Reading Notes: Demand and Productivity

Here are two interesting articles on demand and productivity that people have recently brought to my attention.

The economic historian Gavin Wright — author of the classic account of the economic logic of the plantation — just sent me a piece he wrote a few years ago on the productivity boom of the 1990s. As he said in his email, his account of the ‘90s is very consistent with the suggestions I make in my Roosevelt paper about how strong demand might stimulate productivity growth.

In this article, Wright traces the idea that high wage regions will experience faster productivity growth back to H. J. Habbakuk’s 1962 American and British Technology in the Nineteenth Century. Then he assembles a number of lines of evidence that rapid wage growth drove the late-1990s productivity acceleration, rather than vice versa.

He points out that the widely-noted “productivity explosion” of the 1920s — from 1.5 percent a year to over 5 percent — was immediately preceded by a period of exceptionally strong wage growth: “The real price of labor in the 1920s … was between 50 and 70 percent higher than a decade earlier.” [1] The pressure of high wages, he suggests, encouraged the use of electricity and other general-purpose technologies, which had been available for decades but only widely adopted in manufacturing in the 1920s. Conversely, we can see the productivity slowdown of the 1970s as, at least in part, a result of the deceleration of wage growth, which — Wright argues — was the result of institutional changes including the decline of unions, the erosion of the minimum wage and other labor regulations, and more broadly the shift back toward “‘flexible labor markets,’ reversing fifty years of labor market policy.”

Turning to the 1990s, the starting point is the sharp acceleration of productivity in the second half of the decade. This acceleration was very widely shared, including sectors like retail where historically productivity growth had been limited. The timing of this acceleration has been viewed as a puzzle, with no “smoking gun” for simultaneous productivity boosting innovations across this range of industries over a short period. But “if you look at the labor market, you can find a smoking gun in the mid-1990s. … real hourly wages finally began to rise at precisely that time, after more than two decades of decline. … Unemployment rates fell below 4 percent — levels reached only briefly in the 1960s… Should it be surprising that employers turned to labor-saving technologies at this time?” This acceleration in real wages, Wright argues, was not the result of higher productivity or other supply-side factors; rather “it is most plausibly attributed to macroeconomic conditions, when an accommodating Federal Reserve allowed employment to press against labor supply for the first time in a generation.”

The productivity gains of the 1990s did, of course, involve new use of information technology. But the technology itself was not necessarily new. “James Cortada [2004] lists eleven key IT applications in the retail industry circa 1995-2000, including electronic shelf levels, scanning, electronic fund transfer, sales-based ordering and internet sales … with the exception of e-business, the list could have come from the 1970s and 1980s.”

Wright, who is after all a historian, is careful not to argue that there is a general law linking higher wages to higher productivity in all historical settings. As he notes, “such a claim is refuted by the experience of the 1970s, when upward pressures on wages led mainly to higher inflation…” In his story, both sides are needed — the technological possibilities must exist, and there must be sufficient wage pressure to channel them into productivity-boosting applications. I don’t think anyone would say he’s made a decisive case , but if you’re inclined to a view like this the article certainly gives you more material to support it.


A rather different approach to these questions is this 2012 paper by Servaas Storm and C. W. M. Naastepad. Wright is focusing on a few concrete episodes in the history of a particular country, which he explores using a variety of material — survey and narrative as well as conventional economic data. Storm and Naastepad are proposing a set of general rules that they support with a few stylized facts and then explore via of the properties of a formal model. There are things to be learned from both approaches.

In this case the model is simple: output is demand-determined. Demand is either positive or negative function of the wage share (i.e. the economy is either wage-led or profit-led). And labor productivity is a function of both output and the wage, reflecting two kinds of channels by which demand can influence productivity. And an accounting identity says that employment growth is qual to output growth less labor productivity growth. The productivity equation is the distinctive feature here. Storm and Naastepad adopt as “stylized facts” — derived from econometric studies but not discussed in any detail — that both parameters are on the order of 0.4: An additional one percent growth in output, or in wages, will lead to an 0.4 percent growth in labor productivity.

This is a very simple structure but it allows them to draw some interesting conclusions:

– Low wages may boost employment not through increased growth or competitiveness, but through lower labor productivity. (They suggest that this is the right way to think about the Dutch “employment miracle of the 1990s.)

– Conversely, even where demand is wage-led (i.e. a shift to labor tends to raise total spending) faster wage growth is not an effective strategy for boosting employment, because productivity will rise as well. (Shorter hours or other forms of job-sharing, they suggest, may be more successful.)

– Where demand is strongly wage-led (as in the Scandinavian countries, they suggest), profits will not be affected much by wage growth. The direct effect of higher wages in this case could be mostly or entirely offset by the combination of higher demand and higher productivity. If true, this has obvious implications for the feasibility of the social democratic bargain there.

– Where demand is more weakly wage-led or profit-led (as with most structuralists, they see the US as the main example of the latter), distributional conflicts will be more intense. On the other hand, in this case the demand and productivity effects work together to make wage restraint a more effective strategy for boosting employment.

It’s worth spelling out the implications a bit more. A profit-led economy is one in which investment decisions are very sensitive to profitability. But investment is itself a major influence on profit, as a source of demand and — emphasized here — as a source of productivity gains that are captured by capital. So wage gains are more threatening to profits in a setting in which investment decisions are based largely on profitability. In an environment in which investment decisions are motivated by demand or exogenous animal spirits (“only a little more than an expedition to the South Pole, based on a calculation of benefits to come”), capitalists have less to fear from rising wages. More bluntly: one of the main dangers to capitalists of a rise in wages, is their effects on the investment decisions of other capitalists.

What Recovery: Reading Notes

My Roosevelt Institute paper on potential output came out last week. (Summary here.) The paper has gotten some more press since Neil Irwin’s Times piece, including Ryan Cooper in The Week and Felix Salmon in Slate. My favorite headline is from Boing Boing: American Wages Are So Low, the Robots Don’t Want Your Jobs.

In the paper I tried to give a fairly comprehensive overview of the evidence and arguments that the US economy is not in any meaningful sense at potential output or full employment. But of course it was just one small piece of a larger conversation. Here are a few things I’ve found interesting recently on the same set of issues. .

Perhaps the most important new academic contribution to this debate is this paper by Olivier Coibion, Yuriy Gorodnichenko, and Mauricio Ulate, on estimates of potential output, which came out too late for me to mention in the Roosevelt report. Their paper rigorously demonstrates that, despite their production-function veneer, the construction of potential output estimates ensures that any persistent change in growth rates will appear as a change in potential. It follows that there is “little value added in estimates of potential GDP relative to simple measures of statistical trends.” (Matthew Klein puts it more bluntly in an Alphaville post discussing the paper: “‘Potential’ output forecasts are actually worthless.”) The paper proposes an alternative measure of potential output, which they suggest can distinguish between transitory demand shocks and permanent shifts in the economy’s productive capacity. This alternative measure gives a very similar estimate for the output gap as simply looking at the pre-2008 forecasts or extrapolating from the pre-2008 trend.  “Our estimates imply that U.S. output remains almost 10 percentage points below potential output, leaving ample room for policymakers to close the gap through demand-side policies if they so chose to.” Personally, I ‘m a little less convinced by their positive conclusions than by their negative ones. But this paper should definitely put to the rest the idea (as in last year’s notorious CEA-chair letter) that it is obviously wrong — absurd and unserious — that a sufficient stimulus could deliver several years of 4 percent real growth, until GDP returned to its pre-recession trend. It may or may not be true, but it isn’t crazy.

Many of the arguments in my paper were also made in this valuable EPI report by Josh Bivens, reviving the old idea of a “high pressure economy”. Like me, Bivens argues that slow productivity growth is largely  attributable to low investment, which in turn is due to weak demand and slow wage growth, which blunts the incentive for business to invest in labor-saving technology. One important point that Bivens makes that I didn’t, is that much past variation in productivity growth has been transitory; forecasts of future productivity growth based on the past couple of years have consistently performed worse than forecasts based on longer previous periods. So historical evidence gives us no reason see the most recent productivity slowdown as permanent. My one quibble is that he only discusses faster productivity growth and higher inflation as possible outcomes of a demand-driven acceleration in wages. This ignores the third possible effect, redistribution from from profits to wages — in fact a rise in the labor share is impossible without a period of “overfull” employment.

Minneapolis Fed president Neel Kashkari wrote a long post last fall on “diagnosing and treating the slow recovery.” Perhaps the most interesting thing here is that he poses the question at all. There’s a widespread view that once you correct for demographics, the exceptional performance of the late 1990s, etc., there’s nothing particularly slow about this recovery — no problem to diagnose or treat.

Another more recent post by Kashkari focuses on the dangers of forcing the Fed to mechanically follow a Taylor rule for setting interest rates. By his estimate, this would have led to an additional 2.5 million unemployed people this year. It’s a good illustration of the dangers of taking the headline measures of economic performance too literally. I also like its frank acknowledgement that the Fed — like all real world forecasters — rejects rational expectations in the models it uses for policymaking.

Kashkari’s predecessor Narayan Kocherlakota — who seems to agree more with the arguments in my paper — has a couple short but useful posts on his personal blog. The first, from a year ago, is probably the best short summary of the economic debate here that I’ve seen. Perhaps the key analytic point is that following a period of depressed investment, the economy may reach full employment given the existing capital stock while it is still well short of potential. So a period of rapid wage growth would not necessarily mean that the limits of expansionary policy have ben reached, even if those wage gains were fully passed through to higher prices. His emphasis:

Because fiscal policy has been too tight, we have too little public capital. … At the same time, physical investment has been too low… Conditional on these state variables, we might well be close to full employment.  … But, even though we’re close to full employment, there’s a lot of room for super-normal growth. Both capital and TFP are well below their [long run level].  The full-employment growth rate is going to be well above its long-run level for several years.  We can’t conclude the economy is overheating just because it is growing quickly.

His second post focuses on the straightforward but often overlooked point that policy should take into account not just our best estimates but our uncertainty about them, and the relative risks of erring on each side. And if there is even a modest chance that more expansionary policy could permanently raise productivity, then the risks are much greater on the over-contractionary side. [1] In particular, if we are talking about fiscal stimulus, it’s not clear that there are any costs at all. “Crowding out” is normally understood to involve a rise in interest rates and a shift from private investment to public spending. In the current setting, there’s a strong case that higher interest rates  at full employment would be a good thing (at least as long as we still rely on as the main tool of countercyclical policy). And it’s not obvious, to say the least, that the marginal dollar of private investment is more socially useful than many plausible forms of public spending. [2] Kashkari has a post making a similar argument in defense of his minority vote not to raise rates at the most recent FOMC meeting. (Incidentally, FOMC members blogging about their decisions is a trend to be encouraged.)

In a post from March which I missed at the time, Ryan Avent tries to square the circle of job-destroying automation and slow productivity growth. One half of the argument seems clearly right to me: Abundant labor and low wages discourage investment in productivity-raising technologies. As Avent notes, early British and even more American industrialization owe a lot to scarce labor and high wages. The second half of the argument is that labor is abundant today precisely because so much has been displaced by technology. His claim is that “robots taking the jobs” is consistent with low measured productivity growth if the people whose jobs are taken end up in a part of the economy with a much lower output per worker. I’m not sure if this works; this seems like the rare case in economics where an eloquent story would benefit from being re-presented with math.

