a fixed money supply set by policy. You could think of it as another intervention in the centuries-old Currency School vs. Banking School debate — except that unlike most Currency School advocates over the past two centuries, Kumhof and Benes acknowledge that the Banking School is right about how existing financial systems operate, and that 100% reserves is not a return to some “natural” arrangement but a radical and far-reaching reform.

Why wouldn’t it work?

On the first goal, improving the reliability of stabilization policy, it’s important to recognize that deposits are not where the action is, and haven’t been for a long time. So 100% reserve backing of deposits is really the smallest piece of this thing. In effect, it’s a proposal to tighten the Fed’s handle on the narrow money supply — M1, in the jargon. but most means of payment in the economy aren’t captured by M1 — they don’t take the form of deposits, and haven’t for a long time. (In this respect things have really changed since 1936.) So it wouldn’t be enough to tighten the rules on deposit creation; you’d have to abolish (or impose the same reserve requirements on) all the other assets that serve as means of payment (and are more or less captured in M2 and formerly in M3), and prevent the financial system from developing new ones.

The proposal does do this, but it’s pretty draconian — under Kumhof and Benes’ plan “there is no lending at all between private agents.” As soon as you relax that restriction, the plan’s advantages in terms of stabilization go away. An absolute legal prohibition on IOUs might please Ezra Pound, but it’s hard to see it playing well among any of the IMF’s other constituencies. And the reality is if anything worse than that, because, as the Islamic world has been finding for 1,400 years now, it is very hard to legally distinguish debt contracts from other kinds of private contracts. So in practice you’d need an almost Soviet level of control over economic activity to realize something like this.

Perhaps I’m exaggerating the practical difficulties faced by the plan, but even if you could overcome them, it would only solve half the problem. The proposal only strengthens contractionary policy, not expansionary policy. It might have prevented the acceleration in credit creation in the 1980s and 1990s, but wouldn’t have done anything to boost credit creation and real activity in the past few years. It’s true that it would prevent the specific dynamic that Fisher (and later Friedman) blamed for the Depression, a positive feedback in a downturn between bank failures and a falling money supply. But that dynamic no longer exists, given deposit insurance and active countercyclical monetary policy, altho I suppose one could imagine it reappearing again in the future…

Part of the issue is whether you think lack of effective demand = lack of nominal effective demand = excess demand for money, by definition. This is the standard New Keynesian view, borrowed from monetarism. In this view a recession necessarily involves an insufficient money supply. But I don’t accept this. And once you accept that recessions involve multiple equilibria or coordination failures, there is no reason to think that increasing the supply of money must logically be a reliable way to get out of one, and lots of empirical evidence that it isn’t.

But even if the “Chicago plan” is not a workable solution to the breakdown of the monetary policy transmission mechanism, it’s a useful exercise. At the least, it calls attention to the fact that there is a breakdown — in a monetarist world, reforming the financial system to allow the central bank to control the money supply would be like legislating the law of gravity. Kumhof and Benes are clear that this proposal is only meaningful because under current arrangements, money is fully endogenous:

The critical feature of our theoretical model is that it exhibits the key function of banks in modern economies, which is not their largely incidental function as financial intermediaries between depositors and borrowers, but rather their central function as creators and destroyers of money. A realistic model needs to reflect the fact that under the present system banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending. This fact can be verified in the description of the money creation system in many central bank statements, and it is obvious to anybody who has ever lent money and created the resulting book entries.

(As a footnote tartly notes, that includes Kumhof, a former banker.)

So while the proposal doesn’t describe something you could actually do, it does help illuminate the current system of credit creation, via a sharply contrasting ideal alternative.

How about the second goal, eliminating the value-subtracting activity of banks “financing” government debt? Here I think they are onto something important. Interest is a payment for liquidity, as we’ve known since Keynes. So there is no economic reason for the government to pay interest to financial intermediaries when its own liabilities are the most liquid there are.

The problem here is, it’s not clear why, once you recognize this, you would stop at splitting of the payment system from credit creation. Why doesn’t the state provide means of payment directly? Whatever arguments there were for a state monopoly on money issue presumably don’t go away when money becomes electronic, so why isn’t there a public debit card just like there is federal currency? (This becomes really obvious when you look at the outright scams that happen when private businesses manage EBT cards, etc.) Of course there are people who want private currencies, but they are crazy libertarians. And yet without anyone accepting their arguments, we’ve implicitly gone along with them as the economy has moved toward electronic means of payment — every time you pay with a debit or credit card, some financial parasite takes their cut. The obvious solution is to end the private monopoly on means of payment. (What do want? Postal savings and a public payment system! When do we want them? Now!) Benes and Kumhof don’t go all the way there, but their plan is at least a step in that direction.

There’s a broader point here. Axel Leijonhufvud (among others) suggests that the fundamental reason there is a term premium (and at least part of the reason there is a liquidity premium) is that there is a chronic excess of long-term, illiquid assets in the form of physical capital, because of the technical superiority of roundabout production processes. That is, the time to maturity of the representative asset is longer than the horizon of the typical asset-holder. Thus the “constitutional weakness” (Hicks) at the long end of the credit market.

But if a larger proportion of the private economy’s outside assets are made up of government debt rather than physical capital, (and if a larger proportion of saving is done by institutions rather than households, tho that’s iffier) then this constitutional weakness goes away, and there’s no reason to have anyone collecting a fee for maturity transformation. Ashwin at Macroeconomic Resilience has written some very smart stuff about this.

Banks came into existence, in other words, in a world where most savers had a very high demand for liquidity, and most liabilities were risky and illiquid. So you needed someone to stand between, to intermediate. But today most saving is via institutional investors with long horizons — pensions etc. — or internal to the firm, while a very large proportion of borrowing is by sovereign governments, and so less risky/more liquid than anything banks can issue. In this world there’s no need for intermediaries in the old sense; they’re just rent-collecting parasites. This is not the way the “Chicago plan” is motivated but it seems like a not-bad way of making the point.

Third piece, the transition. How do you go to a 100%-reserve world without a huge contraction of credit and activity? Here their solution is kind of clever. If you look at US nonfinancial debt, they observe, total business and home mortgage debt together come to about $20 trillion, and total government and non-mortgage household debt also come to about $20 trillion. Only the former, which finances investment, is socially productive, they figure. Under the Chicago Plan, banks would need $20 trillion in new reserves to avoid reducing the investment-financing part of their lending. Where do those new reserves come from? By the central bank buying up and extinguishing the other, non-productive half of the debt. It’s the best-credentialed jubilee proposal you’re likely to see.

Of course banks are worse off because half their interest-earning assets are replaced with sterile reserves. But in the logic of the proposal, there’s no social cost to that, since the lost interest income was for value-substracting “anti-intermediation” (my phrase, not theirs) activity; it was the banks’ fee for substituting less liquid for more liquid assets. Strictly speaking,though, this only applies to government debt. It’s not clear what’s supposed to happen with the stuff the non-mortgage household debt was paying for. Some of it, like credit card debt, was incurred just incidentally to making payments, and would no longer be needed in a world with separate payment and credit systems. As for the rest, they don’t say. It would be logical to see it as mostly for essentials that are better provide publicly, financed by continued reserve issuance. But that would be, as somebody said, not just reading between the lines, but off the edge of the page.

Overall, I like it. A lot. Not because I think it’s a good policy proposal or even (probably) a useful focal point for political mobilization. In general, I think that one should avoid, even for rhetorical purposes, the presumption that economic policy is set by a benevolent philosopher-king (an assumption baked into standard macro models). Agreeing on how the banking system “should” function under some more or less implicit set of constraints will not get us a bit closer to a society fit for human beings. But politically, having paper from the IMF suggesting, even in this rather artificial way, that the simplest solution to excessive debt is just to abolish it, has got to be useful in the coming rising of the debtors. Intellectually, meanwhile, what I like about this is that it puts in sharp relief how little the existing financial system can be explained, as it usually is, as the solution to the economic problems of intermediation and liquidity provision. If the functions banks are supposedly performing could be performed much more efficiently and easily without them, then banks must really be for something else.

