Secular Stagnation, Progress in Economics

It’s the topic of the moment. Our starting point is this Paul Krugman post, occasioned by this talk by Lawrence Summers.

There are two ways to understand “secular stagnation.” One is that the growth rate of income and output will be slower in the future. The other is that there will be a systematic tendency for aggregate demand to fall short of the economy’s potential output. It’s the second claim that we are interested in.

For Krugman, the decisive fact about secular stagnation is that it implies a need for persistently negative interest rates. That achieved, there is no implication that growth rates or employment need to be lower in the future than in the past. He  is imagining a situation where current levels of employment and growth rates are maintained, but with permanently lower interest rates.

We could also imagine a situation where full employment was maintained by permanently higher public spending, rather than lower interest rates. Or we could imagine a situation where nothing closed the gap and output fell consistently short of potential. What matters is that aggregate expenditure by the private sector tends to fall short of the economy’s potential output, by a growing margin. For reasons I will explain down the road, I think this is a better way of stating the position than a negative “natural rate” of interest.

I think this conversation is a step forward for mainstream macroeconomic thought. There are further steps still to take. In this post I describe what, for me, are the positive elements of this new conversation. In subsequent posts, I will talk about the right way of analyzing these questions more systematically — in terms of a Harrod-type growth model — and  about the wrong way — in terms of the natural rate of interest.

The positive content of “secular stagnation”

1. Output is determined by demand.

The determination of total output by total expenditure is such a familiar part of the macroeconomics curriculum that we forget how subversive it is. It denies the logic of scarcity that is the basis of economic analysis and economic morality. Since Mandeville’s Fable of the Bees, it’s been recognized that if aggregate expenditure determines aggregate income, then, as Krugman says, “vice is virtue and virtue is vice.”

A great deal of the history of macroeconomics over the past 75 years can be thought of as various efforts to expunge, exorcize or neutralize the idea of demand-determined income, or at least to safely quarantine it form the rest of economic theory. One of the most successful quarantine strategies was to recast demand constraints on aggregate output as excess demand for money, or equivalently as the wrong interest rate. What distinguished real economies from the competitive equilibrium of Jevons or Walras was the lack of a reliable aggregate demand “thermostat”. But if a central bank or other authority set that one price or that one quantity correctly, economic questions could again be reduced to allocation of scarce means to alternative ends, via markets. Both Hayek and Friedman explicitly defined the “natural rate” of interest, which monetary policy should maintain, as the rate that would exist in a Walrasian barter economy. In postwar and modern New Keynesian mainstream economics, the natural rate is defined as the market interest rate that produces full employment and stable prices, without (I think) explicit reference to the intertemporal exchange rate that is called the interest rate in models of barter economies. But he equivalence is still there implicitly, and is the source of a great deal of confusion.

I will return to the question of what connection there is, if any, between the interest rates we observe in the world around us, and what a paper like Samuelson 1958 refers to as the “interest rate.” The important thing for present purposes is:

Mainstream economic theory deals with the problems raised when expenditure determines output, by assuming that the monetary authority sets an interest rate such that expenditure just equals potential output. If such a policy is followed successfully, the economy behaves as if it were productive capacity that determined output. Then, specifically Keynesian problems can be ignored by everyone except the monetary-policy technicians. One of the positive things about the secular stagnation conversation, from my point of view, is that it lets Keynes back out of this box.

That said, he is only partway out. Even if it’s acknowledged that setting the right interest rate does not solve the problem of aggregate demand as easily as previously believed, the problem is still framed in terms of the interest rate.

2. Demand normally falls short of potential

Another strategy to limit the subversive impact of Keynes has been to consign him to the sublunary domain of the short run, with the eternal world of long run growth still classical. (It’s a notable — and to me irritating — feature of macroeconomics textbooks that the sections on growth seem to get longer over time, and to move to the front of the book.) But if deviations from full employment are persistent, we can’t assume they cancel out and ignore them when evaluating an economy’s long-run trajectory.

One of the most interesting parts of the Summers talk came when he said, “It is a central pillar of both classical models and Keynesian models, that it is all about fluctuations, fluctuations around a given mean.” (He means New Keynesian models here, not what I would consider the authentic Keynes.) “So what you need to do is have less volatility.” He introduces the idea of secular stagnation explicitly as an alternative to this view that demand matters only for the short run. (And he forthrightly acknowledges that Stanley Fischer, his MIT professor who he is there to praise, taught that demand is strictly a short-run phenomenon.) The real content of secular stagnation, for Summers, is not slower growth itself, but the possibility that the same factors that can cause aggregate expenditure to fall short of the economy’s potential output can matter in the long run as well as in the short run.

Now for Summers and Krugman, there still exists a fundamentals-determined potential growth rate, and historically the level of activity did fluctuate around it in the past. Only in this new era of secular stagnation, do we have to consider the dynamics of an economy where aggregate demand plays a role in long-term growth. From my point of view, it’s less clear that anything has changed in the behavior of the economy. “Secular stagnation” is only acknowledging what has always been true. The notion of potential output was never well defined. Labor supply and technology, the supposed fundamentals, are strongly influenced by the level of capacity utilization. As I’ve discussed before, once you allow for Verdoorn’s Law and hysteresis, it makes no sense to talk about the economy’s “potential growth rate,” even in principle. I hope the conversation may be moving in that direction. Once you’ve acknowledged that the classical allocation-of-scarce-means-to-alternative-ends model of growth doesn’t apply in present circumstances, it’s easier to take the next step and abandon it entirely.

3. Bubbles are functional

One widely-noted claim in the Summers talk is that asset bubbles have been a necessary concomitant of full employment in the US since the 1980s. Before the real estate bubble there was the tech bubble, and before that there was the commercial real estate bubble we remember as the S&L crisis. Without them, the problem of secular stagnation might have posed itself much earlier.

This claim can be understood in several different, but not mutually exclusive, senses. It may be (1) interest rates sufficiently low to produce full employment, are also low enough to provoke a bubble. It may be (2) asset bubbles are an important channel by which monetary policy affects real activity. Or it may be (3) bubbles are a substitute for the required negative interest rates. I am not sure which of these claims Summers intends. All three are plausible, but it is still important to distinguish them. In particular, the first two imply that if interest rates could fall enough to restore full employment, we would have even more bubbles — in the first case, as an unintended side effect of the low rates, in the second, as the channel through which they would work. The third claim implies that if interest rates could fall enough to restore full employment, it would be possible to do more to restrain bubbles.

An important subcase of (1) comes when there is a minimum return that owners of money capital can accept. As Keynes said (in a passage I’m fond of quoting),

The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners.[2] If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money.  Cf. the nineteenth-century saying, quoted by Bagehot, that “John Bull can stand many things, but he cannot stand 2 per cent.”

If this is true, then asking owners of money wealth to accept rates of 2 percent, or perhaps much less, will face political resistance. More important for our purposes, it will create an inclination to believe the sales pitch for any asset that offers an acceptable return.