Along somewhat similar lines, Simon Wren-Lewis points out that unemployment may fall because workers “price themselves into jobs” by accepting lower-wage (and presumably lower-productivity) jobs. But this doesn’t mean that the aggregate demand problem has been solved — instead, we’ve simply replaced open unemployment with what Joan Robinson called “disguised unemployment,” as some of people’s capacity for work continues to go to waste even while they are formally employed. “But there is a danger that central bankers would look at unemployment, … and conclude that we no longer have inadequate aggregate demand…. If demand deficiency is still a problem, this would be a huge and very costly mistake.”

Karl Smith at the Niskanen Center links this debate to the older one over the neutrality of money. Central bank interventions — and aggregate demand in general — are understood to be changes in the flow of money spending in the economy. But a lon-standing tradition in economic theory says that money should be neutral in the long run. As we are look at longer periods, changes in output and employment should depend more and more on real resources and technological capacities, and less and less on spending decisions — in the limit not at all. If you want to know why GDP fell in one quarter but rose in the next (this is something I always tell my undergraduates) you need to ask who chose to reduce their spending in the first period and who chose to increase it in the first. But if you want to know why we are materially richer than our grandparents, it would be silly to say it’s because we choose to spend more money. This is the reason why I’m a bit impatient with people who respond to the fact that, relative to the pre-2008 trend, output today has not recovered from the bottom of the recession, by saying “the trend doesn’t matter, deviations in output are always persistent.” This might be true but it’s a radical claim. It means you either take the real business cycle view that there’s no such thing as aggregate demand, even recessions are due to declines in the economy’s productive potential; or you must accept that in some substantial sense we really are richer than our grandparents because we spend more money. You can’t assert that GDP is not trend-stationary to argue against an output gap today unless you’re ready to accept these larger implications.

The invaluable Tom Walker has a fascinating post going back to even older debates, among 19th century anti-union and pro-union pamphleters, about whether there was a fixed quantity of labor to be performed and whether, in that case, machines were replacing human workers. The back and forth (more forth than back: there seem to be a lot more anti-labor voices in the archives) is fun to read, but what’s the payoff for todays’ debates?

The contemporary relevance of this excursion into the archives is that economic policy and economic thought walks on two legs. Conservative economists hypocritically but strategically embrace both the crowding out arguments for austerity and the projected lump-of-labor fallacy claims against pensions and shorter working time. They are for a “fixed amount” assumption when it suits their objectives and against it when it doesn’t. There is ideological method to their methodological madness. That consistency resolves itself into the “self-evidence” that nothing can be done.

That’s exactly right. When we ask why labor’s share has fallen so much over the past generation, we’re told it’s because of supply and demand — an increased supply of labor from China and elsewhere, and a decreased demand thanks to technology. But if it someone says that it might be a good idea then to limit the supply of labor (by lowering the retirement age, let’s say) and to discourage capital-intensive production, the response is “are you crazy? that will only make everyone poorer, including workers.” Somehow distribution is endogenous when it’s a question of shifts in favor of capital, but becomes exogenously fixed when it’s a question of reversing them.

A number of heterdox writers have identified the claim that productivity growth depends on demand as Verdoorn’s law (or the Kaldor-Verdoorn Law). For example, the Post Keynesian blogger Ramanan mentions it here and here. I admit I’m a bit dissatisfied with this “law”. It’s regularly asserted by heterodox people but you’ll scour our literature in vain looking for either a systematic account of how it is supposed to operate or quantitative evidence of how and how much (or whether) it does.

Adam Ozimek argues that the recent rise in employment should be seen as an argument for continued expansionary policy, not a shift away from it. After all, a few years ago many policymakers believed such a rise was impossible, since the decline in employment was supposed to be almost entirely structural.

Finally, Reihan Salam wants to enlist me for the socialist flank of a genuinely populist Trumpism. This is the flipside of criticism I’ve sometimes gotten for making this argument — doesn’t it just provide intellectual ammunition for the Bannon wing of the administration and its calls for vast infrastructure spending,  which is also supposed to boost demand and generate much faster growth? Personally I think you need to make the arguments for what you think is true regardless of their political valence. But I might worry about this more if I believed there was even a slight chance that Trump might try to deliver for his working-class supporters.


[1] Kocherlakota talks about total factor productivity. I prefer to focus on labor productivity because it is based on directly observable quantities, whereas TFP depends on estimates not only of the capital stock but of various unobservable parameters. The logic of the argument is the same either way.

[2] I made similar arguments here.


EDIT: My comments on the heterodox literature on the Kaldor-Verdoorn Law were too harsh. I do feel this set of ideas is underdeveloped, but there is more there than my original post implied. I will try to do a proper post on this work at some point.

The Big Question for Macroeconomic Policy: Is This Really Full Employment?

Cross-posted from the Roosevelt Institute’s Next New Deal blog. This is a summary of my new paper What Recovery? The Case for Continued Expansionary Policy, also discussed in Neil Irwin’s July 26 article in the Times.


“Right now,” wrote Senator Chuck Schumer in a New York Times op-ed on Monday, “millions of unemployed or underemployed people, particularly those without a college degree, could be brought back into the labor force” with appropriate government policies. With this seemingly anodyne point, Schumer took sides in a debate that has sharply divided economists and policymakers: Is the US economy today operating at potential, with enough spending to make full use of its productive capacity? Or is there still substantial slack, unused capacity that could be put to work if someone — households, businesses or governments — decided to spend more? Is there an aggregate-demand problem that government should be trying to solve?

It’s difficult to answer this question because the economic signals seem to point in conflicting directions. Despite the recession officially ending in June 2009 and the economy enjoying steady growth for the past eight years, GDP is still far below the pre-2008 trend. If we compare GDP to forecasts made before the recession, the gap that opened up during the recession has not closed at all — in fact, it continues to get wider. Meanwhile, the official unemployment rate — probably the most watched indicator for the state of aggregate demand — is down to 4.4%, well below the level that was considered full employment even a few years ago. But this positive performance only partially reflects an increase in the number of Americans with jobs; mostly it comes from a decline in the size of the labor force — people who have or are seeking jobs. The fraction of the adult population employed is down to 60 percent from 63 percent a decade ago (and nearly 65 percent at the end of the 1990s).

Is this decline in the fraction of people employed the inevitable result of an aging population and similar demographic changes, or is it a sign that, despite the low measured unemployment rate, the economy is still far short of full employment? The Federal Reserve — one of the main sites of macroeconomic policy — has already indicated its belief that full employment has been reached by raising interest rates 3 times since December 2016. Fed Chair and Janet Yellen are evidently convinced that the economy has reached its potential — that, given the real resources available, output and employment are as high as can reasonably be expected.

Other policymakers have been divided on the question, in ways that often cut across partisan lines. Senator Schumer’s statement — that the decline in employment is not an inevitable trend but rather a problem that government can and should solve — is a sign of new clarity coming to this murky debate. Along with his call for $1 trillion in new infrastructure spending, it’s an important acknowledgement that, despite the progress made since 2008, the country remains far from full employment.

In a new paper out this week, we at the Roosevelt Institute offer support for the emerging consensus that the economy needs policies to boost demand. The paper reviews the available data on where the economy is relative to its potential. We find that the balance of evidence suggests there is still a great deal of space for more expansionary policy.

We offer several lines of argument in support of this conclusion.

GDP has not recovered from the recession. GDP remains about 10 percent below both the long-term trend and the level that was predicted by the CBO and other forecasts prior to the 2008–2009 recession. There is no precedent in the postwar period for such a persistent decline in output. During the sixty years between 1947 and 2007, growth lost in recessions was always regained in the subsequent recovery.

The aging population does not explain low labor force participation. It is true that an aging population should contribute to lower employment, since older people are less likely to work than younger people. But this simple demographic story cannot explain the full fall in employment. Starting from the employment peak in 2000, aging trends only explain about half the decrease in employment that has actually occurred. And there are good reasons to think that even this overstates the role of demographics. First, during the same period, education levels have increased. Historically, higher education has been associated with higher employment rates, just as a share of elderly people has been associated with less employment; statistically, these two effects should just about cancel out. Second, the post-recession fall in employment rates is not concentrated in older age groups, but among people in their 20s — something that a demographic story cannot explain.

The weak economy has held back productivity. About half the shortfall in GDP relative to the pre-2008 trend is explained by exceptionally slow productivity growth — that is, slow growth in output per worker. While many people assume that productivity is the result of technological progress outside the reach of macroeconomic policy, there are good reasons to think that the productivity slowdown is at least in part due to weak demand. Among the many possible links: Business investment, which is essential to raising productivity, has been extraordinarily weak over the past decade, and economists have long believed that demand is a central factor driving investment. And slow wage growth — a sign of labor-market weakness — reduces the incentive to adopt productivity-boosting technology.

Only a demand story makes sense. The overall economic picture is hard to understand except in terms of a continued demand shortfall. If employment is falling due to demographics, that should be associated with rising productivity and wages, as firms compete for scarce labor. If productivity growth is slow because there aren’t any more big innovations to make, that should be associated with faster employment growth and low profits, as firms can no longer find new ways to replace labor with capital. But neither of these scenarios match the actual economy. And both stories predict higher inflation, rather than the persistent low inflation we have actually encouraged. So even if supply-side stories explain individual pieces of macroeconomic data, it is almost impossible to make sense of the big picture without a large fall in aggregate demand.

Austerity is riskier than stimulus. Finally, we argue that, if policymakers are uncertain about how much space the economy has for increased demand, they should consider the balance of risks on each side. Too much stimulus would lead to higher inflation — easy to reverse, and perhaps even desirable, given the continued shortfall of inflation relative to the official 2 percent target. An overheated economy would also see real wages rise faster than productivity. While policymakers often see this as something to avoid, the decline in the wage share over the past decade cannot be reversed without a period of such “excess” wage growth. On the other hand, if there is still an output gap, failure to take aggressive steps to close it means foregoing literally trillions of dollars of useful goods and services and condemning millions of people to joblessness.

Fortunately, the solution to a demand shortfall is no mystery. Since Keynes, economists have known that when an economy is operating below its potential, all that is needed is for someone to spend more money. Of course, it’s best if that spending also serves some useful social purpose; exactly what that should look like will surely be the subject of much debate to come. But the first step is to agree on the problem. Today’s economy is still far short of its potential. We can do better.

What Does Crowding Out Even Mean?

Paul Krugman is taking some guff for this column where he argues that the US economy is now at potential, or full employment, so any shift in the federal budget toward deficit will just crowd out private demand.

Whether higher federal spending (or lower taxes) could, in present conditions, lead to higher output is obviously a factual question, on which people may read the evidence in different ways. As it happens, I don’t agree that current output is close to the limits of current productive capacity. But that’s not what I want to write about right now. Instead I want to ask: What concretely would crowding out even mean right now?

Below, I run through six possible meanings of crowding out, and then ask if any of them gives us a reason, even in principle, to worry about over-expansionary policy today. (Another possibility, suggested by Jared Bernstein, is that while we don’t need to worry about supply constraints for the economy as a whole, tax cuts could crowd out useful spending due to some unspecified financial constraint on the federal government. I don’t address that here.) Needless to say, doubts about the economic case for crowding-out are in no way an argument for the specific deficit-boosting policies favored by the new administration.