EDIT: Oh and also, I’ve got to quote this bit:

Any debate on the origins of money is not of merely academic interest, because it leads directly to a debate on the nature of money, which in turn has a critical bearing on arguments as to who should control the issuance of money. … Since the thirteenth century [the] precious-metals-based system has, in Europe, been accompanied, and increasingly supplanted, by the private issuance of bank money, more properly called credit. On the other hand, the historically and anthropologically correct state/institutional story for the origins of money is one of the arguments supporting the government issuance and control of money under the rule of law. In practice this has mainly taken the form of interest-free issuance of notes or coins, although it could equally take the form of electronic deposits.

There is another issue that tends to get confused with the much more fundamental debate concerning the control over the issuance of money, namely the debate over “real” precious-metals-backed money versus fiat money. … this debate is mostly a diversion, because even during historical regimes based on precious metals the main reason for the high relative value of precious metals was … government fiat and not the intrinsic qualities of the metals.These matters are especially confused in Smith (1776), who takes a primitive commodity view of money…

The historical debate concerning the nature and control of money is the subject of Zarlenga (2002), a masterful work that traces this debate back to ancient Mesopotamia, Greece and Rome. Like Graeber (2011), he shows that private issuance of money has repeatedly led to major societal problems throughout recorded history, due to usury associated with private debts. Zarlenga does not adopt the common but simplistic definition of usury as the charging of “excessive interest”, but rather as “taking something for nothing” through the calculated misuse of a nation’s money system for private gain.

This is a really smart passage for a bunch of reasons. But what I really like about it is that it vindicates my position in the great Graeber debate on about three different levels. Take that, Mike Beggs!

Interest Rates and Expectations: Responses and Further Thoughts

Some good questions asked in comments to yesterday’s post.

Random Lurker doubts whether there is a strict inverse relationship between interest rates and bond values. Indeed there is not, apart from perpetuities (bonds with an infinite maturity, where the principle is never repaid.) I should have been clearer in the post, I was talking about perpetuities just as a simplification of the general case of long assets. But I would argue it’s a reasonable simplification. If you think that the importance of interest rates is primarily for the valuation (rather than the financing) of capital goods, and you think that capital goods are effectively infinitely lived, then an analysisis in terms of perpetuities is the strcitly correct way to think about it. (Both assumptions are defensible, as a first approximation, and Keynes seems to have held both.) On the other hand, if you are thinking in terms of financing conditions for long but not infinitely lived assets, the perpetuity is only an approximation, but for long maturities it’s a reasonably close one. For example, a 30 year bond loses 14% of its value when interest rates rise from 5% to 6%, compared with a 20% loss for a perpetuity. Qualitatively the story will hold as long as the interest rates that matter are much longer than the timescale of business cycles.

Max is confused about my use of “bull” and “bear.” Again, I should have been clearer: I am using the terms in the way that Keynes did, to refer to bullishness and bearishness about bond prices, not about the economy in general.

Finally, the shortest but most substantive comment, from Chris Mealy:

Forcing Bill Gross to lose billions in slow motion is a crazy way to get to full employment.

It is! And that is kind of the point.

I wrote this post mainly to clarify my own thinking, not to make any policy or political argument. But obviously the argument that comes out of this is that while monetary policy can help stabilize demand, it’s very weak at restoring demand once it’s fallen – and not just because short rates can’t go below zero, or because central banks are choosing the wrong target. (Although it is certainly true, and important, that central bankers are not really trying to reduce unemployment.)

Here is the thing: expectations of returns on investment are also conventional and moderately elastic. Stable full employment requires both that expected sales are equal to expenditure at full employment, and that interest rates are such that the full employment level of output is chosen by profit-maximizing businesses. But once demand has fallen – and especially if it has remained depressed for a while – expected sales fall, so the interest rate that would have been low enough to prevent the fall in activity is no longer low enough to reverse it. This is why you temporarily need lower rates than you will want when the economy recovers. But the expectation of long rates returning to their old level will prevent them from falling in the first place. “The power of the central bank to affect the long rate is limited by the opinions about its normal level inherited from the past.” This is why monetary policy cannot work in a situation like this without Bill Gross first losing billions – it’s the only way to change his opinion.

Leijonhufvud:

Suppose that a situation arises in which the State of Expectation happens to be “appropriate”… but that the long rate is higher than “optimal,” so that asset demand prices are too low for full employment… Then it seems quite reasonable to demand that the Central Bank should go to great lengths in trying to reduce the interest rate… If, however, the actual interest rate equals the “optimal” rate consistent with the suggested “neutral state,” while asset prices are too low due to a State of Expectation which is “inappropriately pessimistic”-what then?

Consider what would happen if, in this situation, the long bond rate were forced down to whatever level was necessary to equate ex ante rates of saving and investment at full employment. This would mean that prices of bonds-assets with contractually fixed long receipt streams-would shoot up while equity prices remained approximately constant instead of declining. Through a succession of short periods, with aggregate money expenditures at the full employment level, initial opinions about the future yield on capital would be revealed as too pessimistic. Anticipated returns to capital go up. The contractually fixed return streams on bonds remain the same, and it now becomes inevitable that bond-holders take a capital loss (in real terms).

The Central Bank now has two options. (a) It may elect to stand by [leaving rates at very low levels.] … Since the situation is one of full employment, inflation must result and the “real value” of nominally fixed contracts decline. (b) It may choose … to increase market rate sufficiently to prevent any rise in [inflation]. Bond-holders lose again, since this means a reduction in the money value of bonds.

In other words, in our world of long-lived assets, if you rely only on monetary policy to get you out of depression, Bill Gross has to lose money. On a theoretical level, the fact that the lifetime of capital goods is long relative to the period over which we can reliably treat “fundamentals” as fixed means that the Marshallian long run, in which the capital stock is fully adjusted, does not apply to any actual economy. (This fact has many important implications beyond the scope of these posts.)

The key point for our purposes is that, in the slump, investment demand is lower than it will be once the economy recovers. So if the interest rate falls enough to end the recession, then you must have either a rise in rates or inflation once the slump ends. But either of those will mean losses for bondholders, anticipation of which will prevent long rates from falling the first place. Only if you successfully fool bond market participants can monetary policy produce recovery on a timescale significantly less than average asset life. The alternative is to prove the pessimistic expectations of entrepreneurs wrong by directly raising incomes, but that seems to be off the table.

This point is obvious, but it’s strangely ignored, perhaps because discussion of monetary policy is almost entirely focused on how optimal policy can prevent slumps from occurring in the first place. The implicit assumption of Krugman’s ISLM analysis, for instance, is that investment demand has permanently fallen, presumably unrelatedly to demand conditions themselves. So the new low rate is permanently appropriate. But — I feel it’s it’s safe to say — Krugman, and certainly market participants, don’t really believe this. But if policy is going to be reversed, on a timescale significantly shorter than the duration of the assets demand for which is supposed to be affected by monetary policy, then policy will not work at all.

At this point, though, it would seem that we have proven too much. The question becomes not, why isn’t monetary policy working now, but, How did monetary policy ever work? I can think of at least four answers, all of which probably have some truth to them.

1. It didn’t. The apparent stability of economies with active central banks is due to other factors. Changes in the policy not been stabilizing, or have even been destabilizing. This is consistent with the strand of the Post Keynesian tradition that emphasizes the inflationary impact of rate increases, since short rates are a component of marginal costs; but it is also basically the view of Milton Friedman and his latter-day epigones in the Market Monetarist world. I’m sympathetic but don’t buy it; I think the evidence is overwhelming that high interest rates are associated with low income/output, and vice versa.

2. The focus on long-lived goods is a mistake. The real effect of short rates is not via long rates, but on stuff that is financed directly by short borrowing, particularly inventories and working capital. I’m less sure about this one, but Keynes certainly did not think it was important; for now let’s follow him. A variation is income distribution, including corporate cashflow. Bernanke believes this. I’m doubtful that it’s the main story, but I presume there is something in it; how much is ultimately an empirical question.