Randy Wray says that Summers is carrying water here for his own reputation and his masters in Finance. The case for bubbles as necessary for full employment justifies his past support for financial deregulation, and helps make the case against any new regulation in the future. That may be true. But I still think he is onto something important. There’s a long-standing criticism of market-based finance that it puts an excessive premium on liquidity and discourages investment in long-lived assets. A systematic overestimate of the returns from fixed assets might be needed to offset the systematic overestimate of the costs of illiquidity.

Another reason I like this part of Summers’ talk is that it moves us toward recognizing the fundamental symmetry between between monetary policy conventionally defined, lender of last resort operations and bank regulations. These are different ways of making the balance sheets of the financial sector more or less liquid. The recent shift from talking about monetary policy setting the money stock to talking about setting interest interest rates was in a certain sense a step toward realism, since there is nothing in modern economies that corresponds to a quantity of money. But it was also a step toward greater abstraction, since it leaves it unclear what is the relationship between the central bank and the banking system that allows the central bank to set the terms of private credit transactions. Self-interested as it may be, Summers call for regulatory forbearance here is an intellectual step forward. It moves us toward thinking of what central banks do neither in terms of money, nor in terms of interest rates, but in terms of liquidity.

Finally, note that in Ben Bernanke’s analysis of how monetary policy affects output, asset prices are an important channel. That is an argument for version (2) of the bubbles claim.

4. High interest rates are not coming back

For Summers and Krugman, the problem is still defined in terms of a negative “natural rate” of interest. (To my mind, this is the biggest flaw in their analysis.) So much of the practical discussion comes down to how you convince or compel wealth owners to hold assets with negative yields. One solution is to move to permanently higher inflation rates. (Krugman, to his credit, recognizes that this option will only be available when or if something else raises aggregate demand enough to push against supply constraints.) I am somewhat skeptical that capitalist enterprises in their current form can function well with significantly higher inflation. The entire complex of budget and invoicing practices assumes that over some short period — a month, a quarter, even a year — prices can be treated as constant. Maybe this is an easy problem to solve, but maybe not. Anyway, it would be an interesting experiment to find out!

More directly relevant is the acknowledgement that interest rates below growth rates may be a permanent feature of the economic environment for the foreseeable future. This has important implications for debt dynamics (both public and private), as we’ve discussed extensively on this blog. I give Krugman credit for saying that with i < g, it is impossible for debt to spiral out of control; a deficit of any level, maintained forever, will only ever cause the debt-GDP ratio to converge to some finite level. (I also give him credit for acknowledging that this is a change in his views.) This has the important practical effect of knocking another leg out from the case for austerity. It’s been a source of great frustration for me to see so many liberal, “Keynesian” economists follow every argument for stimulus with a pious invocation of the need for long-term deficit reduction. If people no longer feel compelled to bow before that shrine, that is progress.

On a more abstract level, the possibility of sub-g or sub-zero interest rates helps break down the quarantining of Keynes discussed above. Mainstream economists engage in a kind of doublethink about the interest rate. In the context of short-run stabilization, it is set by the central bank. But in other contexts, it is set by time preferences and technological tradeoff between current and future goods. I don’t think there was ever any coherent way to reconcile these positions. As I will explain in a following post, the term “interest rate” in these two contexts is being used to refer to two distinct and basically unrelated prices. (This was the upshot of the Sraffa-Hayek debate.) But as long as the interest rate observed in the world (call it the “finance” interest rate) behaved similarly enough to the interest rate in the models (the “time-substitution” interest rate), it was possible to ignore this contradiction without too much embarrassment.

There is no plausible way that the “time substitution” interest rate can be negative. So the secular stagnation conversation is helping reestablish the point — made by Keynes in chapter 17 of the General Theory, but largely forgotten — that the interest rates we observe in the world are something different. And in particular, it is no longer defensible to treat the interest rate as somehow exogenous to discussions about aggregate demand and fiscal policy. When I was debating fiscal policy with John Quiggin, he made the case for treating debt sustainability as a binding constraint by noting that there are long periods historically when interest rates were higher than growth rates. It never occurred to him that it makes no sense to talk about the level of interest rates as an objective fact, independent of the demand conditions that make expansionary fiscal policy desirable. I don’t mean to pick on John — at the time it wasn’t clear to me either.

Finally, on the topic of low interest forever, I liked Krugman’s scorn for the rights of interest-recipients:

How dare anyone suggest that virtuous individuals, people who are prudent and save for the future, face expropriation? How can you suggest steadily eroding their savings either through inflation or through negative interest rates? It’s tyranny!
But in a liquidity trap saving may be a personal virtue, but it’s a social vice. And in an economy facing secular stagnation, this isn’t just a temporary state of affairs, it’s the norm. Assuring people that they can get a positive rate of return on safe assets means promising them something the market doesn’t want to deliver – it’s like farm price supports, except for rentiers.

It’s a nice line, only slightly spoiled by the part about “what the market wants to deliver.” The idea that it is immoral to deprive the owners of money wealth of their accustomed returns is widespread and deeply rooted. I think it lies behind many seemingly positive economic claims. If this conversation develops, I expect we will see more open assertions of the moral entitlement of the rentiers.

Thomas Sargent Abandons Rational Expectations, Converts to Post Keynesianism

From Keynes (1937), “The General Theory of Employment”:

We have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. Sometimes we are not much concerned with their remoter consequences, even though time and chance may make much of them. But sometimes we are intensely concerned with them… The whole object of the accumulation of wealth is to produce results, or potential results, at a comparatively distant, and sometimes indefinitely distant, date. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders wealth a peculiarly unsuitable subject for the methods of the classical economic theory. … 

By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty… Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of an European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.

Better late than never, I suppose…

UPDATE: OK, ok, Sargent has written a lot about uncertainty and expectations.  Harry Konstantidis points out this 1972 article Rational Expectations and the Term Structure of Interest Rates, which is … really interesting, actually. It’s an empirical test of whether the behavior of interest rates over time is consistent with bond prices being set by a process of rational expectations. The conclusions are surprisingly negative:

The evidence summarized above implies that it is difficult to maintain both that only expectations determine the yield curve and that expectations are rational in the sense of efficiently incorporating available information. The predictions of the random walk version of the model are fairly decisively rejected by the data, particularly for forward rates with less than five years term to maturity. … 

It is clear that our conclusions apply with equal force to the diluted form of the expectations hypothesis that allows forward rates to be determined by expectations plus time-invariant liquidity premiums. … On the other hand, it would clearly be possible to determine a set of time-dependent “liquidity premiums” that could be used to adjust the forward rates so that the required sequences would display “white” spectral densities. … While this procedure has its merits in certain instances, it is essentially arbitrary, there being no adequate way to relate the “liquidity premiums” so derived to objective characteristics of markets… 

An alternative way to “save” the doctrine that expectations alone determine the yield curve in the face of empirical evidence like that presented above is to abandon the hypothesis that expectations are rational. Once that is done, the model becomes much freer, being capable of accommodating all sorts of ad hoc, plausible hypotheses about the formation of expectations. Yet salvaging the expectations theory in that way involves building a model of the term structure that … permits expectations to be formed via a process that could utilize available information more efficiently and so enhance profits. That seems … extremely odd.