The most straightforward crowding-out story starts from a fixed supply of private savings. These savings can either be lent to the government, or to business. The more the former takes, the less is left for the latter. But as Keynes pointed out long ago, this simple loanable-funds story assumes what it sets out to prove. The total quantity of saving is fixed only if total income is fixed. If higher government spending can in fact raise total income, it will raise total saving as well. We can only tell a story about government and business competing for a given pool of saving if we have already decided for some other reason that GDP can’t change.

The more sophisticated version, embodied in the textbook ISLM model, postulates a fixed supply of money, rather than saving. [1] In Hicks’ formulation, money is used both for transactions and as the maximally liquid store of wealth. The higher is output, the more money is needed for transactions, and the less is available to be held as wealth. By the familiar logic of supply and demand, this means that wealthholders must be paid more to part with their remaining stock of money. The price wealthholders receive to give up their money is interest; so as GDP rises, so does the interest rate.

Unlike the loanable funds story with fixed saving, this second story does give a logically coherent account of crowding out. In a world of commodity money, if such ever was, it might even be literally true. But in a world of bank-created credit money, it’s at best a metaphor. Is it a useful metaphor? That would require two things. First, that the interest rate (whichever one we are interested in) is set by the financial system. And second, that the process by which this happens causes rates to systematically rise with demand. The first premise is immediately rejected by the textbooks, which tell us that “the central bank sets the interest rate.” But we needn’t take this at face value. There are many interest rates, not just one, and the spreads between them vary quite a bit; logically it is possible that strong demand could lead to wider spreads, as banks stretch must their liquidity further to make more loans. But in reality, the opposite seems more likely. Government debt is a source of liquidity for private banks, not a use of it; lending more to the government makes it easier, not harder, for them to also lend more to private borrowers. Also, a booming economy is one in which business borrowers are more profitable; marginal borrowers look safer and are likely to get better terms. And rising inflation, obviously, reduces the real value of outstanding debt; however annoying this is to bankers, rationally it makes them more willing to lend more to their now less-indebted clients. Wicksell, the semi-acknowledged father of modern central banking theory, built his big book around the premise that in a credit-money system, inflation would give private banks no reason to raise interest rates.

And in fact this is what we see. Interest rate spreads are narrow in booms; they widen in crises and remain wide in downturns.

So crowding out mark two, the ISLM version, requires us to accept both that central banks cannot control the economically relevant interest rates, and that private banks systematically raise interest rates when times are good. Again, in a strict gold standard world there might something to this — banks have to raise rates, their gold reserves are running low — but if we ever lived in that world it was 150 or 200 years ago or more.

A more natural interpretation of the claim that the economy is at potential, is that any further increase in demand would just  lead to inflation. This is the version of crowding out in better textbooks, and also the version used by MMT folks. On a certain level, it’s obviously correct. Suppose the amount of money-spending in an economy increases. Then either the quantity of goods and services increases, or their prices do. There is no third option: The total percent increase in money spending, must equal the sum of the percent increase in “real” output and the percent increase in average prices. But how does the balance between higher output and higher prices play out in real life? One possibility is that potential output is a hard line: each dollar of spending up to there increases real output one for one, and leaves prices unchanged; each dollar of spending above there increases prices one for one and leaves output unchanged. Alternatively, we might imagine a smooth curve where as spending increases, a higher fraction of each marginal dollar translates into higher prices rather than higher output. [2] This is certainly more realistic, but it invites the question of which point exactly on this curve we call “potential”. And it awakens the great bane of postwar macro – an inflation-output tradeoff, where the respective costs and benefits must be assessed politically.

Crowding out mark three, the inflation version, is definitely right in some sense — you can’t produce more concrete use values without limit simply by increasing the quantity of money borrowed by the government (or some other entity). But we have to ask first, positively, when we will see this inflation, and second, normatively, how we value lower inflation vs higher output and income.

In the post-1980s orthodoxy, we as society are never supposed to face these questions. They are settled for us by the central bank. This is the fourth, and probably most politically salient, version of crowding out: higher government spending will cause the central bank to raise interest rates. This is the practical content of the textbook story, and in fact newer textbooks replace the LM curve — where the interest rate is in some sense endogenous — with a straight line at whatever interest rate is chosen by the central bank. In the more sophisticated textbooks, this becomes a central bank reaction function — the central bank’s actions change from being policy choices, to a fundamental law of the economic universe. The master parable for this story is the 1990s, when the Clinton administration came in with big plans for stimulus, only to be slapped down by Alan Greenspan, who warned that any increase in public spending would be offset by a contractionary shift by the federal reserve. But once Clinton made the walk to Canossa and embraced deficit reduction, Greenspan’s fed rewarded him with low rates, substituting private investment in equal measure for the foregone public spending. In the current contest, this means: Any increase in federal borrowing will be offset one for one by a fall in private investment —  because the Fed will raise rates enough to make it happen.

This story is crowding out mark four. It depends, first, on what the central bank reaction function actually is — how confident are we that monetary policy will respond in a direct, predictable way to changes in the federal budget balance or to shifts in demand? (The more attention we pay to how the monetary sausage gets made, the less confident we are likely to be.) And second, on whether the central bank really has the power to reliably offset shifts in fiscal policy. In the textbooks this is taken for granted but there are reasons for doubt. It’s also not clear why the actions of the central bank should be described as crowding out by fiscal policy. The central bank’s policy rule is not a law of nature. Unless there is some other reason to think expansionary policy can’t work, it’s not much of an argument to say the Fed won’t allow it. We end up with something like: “Why can’t we have deficit-financed nice things?” “Because the economy is at potential – any more public spending will just crowd out private spending.” “How will it be crowded out exactly?” “Interest rates will rise.” “Why will they rise?” “Because the federal reserve will tighten.” “Why will they tighten?” “Because the economy is at potential.”

Suppose we take the central bank out of the picture. Suppose we allow supply constraints to bind on their own, instead of being anticipated by the central planners at the Fed. What would happen as demand pushed up against the limits of productive capacity? One answer, again, is rising inflation. But we shouldn’t expect prices to all rise in lockstep. Supply constraints don’t mean that production growth halts at once; rather, bottlenecks develop in specific areas. So we should expect inflation to begin with rising prices for inputs in inelastic supply — land, oil, above all labor. Textbook models typically include a Phillips curve, with low unemployment leading to rising wages, which in turn are passed on to higher prices.

But why should they be passed on completely? It’s easy to imagine reasons why prices don’t respond fully or immediately to changes in wages. In which case, as I’ve discussed before, rising wages will result in an increase in the wage share. Some people will object that such effects can only be temporary. I’m not sure this makes sense — why shouldn’t labor, like anything else, be relatively more expensive in a world where it is relatively more scarce? But even if you think that over the long-term the wage share is entirely set on the supply side, the transition from one “fundamental” wage share to another still has to involve a period of wages  rising faster or slower than productivity growth — which in a Phillips curve world, means a period above or below full employment.

We don’t hear as much about the labor share as the fundamental supply constraint, compared with savings, inflation or interest rates. But it comes right out of the logic of standard models. To get to crowding out mark five, though, we have to take one more step. We have to also postulate that demand in the economy is profit-led — that a distributional shift from profits toward wages reduces desired investment by more than it increases desired consumption. Whether (or which) real economies display wage-led or profit-led demand is a subject of vigorous debate in heterodox macro. But there’s no need to adjudicate that now. Right now I’m just interested in what crowding out could possibly mean.

Demand can affect distribution only if wage increases are not fully passed on to prices. One reason this might happen is that in an open economy, businesses lack pricing power; if they try to pass on increased costs, they’ll lose market share to imports. Follow that logic to its endpoint and there are no supply constraints — any increase in spending that can’t be satisfied by domestic production is met by imports instead. For an ideal small, open economy potential output is no more relevant than the grocery store’s inventory is for an individual household when we go shopping. Instead, like the household, the small open economy faces a budget constraint or a financing constraint — how much it can buy depends on how much it can pay for.

Needless to say, we needn’t go to that extreme to imagine a binding external constraint. It’s quite reasonable to suppose that, thanks to dependence on imported inputs and/or demand for imported consumption goods, output can’t rise without higher imports. And a country may well run out of foreign exchange before it runs out of domestic savings, finance or productive capacity. This is the idea behind multiple gap models in development economics, or balance of payments constrained growth. It also seems like the direction orthodoxy is heading in the eurozone, where competitiveness is bidding to replace inflation as the overriding concern of macro policy.

Crowding out mark six says that any increase in demand from the government sector will absorb scarce foreign exchange that will no longer be available to private sector. How relevant it is depends on how inelastic import demand is, the extent to which the country as a whole faces a binding budget or credit constraint and, what concrete form that constraint faces — what actually happens if international creditors are stiffed, or worry they might be? But the general logic is that higher spending will lead to a higher trade deficit, which at some point can no longer be financed.

So now we have six forms of crowding out:

1. Government competes with business for fixed saving.

2. Government competes with business for scarce liquidity.

3. Increased spending would lead to higher inflation.

4. Increased spending would cause the central bank to raise interest rates.

5. Overfull employment would lead to overfast wage increases.

6. Increased spending would lead to a higher trade deficit.

The next question is: Is there any reason, even in principle, to worry about any of these outcomes in the US today? We can decisively set aside the first, which is logically incoherent, and confidently set aside the second, which doesn’t fit a credit-money economy in which government liabilities are the most liquid asset. But the other four certainly could, in principle, reflect real limits on expansionary policy. The question is: In the US in 2017, are higher inflation, higher interest rates, higher wages or a weaker balance of payments position problems we need to worry about? Are they even problems at all?

First, higher inflation. This is the most natural place to look for the costs of demand pushing up against capacity limits. In some situations you’d want to ask how much inflation, exactly, would come from erring on the side of overexpansion, and how costly that higher inflation would be against the benefits of lower unemployment. But we don’t have to ask that question right now, because inflation is by conventional measures, too low; so higher inflation isn’t a cost of expansionary policy, but an additional benefit. The problem is even worse for Krugman, who has been calling for years now for a higher inflation target, usually 4 percent. You can’t support higher inflation without supporting the concrete action needed to bring it about, namely, a period of aggregate spending in excess of potential. [2] Now you might say that changing the inflation target is the responsibility of the Fed, not the fiscal authorities. But even leaving aside the question of democratic accountability, it’s hard to take this response seriously when we’ve spent the last eight years watching the Fed miss its existing target; setting a new higher target isn’t going to make a difference unless something else happens to raise demand. I just don’t see how you can write “What do we want? Four percent! When do we want it? Now!” and then turn around and object to expansionary fiscal policy on the grounds that it might be inflationary.

OK, but what if the Fed does raise rates in response to any increase in the federal budget deficit, as many observers expect? Again, if you think that more expansionary policy is otherwise desirable, it would seem that your problem here is with the Fed. But set that aside, and assume our choice is between a baseline 2018-2020, and an alternative with the same GDP but with higher budget deficits and higher interest rates. (This is the worst case for crowding out.) Which do we prefer? In the old days, the low-deficit, low-interest world would have been the only respectable choice: Private investment is obviously preferable to whatever government deficits might finance. (And to be fair, in the actual 2018-2020, they will mostly be financing high-end tax cuts.) But as Brad DeLong points out, the calculation is different today. Higher interest rates are now a blessing, not a curse, because they create more running room for the Fed to respond to a downturn. [3] In the second scenario, there will be some help from conventional monetary policy in the next recession, for whatever it’s worth; in the first scenario there will be no help at all. And one thing we’ve surely learned since 2008 is the costs of cyclical downturns are much larger than previously believed. So here again, what is traditionally considered a costs of pushing past supply constraints turns out on closer examination to be a benefit.