3. The answer suggested by the analysis here: Monetary policy works well when the required interest rate variation stays within the conventional “normal” range. In this range, there are enough bulls and bears for the marginal bond buyer to expect the current level of interst to continue indefinitely, so that bond prices are not subject to stabilizing speculation and there is no premium for expected capital losses or gains; so long rates should move more or less one for one with short rates. This works on a theoretical level, but it’s not obvious that it particularly fits the data.

4. The most interesting possibility, to me: When countercylclical monetary policy seemed effective, it really was, but on different principles. Autonomous demand and interest rates were normally at a level *above* full employment, and stabilization was carried out via direct controls on credit creation, such as reserve requirements. A variation on this is that monetary policy has only ever worked through the housing market.

Regardless of the historical issue, the most immediately interesting question is how and whether monetary policy can work now. And here, we can safely say that channels 2,3 and 4, even if real, are exhausted. So in the absence of fiscal policy, it really does come down to the capacity of sustained low short rates to bring expected long rates down. Sorry, Bill Gross!

UPDATE: I was just reading this rightly classic paper by Chari, Kehoe and McGrattan. They’re pure freshwater, everything I hate. But New Keynesians are just real business cycle theorists with a bad conscience, which means the RBCers pwn them every time in straight-up debate. As here.I’m not interested in that, though, though the paper is worth reading if you want the flavor of what “modern macro” is all about. Rather, I’m interested in this subsidiary point in their argument:

as is well-known, during the postwar period, short rates and long rates have a very similar secular pattern. … Second, a large body of work in finance has shown that the level of the long rate is well-accounted for by the expectations hypothesis. … Combining these two features of the data implies that when the Fed alters the current short rate, private agents significantly adjust their long-run expectations of the future short rate, say, 30 years into the future. At an intuitive level, then, we see that Fed policy has a large random walk component to it.

In what sense this is true, I won’t venture to guess. It seems, at least, problematic, given that they also think that “interest rates … should be kept low on average.” The important point for my purposes, tho, is just that even the ultra-orthodox agree, that for a change in monetary policy to be effective, it has to be believed to be permanent. “If that which is at all were not forever…”

Interest Rates and (In)elastic Expectations

[Apologies to any non-econ readers, this is even more obscure than usual.]

Brad DeLong observed last week that one of the most surprising things about the Great Recession is how far long-term interest rates have followed short rates toward zero.

I have gotten three significant pieces of the past four years wrong. Three things surprised and still surprise me: (1.) The failure of central banks to adopt a rule like nominal GDP targeting, or it’s equivalent. (2.) The failure of wage inflation in the North Atlantic to fall even farther than it has–toward, even if not to, zero. (3.) The failure of the yield curve to sharply steepen: federal funds rates at zero I expected, but 30-Year U.S. Treasury bond nominal rates at 2.7% I did not.

… The third… may be most interesting.

Back in March 2009, the University of Chicago’s Robert Lucas confidently predicted that within three years the U.S. economy would be back to normal. A normal U.S. economy has a short-term nominal interest rate of 4%. Since the 10-Year U.S. Treasury bond rate tends to be one percentage point more than the average of expected future short-term interest rates over the next decade, even five expected years of a deeply depressed economy with essentially zero short-term interest rates should not push the 10-Year Treasury rate below 3%. (And, indeed, the Treasury rate fluctuated around 3 to 3.5% for the most part from late 2008 through mid 2011.) But in July of 2011 the 10-Year U.S. Treasury bond rate crashed to 2%, and at the start of June it was below 1.5%. [

The possible conclusions are stark: either those investing in financial markets expect … [the] current global depressed economy to endure in more-or-less its current state for perhaps a decade, perhaps more; or … the ability of financial markets to do their job and sensibly price relative risks and returns at a rational level has been broken at a deep and severe level… Neither alternative is something I would have or did predict, or even imagine.

I also am surprised by this, and for similar reasons to DeLong. But I think the fact that it’s surprising has some important implications, which he does not draw out.

Here’s a picture:

The dotted black line is the Federal Funds rate, set, of course, by the central bank. The red line is the 10-year Treasury; it’s the dip at the far right in that one that surprises DeLong (and me). The green line is the 30-year Treasury, which behaves similarly but has fallen by less. Finally, the blue line is the BAA bond rate, a reasonable proxy for the interest rate faced by large business borrowers; the 2008 financial crisis is clearly visible. (All rates are nominal.) While the Treasury rates are most relevant for the expectations story, it’s the interest rates faced by private borrowers that matter for policy.

The recent fall in 10-year treasuries is striking. But it’s at least as striking how slowly and incompletely they, and corporate bonds, respond to changes in Fed policy, especially recently. It’s hard to look at this picture and not feel a twinge of doubt about the extent to which the Fed “sets” “the” interest rate in any economically meaningful sense. As I’ve mentioned here before, when Keynes referred to the “liquidity trap,” he didn’t mean the technical zero lower bound to policy rates, but its delinking from the economically-important long rates. Clearly, it makes no difference whether or not you can set a policy rate below zero if there’s reason to think that longer rates wouldn’t follow it down in any case. And I think there is reason to think that.

The snapping of the link between monetary policy and other rates was written about years ago by Benjamin Friedman, as a potential; it figured in my comrade Hasan Comert’s dissertation more recently, as an actuality. Both of them attribute the disconnect to institutional and regulatory changes in the financial system. And I agree, that’s very important. But after reading Leijonhufvud’s On Keynesian Economics and the Economics of Keynes [1], I think there may be a deeper structural explanation.

As DeLong says, in general we think that long interest rates should be equal to the average expected short rates over their term, perhaps plus a premium. [2] So what can we say about interest rate expectations? One obvious question is, are they elastic or inelastic? Elastic expectations change easily; in particular, unit-elastic expectations mean that whatever the current short rate is, it’s expected to continue indefinitely. Inelastic expectations change less easily; in the extreme case of perfectly inelastic interest rate expectations, your prediction for short-term interest rates several years from now is completely independent of what they are now.

Inelastic interest-rate expectations are central to Keynes’ vision of the economy. (Far more so than, for instance, sticky wages.) They are what limit the effectiveness of monetary policy in a depression or recession, with the liquidity trap simply the extreme case of the general phenomenon. [3] His own exposition is a little hard to follow, but the simplest way to look at it is to recall that when interest rates fall, bond prices rise, and vice versa. (In fact they are just two ways of describing the same thing.) So if you expect a rise in interest rates in the future that means you’ll expect a capital loss if you hold long-duration bonds, and if you expect a fall in interest rates you’ll expect a capital gain. So the more likely it seems that short-term interest rates will revert to some normal level in the future, the less long rates should follow short ones.

This effect gets stronger as we consider longer maturities. In the limiting case of a perpetuity — a bond that makes a fixed dollar period every period forever — the value of the bond is just p/i, where p is the payment in each period and i is the interest rate. So when you consider buying a bond, you have to consider not just the current yield, but the possibility that interest rates will change in the future. Because if they do, the value of the bonds you own will rise or fall, and you will experience a capital gain or loss. Of course future interest rates are never really known. But Keynes argued that there is almost always a strong convention about the normal or “safe” level of interest.

Note that the logic above means that the relationship between short and long rates will be different when rates are relatively high vs. when they are relatively low. The lower are rates, the greater the capital loss from an increase in rates. As long rates approach zero, the potential capital loss from an increase approaches infinity.

Let’s make this concrete. If we write i_s for the short interest rate and i_l for the long interest rate, B for the current price of long bonds, and BE for the expected price of long bonds a year from now, then for all assets to be willing held it must be the case that i_l = i_s – (BE/B – 1), that is, interest on the long bond will need to be just enough higher (or lower) than the short rate to cancel out the capital loss (or gain) expected from holding the long bond. If bondholders expect the long run value of bond prices to be the same as the current value, then long and short rates should be the same. [*] Now for simplicity let’s assume we are talking about perpetuities (the behavior of long but finite bonds will be qualitatively similar), so B is just 1/i_l. [4] Then we can ask the question, how much do short rates have to fall to produce a one point fall in long rates.