In other words: Observed yields are inconsistent with a simple version of rational expectations. They could be made consistent, but only by trvializing the theory by adding ad hoc adjustments that could fit anything. We might conclude that expectations are not rational, but that’s too scary. So … who knows.

One unambiguous point, though, is that under rational expectations interest rates should follow a random walk, and your best prediction of interest rates on a given instrument at some future date should be the rate today. Just saying “I don’t now” is not consistent with rational expectations — for one thing, it gives you no basis for deciding whether a product like the one being advertised here is priced fairly. Sargent’s “No” is consistent, though, with fundamental uncertainty in the Keynes sense. In that case the decision to buy or not buy is based on nonrational behavioral rules — like, say, looking at endorsements of recognized authorities. (Keynes: “Knowing that our individual judgment is worthless, we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed.”) So I stand by my one-liner.

Does the Fed Control Interest Rates?

Casey Mulligan goes to the New York Times to say that monetary policy doesn’t work. This annoys Brad DeLong:

THE NEW YORK TIMES PUBLISHES CASEY MULLIGAN AS A JOKE, DOESN’T IT? 

… The third joke is the entire third paragraph: since the long government bond rate is made up of the sum of (a) an average of present and future short-term rates and (b) term and risk premia, if Federal Reserve policy affects short rates then–unless you want to throw every single vestige of efficient markets overboard and argue that there are huge profit opportunities left on the table by financiers in the bond market–Federal Reserve policy affects long rates as well. 

Casey B. Mulligan: Who Cares About Fed Funds?: New research confirms that the Federal Reserve’s monetary policy has little effect on a number of financial markets, let alone the wider economy…. Eugene Fama of the University of Chicago recently studied the relationship between the markets for overnight loans and the markets for long-term bonds…. Professor Fama found the yields on long-term government bonds to be largely immune from Fed policy changes…

Krugman piles on [1]; the only problem with DeLong’s post, he says, is that

it fails to convey the sheer numbskull quality of Mulligan’s argument. Mulligan tries to refute people like, well, me, who say that the zero lower bound makes the case for fiscal policy. … Mulligan’s answer is that this is foolish, because monetary policy is never effective. Huh? 

… we have overwhelming empirical evidence that monetary policy does in fact “work”; but Mulligan apparently doesn’t know anything about that.

Overwhelming evidence? Citation needed, as the Wikipedians say.

Anyway, I don’t want to defend Mulligan — I haven’t even read the column in question — but on this point, he’s got a point. Not only that: He’s got the more authentic Keynesian position.

Textbook macro models, including the IS-LM that Krugman is so fond of, feature a single interest rate, set by the Federal Reserve. The actual existence of many different interest rates in real economies is hand-waved away with “risk premia” — market rates are just equal to “the” interest rate plus a prmium for the expected probability of default of that particular borrower. Since the risk premia depnd on real factors, they should be reasonably stable, or at least independent of monetary policy. So when the Fed Funds rate goes up or down, the whole rate structure should go up and down with it. In which case, speaking of “the” interest rate as set by the central bank is a reasonable short hand.

How’s that hold up in practice? Let’s see:

The figure above shows the Federal Funds rate and various market rates over the past 25 years. Notice how every time the Fed changes its policy rate (the heavy black line) the market rates move right along with it?

Yeah, not so much.

In the two years after June 2007, the Fed lowered its rate by a full five points. In this same period, the rate on Aaa bonds fell by less 0.2 points, and rates for Baa and state and local bonds actually rose. In a naive look at the evidence, the “overwhelming” evidence for the effectiveness of monetary policy is not immediately obvious.

Ah but it’s not current short rates that long rates are supposed to follow, but expected short rates. This is what our orthodox New Keynesians would say. My first response is, So what? Bringing expectations in might solve the theoretical problem but it doesn’t help with the practical one. “Monetary policy doesn’t work because it doesn’t change expectations” is just a particular case of “monetary policy doesn’t work.”

But it’s not at all obvious that long rates follow expected short rates either. Here’s another figure. This one shows the spreads between the 10-Year Treasury and the Baa corporate bond rates, respectively, and the (geometric) average Fed Funds rate over the following 10 years.

If DeLong were right that “the long government bond rate is made up of the sum of (a) an average of present and future short-term rates and (b) term and risk premia” then the blue bars should be roughly constant at zero, or slightly above it. [2] Not what we see at all. It certainly looks as though the markets have been systematically overestimating the future level of the Federal Funds rate for decades now. But hey, who are you going to believe, the efficient markets theory or your lying eyes? Efficient markets plus rational expectations say that long rates must be governed by the future course of short rates, just as stock prices must be governed by future flows of dividends. Both claims must be true in theory, which means they are true, no matter how stubbornly they insist on looking false.

Of course if you want to believe that the inherent risk premium on long bonds is four points higher today than it was in the 1950s, 60s and 70s (despite the fact that the default rate on Treasuries, now as then, is zero) and that the risk premium just happens to rise whenever the short rate falls, well, there’s nothing I can do to stop you.

But what’s the alternative? Am I really saying that players in the bond market are leaving huge profit opportunities on the table? Well, sometimes, maybe. But there’s a better story, the one I was telling the other day.

DeLong says that if rates are set by rational, profit-maximizing agents, then — setting aside default risk — long rates should be equal to the average of short rates over their term. This is a standard view, everyone learns it. but it’s not strictly correct. What profit-maximizing bond traders do, is set long rates equal to the expected future value of long rates.

I went through this in that other post, but let’s do it again. Take a long bond — we’ll call it a perpetuity to keep the math simple, but the basic argument applies to any reasonably long bond. Say it has a coupon (annual payment) of $40 per year. If that bond is currently trading at $1000, that implies an interest rate of 4 percent. Meanwhile, suppose the current short rate is 2 percent, and you expect that short rate to be maintained indefinitely. Then the long bond is a good deal — you’ll want to buy it. And as you and people like you buy long bonds, their price will rise. It will keep rising until it reaches $2000, at which point the long interest rate is 2 percent, meaning that the expected return on holding the long bond and rolling over short bonds is identical, so there’s no incentive to trade one for the other. This is the arbitrage that is supposed to keep long rates equal to the expected future value of short rates. If bond traders don’t behave this way, they are missing out on profitable trades, right?

Not necessarily. Suppose the situation is as described above — 4 percent long rate, 2 percent short rate which you expect to continue indefinitely. So buying a long bond is a no-brainer, right? But suppose you also believe that the normal or usual long rate is 5 percent, and that it is likely to return to that level soon. Maybe you think other market participants have different expectations of short rates, maybe you think other market participants are irrational, maybe you think… something else, which we’ll come back to in a second. For whatever reason, you think that short rates will be 2 percent forever, but that long rates, currently 4 percent, might well rise back to 5 percent. If that happens, the long bond currently trading for $1000 will fall in price to $800. (Remember, the coupon is fixed at $40, and 5% = 40/800.) You definitely don’t want to be holding a long bond when that happens. That would be a capital loss of 20 percent. Of course every year that you hold short bonds rather than buying the long bond at its current price of $1000, you’re missing out on $20 of interest; but if you think there’s even a moderate chance of the long bond falling in value by $200, giving up $20 of interest to avoid that risk might not look like a bad deal.