Third, the danger of more expansionary policy is that it will lead to a rise in the wage share. You don’t hear this one as much. I’ve suggested elsewhere that something like this may often motivate actual central bank decisions to tighten. Presumably it’s not what someone like Krugman is thinking about. But regardless of what’s in people’s heads, there’s a serious problem here for the crowding-out position. Let’s say that we believe, as both common sense and the textbooks tells us, that the rate of wage growth depends on the level of unemployment. Suppose  we define full employment in the conventional way as the level of unemployment that leads to nominal wage growth just equal to productivity growth plus the central bank’s inflation target. Then by definition, any increase in the wage share requires a period of overfull employment — of unemployment below the full employment level. This holds even if you think the labor share in the long run is entirely technologically determined. A forteori it holds if you think that the wage share is in some sense political, the result of the balance of forces between labor and capital.

Again, I’m simply baffled how someone can believe at the same time that the rising share of capital in national income is a problem, and that there is no space for expansionary policy once full employment is reached. [4] Especially since the unemployment target is missed so often from the other side. If you have periods of excessively high unemployment but no periods of excessively low unemployment, you get a kind of ratchet effect where the labor share can only go down, never up. I think this sort of cognitive dissonance happens because economics training puts aggregate demand in one box and income distribution in another. But this sort of hermetic separation isn’t really sustainable. The wage share can only be higher in the long run if there is some short-run period in which it rises.

Finally, the external constraint. It is probably true that more expansionary fiscal policy will lead to bigger trade deficits. But this only counts as crowding out if those deficits are in some sense unsustainable. Is this the case for the US? There are a lot of complexities here but the key point is that almost all our foreign liabilities (and all of the government’s) are denominated in dollars, and almost all our imports are invoiced in dollars. Personally, I think the world is still more likely to encounter a scarcity of dollar liquidity than a surfeit, so the problem of an external constraint doesn’t even arise. But let’s say I’m wrong and we get the worst-case scenario where the world is no longer willing to hold more dollar liabilities. What happens? Well, the value of the dollar falls. At a stroke, US foreign liabilities decline relative to foreign assets (which are almost all denominated in their home currencies), improving the US net international investment position; and US exports get cheaper for the rest of the world, improving US competitiveness. The problem solves itself.

Imagine a corporation with no liabilities except its stock, and that also paid all its employers and supplies in its own stock and sold its goods for its own stock. How could this business go bankrupt? Any bad news would instantly mean its debts were reduced and its goods became cheaper relative to its competitors’. The US is in a similar position internationally. And if you think that over the medium term the US should be improving its trade balance then, again, this cost of over-expansionary policy looks like a benefit — by driving down the value of the dollar, “irresponsible” policy will set the stage for a more sustainable recovery. The funny thing is that in other contexts Krugman understands this perfectly.

So as far as I can tell, even if we accept that the US economy has reached potential output/full employment, none of the costs for crossing this line are really costs today. Perhaps I’m wrong, perhaps I’m missing something. but it really is incumbent on anyone who argues there’s no space for further expansionary policy to explain what concretely would be the results of overshooting.

In short: When we ask how close the economy is to potential output, full employment or supply constraints, this is not just a factual question. We have to think carefully about what these terms mean, and whether they have the significance we’re used to in today’s conditions. This post has been more about Krugman than I intended, or than he deserves. A very large swathe of established opinion shares the view that the economy is close to potential in some sense, and that this is a serious objection to any policy that raises demand. What I’d like to ask anyone who thinks this is: Do you think higher inflation, a higher “natural” interest rate, a higher wage share or a weaker dollar would be bad things right now? And if not, what exactly is the supply constraint you are worried about?


[1] The LM in ISLM stands for liquidity-money. It’s supposed to be the combination of interest rates and output levels at which the demand for liquidity is satisfied by a given stock of money.

[2] OK, some people might say the Fed could bring about higher inflation just by announcing a different target. But they’re not who I’m arguing with here.

[3] Krugman himself says he’d “be a lot more comfortable … if interest rates were well clear of the ZLB.” How is that supposed to happen unless something else pushes demand above the full employment level at current rates?

[4] It would of course be defensible to say that the downward redistribution from lower unemployment would be outweighed by the upward redistribution from the package of tax cuts and featherbedding that delivered it. But that’s different from saying that a more expansionary stance is wrong in principle.

Rogoff on the Zero Lower Bound

I was at the ASSAs in Chicago this past weekend. [1] One of the most interesting panels I went to was this one, on Advances in Open Economy Macroeconomics. Among other big names, Ken Rogoff was there, as the discussant for a rather strange paper by Pierre-Olivier Gourinchas and Helene Rey.

The Gourinchas and Rey paper, like much of mainstream macro these days, made a big deal of how different everything is at the zero lower bound. Rogoff wasn’t having it. Here’s a rough transcript of what he said:

The obsession with the zero lower bound is encouraging all kinds of wacko ideas. People are saying that at the ZLB, productivity increases are bad (Eggertsson/Krugman/Summers), protectionism is good (Eichngreen), price flexibility is bad, and so on.

But there is an emerging literature that says economists are taking the zero lower bound too literally. In fact, getting negative rates is not that hard. So before you take seriously these, let’s say, very creative ideas, it would be simpler to think about getting rid of the zero bound.

There are lots of ways to do it. I talk about some in my book, but people already understood this back in the 1930s. There was Robert Eisler’s proposal to have banks accept cash deposits at a discount, for instance, which would have effectively created negative rates. If Keynes had read Eisler, he might have gone in a different direction. [2] It’s a very old idea — Kublai Khan did something similar. There will be pushback from the financial sector, of course, who think negative rates will be costly for them, but fundamentally it is not hard to do.

These rather striking comments crystallized something in my mind. What is the big deal about the ZLB? For mainstream macroeconomists, including Gourinchas and Rey in this paper, the reason the ZLB matters is that it prevents the central bank form setting an interest rate low enough to keep output at potential. [3] It’s precisely this that makes inapplicable the conventional analysis of a nonmonetary problem of allocating scarce resources between alternative ends, and requires thinking about other entry points. If the central bank can’t solve the problem of aggregate demand then you have to take it seriously, with all the wacko and/or creative stuff that follows.

In the dominant paradigm, this is a specific technical problem of getting interest rates below zero. Solve that, and we are back in the comfortable Walrasian world. But for those of us on the heterodox side, it is never the case that the central bank can reliably keep output at potential — maybe because market interest rates don’t respond to the policy rate, or because output doesn’t respond to interest rates, or because the central bank is pursuing other objectives, or because there is no well-defined level of “potential” to begin with. (Or, in reality, all four.) So what people like Gourinchas and Rey, or Paul Krugman, present as a special, temporary state of the economy, we see as the general case.

One way of looking at this is that the ZLB is a device to allow economists like Krugman and Gourinchas and Rey — who whatever their scholarly training, are aware of the concrete reality around them — to make Keynesian arguments without forfeiting their academic respectability. You can understand why someone like Rogoff sees that as cheating. We’ve spent decades teaching that the fundamental constraint on the economy is the real endowment of resources and technology; that saving boosts growth; that trade is always win-win; that money and finance matter only in the short run (and the short run is tolerably short). The practical problem of negative policy rates doesn’t let you forget all of that.

Which, if you turn it around, perhaps reflects well on the ZLB crowd. Maybe they want to forget all that? Maybe, you could say, they take the zero lower bound seriously because they don’t take it literally. That is, they treat it as a hard constraint precisely because they are aware that it is only a stand-in for a deeper reality.


[1] The big annual economics conference. It stands for Allied Social Sciences Association — the disciplinary imperialism is right there in the name.

[2] This was an odd thing for Rogoff to say, since of course while Keynes didn’t discuss Eisler as far as I know, he talks at length about the similar proposals for depreciating cash of Silvio Gesell and Major Douglas. Notoriously he says these “brave cranks and heretics” have more to offer than Marx.

[3] Gourinchas and Rey are reality-based enough to say “the policy rate,” not “the interest rate.”


EDIT: Added the seriously-but-not-literally phrasing as suggested by Steve Roth on Twitter.

Demand and Productivity

I’m picking up, after some months, the project I was working on over the summer on potential output. Obviously the political context is different now. But the questions of what potential output actually means, how tightly it binds, and how close the economy is to it at any given moment, are not going away. Previous entries: onetwothreefour, and five.


You’ve probably heard the story about Ed Rensi, the former McDonald’s CEO who claimed the company’s move to replace cashier’s with self-serve kiosks was a response to minimum wage increases.

“I told you so,” he writes. “In 2013, when the Fight for $15 was still in its growth stage, I and others warned that union demands for a much higher minimum wage would force businesses with small profit margins to replace full-service employees with costly investments in self-service alternatives.”

Is this for real? Maybe not: The shift toward kiosks has been happening for a while, so it’s not just a response to the recent minimum wage hikes; and it may not end up reducing labor costs anyway.

But let’s say the move is as as Rensi claims. Then we should call it what it is: an increase in labor productivity. With fewer workers McDonald’s will produce just as many hamburgers; in other words, production per worker will be higher. [1]

As I’ve suggested, this sort of thing is a real problem for a certain strand of minimum wage advocacy. Advocates like to point to productivity gains in response to higher wages as an argument in their favor. (The gains are usually imagined in terms of loyalty, motivation, lower turnover, etc. rather than machines, but functionally it’s the same.) But productivity gains can only reduce the job losses from a minimum wage increase if those losses are large; they are not consistent with a story in which employment stays the same. [2]

But at the macro level, this dynamic has different implications. If the McDonald’s case is typical — if higher labor costs regularly lead to higher productivity — then we need to rethink our idea of supply constraints. There is more space for expansionary policy than we usually think.

Let’s start at the beginning. Suppose there is some policy change, or some random event, that boosts desired spending in the economy. It could be more government spending, it could be lower interest rates, it could be a rise in exports. What happens then?

In the conventional story, higher spending normally leads to greater production of goods and services, which in turn requires higher employment. This leaves fewer people unemployed. Lower unemployment increases the bargaining power of workers, forcing employers to bid up nominal wages. [3] These higher wages are passed on to prices, leading to higher inflation. When inflation reaches whatever level is considered price stability, then we say the economy is at full employment, or at potential output. (In this story the two are equivalent.) If spending continues to rise past this point, the responsible authorities (normally the central bank) will intervene to bring it back down.

This is the story you’ll find in any good undergraduate macroeconomics textbook. It’s a reasonable story, as far as these things go. In the strong form it’s usually given in, it implies a hard limit to how much demand can increase before inflation starts rising unacceptably. Once the pool of unemployed workers falls to the “full employment” level, any further increase in employment will lead to rapid increases in money wages, which will be passed on one for one to inflation.