Obviously, the answer will depend on expectations. The standard economist’s approach to expectations is to say they are true predictions of the future state of the world, an approach with some obvious disadvantages for those of us without functioning time machines. A simpler, and more empirically relevant, way of framing the question, is to ask how expectations change based on changes in the current state of the world — which unlike the future, we can observe. Perfectly inelastic expectations mean that your best guess about interest rates at some future date is not affected at all by the current level of interest rates; unit-elastic expectations mean that your best guess changes one for one with the current level. An of course there are all the possibilities in between. Let’s quantify this as the subjective annual probability that a departure of interest rates from their current or “normal” level will subsequently be reversed. Now we can calculate the exact answer to the question posed above, as shown in the next figure.

For instance, suppose short rates are initially at 6 percent, and suppose this is considered the “normal” level, in the sense that the marginal participant in the bond market regards an increase or decrease as equally likely. Then the long rate will also be 6 percent. Now we want to get the long rate down to 5 percent. Suppose interest rate expectations are a bit less than unit elastic — i.e. when market rates change, people adjust their views of normal rates by almost but not quite as much. Concretely, say that the balance of expectations is that there is net 5 percent annual chance that rates will return to their old normal level. If the long rate does rise back to 6 percent, people who bought bonds at 5 percent will suffer a capital loss of 20 percent. A 5 percent chance of a 20 percent loss equals an expected annual loss of 1 percent, so long rates will need to be one point higher than short rates for people to hold them. [5] So from a starting point of equality, for long rates to fall by one point, short rates must fall by two points. You can see that on the blue line on the graph. You can also see that if expectations are more than a little inelastic, the change in short rates required for a one-point change in long rates is impossibly large unless rates are initially very high.

It’s easy enough to do these calculations; the point is that unless expectations are perfectly elastic, we should always expect long rates to change less than one for one with short rates; the longer the rates considered, the more inelastic expectations, and the lower initial rates, the less responsive long rates will be. At the longest end of the term structure — the limiting case of a perpetuity — it is literally impossible for interest rates to reach zero, since that would imply an infinite price.

This dynamic is what Keynes was talking about when he wrote:

If . . . the rate of interest is already as low as 2 percent, the running yield will only offset a rise in it of as little as 0.04 percent per annum. This, indeed, is perhaps the chief obstacle to a fall in the rate of interest to a very low level . . . [A] long-term rate of interest of (say) 2 percent leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.

Respectable economists like DeLong believe that there is a true future path of interest rates out there, which current rates should reflect; either the best current-information prediction is of government policy so bad that the optimal interest rate will continue to be zero for many years to come, or else financial markets have completely broken down. I’m glad the second possibility is acknowledged, but there is a third option: There is no true future course of “natural” rates out there, so markets adopt a convention for normal interest rates based on past experience. Given the need to take forward-looking actions without true knowledge of the future, this is perfectly rational in the plain-English sense, if not in the economist’s.

A final point: For Keynes — a point made more clearly in the Treatise than in the General Theory — the effectivness of monetary policy depends critically on the fact that there are normally market participants with differing expectations about future interest rates. What this means is that when interest rates rise, people who think the normal or long-run rate of interest is relatively low (“bulls”) can sell bonds to people who think the normal rate is high (“bears”), and similarly when interest rates fall the bears can sell to the bulls. Thus the marginal bond will be held held by someone who thinks the current rate of interest is the normal one, and so does not require a premium for expected capital gains or losses. This is the same as saying that the market as a whole behaves as if expectations are unit-elastic, even though this is not the case for individual participants. [6] But when interest rates move too far, there will no longer be enough people who think the new rate is normal to willingly hold the stock of bonds without an interest-rate risk premium. In other words, you run out of bulls or bears. Keynes was particularly concerned that an excess of bear speculators relative to bulls could keep long interest rates permanently above the level compatible with full employment. The long rate, he warned,

may fluctuate for decades about a level which is chronically too high for full employment; – particularly if it is the prevailing opinion that the rate of interest is self-adjusting, so that the level established by convention is thought to be rooted in objective grounds much stronger than convention, the failure of employment to attain an optimum level being in no way associated, in the minds either of the public or of authority, with the prevalence of an inappropriate range of rates of interest’.

If the belief that interest rates cannot fall below a certain level is sufficiently widespread, it becomes self-fulfilling. If people believe that long-term interest rates can never persistently fall below, say, 3 percent, then anyone who buys long bonds much below that is likely to lose money. And, as Keynes says, this kind of self-stabilizing convention is more likely to the extent that people believe that it’s not just a convention, but that there is some “natural rate of interest” fixed by non-monetary fundamentals.

So what does all this mean concretely?

1. It’s easy to see inelastic interest-rate expectations in the data. Long rates consistently lag behind short rates. During the 1960s and 1970s, when rates were secularly rising, long rates were often well below the Federal Funds rate, especially during tightening episodes; during the period of secularly falling rates since 1980, this has almost never happened, but very large term spreads have become more common, especially during loosening episodes.

2. For the central bank to move long rates, it must persuade markets that changes in policy are permanent, or at least very persistent; this is especially true when rates are low. (This is the main point of this post.) The central bank can change rates on 30-year bonds, say, only by persuading markets that average rates over the next 30 years will be different than previously believed. Over small ranges, the existence of varying beliefs in the bond market makes this not too difficult (since the central bank doesn’t actually have to change any individual’s expectations if bond sales mean the marginal bondholder is now a bull rather than a bear, or vice versa) but for larger changes it is more difficult. And it becomes extremely difficult to the extent that economic theory has taught people that there is a long run “natural” rate of interest that depends only on technology and time preferences, which monetary policy cannot affect.

Now, the obvious question is, how sure are we that long rates are what matters? I’ve been treating a perpetual bond as an approximation of the ultimate target of monetary policy, but is that reasonable? Well, one point on which Keynes and today’s mainstream agree is that the effect of interest rates on the economy comes through demand for long-lived assets — capital goods and housing. [7] According to the BEA, the average current-cost age of private fixed assets in the US is a bit over 21 years, which implies that the expected lifetime of a new fixed asset must be quite a bit more than that. For Keynes (Leijonhufvud stresses this point; it’s not so obvious in the original texts) the main effect of interest rates is not on the financing conditions for new fixed assets, as most mainstream and heterodox writers both assume, but on the discount rate used of the assets. In that case the maturity of assets is what matters. On the more common view, it’s the maturity of the debt used to finance them, which may be a bit less; but the maturity of debt is usually matched to the maturity of assets, so the conclusion is roughly the same. The relevant time horizon for fixed assets is long enough that perpetuities are a reasonable first approximation. [8]

3. So if long rates are finally falling now, it’s only because an environment of low rates is being established as new normal. There’s a great deal of resistance to this, since if interest rates do return to their old normal levels, the capital losses to bondholders will be enormous. So to get long rates down, the Fed has to overcome intense resistance from bear speculators. Only after a great deal of money has been lost betting on a return of interest rates to old levels will market participants begin to accept that ultra-low rates are the new normal. The recent experience of Bill Gross of PIMCO (the country’s largest bond fund) is a perfect example of this story. In late 2010, he declared that interest rates could absolutely fall no further; it was the end of the 30-year bull market in bonds. A year later, he put his money where his mouth was and sold all his holdings of Treasuries. As it turned out, this was just before bond prices rose by 30 percent (the flipside of the fall in rates), a misjudgment that cost his investors billions. But Gross and the other “bears” had to suffer those kinds of losses for the recent fall in long rates to be possible. (It is also significant that they have not only resisted in the market, but politically as well.) The point is, outside a narrow range, changes in monetary policy are only effective when they cease to be perceived as just countercyclical, but as carrying information about “the new normal.” Zero only matters if it’s permanent zero.