Of course, even if you think the long bond is likely to fall in value to $800, that doesn’t mean you won’t buy it for anything above that. if the current price is only a bit above $800 (the current interest rate is only a bit below the “normal” level of 5 percent) you might think the extra interest you get from buying a long bond is enough to compensate you for the modest risk of a capital loss. So in this situation, the equilibrium price of the long bond won’t be at the normal level, but slightly below it. And if the situation continues long enough, people will presumably adjust their views of the “normal” level of the long bond to this equilibrium, allowing the new equilibrium to fall further. In this way, if short rates are kept far enough from long rates for long enough, long rates will eventually follow. We are seeing a bit of this process now. But adjusting expectations in this way is too slow to be practical for countercyclical policy. Starting in 1998, the Fed reduced rates by 4.5 points, and maintained them at this low level for a full six years. Yet this was only enough to reduce Aaa bond rates (which shouldn’t include any substantial default risk premium) by slightly over one point.

In my previous post, I pointed out that for policy to affect long rates, it must include (or be believed to include) a substantial permanent component, so stabilizing the economy this way will involve a secular drift in interest rates — upward in an economy facing inflation, downward in one facing unemployment. (As Steve Randy Waldman recently noted, Michal Kalecki pointed this out long ago.) That’s important, but I want to make another point here.

If the primary influence on current long rates is the expected future value of long rates, then there is no sense in which long rates are set by fundamentals.  There are a potentially infinite number of self-fulfilling expected levels for long rates. And again, no one needs to behave irrationally for these conventions to sustain themselves. The more firmly anchored is the expected level of long rates, the more rational it is for individual market participants to act so as to maintain that level. That’s the “other thing” I suggested above. If people believe that long rates can’t fall below a certain level, then they have an incentive to trade bonds in a way that will in fact prevent rates from falling much below that level. Which means they are right to believe it. Just like driving on the right or left side of the street, if everyone else is doing it it is rational for you to do it as well, which ensures that everyone will keep doing it, even if it’s not the best response to the “fundamentals” in a particular context.

Needless to say, the idea that that long-term rate of interest is basically a convention straight from Keynes. As he puts it in Chapter 15 of The General Theory,

The rate of interest is a highly conventional … phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable; subject, of course, in a changing society to fluctuations for all kinds of reasons round the expected normal. 

You don’t have to take Keynes as gospel, of course. But if you’ve gotten as much mileage as Krugman has out of the particular extract of Keynes’ ideas embodied in the IS-LM mode, wouldn’t it make sense to at least wonder why the man thought this about interest rates, and if there might not be something to it.

Here’s one more piece of data. This table shows the average spread between various market rates and the Fed Funds rate.

Spreads over Fed Funds by decade
10-Year Treasuries Aaa Corporate Bonds Baa Corporate Bonds State & Local Bonds
1940s 2.2 3.3
1950s 1.0 1.3 2.0 0.7
1960s 0.5 0.8 1.5 -0.4
1970s 0.4 1.1 2.2 -1.1
1980s 0.6 1.4 2.9 -0.9
1990s 1.5 2.6 3.3 0.9
2000s 1.5 3.0 4.1 1.8

Treasuries carry no default risk; a given bond rating should imply a fixed level of default risk, with the default risk on Aaa bonds being practically negligible. [3] Yet the 10-year treasury spread has increased by a full point and the corporate bond rates by about two points, compared with the postwar era. (Municipal rates have risen by even more, but there may be an element of genuine increased risk there.) Brad DeLong might argue that society’s risk-bearing capacity has decline so catastrophically since the 1960s that even the tiny quantum of risk in Aaa bonds requires two full additional points of interest to compensate its quaking, terrified bearers. And that this has somehow happened without requiring any more compensation for the extra risk in Baa bonds relative to Aaa. I don’t think even DeLong would argue this, but when the honor of efficient markets is at stake, people have been known to do strange things.

Wouldn’t it be simpler to allow that maybe long rates are not, after all, set as “the sum of (a) an average of present and future short-term rates and (b) [relatively stable] term and risk premia,” but that they follow their own independent course, set by conventional beliefs that the central bank can only shift slowly, unreliably and against considerable resistance? That’s what Keynes thought. It’s what Alan Greenspan thinks. [4] And also it’s what seems to be true, so there’s that.

[1] Prof. T. asks what I’m working on. A blogpost, I say. “Let me guess — it says that Paul Krugman is great but he’s wrong about this one thing.” Um, as a matter of fact…

[2] There’s no risk premium on Treasuries, and it is not theoretically obvious why term premia should be positive on average, though in practice they generally are.

[3] Despite all the — highly deserved! — criticism the agencies got for their credulous ratings of mortgage-backed securities, they do seem to be good at assessing corporate default risk. The cumulative ten-year default rate for Baa bonds issued in the 1970s was 3.9 percent. Two decades later, the cumulative ten-year default rate for Baa bonds issued in the 1990s was … 3.9 percent. (From here, Exhibit 42.)

[4] Greenspan thinks that the economically important long rates “had clearly delinked from the fed funds rate in the early part of this decade.” I would only add that this was just the endpoint of a longer trend.

What is the Liquidity Trap?

In the common usage, popularized by Krugman, a liquidity trap is just a situation where the interest rate set by the central bank has reached zero. Since it can’t go below that (the Zero Lower Bound), if more expansionary policy is needed it will have to take the form of fiscal policy or unconventional monetary policy — quantitative easing and so on. But if there were some technical fix (a tax on excess reserves, say, or abolishing cash) that allowed central banks to make the policy rate negative, there would be no limit to the capacity of monetary policy to overcome any shortfall in demand. The idea — expressed by modern monetarists in the form of the negative natural rate — is that there are so few investment opportunities with positive expected returns that if investment rose enough to equal desired saving at full employment, the expected return on the marginal new unit of capital would be negative. So you’d need a negative cost of capital to get businesses to undertake it.

That makes sense, I guess. But it’s not what Keynes meant by liquidity trap. And Keynes’ version, I think, is more relevant to our current predicament.

Keynes himself doesn’t use the term, and his explanation of the phenomenon, in chapters 13 and 15 of the General Theory, is rather confusing. (Lance Taylor has a much clearer statement of it in Reconstructing Macroeconomics, which I may add a summary or excerpt of to this post when I get home tonight and have the book.) So rather than quote chapter and verse, I’m just going to lay out what I understand the argument to be.

Interest, says Keynes, is not, as the classical economists said, the price of consuming in the future relative to the consuming in the present. It is the price of holding an illiquid rather than a liquid asset today. (This is one of the main points of the book.) The cost of holding an illiquid asset (a bond, let’s say) is the inconvenience that it can’t be used for transaction purposes, but also the opportunity cost of not being able to buy a bond later, if interest rates rise. Another way of saying the same thing: The risk of holding a bond is not just that you won’t have access to means of payment when you need it; it is also the capital loss you will suffer if interest rates rise while you are holding the bond. (Remember, the price of an existing bond always moves inversely with the interest rate.)