One place this chain can break is that new workers are not necessarily drawn from the ranks of the currently unemployed — that is, if the size of the laborforce is endogenous. Insofar as people counted as out of the laborforce are in fact available for employment (or net immigration responds to demand), an increase in output doesn’t have to reduce the ranks of the officially unemployed. In other words, the official unemployment rate may underestimate the space available for raising output via increased employment. This motivates the question of how much the the fall in laborforce participation since 2007 is due to demographics, and how much is due to weak demand.

The conventional story can also break down at two other places if productivity growth is endogenous. First, output can increase without a proportionate increase in employment. And second, wages can rise without a proportionate rise in prices.

It’s useful to think about this in terms of a couple of accounting identities, which in my opinion should be part of every macroeconomics textbook. [4] The first is obvious (but worth spelling out), the second a little less so:

(1) growth in demand = percent change in labor productivity + percent change in employment + inflation

(2) percent change in nominal wages = percent change in labor productivity + percent change in labor share + inflation

The standard story is that productivity change on its own due to technology, and the labor shared is fixed and can be ignored in this context. If productivity and labor share can be taken as given, then an increase in demand (money spent on final goods and services) must lead to higher inflation if either employment fails to rise, or if it rises only with higher wages. In this story, if nominal wages rise thanks to a lower unemployment rats, that will pass on one for one to inflation. Pick up an advanced undergraduate textbook like Blanchard or Krugman or Carlin and Soskice, and you will find a Phillips curve of exactly this form, with exactly this story behind it. [5] Policy discussions at central banks conducted in same terms.

This is what underlies idea of hard supply constraints. Output growth is dictated by the fixed, exogenous growth of the laborforce and of productivity. If changes in demand push the economy off that fixed trajectory, all you’ll get is higher or lower inflation. Concretely: To keep inflation at 2 percent, unemployment must be such as to generate nominal wage growth 2 points above the technologically-determined growth of productivity.

But an alternative story is that variation in demand can lead to adjustment in one of the other terms. One possibility is that the laborforce adjusts, as participation rates vary in response to demand conditions. This is what is most often meant by hysteresis: persistent deviations in unemployment from the “natural” level lead to people entering or exiting the laborforce. That implies that even when headline unemployment rates are fairly low, further increases in employment may be possible without a rise in wages. Another possibility is that while higher employment will lead to (or require) higher wages, the wage increase is not passed on to prices but comes at the expense of profits instead. This is Anwar Shaikh’s classical Phillips curve; I’ve written about it here before.

A third possibility is that higher wages are accompanied by higher productivity. Again, this appears as a problem when we are talking about wage increases from legislation, union contracts, or similar developments. But it’s not a problem if the wage increases are thanks to low unemployment. In this case, the joint movement of wages and productivity just means that output can rise higher — that supply constraints are softer. That’s what I want to focus on now.

There are a number of reasons why productivity might rise with wages. Some of them simply amount to mismeasurement of employment — it appears that output per worker is rising but really the effective number of workers is. Others are more fundamental. If productivity responds strongly and persistently to demand, it blurs the distinction between aggregate supply and aggregate demand, to the point that it’s not clear what “potential output” even means.


Suppose we do find a consistent pattern where, if demand is strong, unemployment is low, and wages are rising rapidly, then productivity growth is high. What could be happening?

1. Increased hours. If we measure productivity as output per worker, as we usually do, then an increase in average hours worked will show up as an increase in productivity. There is a cyclical component to this — in recessions, employers reduce hours as well as laying off workers. According to the BLS, seasonally adjusted weekly hours fell from 34.4 prior to the recession to a low of 33.7 in summer 2009. While a 2 percent fall in hours might seem small, it’s a big change in less than two years, especially when you consider that real output per worker normally rises by less than 2 percent a year.

2. Workers moving into real jobs from pseudo-employment or disguised unemployment. In any economy there are activities that are formally classified as jobs but are not employment in any substantive sense — you can take these “jobs” without anyone making a decision to hire you, and they don’t come with a wage or any similar claim on any established production process. Joan Robinson’s examples were someone who gathers firewood in a poor country, or sells pencils on streetcorners in a richer one. You could add work in family businesses and various kinds of self-employment and commission-based work to this category. In countries with traditional rural sectors — not the US — work on a family farm is the big item here. These activities absorb people who are unable to find formal jobs; the marginal product of additional workers here is normally very low. So if higher demand draws people from this kind of disguised unemployment back into regular jobs, measured productivity will rise.

3. Workers may be more fully utilized at their existing jobs. Because hiring and firing is costly, business don’t immediately adjust staffing in response to changes in sales. when demand falls, businesses will initially keep some redundant workers because paying them is cheaper than laying them off and replacing them later; and when demand rises, businesses will first try to get more work out of existing employees rather than paying the costs of hiring more. Some of this takes the form of the hours adjustment above, but some of it simply takes the form of hiring “too little” or “too much” labor for the current level of production. These changes in the utilization of existing labor will show up as changes in labor productivity.

4. Higher wages may lead to more capital-intensive production. This is the McDonald’s story: When labor gets more expensive (or scarcer), businesses use more capital instead. This is presumably what people mean when they say “Econ 101” shows that rising wages lead to less employment (assuming they mean anything at all). This may be seen as a negative when it’s a question of raising wages through legislation or unions, but it shouldn’t be when it’s a question of rising wages due to labor scarcity. Insofar as businesses can substitute machines for labor, rising wages will not be passed on to prices, so there is more space to push unemployment down.

5. Productivity-boosting innovations may be more likely when demand is strong and wages rise. This is a variant of the previous story. Now instead of high wage leading business to adopt more capital-intensive techniques from those already available, they redirect innovation toward developing new labor-saving techniques. Conceptually this is not a big difference, but it implies a different signal in the data. In the previous case we would expect  the productivity improvements to be associated with higher investment and to be concentrated at the firms actually experiencing higher wages costs; in this case they might not be.

6. The composition of employment may shift toward higher-productivity sectors. This might happen for either of two reasons. First, higher wages will disproportionately raise costs for more labor-intensive sectors; these higher costs may be absorbed by profits or by prices, but either way they will presumably depress growth in those sectors to the benefit of less labor-intensive, more productive ones. Second, it may so happen that the more income-elastic sectors are also higher-productivity ones. In the short run this is presumably true since durables and investment goods are both capital-intensive and income-elastic. Over the longer run, the opposite is more likely — the composition of demand slowly but steadily shifts toward lower-productivity sectors.

7. The composition of employment may shift toward higher-productivity firms. This sounds similar but it’s a different story. Technical change isn’t an ineffable output-raising essence diffusing across society, it’s embodied in specific new production processes and new businesses — Schumpeter’s new plant, new firms, new men. This means that productivity increases often require new or growing firms to attract workers away from established ones. Given the “frictions” in the labor market, this will require offering a wage significantly above the going rate. And on the other side the fact that the least productive firms can’t afford to pay higher wages will cause them to decline or exit, which also raises average productivity. When wages are flat, on the other hand, low-productivity firms can continue operating. In this sense, higher wages are an integral part of productivity growth. [6]

8. There may be increasing returns in production. It may literally be the case that output per worker rises — at the firm, industry or economy-wide level — when the number of workers rises. Or this may be a more abstract version of some of the stories above. It’s worth noting that increasing returns is an area where the intuitions of people with economics training diverge sharply from people who look at the economy through other lenses. To almost anyone except an economist, it’s obvious that  costs normally fall as more of something is produced. [7]

All of these stories imply that higher demand should lead to higher measured labor productivity. But to figure out how strong this relationship is in reality, we’ll look at different data depending on which of these stories we think it works through.

Another important difference between the stories is they imply different domains over which the relationship should operate. The first three suggest a more or less immediate response of productivity to changes in demand, but also one that cannot continue indefinitely. There’s limits to how much hours per worker can rise and how much additional effort can be extracted from the existing workforce, and a limited pool of disguised unemployment to draw from. (The last is not true in developing countries, where the “latent reserve army” in subsistence agriculture may be effectively unlimited.) The other mechanisms are presumably slower, requiring a sustained “high-pressure economy.”  With these stories, increased demand may push the economy up against supply constraints, with rising inflation, bottlenecks, and so on; but if it keeps pushing against them, eventually they’ll give. In this case, potential output is a medium-term constraint — over longer periods it can adjust to actual output, rather than the reverse.  So in the opposite of conventional story, a temporary increase in inflation can lead to a permanent increase in output. People like Laurence Ball say exactly this about hysteresis, but they are usually thinking of the longer-run adjustment coming on the laborforce side.

If we follow this a step further, we could even say that in the long run, the big problem isn’t that excessively high wages do lead to the substitution of capital for labor but that excessively low wages don’t. People like Arthur Lewis argue that it’s the low wages of poor countries that have led to low productivity there, and not vice versa; there’s a well-known argument that the reason the industrial revolution happened first in Britain rather than in China or India (or Italy or France) is not that that the necessary technical innovations were present only in Britain. They were present many places; it was the uniquely high cost of British labor that made them profitable to adopt for production.


I think that productivity does respond to demand. I think this is a good reason to doubt whether the US economy close to “potential output” today, and to doubt what, if anything, this concept actually means. But I also think we need to be clearer about how they are linked concretely. If we want to tell a story about productivity responding to demand, it makes a difference which of the stories above we have in mind. Heterodox people, it seems to me, are too quick to just invoke Verdoorn’s law (productivity rises with output), and justify it with some vague comments about how labor is used more efficiently when it is scarce. [8] Does this apparent law work via substitution of machines for labor, or through fuller utilization of existing employees’ times, or through reallocation of labor to more productive firms and/or industries, or through a labor-saving-bias in technical change, or pure increasing returns, or what? If you’re just making a formal model it may not matter. But if we want to connect the model to concrete historical developments, it certainly does.

Personally, I am most interested in the reallocation stories. They shift our idea of the fundamental constraint on capitalist economies from biophysical resources, to coordination. The great difficulty for any program of raise or transform production —  industrialization, wartime mobilization, decarbonization — isn’t the limited supply of “real” resources, but the speed at which people’s productive activity can be redirected in a coordinated way. This connects with the historical fact that the more rapid and the larger scale is economic development, the more it requires some form of central planning. And it implies that at the most basic level, what the capitalist provides is not money or means of production, but cooperation.

To tell this story, it would be nice if big shifts in productivity growth took the form of changes in the composition of employment, rather than higher output per worker in given jobs. That may or may not be there in the data. For the more immediate question of how much space there is in the US for further expansion, it doesn’t matter as much which of these stories is at work, as long as we can show that at least some of them are. [9]

In the next post or two — which I hope to write in the next week, but we’ll see — I will ask what we can say about the link between demand and productivity based on historical US data. In particular, it’s fairly straightforward to decompose changes in output per worker into three components: within-industry output per hour, within-industry hours per worker, and shifts in the employment between industries. Splitting up productivity growth this way cannot, of course, directly establish a causal link with demand. but it can help clarify which stories are plausible and which are not.



[1] Throughout this discussion, I use “productivity” to mean labor productivity — output per worker or per hour. There is also “total factor productivity,” which purports to be a measure of output for a given input of labor and capital. This concept, which IMF chief economist Paul Romer memorably called “phlogiston,” is measured as the residual from a production function — the output growth the function does not explain. Since construction of the production function requires several unobseravable parameters, total factor productivity cannot be derived even in principle from economic data. It’s a fun toy for economic theory but useless for describing the behavior of actual economies.