4. An implication of this is that in a world where the lifespan of assets is much longer than the scale of business-cycle fluctuations, we cannot expect interest rates to be stationary if monetary policy is the main stabilization tool. Unless expectations are very elastic, effective monetary policy require secular drift in interest rates, since each short-term stabilization episode will result in a permanent change in interest rates. [9] You can see this historically: the fall in long rates in the 1990 and 2000 loosenings both look about equal to the permanent components of those changes. This is a problem for two reasons: First, because it means that monetary policy must be persistent enough to convince speculators that it does represent a permanent change, which means that it will act slower, and require larger changes in short rates (with the distortions those entail) than in the unit-elastic expectations case. And second, because if there is some reason to prefer one long-ru level of interest rates to another (either because you believe in a “natural” rate, or because of the effects on income distribution, asset price stability, etc.) it would seem that maintaining that rate is incompatible with the use of monetary policy for short-run stabilization. And of course the problem is worse, the lower interest rates are.

5. One way of reading this is that monetary policy works better when interest rates are relatively high, implying that if we want to stabilize the economy with the policy tools we have, we should avoid persistently low interest rates. Perhaps surprisingly, given what I’ve written elsewhere, I think there is some truth to this. If “we” are social-welfare-maximizing managers of a capitalist economy, and we are reliant on monetary policy for short-run stabilization, then we should want full employment to occur in the vicinity of nominal rates around 10 percent, versus five percent. (One intuitive way of seeing this: Higher interest rates are equivalent to attaching a low value to events in the future, while low interest rates are equivalent to a high value on those events. Given the fundamental uncertainty about the far future, choices in the present will be more stable if they don’t depend much on far-off outcomes.) In particular — I think it is a special case of the logic I’ve been outlining here, though one would have to think it through — very low interest rates are likely to be associated with asset bubbles. But the conclusion, then, is not to accept a depressed real economy as the price of stable interest rates and asset prices, but rather to “tune” aggregate demand to a higher level of nominal interest rates. One way to do this, of course, is higher inflation; the other is a higher level of autonomous demand, either for business investment (the actual difference between the pre-1980 period and today, I think), or government spending.

[1] The most invigorating economics book I’ve read in years. It’ll be the subject of many posts here in the future, probably.

[2] Why there should be a pure term premium is seldom discussed but actually not straightforward. It’s usually explained in terms of liquidity preference of lenders, but this invites the questions of (1) why liquidity preference outweighs “solidity preference”; and (2) why lenders’ preferences should outweigh borrowers’. Leijonhufvud’s answer, closely related to the argument of this post, is that the “excessively long” lifespan of physical capital creates chronic excess supply at the long end of the asset market. In any case, for the purpose of this post, we will ignore the pure premium and assume that long rates are simply the average of expected short rates.

[3] Keynes did not, as is sometimes suggested by MMTers and other left Keynesians, reject the effectiveness of monetary policy in general. But he did believe that it was much more effective at stabilizing full employment than at restoring full employment from a depressed state.

[4] I will do up these equations properly once the post is done.

[5] I anticipate an objection to reasoning on the basis of an equilibrium condition in asset markets. I could just say, Keynes does it. But I do think it’s legitimate, despite my rejection of the equilibrium methodology more generally. I don’t think there’s any sense that human behavior can be described as maximizing some quantity called utility,” not even as a rough approximation; but I do think that capitalist enterprises can be usefully described as maximizing profit. I don’t think that expectations in financial markets are “rational” in the usual economists’ sense, but I do think that one should be able to describe asset prices in terms of some set of expectations.

[6] We were talking a little while ago with Roger Farmer, Rajiv Sethi, and others about the desirability of limiting economic analysis to equilibria, i.e. states where all expectations are fulfilled. This implies, among other things, that all expectations must be identical. Keynes’ argument for why long rates are more responsive to short rates within some “normal” range of variation is — whether you think it’s right or not — an example of something you just can’t say within Farmer’s preferred framework.

[7] Despite this consensus, this may not be entirely the case; and in fact to the extent that monetary policy is effective in the real world, other channels, like income distribution, may be important. But let’s assume for now that demand for long-lived assets is what matters.

[8] Hicks had an interesting take on this, according to Leijonhufvud. Since the production process is an integrated whole, “capital” does not consist of particular goods but of a claim on the output of the process as a whole. Since this process can be expected to continue indefinitely, capital should be generally assumed to be infinitely-lived. When you consider how much of business investment is motivated by maintaining the firm’s competitive position — market share, up to date technology, etc. — it does seem reasonable to see investment as buying not a particular capital good but more of the firm as a whole.

[9] There’s an obvious parallel with the permanent inflation-temporary employment tradeoff of mainstream theory. Except, I think mine is correct!

The Story of Q

More posts on Greece, coming right up. But first I want to revisit the relationship between finance and nonfinancial business in the US.

Most readers of this blog are probably familiar with Tobin’s q. The idea is that if investment decisions are being made to maximize the wealth of shareholders, as theory and, sometimes, the law say they should be, then there should be a relationship between the value of financial claims on the firm and the value of its assets. Specifically, the former should be at least as great as the latter, since if investing another dollar in the firm does not increase its value to shareholders by at least a dollar, then that money would better have been returned to them instead.

As usual with anything interesting in macroeconomics, the idea goes back to Keynes, specifically Chapter 12 of the General Theory:

the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur.

It was this kind of reasoning that led Hyman Minsky to describe Keynes as having “an investment theory of the business cycle, and a financial theory of investment.” Axel Leijonhufvud, on the other hand, would warn us against taking the dramatis personae of this story too literally; the important point, he would argue, is the way in which investment responds to the shifts in the expected return on fixed investment versus the long-term interest rate. For better or worse, postwar Keynesians including the eponymous Tobin followed Keynes here in thinking of one group of decisionmakers whose expectations are embodied in share prices and another group setting investment within the firm. If shareholders are optimistic about the prospects for a business, or for business in general, the value of shares relative to the cost of capital goods will rise, a signal for firms to invest more; if they are pessimistic, share prices will fall relative to the cost of capital goods, a signal that further investment would be, from the point of view of shareholders, value-subtracting, and the cash should be disgorged instead.

There are various specifications of this relationship; for aggregate data, the usual one is the ratio of the value corporate equity to corporate net worth, that is, to total assets minus total liabilities. In any case, q fails rather miserably, both in the aggregate and the firm level, in its original purpose, predicting investment decisions. Here is q for nonfinancial corporations in the US over the past 60 years, along with corporate investment.

The orange line is the standard specification of q; the dotted line is equity over fixed assets, which behaves almost identically. The black line shows nonfinancial corporations’ nonresidential fixed investment as a share of GDP. As you can see, apart from the late 90s tech boom, there’s no sign that high q is associated with high investment, or low q with low investment. In fact, the biggest investment boom in postwar history, in the late 1970s, comes when q was at its low point. [*]

The obvious way of looking at this is that, contra Tobin and (at least some readings of) Keynes, stock prices don’t seem to have much to do with fixed investment. Which is not so strange, when you think about it — it’s never been clear why managers and entrepreneurs should substitute the stock market’s beliefs about the profitability of some new investment for their own, presumably better-informed, one. Just as well, given the unanchored gyrations of the stock market.

This is true as far as it goes, but there’s another way of looking at it. Because, q isn’t just uncorrelated with investment; for most of the period, at least until the 1990s, it’s almost always well below 1. This is even more surprising when you consider that a well-run firm with an established market ought to have a q above one, since it will presumably have intangible assets — corporate culture, loyal customers and so on — that don’t show up on the balance sheet. In other words, measured assets should seem to be “too low”. But in fact, they’re almost always too high. For most of the postwar period, it seems that corporations were systematically investing too much, at least from the point of view maximizing shareholder value.