This last factor isn’t so important in normal times, when opinions about the future rates of bonds vary; if the supply of liquidity rises, there will be somebody who finds themselves more liquid than they need to be and who doesn’t expect a rise in interest rates in the near future, who will purchase bonds, driving up their price and driving the interest rate down. The problem arises when there is a consensus about the future level of interest rates. At that point, anyone who holds a bond yielding below that level will be anxious to sell it, to avoid the capital loss when interest rates inevitably rise. (Or equivalently, to be able to purchase a higher yield bond when they do.) This effect is strongest at low interest rates, since bondholders not only are more likely to expect a capital loss in the future, but are getting very little interest in the present to compensate them for it. Or as Keynes says,

Nevertheless, circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest. For … opinion about the future of the rate of interest may be so unanimous that a small [decrease] in present rates may cause a mass movement into cash. It is interesting that the stability of the system and its sensitiveness to changes in the quantity of money should be so dependent on the existence of a variety of opinion about what is uncertain. Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ.

In other words, the essence of the liquidity trap is a convention about the normal level of interest rates. It’s important to note that this convention is self-stabilizing — if everyone believes that interest rates on a particular class of bond cannot be below 3 percent, say, for any extended period of time, then anyone who finds themselves holding a bond yield less than 3 percent will be anxious to sell it. And their efforts to do so will push the price of the bonds down, which itself will increase their yield back to 3 percent, so that the people who did not share the convention are the ones who end up suffering the loss.

This probably seems confusing and tedious to most readers (and tediously familiar to most of the rest.) Maybe it will be clearer and more interesting with some pictures:

10-Year Treasury Rate and the Federal Funds Rate
BAA Bond Rates and the Federal Funds Rate

The horizontal axis of this scatterplot is the Federal Funds rate. The vertical axis shows a market interest rate — the 10-year Treasury bond rate in the first one, and the BAA corporate bond rate in the second. The heavy black diagonal corresponds to a market rate equal to the Fed Funds rate. In both cases, there’s a clear positive relationship over normal ranges of policy rates — 3 percent to 8 percent or so. But outside of this range, particularly at the bottom end, the relationship breaks down. The floor on Treasuries is a hard 3 percent or so, while the floor on BAA bonds varies from time to time but also doesn’t go below 3 percent. [1] This is Keynes’ liquidity trap. [2] And when you look at it, it becomes much less clear that the inability to extend the black line past the origin — Krugman’s liquidity trap — is the problem here. What good would it do, if market rates stop following the policy rate well before that?

UPDATE: A smart, skeptical comment by Bruce Wilder leads me to reformulate the argument in a hopefully clearer way.

The necessary and sufficient condition for a liquidity trap is a consensus among market participants that nominal interest rates are more likely to rise than to fall over the relevant time horizon. Obviously, one basis for such a consensus might be that it is literally impossible for short rates to fall any further. [3] In this sense the ZLB liquidity trap is a special case of the Keynesian liquidity trap. But the Keynesian concept is broader, because conventions about the floor of interest rates can be strongly self-stabilizing, especially where they are backed up by the political power of rentiers.

[1] “The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money. … Cf. the nineteenth-century saying, quoted by Bagehot, that ‘John Bull can stand many things, but he cannot stand 2 per cent.'”

[2] It also, not coincidentally, looks like the textbook LM curve. The replacement of LM with an central bank-determined interest rate curve in newer textbooks, is not progress.

[3] Note that it is not in fact the case that nominal interests cannot be negative, because in the real world cash has substantial carrying costs.

Are Wages Too High?

Here’s a good one for the right-for-the-wrong-reasons file.

David Glasner is one of an increasing number of Fed critics who would like to see a higher inflation target. Today, he takes aim at a Wall Street Journal editorial that claims that the real victims of cheaper money wouldn’t be, you know, people who own money — creditors — as one might think, but working people. Higher inflation just means lower real wages, says the Journal. Crocodile tears, says Glasner — since when does the Journal care about wage workers? So far, so good, says me.

“What makes this argument so disreputable,”he goes on,

is not just the obviously insincere pretense of concern for the welfare of the working class, but the dishonest implication that employment in a recession or depression can be increased without an, at least temporary, reduction in real wages. Rising unemployment during a contraction implies that real wages are, in some sense, too high, so that a falling real wage tends to be a characteristic of any recovery, at least in its early stages. The only question is whether the falling real wage is brought about through prices rising faster than wages or by wages falling faster than prices. If the Wall Street Journal and other opponents of rising prices don’t want prices to erode real wages, they are ipso facto in favor of falling money wages.

And here we have taken a serious wrong turn.

Glasner is certainly not alone in thinking that rising prices are associated with falling real wages, and vice versa. And he’s also got plenty of company in his belief that since the wage is equal to the marginal product of labor, and marginal products should decline, in the short run higher employment implies a lower real wage. But is he right? Is it true that if employment is to rise, “the only question” is whether wages fall directly or via inflation? Is it true that unemployment necessarily means that wages are too high?

Empirically, it seems questionable. Let’s look at unemployment and wages in the past few decades in the United States. The graph below shows the real hourly wage on the x-axis and the unemployment rate on the y-axis. The red dots show the two years after the peak of unemployment in each of the past five recessions. If reducing unemployment always required lower real wages, the red dots should consistently make upward sloping lines. The real picture, though, is more complicated.

As we can see, the early 2000s recovery and, arguably, the early 1980s recovery were associated with falling real wages. but in the early 1990s, employment recovered with constant real wages — that’s what the vertical line over on the left means. And in the two recessions of the 1970s, the recoveries combined falling unemployment with strongly rising real wages. If we look at other advanced countries, it’s this last pattern we see most often. (I show some examples after the fold.) So while rising employment is sometimes accompanied by a falling real wage, it is clearly not true that, as Glasner claims, it necessarily must be.

This is an important question to get straight. There seems to be a certain convergence happening between progressive-liberal economists and neo-monetarists like Glasner on the desirability of higher inflation in general and nominal GDP targeting in particular. There’s something to be said for this; inflation is the course of least resistance to cancel the debts. But we in the party of movement can’t support this idea or make it part of a broader popular economic program if it’s really a stalking horse for lower wages.

Fortunately, the macroeconomic benefits of a rising price level don’t depend on a falling real wage.
More broadly, the idea that reducing unemployment necessarily means reducing wages doesn’t hold up. It’s wrong empirically, and it involves a basic misunderstanding of what’s going on in recessions.

Yes, labor is idle in a recession, but does that mean its price, the wage, is too high? There is also more excess capacity in the capital stock in a recession; by the same logic, that would mean profits are too high. Real estate vacancy rates are high in a recession, so rents must also be too high. In fact, every factor of production is underutilized in recessions, but it’s logically impossible for the relative price of all factors to be too high. A shortfall in demand for output as a whole (or excess demand for the means of payment, if you’re a monetarist) doesn’t tell us anything about whether relative prices are out of line, or in which direction. If we were seeing technological unemployment — people thrown out of work by the adoption of more capital-intensive forms of production — then there might be something to the statement that “unemployment … implies that real wages are, in some sense, too high.” But that’s not what we see in recessions at all.