Nonetheless it is widely used — for instance by the CBO as discussed here. As Nathan Tankus pointed out to me the other day, under the ARRA Medicare payments to hospitals are reduced each year based on an estimate of TFP growth for the economy as a whole. It’s a great example of the crackpot wonkery of the law’s authors.

[2] Unless productivity improvements all take the form of higher quality, rather than higher output per worker.

[3] This unemployment-money wages relationship was the original Phillips curve, but it’s better now to refer to it as a wage curve.

[4] It’s a topic for another time, but I think it would be very natural to replace the “aggregate supply” framework of the textbooks with these two identities.

[5] Other textbooks, like Mankiw, base the wage-unemployment relationship on a labor-supply curve rather than a bargaining relationship. Graduate textbooks, of course, replace the institutional detail of workers and employers with a single representative agent, in order to make more space for playing with math.

[6]  Andrew Glyn and his coauthors have a good discussion of this in the context of the postwar boom in  Capitalism Since 1945 (p. 122-123).

[7] For example, here’s Laurie Winkless in Science and the City, which happens to be sitting nearby:

Bessemer’s system rapidly began to change the world of steel manufacturing, and by 1875, costs had dropped to $32 (£23) per tonne. as always, in the supply-and-demand equation, the availability of cheap, high-quality steel made it immensely popular, leading to another huge drop in the price per tonne.

Winkless has made the mistake of studying the actual history of the steel history. If she were an economist, she would know that in the world of supply and demand, immense popularity makes prices rise, not fall!

[8] In Shaikh’s Capitalism, for example, there are a number of models that rely on the claim that productivity rises with output. It’s a big book and I may well have missed a part where he explains more fully why this is true. But as far as I can tell, all he says is that higher unit labor costs “provide a strong incentive for firms to raise productivity.”

[9] The politics of this question under Trump are for another time. But certainly Jeff Spross is right that we don’t want to oppose Trump’s (dubious) plans for a big stimulus by embracing the politics of austerity. We should not respond to Trump by reflexively insisting that the US is already at full employment, and by mocking “vulgar Keynesians” who think there might still be problems for macro policy to solve.


EDIT: Fixed the footnote numbering, which was garbled before.

Lost in Fiscal Space

Arjun and Jayadev and I have a working paper up at the Washington Center for Equitable Growth on the conflict between conventional macroeconomic policy and Lerner-style functional finance. Here’s the accompanying blogpost, cross-posted from the WCEG blog.


One pole of current debates about U.S. fiscal policy is occupied by the “functional finance” position—the view usually traced back to the late economist Abba Lerner—that a government’s budget balance can be set at whatever level is needed to stabilize aggregate demand, without worrying about the level of government debt. At the other pole is the conventional view that a government’s budget balance must be set to keep debt on a sustainable trajectory while leaving the management of aggregate demand to the central bank. Both sides tend to assume that these different policy views come from fundamentally different ideas about how the economy works.

A new working paper, “Lost in Fiscal Space,” coauthored by myself and Arjun Jayadev, suggests that, on the contrary, the functional finance and the conventional approaches can be understood in terms of the same analytic framework. The claim that fiscal policy can be used to stabilize the economy without ever worrying about debt sustainability sounds radical. But we argue that it follows directly from the standard macroeconomic models that are taught to undergraduates and used by policymakers.

Here’s the idea. There are two instruments: first, the interest rate set by the central bank; and second, the fiscal balance—the budget surplus or deficit. And there are two targets: the level of aggregate demand consistent with acceptable levels of inflation and unemployment; and a stable debt-to-GDP ratio. Each instrument affects both targets—output depends on both the interest rate set by monetary authorities and on the fiscal balance (as well as a host of other factors) while the change in the debt depends on both new borrowing and the interest paid on existing debt. Conventional policy and functional finance represent two different choices about which instrument to assign to which target. The former says the interest rate instrument should focus on demand and the fiscal-balance instrument should focus on the debt-ratio target, the latter has them the other way around.

Does it matter? Not necessarily. There is always one unique combination of interest rate and budget balance that delivers both stable debt and price stability. If policy is carried out perfectly then that’s where you will end up, regardless of which instrument is assigned to which target. In this sense, the functional finance position is less radical than either its supporters or its opponents believe.

In reality, of course, policies are not followed perfectly. One common source of problems is when decisions about each instrument are made looking only at the effects on its assigned target, ignoring the effects on the other one. A government, for example, may adopt fiscal austerity to bring down the debt ratio, ignoring the effects this will have on aggregate demand. Or a central bank may raise the interest rate to curb inflation, ignoring the effects this will have on the sustainability of the public debt. (The rise in the U.S. debt-to-GDP ratio in the 1980s owes more to Federal Reserve chairman Paul Volcker’s interest rate hikes than to President Reagan’s budget deficits.) One natural approach, then, is to assign each target to the instrument that affects it more powerfully, so that these cross-effects are minimized.

So far this is just common sense; but when you apply it more systematically, as we do in our working paper, it has some surprising implications. In particular, it means that the metaphor of “fiscal space” is backward. When government debt is large, it makes more sense, not less, to use active fiscal policy to stabilize demand—and leave the management of the public debt ratio to the central bank. The reason is simple: The larger the debt-to-GDP ratio, the more that changes in the ratio depend on the difference in between the interest rate and the growth rate of GDP, and the less those changes depend on current spending and revenue (a point that has been forcefully made by Council of Economic Advisers Chair Jason Furman). This is what we see historically: When the public debt is very large, as in the United States during and immediately after the Second World War, the central bank focused on stabilizing the public debt rather than on stabilizing demand, which means responsibility for aggregate demand fell to the budget authorities.

We hope this paper will help clarify what’s at stake in current debates about U.S. fiscal policy. The question is not whether it’s economically feasible to use fiscal policy as our primary instrument to manage aggregate demand. Any central bank that is able to achieve its price stability and full employment mandates is equally able to keep the debt-to-GDP ratio constant while the budget authorities manage demand. The latter task may even be easier, especially when debt is already high. The real question is who we, as a democratic society, trust to make decisions about the direction of the economy as a whole.

UPDATE: Nick Rowe has an interesting response here. (And an older one here, with a great comments thread following it.)

Links for October 14

Now we are making progress. This piece by CEA chair Jason Furman on “the new view” of fiscal policy seems like a big step forward for mainstream policy debate. He goes further than anyone comparably prominent in rejecting the conventional macro-policy wisdom of the past 30 years. From where I’m sitting, the piece advances beyond the left edge of the current mainstream discussion in at least three ways.

First, it abandons the idea of zero interest rates as a special state of exception and accepts the idea of fiscal policy as a routine tool of macroeconomic stabilization. Reading stuff like this, or like SF Fed President John Williams saying that fiscal policy should be “a first responder to recessions,” one suspects that the post-1980s consensus that stabilization should be left to the central banks may be gone for good. Second, it directly takes on the idea that elected governments are inherently biased toward stimulus and have to be institutionally restrained from overexpansionary policy. This idea — back up with some arguments about  the“time-inconsistency” of policy that don’t really make sense — has remained a commonplace no matter how much real-world policy seems to lean the other way. It’s striking, for instance, to see someone like Simon Wren-Lewis rail against “the austerity con” in his public writing, and yet in his academic work take it as an unquestioned premise that elected governments suffer from “deficit bias.” So it’s good to see Furman challenge this assumption head-on.

The third step forward is the recognition that the long-run evolution of the debt ratio depends on GDP growth and interest rates as well as on the fiscal balance. Some on the left will criticize his assumption that the debt ratio is something policy should be worried about at all — here the new view has not yet broken decisively with the old view; I might have some criticisms of him on this point myself. But it’s very important to point out, as he does, that “changes in the debt ratio depend on two factors: the difference between the interest rate and the growth rate… and the primary balance… The larger the debt is, the more changes in r – g dwarf the primary balance in the determination of debt dynamics.” (Emphasis added.) The implication here is that the “fiscal space” metaphor is backward — if the debt ratio is a target for policy, then a higher current ratio means you should focus more on growth, and that responsibility for the “sustainability” of the debt rests more with the monetary authority than the fiscal authority. Admittedly Furman doesn’t follow this logic as far as Arjun and I do in our paper, but it’s significant progress to foreground the fact the debt ratio has both a numerator and a denominator.

If you’re doubting whether there’s anything really new here, just compare this piece with what his CEA chair predecessor Christina Romer was saying a decade ago — you couldn’t ask for a clearer statement of what Furman now rejects as “the old view.” It’s also, incidentally, a sign of how far policy discussions — both new view and old view — are from academic macro. DSGE models and their associated analytic apparatus don’t have even a walk-on part here. I think left critics of economics are too quick to assume that there is a tight link — a link at all, really — between orthodox theory and orthodox policy.


Why do stock exchanges exist? I really enjoyed this John Cochrane post on volume and information in financial markets. The puzzle, as he says, is why there is so much trading — indeed, why there is any trading at all. Life cycle and risk preference motivations could support, at best, a minute fraction of the trading we see; but information trading — the overwhelming bulk of actual trading — has winners and losers. As Cochrane puts it:

all trading — any deviation of portfolios from the value-weighted market index — is zero sum. Informed traders do not make money from us passive investors, they make money from other traders. It is not a puzzle that informed traders trade and make money. The deep puzzle is why the uninformed trade, when they could do better by indexing. …

Stock exchanges exist to support information trading. The theory of finance predicts that stock exchanges, the central institution it studies, the central source of our data, should not exist. The tiny amounts of trading you can generate for life cycle or other reasons could all easily be handled at a bank. All of the smart students I sent to Wall Street for 20 years went to participate in something that my theory said should not exist.

At first glance this might seem like one of those “puzzles” beloved of economists, where you describe some real-world phenomena in terms of a toy model of someone maximizing something, and then treat the fact that it doesn’t work very well as a surprising fact about the world rather than an unsurprising fact about your description. But in this case, the puzzle seems real; the relevant assumptions apply in financial markets in a way they don’t elsewhere.

I like that Cochrane makes no claim to have a solution to the puzzle — the choice to accept ignorance rather than grab onto the first plausible answer is, arguably, the starting point for scientific thought and certainly something economists could use more of. (One doesn’t have to accept the suggestion that if we have no idea what social needs, if any, are met by financial markets, or if there is too much trading or too little, that that’s an argument against regulation.) And I like the attention to what actual traders do (and say they do), which is quite different from what’s in the models.


Yes, we know it’s not a “real” Nobel. So the Nobel went to Hart and Holmstrom. Useful introductions to their work are here and here. Their work is on contract theory: Why do people make complex ongoing agreements with each other, instead of just buying the things they want? This might seem like one of those pseudo-puzzles — as Sanjay Reddy notes on Twitter, the question only makes sense if you take economists’ ideal world as your starting point. There’s a whole genre of this stuff: Take some phenomenon we are familiar with from everyday life, or that has been described by other social scientists, and show that it can also exist in a world of exchange between rational monads. Even at its best, this can come across like a guy who learns to, I don’t know, play Stairway to Heaven with a set of spoons. Yes, getting the notes out takes real skill, and it doesn’t sound bad, but it’s not clear why you would play it that way if you weren’t for some reason already committed to the gimmick. Or in this case, it’s not clear what we learn from translating a description of actual employment contracts into the language of intertemporal optimization; the process requires as an input all the relevant facts about the phenomenon it claims to explain. What’s the point, unless you are for some already committed to ignoring any facts about the world not expressed in the formalism of economics? This work — I admit I don’t know it well — also makes me uncomfortable with the way it seems to veer opportunistically between descriptive and prescriptive. Is this about how actual contracts really are optimal given information constraints and so on, or is it about how optimal contracts should be written? Anyway, here’s a more positive assessment from Mark Thoma.