I was talking with Suresh the other day about labor, and about the way labor organizing can be seen as a kind of assertion of a property right. Whether shareholders are “the” residual claimants of a firm’s earnings is ultimately a political question, and in times and places where labor is strong, they are not. Same with tenant organizing — you could see it as an assertion that long-time tenants have a property right in their homes, which I think fits most people’s moral intuitions.

Seen from this angle, the fact that businesses were investing “too much” during much of the postwar decades no longer is a sign they were being irrational or made a mistake; it just suggests that they were considering the returns to claimants other than shareholders. Though one wouldn’t what to read too much into it, it’s interesting in this light that for the past dozen years aggregate q has been sitting at one, exactly where loyal agents for shareholders would try to keep it. In liberal circles, the relatively low business investment of the past decade is often considered a sign of something seriously wrong with the economy. But maybe it’s just a sign that corporations have learned to obey their masters.

EDIT: In retrospect, the idea of labor as residual claimant does not really belong in this argument, it just confuses things. I am not suggesting that labor was ever able to compel capitalist firms to invest more than they wanted, but rather that “capitalists” were more divided sociologically before the shareholder revolution and that mangers of firms chose a higher level of investment than was optimal from the point of view of owners of financial assets. Another, maybe more straightforward way of looking at this is that q is higher — financial claims on a firm are more valuable relative to the cost of its assets — because it really is better to own financial claims on a productive enterprise today than in the pr-1980 period. You can reliably expect to receive a greater share of its surplus now than you could then.

[*] One of these days I really want to write something abut the investment boom of the 1970s. Nobody seems to realize that the highest levels of business investment in modern US history came in 1978-1981, supposedly the last terrible days of stagflation. Given the general consensus that fixed capital formation is at the heart of economic growth, why don’t people ask what was going right then?

Part of it, presumably, must have been the kind of sociological factors pointed to here — this was just before the Revolt of the Rentiers got going, when businesses could still pursue growth, market share and innovation for their own sakes, without worrying much about what shareholders thought. Part must have been that the US was still able to successfully export in a range of industries that would become uncompetitive when the dollar appreciated in the 1980s. But I suspect the biggest factor may have been inflation. We always talk about investment being encouraged by stuff that makes it more profitable for capitalists to hold their wealth in the form of capital goods. But logically it should be just as effective to reduce the returns and/or safety of financial assets. Since neither nominal interest rates nor stock prices tracked inflation in the 1970s, wealthholders had no choice but to accept holding a greater part of their wealth in the form of productive business assets. The distributional case for tolerating inflation is a bit less off-limits in polite conversation than it was a few years ago, but the taboo on discussing its macroeconomic benefits is still strong. Would be nice to try violating that.

Only Ever Equilibrium?

Roger Farmer has a somewhat puzzling guest post up at Noah Smith’s place, arguing that economics is right to limit discussion to equilibrium:

An economic equilibrium, in the sense of Nash, is a situation where a group of decision makers takes a sequence of actions that is best, (in a well defined sense), on the assumption that every other decision maker in the group is acting in a similar fashion. In the context of a competitive economy with a large number of players, Nash equilibrium collapses to the notion of perfect competition. The genius of the rational expectations revolution, largely engineered by Bob Lucas, was to apply that concept to macroeconomics by successfully persuading the profession to base our economic models on Chapter 7 of Debreu’s Theory of Value… In Debreu’s vision, a commodity is indexed by geographical location, by date and by the state of nature. Once one applies Debreu’s vision of general equilibrium theory to macroeconomics, disequilibrium becomes a misleading and irrelevant distraction.

The use of equilibrium theory in economics has received a bad name for two reasons.

First, many equilibrium environments are ones where the two welfare theorems of competitive equilibrium theory are true, or at least approximately true. That makes it difficult to think of them as realistic models of a depression, or of a financial collapse… Second, those macroeconomic models that have been studied most intensively, classical and new-Keynesian models, are ones where there is a unique equilibrium. Equilibrium, in this sense, is a mapping from a narrowly defined set of fundamentals to an outcome, where an outcome is an observed temporal sequence of unemployment rates, prices, interest rates etc. Models with a unique equilibrium do not leave room for non-fundamental variables to influence outcomes…

Multiple equilibrium models do not share these shortcomings… [But] a model with multiple equilibria is an incomplete model. It must be closed by adding an equation that explains the behavior of an agent when placed in an indeterminate environment. In my own work I have argued that this equation is a new fundamental that I call a belief function.

(Personally, I might just call it a convention.)

Some recent authors have argued that rational expectations must be rejected and replaced by a rule that describes how agents use the past to forecast the future. That approach has similarities to the use of a belief function to determine outcomes, and when added to a multiple equilibrium model of the kind I favor, it will play the same role as the belief function. The important difference of multiple equilibrium models, from the conventional approach to equilibrium theory, is that the belief function can coexist with the assumption of rational expectations. Agents using a rule of this kind, will not find that their predictions are refuted by observation. …

So his point here is that in a model with multiple equilibria, there is no fundamental reason why the economy should occupy one rather than another. You need to specify agents’ expectations independently, and once you do, whatever outcome they expect, they’ll be correct. This allows for an economy to experience involuntary unemployment, for example, as expectations of high or low income lead to increased or curtailed expenditure, which results in expected income, whatever it was, being realized. This is the logic of the Samuelson Cross we teach in introductory macro. But it’s not, says Farmer, a disequilibrium in any meaningful way:

If by disequilibrium, I am permitted to mean that the economy may deviate for a long time, perhaps permanently, from a social optimum; then I have no trouble with championing the cause. But that would be an abuse of the the term ‘disequilibrium’. If one takes the more normal use of disequilibrium to mean agents trading at non-Walrasian prices, … I do not think we should revisit that agenda. Just as in classical and new-Keynesian models where there is a unique equilibrium, the concept of disequilibrium in multiple equilibrium models is an irrelevant distraction.

I quote this at such length because it’s interesting. But also because, to me at least, it’s rather strange. There’s nothing wrong with the multiple equilibrium approach he’s describing here, which seems like a useful way of thinking about a number of important questions. But to rule out a priori any story in which people’s expectations are not fulfilled rules out a lot of other useful ways about thinking about important questions.

At INET in Berlin, the great Axel Leijonhufvud gave a talk where he described the defining feature of a crisis as the existence of inconsistent contractual commitments, so that some of them would have to be voided or violated.

What is the nature of our predicament? The web of contracts has developed serious inconsistencies. All the promises cannot possibly be fulfilled. Insisting that they should be fulfilled will cause a collapse of very large portions of the web.

But Farmer is telling us that economists not only don’t need to, but positively should not, attempt to understand crises in this sense. It’s an “irrelevant distraction” to consider the case where people entered into contracts with inconsistent expectations, which will not all be capable of being fulfilled. Farmer can hardly be unfamiliar with these ideas; after all he edited Leijonhufvud’s festschrift volume. So why is he being so dogmatic here?

I had an interesting conversation with Rajiv Sethi after Leijonhufvud’s talk; he said he thought that the inability to consider cases where plans were not realized was a fundamental theoretical shortcoming of mainstream macro models. I don’t disagree.

The thing about the equilibrium approach, as Farmer presents it, isn’t just that it rules out the possibility of people being systematically wrong; it rules out the possibility that they disagree. This strikes me as a strong and importantly empirically false proposition. (Keynes suggested that the effectiveness of monetary policy depends on the existence of both optimists and pessimists in financial markets.) In Farmer’s multiple equilibrium models, whatever outcome is set by convention, that’s the outcome expected by everyone. This is certainly reasonable in some cases, like the multiple equilibria of driving on the left or the right side of the road. Indeed, I suspect that the fact that people are irrationally confident in these kinds of conventions, and expect them to hold even more consistently than they do, is one of the main things that stabilizes these kind of equilibria. But not everything in economics looks like that.