Glasner is hardly the only one who thinks that unemployment must somehow involve excessive wages. If he were, he’d hardly be worth arguing with. It’s a common view today, and it was even more common before World War II. Glasner quotes Mises (yikes!), but Schumpeter said the same thing. More interestingly, so did Keynes. In Chapter Two of the General Theory, he announces that he is not challenging what he calls the first postulate of the classical theory of employment, that the wage is equal to the marginal product of labor. And he draws the same conclusion from this that Glasner does:

with a given organisation, equipment and technique, real wages and the volume of output (and hence of employment) are uniquely correlated, so that, in general, an increase in employment can only occur to the accompaniment of a decline in the rate of real wages. Thus I am not disputing this vital fact which the classical economists have (rightly) asserted… [that] the real wage earned by a unit of labour has a unique (inverse) correlation with the volume of employment. Thus if employment increases, then, in the short period, the reward per unit of labour in terms of wage-goods must, in general, decline… This is simply the obverse of the familiar proposition that industry is normally working subject to decreasing returns… So long, indeed, as this proposition holds, any means of increasing employment must lead at the same time to a diminution of the marginal product and hence of the rate of wages measured in terms of this product.

So, wait, if Keynes says it then it can’t be a basic misunderstanding of the principle of aggregate demand, can it? Well, here’s where things get interesting.

Keynes didn’t participate much in the academic discussions following the The General Theory; the last decade of his life was taken up with practical policy work. (As Hyman Minsky observed, this may be one reason why many of his more profound ideas never made into postwar Keynesianism.) But he take part in a discussion in the pages of the Quarterly Journal of Economics, in which the “most important” contribution, per Keynes, was from Jacob Viner, who zeroed in on exactly this question. Viner:

Keynes’ reasoning points obviously to the superiority of inflationary remedies for unemployment over money-wage reductions. … there would be a constant race between the printing press and the business agents of the trade unions, with the problem of unemployment largely solved if the printing press could maintain a constant lead…  [But] Keynes follows the classical doctrine too closely when he concedes that “an increase in employment can only occur to the accompaniment of a decline in the rate of real wages.” This conclusion results from too unqualified an application of law-of-diminishing-returns analysis, and needs to be modified for cyclical unemployment… If a plant geared to work at say 80 per cent of rated capacity is being operated at say only 30 per cent, both the per capita and the marginal output of labor may well be lower at the low rate of operations than at the higher rate, the law of diminishing returns notwithstanding. There is the further empirical consideration that if employers operate in their wage policy in accordance with marginal cost analysis, it is done only imperfectly and unconsciously…

Viner makes two key points here: First, it is not necessarily the case that the marginal product of labor declines with output, especially in a recession or depression when businesses are producing well below capacity. And second, the assumption that wages are equal to marginal product is not a safe one. A third criticism came from Kalecki, that under imperfect competition firms would not set price equal to marginal cost but at some markup above it, a markup that will vary over the course of the business cycle. Keynes fully agreed that all three criticisms — along with some others, which seem less central to me — were correct, and that the first classical postulate was no better grounded than the second. In what I believe was his last substantive economic publication, a 1939 article in the Economic Journal, he returned to the question, showing that it was not true empirically that real wage fall when employment rises and exploring why he and other economists had gotten this wrong. The claim that higher employment must be accommpanied by a lower real wage, he wrote, “is the portion of my book which most needs to be revised.” Indeed, it was the only substantive modification of the argument of the General Theory that he made in his lifetime.

I bring all this up because — well, partly just because I think it’s interesting. But it’s worth being reminded, how much of our current economic debate is  recapitulating what people were figuring out in the 1930s. And it’s interesting to see how just how seductive is the idea that high unemployment means that “real wages are, in some sense, too high.” Even Keynes had to be talked out of it, even though it runs counter to the logic of his whole system, and even though there’s no good theoretical or empirical reason to believe it’s true.

Right, back to empirics. Here are a few more graphs, showing, like the US one above, unemployment on the vertical axis and real hourly wages on the horizontal. Data is from the OECD.

The first picture shows five Western European countries in the decade before the crisis. The important part is the left side; what you see there is that in all five countries unemployment fell sharply in the late 90s/early 2000s, even while real wages increased. In Belgium, for example, unemployment fell from 10 percent to a bit over six percent between 1996 and 2002, at the same time as real wages rose by close to 10 percent. The other four (and almost every country in the EU) show similar patterns.

The second one shows Korea. The 1997 Asian crisis is clearly visible here as the huge spike in unemployment in the middle of the graph. But what’s relevant here is the way it seems to slope backward. That’s because real wages fell along with employment in the crisis, and rose with employment in the recovery. Over the same period that unemployment comes back down from 8 to 4 percent, the real wage index rises from 70 to 80. This is the opposite of what we would expect in the Glasner story.

The third one shows Australia and New Zealand. Australia shows two periods of sharply falling unemployment — one in the 1980s accompanied by flat wages (a vertical line) and one in the 1990s accompanied by rising wages. Of all these countries, only New Zealand’s recoveries show a pattern of falling unemployment accompanied by falling real wages — clearly after 1992, and for a quarter or two in 2000.

You may object that these are mostly small open economies. So while the real wage is deflated by the domestic price level, the real question is whether labor costs are rising or falling relative to trade partners. If employment and wages are rising together, that probably just means the currency is depreciating. I don’t think this is true either. Countries often improve their trade balance even when real wages as measured in a common currency are rising, and conversely. That’s “Kaldor’s paradox” — countries with persistently strengthening trade balances tend to be precisely those with rising relative labor costs. But that will have to wait for a future post.

UPDATE: In comments, Will Boisvert calls the graphs above the worst he’s ever seen. OK!

So, here is the same data presented in a hopefully more legible way. The red line is unemployment, the blue line is the real hourly wage. The key question is, when the red line is falling from a peak, is the blue line falling too, or at least decelerating? And the answer, as above, is: Sometimes, but not usually. There is nothing dishonest in the claim that, in a recession, unemployment can be reduced without a decline in the real wage.



Are Recessions All About Money?

There is a view that seems to be hegemonic among liberal economists, that recessions are fundamentally about money or finance. Not just causally, not just in general, but always, by definition. In this view, the only sense in which one can speak about aggregate demand as a constraint on output, is if we can identify excess demand for some non-produced financial asset.