Still far from full employment. Heres’ a helpful report from the Center for Economics and Policy Research on the state of the labor market. They look at a bunch of alternatives to the conventional unemployment rate and find that all of them show a weaker labor market than in 2006-2007. Hopefully the Clinton administration and/or some Democrats in the Senate will  put some sharp questions to FOMC appointees over the next few years about whether they think the Fed as fulfilled its employmnet mandate, and on what basis. They’ll find some useful ammunition here.


Saving, investment and the natural rate. Here’s a new paper from Lance Taylor taking another swipe at the pinata of the “natural rate”. Taylor points out that if the “natural” interest rate simply means the interest rate at which aggregate demand equals potential output (even setting aside questions about how we measure potential), the concept doesn’t make much sense. If we look at the various flows of spending on goods and services by sector and purpose, we can certainly identify flows that are more or less responsive to interest rates; but there is no reason to think that interest rate changes are the main driver of changes in spending, or that “the” interest rate that balances spending and potential at a given moment is particularly stable or represents any kind of fundamental parameters of the economy. Even less can we think of the “natural” rate as balancing saving and investment, because, among other reasons, “saving” is dwarfed by the financial flows between and within sectors. Taylor also takes Keynes to task (rightly, in my view) for setting us on the wrong track with assumption that households save and “entrepreneurs” invest, when in fact most of the saving in the national accounts takes place within the corporate sector.


On other blogs, other wonders:

At Vox, another reminder that the rise in wealth relative to income that Piketty documents is mainly about the rising value of existing assets, not the savings-and-accumulation process he talks about in his formal models.

Also at Vox: How much did Germany benefit from debt forgiveness after World War II? (A lot.) EDIT: Also here.

Is there really a “global pivot” toward more expansionary fiscal policy? The IMF and Morgan Stanley both say no.

Another one for the short-termism file: Here’s an empirical paper suggesting that when banks become publicly traded, their management starts responding to short-run movements in their stock, taking on more risk as a result.

Matias Vernengo has a new paper on Raul Prebisch’s thought on business cycles and growth. Prebisch would be near the top of my list of twentieth century economists who deserve more attention than they get.

I was just at Verso for the release party for Peter Frase’s new book Four Futures, based on his widely-read Jacobin piece. I don’t really agree with Peter’s views on this — I don’t see the full replacement of human labor by machines as the logical endpoint of either the historical development of capitalism or a socialist political project — but he makes a strong case. If the robot future is something you’re thinking about, you should definitely buy the book.


EDIT: Two I meant to include, and forgot:

David Glasner has a follow-up post on the inconsistency of rational expectations with the “shocks” and comparative statics they usually share models with. It’s probably not worth beating this particular dead horse too much more, but one more inconsistency. As I can testify first-hand, at most macroeconomic journals, “lacks microfoundations” is sufficient reason to reject a paper. But this requirement is suspended as soon as you call something a “shock,” even though technology, the markup, etc. are forms of behavior just as much as economic quantities or prices are. (This is also one of Paul Romer’s points.)

And speaking of people named Romer, David and and Christina Romer have a new working paper on US monetary policy in the 1950s. It’s a helpful paper — it’s always worthwhile to reframe abstract, universal questions as concrete historical ones — but also very orthodox in its conclusions. The Fed did a good job in the 1950s, in their view, because it focused single-mindedly on price stability, and was willing to raise rates in response to low unemployment even before inflation started rising. This is a good example of the disconnect between the academic mainstream and the policy mainstream that I mentioned above. It’s perfectly possible to defend orthodoxy macroeconomic policy without any commitment to, or use of, orthodox macroeconomic theory.


EDIT: Edited to remove embarrassing confusion of Romers.

Links for October 6

More methodenstreit. I finally read the Romer piece on the trouble with macro. Some good stuff in there. I’m glad to see someone of his stature making the  point that the Solow residual is simply the part of output growth that is not explained by a production function. It has no business being dressed up as “total factor productivity” and treated as a real thing in the world. Probably the most interesting part of the piece was the discussion of identification, though I’m not sure how much it supports his larger argument about macro.  The impossibility of extracting causal relationships from statistical data would seem to strengthen the argument for sticking with strong theoretical priors. And I found it a bit odd that his modus ponens for reality-based macro was accepting that the Fed brought down output and (eventually) inflation in the early 1980s by reducing the money supply — the mechanisms and efficacy of conventional monetary policy are not exactly settled questions. (Funnily enough, Krugman’s companion piece makes just the opposite accusation of orthodoxy — that they assumed an increase in the money supply would raise inflation.) Unlike Brian Romanchuk, I think Romer has some real insights into the methodology of economics. There’s also of course some broadsides against the policy  views of various rightwing economists. I’m sympathetic to both parts but not sure they don’t add up to less than their sum.

David Glasner’s interesting comment on Romer makes in passing a point that’s bugged me for years — that you can’t talk about transitions from one intertemporal equilibrium to another, there’s only the one. Or equivalently, you can’t have a model with rational expectations and then talk about what happens if there’s a “shock.” To say there is a shock in one period, is just to say that expectations in the previous period were wrong. Glasner:

the Lucas Critique applies even to micro-founded models, those models being strictly valid only in equilibrium settings and being unable to predict the adjustment of economies in the transition between equilibrium states. All models are subject to the Lucas Critique.

Here’s another take on the state of macro, from the estimable Marc Lavoie. I have to admit, I don’t care for way it’s framed around “the crisis”. It’s not like DSGE models were any more useful before 2008.

Steve Keen has his own view of where macro should go. I almost gave up on reading this piece, given Forbes’ decision to ban on adblockers (Ghostery reports 48 different trackers in their “ad-light” site) and to split the article up over six pages. But I persevered and … I’m afraid I don’t see any value in what Keen proposes. Perhaps I’ll leave it at that. Roger Farmer doesn’t see the value either.

In my opinion, the way forward, certainly for people like me — or, dear reader, like you — who have zero influence on the direction of the economics profession, is to forget about finding the right model for “the economy” in the abstract, and focus more on quantitative description of concrete historical developments. I expressed this opinion in a bunch of tweets, storified here.


The Gosplan of capitalism. Schumpeter described banks as capitalism’s equivalent of the Soviet planning agency — a bank loan can be thought of as an order allocating part of society’s collective resources to a particular project.  This applies even more to the central banks that set the overall terms of bank lending, but this conscious direction of the economy has been hidden behind layers of ideological obfuscation about the natural rate, policy rules and so on. As DeLong says, central banks are central planners that dare not speak their name. This silence is getting harder to maintain, though. Every day there seems to be a new news story about central banks intervening in some new credit market or administering some new price. Via Ben Bernanke, here is the Bank of Japan announcing it will start targeting the yield of 10-year Japanese government bonds, instead of limiting itself to the very short end where central banks have traditionally operated. (Although as he notes, they “muddle the message somewhat” by also announcing quantities of bonds to be purchased.)  Bernanke adds:

there is a U.S. precedent for the BOJ’s new strategy: The Federal Reserve targeted long-term yields during and immediately after World War II, in an effort to hold down the costs of war finance.

And in the FT, here is the Bank of England announcing it will begin buying corporate bonds, an unambiguous step toward direct allocation of credit:

The bank will conduct three “reverse auctions” this week, each aimed at buying the bonds from particular sectors. Tuesday’s auction focuses on utilities and industries. Individual companies include automaker Rolls-Royce, oil major Royal Dutch Shell and utilities such as Thames Water.


Inflation or socialism. That interventions taken in the heat of a crisis to stabilize financial markets can end up being steps toward “a more or less comprehensive socialization of investment,” may be more visible to libertarians, who are inclined to see central banks as a kind of socialism already. At any rate, Scott Sumner has been making some provocative posts lately about a choice between “inflation or socialism”. Personally I don’t have much use for NGDP targeting — Sumner’s idée fixe — or the analysis that underlies it, but I do think he is onto something important here. To translate the argument into Keynes’ terms, the problem is that the minimum return acceptable to wealth owners may be, under current conditions, too high to justify the level of investment consistent with the minimum level of growth and employment acceptable to the rest of society. Bridging this gap requires the state to increasingly take responsibility for investment, either directly or via credit policy. That’s the socialism horn of the dilemma. Or you can get inflation, which, in effect, forces wealthholders to accept a lower return; or put it more positively, as Sumner does, makes it more attractive to hold wealth in forms that finance productive investment.  The only hitch is that the wealthy — or at least their political representatives — seem to hate inflation even more than they hate socialism.


The corporate superorganism.  One more for the “finance-as-socialism” files. Here’s an interesting working paper from Jose Azar on the rise of cross-ownership of US corporations, thanks in part to index funds and other passive investment vehicles.

The probability that two randomly selected firms in the same industry from the S&P 1500 have a common shareholder with at least 5% stakes in both firms increased from less than 20% in 1999Q4 to around 90% in 2014Q4 (Figure 1).1 Thus, while there has been some degree of overlap for many decades, and overlap started increasing around 2000, the ubiquity of common ownership of large blocks of stock is a relatively recent phenomenon. The increase in common ownership coincided with the period of fastest growth in corporate profits and the fastest decline in the labor share since the end of World War II…

A common element of theories of the firm boundaries is that … either firms are separately owned, or they combine. In stock market economies, however, the forces of portfolio diversification lead to … blurring firm boundaries… In the limit, when all shareholders hold market portfolios, the ownership of the firms becomes exactly identical. From the point of view of the shareholders, these firms should act “in unison” to maximize the same objective function… In this situation the firms have in some sense become branches of a larger corporate superorganism.

The same assumptions that generate the “efficiency” of market outcomes imply that public ownership could be just as efficient — or more so in the case of monopolies.

The present paper provides a precise efficiency rationale for … consumer and employee representation at firms… Consumer and employee representation can reduce the markdown of wages relative to the marginal product of labor and therefore bring the economy closer to a competitive outcome. Moreover, this provides an efficiency rationale for wealth inequality reduction –reducing inequality makes control, ownership, consumption, and labor supply more aligned… In the limit, when agents are homogeneous and all firms are commonly owned, … stakeholder representation leads to a Pareto efficient outcome … even though there is no competition in the economy.

As Azar notes, cross-ownership of firms was a major concern for progressives in the early 20th century, expressed through things like the Pujo committee. But cross-ownership also has been a central theme of Marxists like Hilferding and Lenin. Azar’s “corporate superorganism” is basically Hilferding’s finance capital, with index funds playing the role of big banks. The logic runs the same way today as 100 years ago. If production is already organized as a collective enterprise run by professional managers in the interest of the capitalist class as a whole, why can’t it just as easily be managed in a broader social interest?