Here’s Figure 1 from my Fisher dynamics paper with Arjun Jayadev:

See those upward slopes way over on the left? Between 1929 and 1933, household debt relative to GDP rose by abut 40 percent, and nonfinancial business debt relative to GDP nearly doubled. This is not, of course, because families and businesses were borrowing more in the Depression; on the contrary, they were paying down debt as fast as they could. But in the classic debt-deflation story, falling prices and output meant that incomes were falling even fast than debt, so leverage actually increased.

Roger Farmer, if I’m understanding him correctly, is saying that we must see this increase in debt-income ratios as an equilibrium phenomenon. He is saying that households and businesses taking out loans in 1928 must have known that their incomes were going to fall by half over the next five years, while their debt payments would stay unchanged, and chose to borrow anyway. He is saying not just that he believes that, but that as economists we should not consider any other view; we can rule out on methodological grounds the possibility that the economic collapse of the early 1930s caught people by surprise. To Irving Fisher, to Keynes, to almost anyone, to me, the rise in debt ratios in the early 1930s looks like a pure disequilibrium phenomenon; people were trading at false prices, signing nominal contracts whose real terms would end up being quite different from what they expected. It’s one of the most important stories in macroeconomics, but Farmer is saying that we should forbid ourselves from telling it. I don’t get it.

What am I missing here?

Graeber Cycles and the Wicksellian Judgment Day

So it’s halfway through the semester, and I’m looking over the midterms. Good news: Learning has taken place.

One of the things you hope students learn in a course like this is that money consists of three things: demand deposits (checking accounts and the like), currency and bank reserves. The first is a liability of private banks, the latter two are liabilities of the central bank. That money is always someone’s liability — a debt — is often a hard thing for students to get their heads around, so one can end up teaching it a bit catechistically. Balance sheets, with their absolute (except for the exceptions) and seemingly arbitrary rules, can feel a bit like religious formula. On this test, the question about the definition of money was one of the few that didn’t require students to think.

But when you do think about it, it’s a very strange thing. What we teach as just a fact about the world, is really the product of — or rather, a moment in — a very specific historical evolution. We are lumping together two very different kinds of “money.” Currency looks like classical money, like gold; but demand deposits do not. The most obvious difference, at least in the context of macroeconomics, is that one is exogenous (or set by policy) and the other endogenous. We paper this over by talking about reserve requirements, which allow the central bank to set “the” money supply to determine “the” interest rate. But everyone knows that reserve requirements are a dead letter and have been for decades, probably. While monetarists like Nick Rowe insist that there’s something special about currency — they have to, given the logic of their theories — in the real world the link between the “money” issued by central banks and the “money” that matters for the economy has attenuated to imperceptible gossamer, if it hasn’t been severed entirely. The best explanation for how conventional monetary policy works today is pure convention: With the supply of money entirely in the hands of private banks, policy is effective only because market participants expect it to be effective.

In other words, central banks today are like the Chinese emperor Wang Wei-Shao in the mid-1960s film Genghis Khan:

One of the film’s early scenes shows the exquisitely attired emperor, calligraphy brush in hand, elegantly composing a poem. With an ethereal self-assurace born of unquestioning confidence in the divinely ordained course of worldly affairs, he explains that the poem’s purpose is to express his displeasure at the Mongol barbarians who have lately been creating a disturbance on the empire’s western frontier, and, by so doing, cause them to desist.

Today expressions of intentions by leaders of the world’s major central banks typically have immediate repercussions in financial markets… Central bankers’ public utterances … regularly move prices and yields in the financial markets, and these financial variables in turn affect non-financial economic activity… Indeed, a widely shared opinion today is that central bank need not actually do anything. …

In truth the ability of central banks to affect the evolution of prices and output … [is] something of a mystery. … Each [explanation of their influence] … turns out to depend on one or another of a series of by now familiar fictions: households and firms need currency to purchase goods and services; banks can issue only reserve-bearing liabilities; no non-bank financial institutions create credit; and so on.

… at a practical level, there is today [1999] little doubt that a country’s monetary policy not only can but does largely determine the evolution of its price level…, and almost as little doubt that monetary policy exerts significant influence over … employment and output… Circumstances change over time, however, and when they do the fictions that once described matters adequately may no longer do so. … There may well have been a time when the might of the Chinese empire was such that the mere suggestion of willingness to use it was sufficient to make potential invaders withdraw.

What looked potential a dozen years ago is now actual, if it wasn’t already then. It’s impossible to tell any sensible macroeconomic story that hinges on the quantity of outside money. The shift in our language from money, which can be measured — that one could formulate a “quantity theory” of — to discussions of liquidity, still a noun but now not a tangible thing but a property that adheres in different assets to different degrees, is a key diagnostic. And liquidity is a result of the operations of the financial system, not a feature of the natural world or a dial that can be set by the central bank. In 1820 or 1960 or arguably even in 1990 you could tell a kind of monetarist story that had some purchase on reality. Not today. But, and this is my point! it’s not a simple before and after story. Because, not in 1890 either.

David Graeber, in his magisterial Debt: The First 5,000 Years [1], describes a very long alternation between world economies based on commodity money and world economies based on credit money. (Graeber’s idiolect is money and debt; let’s use here the standard terms.) The former is anonymous, universal and disembedded, corresponds to centralized states and extensive warfare, and develops alongside those other great institutions for separating people from their social contexts, slavery and bureaucracy. [2] Credit, by contrast, is personal, particular, and unavoidably connected with specific relationships and obligations; it corresponds to decentralized, heterogeneous forms of authority. The alternations between commodity-money systems,with their transcendental, monotheistic religious-philosophical superstructures; and credit systems, with their eclectic, immanent, pantheistic superstructures, is, in my opinion, the heart of Debt. (The contrast between medieval Christianity, with its endless mediations by saints and relics and the letters of Christ’s name, and modern Christianity, with just you and the unknowable Divine, is paradigmatic.) Alternations not cycles, since there is no theory of the transition; probably just as well.

For Graeber, the whole half-millenium from the 16th through the 20th centuries is a period of the dominion of money, a dominion only now — maybe — coming to an end. But closer to ground level, there are shorter cycles. This comes through clearly in Axel Leijonhufvud’s brilliant short essay on Wicksell’s monetary theory, which is really the reason this post exists. (h/t ~~David Glasner, I think~~ Ashwin at Macroeconomic Resilience.) Among a whole series of sharp observations, Leijonhufvud makes the point that the past two centuries have seen several swings between commodity (or quasi-commodity) money and credit money. In the early modern period, the age of Adam Smith, there really was a (commodity) money economy, you could talk about a quantity of money. But even by the time of Ricardo, who first properly formalized the corresponding theory, this was ceasing to be true (as Wicksell also recognized), and by the later 19th century it wasn’t true at all. The high gold standard era (1870-1914, roughly) really used gold only for settling international balances between central banks; for private transactions, it was an age not of gold but of bank-issued paper money. [3]

If I somehow found myself teaching this course in the 18th century, I’d explain that money means gold, or gold and silver. But by the mid 19th century, if you asked people about the money in their pocket, they would have pulled out paper bills, not so unlike bills of today — except they very likely would have been bills issued by private banks.

The new world of bank-created money worried classical economists like Wicksell, who, like later monetarists, were strongly committed to the idea that the overall price level depends on the amount of money in circulation. The problem is that in a world of pure credit money, it’s impossible to base a theory of the price level on the relationship between the quantity of money and the level of output, since the former is determined by the latter. Today we’ve resolved this problem by just giving up on a theory of the price level, and focusing on inflation instead. But this didn’t look like an acceptable solution before World War II. For economists then — for any reasonable person — a trajectory of the price level toward infinity was an obvious absurdity that would inevitably come to a halt, disastrously if followed too far. Whereas today, that trajectory is the precise definition of price stability, that is, stable inflation. [4] Wicksell was part of an economics profession that saw explaining the price level as a, maybe the, key task; but he had no doubt that the trend was toward an ever-diminishing role for gold, at least domestically, leaving the money supply in the hands of the banks and the price level frighteningly unmoored.