In the simplest case, people want to hold a stock of money in some proportion to their total income. Money is produced only by the government. Now suppose people’s demand for money rises, and the government fails to increase supply accordingly. You might expect the price of money to rise — that is, deflation. But deflation doesn’t restore equilibrium, either because prices are sticky (i.e., deflation can’t happen, or not fast enough), or because deflation itself further raises the demand for money. It might do this by raising precautionary demand, since falling prices make it likely that businesses and households won’t be able to meet obligations fixed in money terms and will face bankruptcy (Irving Fisher’s debt-deflation cycle). Or deflation might increase demand for money by because it redistributes income from net borrowers to net savers, and the latter have a higher marginal demand for money holdings. Or there could be other reasons. In any case, the price of money doesn’t adjust, so government has to keep its quantity growing at the appropriate rate instead. From this perspective,  if we ever see an economy operating bellow full capacity, it is true by definition that there is excess demand for some money-like asset.

This sounds like Milton Friedman. It is Milton Friedman! But it also seems to be most of the liberal macroeconomists who are usually called Keynesians. Here’s DeLong:

there was indeed a “general glut” of newly-produced commodities for sale and of workers to hire. But it was also the case that the excess supply of goods, services, and labor was balanced by an excess demand elsewhere in the economy. The excess demand was an excess demand not for any newly-produced commodity, but instead an excess demand for financial assets, for “money”…

How, exactly, should economists characterize the excess demand in financial markets? Where was it, exactly? That became a subject of running dispute, and the dispute has been running for more than 150 years, with different economists placing the cause of the “general glut” that was excess supply of newly-produced goods and of labor at the door of different parts of the financial system.

The contestants are:

Fisher-Friedman: monetarism: a depression is the result of an excess demand for money–for those liquid assets generally accepted as means of payment that people hold in their portfolios to grease their market transactions. You fix a depression by having the central bank boost the money stock…

Wicksell-Keynes (Keynes of the Treatise on Money, that is): a depression happens when there is an excess demand for bonds… You fix a depression by either reducing the market rate of interest (via expansionary monetary policy) or raising the natural rate of interest (via expansionary fiscal policy) in order to bring them back into equality….

Bagehot-Minsky-Kindleberger: a depression happens because of a panic and a flight to quality, as everybody tries to sell their risky assets and cuts back on their spending in order to try to shift their portfolio in the direction of safe, high-quality assets… You fix a depression by restoring market confidence and so shrinking demand for AAA assets and by increasing the supply of AAA assets….

From the perspective of this Malthus-Say-Mill framework Keynes’s General Theory is a not entirely consistent mixture of (1), (2), and (3)…Note that these financial market excess demands can have any of a wide variety of causes: episodes of irrational panic, the restoration of realistic expectations after a period of irrational exuberance, bad news about future profits and technology, bad news about the solvency of government or of private corporations, bad government policy that inappropriately shrinks asset stocks, et cetera. Nevertheless, in this Malthus-Say-Mill framework it seems as if there is always or almost always something that the government can do to affect asset supplies and demands that promises a welfare improvement

That’s an admirably clear statement. But is it right? I mean, first, is it right that demand constraints can always and only be usefully characterized as excess demand for some financial asset? And second, is that really what the General Theory says?

The first answer is No. Or rather, it’s true but misleading. It is hard to talk sensibly about a “general glut” of currently produced goods except in terms of an excess demand for some money-like financial asset. But recessions and depressions are not mainly characterized by a glut of currently produced goods. They are characterized by an excess of productive capacity. Markets for all currently-produced goods may clear. But there is still a demand constraint, in the sense that if desired expenditure were higher, aggregate output would be higher. The simple Keynesian cross we teach in the second week of undergrad macro is a model of just such an economy, which makes sense without money or any other financial asset. (And is probably more useful than most of what gets taught in graduate courses.) Arguably, this is the normal state of modern capitalist economies.

I’ll come back to this in a future post, hopefully. But it’s important to stress that the notion of aggregate demand limiting output, does not imply that any currently-produced good is in excess supply. [1]

Meanwhile, how about the second question — in the General Theory, did Keynes see demand constraints as being fundamentally about excess demand for money or some other financial asset, with the solution being to change the relative price of currently produced goods, and that asset? Again, the answer is No.

In his explanation of the instability of capitalist economies, Keynes always emphasizes the fluctuations in investment demand (or in his terms, the marginal efficiency of capital schedule). Investment demand is based on the expected returns of new capital goods over their lifetime. But the distribution of future states of the world relevant to those returns is not just stochastic but fundamentally unknown, so expectations about profits on long-lived fixed capital are essentially conventional and unanchored. It is these fluctuations in expectations, and not the demand for financial assets as expressed in liquidity preference, that drives booms and slumps. Keynes:

The fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the rate of interest may seriously aggravate the decline in investment. But the essence of the situation is to be found, nevertheless, in the collapse of the marginal efficiency of capital… Liquidity preference, except those manifestations which are associated with increasing trade and speculation, does not increase until after the collapse in the marginal efficiency of capital.  

It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and probably a necessary condition of it. But for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough [to offset it]. If the reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority. But in fact, this is not usually the case.

In this sense, Keynes agrees with the Real Business Cycle theorists that the cause of a decline in output is not fundamentally located in the financial system, but a fall in the expected profitability of new investment. The difference is that RBC thinks a decline in expected profitability must be due to genuine new information about the true value of future profits. Keynes on the other hand thinks there is no true expected value in that sense, and that our belief about the future are basically irrational. (“Enterprise only pretends to itself to be actuated by the statements in its prospectus … only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come.”) This is an important difference. But the key point here is the bolded sentences. Keynes considers DeLong’s view that the fundamental cause of a downturn is an autonomous increase in demand for safe or liquid assets, and explicitly rejects it.

The other thing to recognize is that Keynes never mentions the zero lower bound. He describes the liquidity trap as theoretical floor of the interest rate, which is above zero, but nothing in his argument depends on it. Rather, he says,

The most stable, and least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in the future, the minimum rate of interest acceptable to the generality of wealthowners. (Cf. the nineteenth-century saying quoted by Bagehot, that “John Bull can stand many things, but he cannot stand 2 percent.”) If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money.

This is an important part of the argument, but it tends to get ignored by mainstream Keynesians, who assume that monetary authority can reliably set “the” interest rate. But as we see clearly today, this is not a good assumption to make. Well before the policy rate reached zero, it had become effectively disconnected from the rates facing business borrowers. And of course the hurdle rate from the point of view of the decisionmakers at a firm considering new investment isn’t just the market interest rate, but that rate plus some additional premium reflecting what Keynes (and later Minsky) calls borrower’s risk.

So, Keynes thought that investment demand was subject to wide, unpredictable fluctuations, and probably also a secular downward trend. He doubted that very large movements in the interest rate could be achieved by monetary policy. And he didn’t think that the moderate movements that could be achieved, would have much effect on investment. [2] Where did that leave him? “Somewhat skeptical of the success of a merely monetary policy directed toward influencing the rate of interest” at stabilizing output and employment; instead, the government must “take an ever greater responsibility for directly organizing investment.”

Of course, DeLong could be misrepresenting Keynes and still be right about economic reality. But we need to at least recognize that aggregate demand is logically separate from the idea of a general glut; that the former, unlike the latter, does not necessarily involve excess demand for any financial asset; and that in practice supply and demand conditions in financial markets are not always the most important or reliable influences on aggregate demand. Keynes, at least, didn’t think so. And he was a smart guy.

[1] The other point, to anticipate a possible objection, is that the investment decision does not involve allocation of a fixed stock of savings between capital goods and financial assets.

[2] The undoubted effectiveness of monetary policy in the postwar decades might seem to argue against this point. But it’s important to recognize — though Keynes himself didn’t anticipate this — that in practice monetary policy has operated largely though its effect on the housing market, not on investment.

Anything We Can Do, We Can Afford

John Maynard Keynes, in a 1942 BBC address:

Let us not submit to the vile doctrine of the nineteenth century that every enterprise must justify itself in pounds, shillings and pence of cash income … Why should we not add in every substantial city the dignity of an ancient university or a European capital … an ample theater, a concert hall, a dance hall, a gallery, cafes, and so forth. Assuredly we can afford this and so much more. Anything we can actually do, we can afford. … We are immeasurably richer than our predecessors. Is it not evident that some sophistry, some fallacy, governs our collective action if we are forced to be so much meaner than they in the embellishments of life? …

Yet these must be only the trimmings on the more solid, urgent and necessary outgoings on housing the people, on reconstructing industry and transport and on replanning the environment of our daily life. Not only shall we come to possess these excellent things. With a big programme carried out at a regulated pace we can hope to keep employment good for many years to come. We shall, in fact, have built our New Jerusalem out of the labour which in our former vain folly we were keeping unused and unhappy in enforced idleness.

 (Collected Works XXVII)

Relevant today, obviously: Thirteen million people unemployed, 25 percent of industrial capacity idle, and capital, if the interest rate is any guide, more abundant than it’s been in decades. If our masters were only interested in what’s best for everyone, as they always claim, now would be the moment for new bridges, hospitals, subways, colleges, and public housing, and for parks, theaters, museums, and cafes. Not to mention wind farms. A recession isn’t the time to trim sails and take short views, it’s the time to go long. So let’s build that New Jerusalem.

Keynes Quote of the Day

From Britain’s Industrial Future:

The notion that the only way to get enough effort out of the brain-worker is to offer him unfettered opportunities of making an unlimited fortune is as baseless as the companion idea that the only way of getting enough effort out of the manual worker is to hold over him the perpetual threat of starvation and misery for himself and those he loves. It has never been even supposed to be true, at all events in England, of the soldier, the statesman, the civil servant, the teacher, the scientist, the technical expert.

And to think this was the Orange Book of 1928! Times have changed.

They sure have. Then, it seemed like the move away from institutions based on material incentives to institutions based on intrinsic motivation was well underway, or at least realizable. While today — perhaps in Britain even more than the US — the tide is running strong the other way, with the good and great eager to get teachers and technicians, if not yet soldiers and statesmen, onto the unlimited-fortune/starvation-and-misery plan.

The context of the quote is interesting, too — it’s part of a larger argument for the “more or less comprehensive socialization of investment” Keynes would continue to argue for in the General Theory. Since managers of private firms already work for “a certain salary, plus the hope of promotion or bonus,” nothing would change if their businesses were publicly owned: “The performance of functions by Public Concerns in place of privately owned Companies and Corporations would make but little difference to the ordinary man.” If soi-disant hard Keynesians read more Keynes, they would find a much more radical vision there than countercyclical fiscal policy.

(via Jim Crotty’s unpublished book on Keynes. Encouraging him to get that thing out is high up on my list of life goals. Britain’s Industrial Future was officially written by a committee of Liberal grandees headed by Lloyd George. But this passage was written by Keynes, Crotty says, and he would know.)

Post Keynesianism in Practice

From the FT the other day:

That Facebook is worth $50bn or Twitter $10bn, is recounted as fact. … But there are still precious few numbers to analyse and business models are no more proved than for dotcoms a decade ago.

To illustrate the ridiculousness of trying to value these things consider LinkedIn. Its S-1 registration statement (with US regulators) provides rudimentary financial statements from which to model the company. Revenues, operating costs, capital expenditure and depreciation and amortisation schedules are available for the past five years. It is then a hop to forecast earnings before interest, tax, depreciation and amortisation and, thus, future free cash flows. Discount these cash flows (made easier because there is no debt) and you’ve got a valuation.

But who on earth knows what forecasts to make? Private secondary markets supposedly value LinkedIn at $2.5bn-$3bn. To arrive at the bottom of that range requires sales to expand 60, 50 then 40 per cent over the next three years, before tailing off to a terminal growth rate of 3 per cent in 2019. Ebitda as a proportion of revenues has to double to 20 per cent and stay there. … If sales growth tapers off faster than expected or if systems spending becomes a bottomless pit, you can halve that valuation for starters. But what if LinkedIn’s platform easily copes with millions of new members? Double ebitda margins to 40 per cent and a $5bn company is easily within reach. Who knows? No wonder it’s easier to simply quote the same price tag as everyone else.

Fundamental or Knightian uncertainty tends to get treated as something airy-fairy, as part of the philosophy-of penumbra rather than economics per se. But as this example shows, it’s unavoidable in plenty of practical questions. Mainstream models avoid dealing with the problem by assuming that the true probability distribution of all possible future events is always known. But in the real world of business people aren’t so silly. As the man says:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market. …

Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave… It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun.

Economists might not believe in Keynes any more. But business journalists certainly seem to!

No More ZLB

Can we please stop talking about the zero lower bound?

Krugman today insists that we do, in fact, face a problem of inadequate demand. And he’s right! But he glosses this as an “excess supply of savings even at a zero interest rate,” which isn’t right at all.

Let’s be clear: There is not “an” interest rate, certainly not a zero one. There are various interest rates, and the ones that are relevant to saving and investment remain high. The BAA corporate bond rate (the red line in the figure below) is currently at 5.7 percent — pretty much exactly where it was in the first half of 2005. And given that inflation is substantially lower than it was five years ago, that particular real interest rate is not only not zero, it’s gone up.


The real question is, can reducing the federal funds rate reduce the economically important interest rates? Now, obviously the answer is No if the fed funds rate (the blue line in the graph) is as low as it can go; in this sense the ZLB is real. But the answer can also be No when the fed funds rate is well above zero, if there’s no reliable link between the overnight Treasury rate and the rates businesses borrow at; and that seems to have been the case since sometime in the ’90s. As the figure shows, the Fed’s recent rate reductions didn’t reduce bond rates at all, even before the Fed Funds rate hit zero; and all the hikes earlier in the decade didn’t raise bond rates either. You’d see a similar picture if you looked at any other economically relevant interest rate. In general, as my friend Hasan Comert shows in his just-defended dissertation, the Fed lost control of the important interest rates some time ago. So the best thing you can say for the zero lower bound, is that arriving there has dramatized a truth that should have been evident for some time already.

As usual, Keynes got it right: “The acuteness and the peculiarity of our contemporary problem arises out of the possibility that the average rate of interest which will allow a reasonable average level of employment is one so unacceptable to wealth-owners that it cannot be readily established merely by manipulating the quantity of money. … The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners.” The failure of interest rates to move to a level compatible with full employment is not a technical problem, but a structural one.