Wicksell was right. Or at least, he was right when he wrote, a bit before 1900. But a funny thing happened on the way to the world of pure credit money. Thanks to new government controls on the banking system, the trend stopped and even reversed. Leijonhufvud:

Wicksell’s “Day of Judgment” when the real demand for the reserve medium would shrink to epsilon was greatly postponed by regime changes already introduced before or shortly after his death [in 1926]. In particular, governments moved to monopolize the note issue and to impose reserve requirements on banks. The control over the banking system’s total liabilities that the monetary authorities gained in this way greatly reduced the potential for the kind of instability that preoccupied Wicksell. It also gave the Quantity Theory a new lease of life, particularly in the United States.

But although Judgment Day was postponed it was not cancelled. … The monetary anchors on which 20th century central bank operating doctrines have relied are giving way. Technical developments are driving the process on two fronts. First, “smart cards” are circumventing the governmental note monopoly; the private sector is reentering the business of supplying currency. Second, banks are under increasing competitive pressure from nonbank financial institutions providing innovative payment or liquidity services; reserve requirements have become a discriminatory tax on banks that handicap them in this competition. The pressure to eliminate reserve requirements is consequently mounting. “Reserve requirements already are becoming a dead issue.”

The second bolded sentence makes a nice point. Milton Friedman and his followers are regarded as opponents of regulation, supporters of laissez-faire, etc. But to the extent that the theory behind monetarism ever had any validity (or still has any validity in its present guises) it is precisely because of strict government control over credit creation. It’s an irony that textbooks gloss over when they treat binding reserve requirements and the money multiplier as if they were facts of nature.

(That’s more traditional textbooks. Newer textbooks replace the obsolete story that the central bank controls interest rates by setting the money supply with a new story that the central bank sets the interest rate by … look, it just does, ok? Formally this is represented by replacing the old upward sloping LM curve with a horizontal MP (for monetary policy) line at the interest rate chosen by the central bank. The old story was artificial and, with respect to recent decades, basically wrong, but it did have the virtue of recognizing that the interest rate is determined in financial markets, and that monetary policy has to operate by changing the supply of liquidity. In the up-to-date modern version, policy might just as well operate by calligraphy.)

So, in the two centuries since Heinrich van Storch lectured the young Grand Dukes of Russia on the economic importance of “precious metals and fine jewels,” capitalism has gone through two full Graeber cycles, from commodity money to credit money, back to (pseudo-)commodity money and now to credit money again. It’s a process that proceeds unevenly; both the reality and the theory of money are uncomfortable hybrids of the two. But reality has advanced further toward the pure credit pole than theory has.

This time, will it make it all the way? Is Leijonhufvud right to suggest that Wicksell’s Day of Judgment was deferred but not canceled, and now is at hand?

Certainly the impotence of conventional monetary policy even before the crisis is a serious omen. And it’s hard to imagine a breakdown of the credit system that would force a return to commodity money, as in, say, medieval China. But on the other hand, it is not hard to imagine a reassertion of the public monopoly on means of payment. Indeed, when you think about it, it’s hard to understand why this monopoly was ever abandoned. The practical advantages of smart cards over paper tokens are undeniable, but there’s no reason that the cards shouldn’t have been public goods just like the tokens were. (For Graeber’s spiritual forefather Karl Polanyi, money, along with land and labor, was one of the core social institutions that could not be treated as commodities without destroying the social fabric.) The evolution of electronic money from credit cards looks contingent, not foreordained. Credit cards are only one of several widely-used electronic means of payment, and there’s no obvious reason why they and not one of the ones issued by public entities should have been adopted universally. This is, after all, an area with extremely strong network externalities, where lock-in is likely. Indeed, in the Benjamin Friedman article quoted above, he explicitly suggests that subway cards issued by the MTA could just as easily have developed into the universal means of payment. After all, the “pay community” of subway riders in New York is even more extensive than the pay community of taxpayers, and there was probably a period in the 1990s when more people had subway cards in their wallets than had credit or debit cards. What’s more, the MTA actually experimented with distributing subway card-reading machines to retailers to allow the cards to be used like, well, money. The experiment was eventually abandoned, but there doesn’t seem to be any reason why it couldn’t have succeeded; even today, with debit/credit cards much more widespread than two decades ago, many campuses find it advantageous to use college-issued smart cards as a kind of local currency.

These issues were touched on in the debate around interchange fees that rocked the econosphere a while back. (Why do checks settle at par — what I pay is exactly what you get — but debit and credit card transactions do not? Should we care?) But that discussion, while useful, could hardly resolve the deeper question: Why have we allowed means of payment to move from being a public good to a private oligopoly? In the not too distant past, if I wanted to give you some money and you wanted to give me a good or service, we didn’t have to pay any third party for permission to make the trade. Now, most of the time, we do. And the payments are not small; monetarists used to (still do?) go on about the “shoe leather costs” of holding more cash as a serious reason to worry about inflation, but no sane person could imagine those costs could come close to five percent of retail spending. And that’s not counting the inefficiencies. This is a private sales tax that we allow to be levied on almost every transaction, just as distortionary and just as regressive as other sales taxes but without the benefit of, you know, funding public services. The more one thinks about it, the stranger it seems. Why, of all the expansions of public goods and collective provision won over the past 100 or 200 years, is this the one big one that has been rolled back? Why has this act of enclosure apparently not even been noticed, let alone debated? Why has the modern equivalent of minting coinage — the prerogative of sovereigns for as long as there’ve been any — been allowed to pass into the hands of Visa and MasterCard, with neoliberal regimes not just allowing but actively encouraging it?

The view of the mainstream — which in this case stretches well to the left of Krugman and DeLong, and on the right to everyone this side of Ron Paul — is that, whatever the causes of the crisis and however the authorities should or do respond, eventually we will return to the status quo ante. Conventional monetary policy may not be effective now, but there’s no reason to doubt that it will one day get back to so being. I’m not so sure. I think people underestimate the extent to which modern central banking depended on a public monopoly on means of payment, a monopoly that arose — was established — historically, and has now been allowed to lapse. Christina Romer’s Berkeley speech on the glorious counterrevolution in macroeconomic policy may not have been anti-perfectly timed just because it was given months before the beginning of the worst recession in 70 years, but because it marked the end of the period in which the body of theory and policy that she was extolling applied.

[1] Information wants to be free. If there’s a free downloadable version of a book out there, that’s what I’m going to link to. But assuming some bank has demand deposits payable to you on the liability side of its balance sheet (i.e. you’ve got the money), this is a book you ought to buy.

[2] In pre-modern societies a slave is simply someone all of whose kinship ties have been extinguished, and is therefore attached only to the household of his/her master. They were not necessarily low in status or living standards, and they weren’t distinguished by being personally subordinated to somebody, since everyone was. And slavery certainly cannot be defined as a person being property, since, as Graeber shows, private property as we know it is simply a generalization of the law of slavery.

[3] A point also emphasized by Robert Triffin in his essential paper Myths and Realities of the So-Called Gold Standard.

[4] Which is a cautionary tale for anyone who thinks the fact that an economic process that involves some ratio diverging to infinity is by defintion unsustainable. Physiocrats thought a trajectory of the farming share of the population toward zeo was an absolute absurdity and that in practice it could certaily not fall below half. They were wrong; and more generally, capitalism is not an equilibrium process. There may be seven unsustainable processes out there, or even more, but you cannot show it simply by noting that the trend of some ratio will take it outside its historic range.

UPDATE: Nick Rowe has a kind of response which, while I don’t agree with it, lays out the case against regarding money as a liability very clearly. I have a long comment there, of which the tl;dr is that we should be thinking — both logically and chronologically — of central bank money evolving from private debt contracts, not from gold currency. I don’t know if Nick read the Leijonhufvud piece I quote here, but the point that it makes is that writing 100-odd years ago, Wicksell started from exactly the position Nick takes now, and then observed how it breaks down with modern (even 1900-era modern) financial systems.

Also, the comments below are exceptionally good; anyone who read this post should definitely read the comments as well.