Global pivot? Gavyn Davies suggests that there has been a global turn toward more expansionary fiscal policy, with the average rich country fiscal balances shifting about 1.5 points toward deficit between 2013 and 2016. As he says,

This seems an obvious path at a time when governments can finance public investment programmes at less than zero real rates of interest. Even those who believe that government programmes tend to be inefficient and wasteful would have a hard time arguing that the real returns on public transport, housing, health and education are actually negative.

I don’t know about that last bit, though — they don’t seem to find it that hard.


Taylor rule toy. The Atlanta Fed has a cool new gadget that lets you calculate the interest rate under various versions of the Taylor Rule. It will definitely be useful in the classroom. Besides the obvious pedagogical value, it also dramatizes a larger point — that macroeconomic variables like “inflation” aren’t objects simply existing in the world, but depend on all kinds of non-obvious choices about measurement and definition.


The new royalists. DeLong summarizes the current debates about monetary policy:

1. Do we accept economic performance that all of our predecessors would have characterized as grossly subpar—having assigned the Federal Reserve and other independent central banks a mission and then kept from them the policy tools they need to successfully accomplish it?

2. Do we return the task of managing the business cycle to the political branches of government—so that they don’t just occasionally joggle the elbows of the technocratic professionals but actually take on a co-leading or a leading role?

3. Or do we extend the Federal Reserve’s toolkit in a structured way to give it the tools it needs?

This is a useful framework, as is the discussion that precedes it. But what jumped out to me is how he reflexively rejects option two. When it comes to the core questions of economic policy — growth, employment, the competing claims of labor and capital — the democratically accountable, branches of government must play no role. This is all the more striking given his frank assessment of the performance of the technocrats who have been running the show for the past 30 years: “they—or, rather, we, for I am certainly one of the mainstream economists in the roughly consensus—were very, tragically, dismally and grossly wrong.”

I think the idea that monetary policy is a matter of neutral, technical expertise was always a dodge, a cover for class interests. The cover has gotten threadbare in the past decade, as the range and visibility of central bank interventions has grown. But it’s striking how many people still seem to believe in a kind of constitutional monarchy when it comes to central banks. They can see people who call for epistocracy — rule by knowers — rather than democracy as slightly sinister clowns (which they are). And they can simultaneously see central bank independence as essential to good government, without feeling any cognitive dissonance.


Did extending unemployment insurance reduce employment? Arin Dube, Ethan Kaplan, Chris Boone and Lucas Goodman have a new paper on “Unemployment Insurance Generosity and Aggregate Employment.” From the abstract:

We estimate the impact of unemployment insurance (UI) extensions on aggregate employment during the Great Recession. Using a border discontinuity design, we compare employment dynamics in border counties of states with longer maximum UI benefit duration to contiguous counties in states with shorter durations between 2007 and 2014. … We find no statistically significant impact of increasing unemployment insurance generosity on aggregate employment. … Our point estimates vary in sign, but are uniformly small in magnitude and most are estimated with sufficient precision to rule out substantial impacts of the policy…. We can reject negative impacts on the employment-to-population ratio … in excess of 0.5 percentage points from the policy expansion.

Media advisory with synopsis is here.


On other blogs, other wonders

Larry Summers: Low laborforce participation is mainly about weak demand, not demographics or other supply-side factors.

Nancy Folbre on Greg Mankiw’s claims that the one percent deserves whatever it gets.

At Crooked Timber, John Quiggin makes some familiar — but correct and important! — points about privatization of public services.

In the Baffler, Sam Kriss has some fun with the new atheists. I hadn’t encountered Kierkegaard’s parable of the madman who tells everyone who will listen “the world is round!” but it fits perfectly.

A valuable article in the Washington Post on cobalt mining in Africa. Tracing out commodity chains is something we really need more of.

Buzzfeed on Blue Apron. The reality of the robot future is often, as here, just that production has been reorganized to make workers less visible.

At Vox, Rachelle Sampson has a piece on corporate short-termism. Supports my sense that this is an area where there may be space to move left in a Clinton administration.

Sven Beckert has edited a new collection of essays on the relationship between slavery and the development of American capitalism. Should be worth looking at — his Empire of Cotton is magnificent.

At Dissent, here’s an interesting review of Jefferson Cowie’s and Robert Gordon’s very different but complementary books on the decline of American growth.

Links for September 23

I am going to strive to make these posts weekly. People need things to read.


The trouble with macro. I haven’t yet read any of the latest big-name additions to the “what’s wrong with macroeconomics?” pile: Romer (with update), Kocherlakota, Krugman, Blanchard. I should read them, maybe I will, maybe you should too. Here’s my own contribution, from a few years ago.


Tankus notes. You may know Nathan Tankus from around the internet. I’ve been telling him for a while that he should have a blog. He’s finally started one, and it’s very much worth reading. I’m having some trouble with one of his early posts. Well, that’s how it works: You comment on what you disagree with, not the things you think are smart and true and interesting — which in this case is a lot.


The shape of the elephant. Branko Milanovic’s “elephant graph” shows the changes in the global distribution of income across persons since 1980, as distinct from the more-familiar distribution of income within countries or between countries. The big story here is that while there has been substantial convergence, it isn’t across the board: The biggest gains were between the 10th and 75th percentiles of the global distribution, and at the very top; gains were much smaller in the bottom 10 percent and between the 70th and 99th percentiles. One question about this has been how much of this is due to China; as David Rosnick and now Adam Corlett of the Resolution Fondation note, if you exclude China the central peak goes away; it’s no longer true that growth was unusually fast in the middle of the global distribution. Corlett also claims that the very slow growth in the upper-middle part of the distribution — close to zero between the 75th and 85th percentiles — is due to big falls in income in the former Soviet block and Japan. Initially I liked the symmetry of this. But now I think Corlett is just wrong on this point; certainly he gives no real evidence for it.  In reality, the slow growth of that part of the distribution seems to be almost entirely an artifact due to the slow growth of population in the upper part of the distribution; correct for that, as Rosnick does here, and the non-China distribution is basically flat between the 10th and 99th percentiles:

Source: David Rosnick
Source: David Rosnick

Yes, there does seem to be slightly slower growth just below the top. But given the imprecision of the data we shouldn’t put much weight on it. And in any case whatever the effect of falling incomes in Japan and Eastern Europe (and blue-collar incomes in the US and western Europe), it’s trivial compared to the increase in China. Outside of China, the global story seems to be the familiar one of the very rich pulling ahead, the very poor falling behind, and the middle keeping pace. Of course, it is true, as the original elephant graph suggested, that the share of income going to the upper-middle has fallen; but again, that’s because of slower population growth in the countries where that part of the distribution is concentrated, not because of slower income gains.

It’s important to stress that no one is claiming that Branko’s figures are wrong, and also that Branko is on the side of the angels here. He’s been fighting the good fight for years against the whiggish presumption of universal convergence.


Equality of opportunity and revolution. Speaking of Branko, here he is on the problem with equality of opportunity:

Upward mobility for some implies downward mobility for the others. But if those currently at the top have a stronghold on the top places in society, there will no upward mobility however much we clamor for it. … In societies that develop quickly even if a lot of mobility is about positional advantages, … it can be compensated by creating enough new social layers, new jobs and by making people richer. …

In more stagnant societies, mobility becomes a zero-sum game. To effect real social mobility in such societies, you need revolutions that, while equalizing chances or rather improving dramatically the chances of those on the bottom, do so at the cost of those on the top. … The French Revolution, until Napoleon to some extent reimposed the old state of affairs, was precisely such an upheaval: it oppressed the upper classes (clergy and nobility) and promoted the poorer classes. The Russian revolution did the same thing; it introduced an explicit reverse discrimination against the sons and daughters of former capitalists, and even of the intellectuals, in the access to education.

I think this is right. The principle of equality of opportunity is incompatible, not just practically but logically, with the principle of inheritance. The only way to realize it is to deprive those at the top of their power and privileges, which by definition is possible only in a revolutionary situation. This is one reason why I have no interest in a political program defined, even in its incremental first steps, in terms of equality of income or wealth. The goal isn’t equality but the abolition of the system which makes quantitative comparisons of people’s life-situations possible.

The post continues:

There is also an age element to such revolutions which fundamentally alter societies and lift those from below to the top. The young people benefit. In a beautiful short novel entitled “The élan of our youth” Alexander Zinoviev, a Russian logician and later dissident, describes the Stalinist purges from a young man’s perspective. The purges of all 40- or 50-year old “Trotskyites” and “wreckers” opened suddenly incredible vistas of upward mobility for those who were 20- or 25-year old.  They could hope, at best, to come to the positions of authority in ten or fifteen years; now, that were suddenly thrown in charge of hundreds of workers, became chief designers of airplanes, top engineers of the metro. What was purge and Gulag for some, was upward mobility for others.

As this suggests, the overturning ofhierarchies didn’t stop with the revolutions themselves — that was the essential content of the various purges, to prevent a new elite from consolidating itself. I’ve always wondered how much vitality revolutionary France and Russia gained from these great overturnings. There are an enormous number of working-class people in our society, I have no doubt, who would be much more capable of running governments and factories, designing airplanes and subways, or teaching economics for that matter, than the people who get to do it.


We simply do not know — but we can fake it. Aswath Damodaran has a delicious post on the valuations that Elon Musk’s bankers came up with to justify Tesla’s acquisition of Solar City. The basic problem in these kinds of exercises is that the same price has to look high to the shareholders of the acquired company and low to the shareholders of the acquiring company. In this case, the Solar City shareholders have to believe that the 0.11 Tesla shares they are getting are worth more than the Solar City share they are giving up, while the Tesla shareholders have to believe just the opposite — that one Solar City share is worth more than the 0.11 Tesla shares they are giving for it. You can square this circle by postulating some gains from the combination — synergies! efficiencies! or, sotto voce, market power — that allows the acquirer to pay a premium over the market price while still supposedly getting a bargain. Those gains may be bullshit but at least there’s a story that makes sense. But as Damodaran explains, that isn’t even attempted here. Instead the two sets of advisors (both ultimately hired by Musk) simply use different assumptions for the growth rates and cost of capital for the two companies, generating two different valuations. For instance, Tesla’s advisors assume that Solar City’s existing business will grow at 3-5% in perpetuity, while Solar City’s advisors assume the same business will grow at 1.5-3%. So one set of shareholders can be told that a Solar City share is definitely worth less than 0.11 Tesla shares, while the other set of shareholders can be told that it is definitely worth more.

So what’s the interest here? Obviously, it’s always fun to se someone throwing shoes at the masters of the universe. But with my macroeconomist hat on, the important thing is it’s a snapshot of the concrete sociology behind the discounting of future cashflows. Whenever we talk about “the market” valuing some project or business, we are ultimately talking about someone at Lazard or Evercore plugging values into a spreadsheet. This is something people who imagine that production decisions are or can be based on market signals — including my Proudhonist friends — would do well to keep in mind. Solar City lost money last year. It lost money this year. It will lose money next year. It keeps going anyway not because “the market” wants it to, but because Musk and his bankers want it to. And their knowledge of the future isn’t any better founded than the rest of ours. Now, you could argue that this case is noteworthy because the projections are unusually bogus. Damodaran suggests they aren’t really, or only by degree. And in any case this sort of special pleading wouldn’t work if there were an objective basis for computing the true value of future cashflows. I suspect it was precisely Keynes’ experience with real-world financial transactions like this that made him stress the fundamental unknowability of the future.


Uber: The bar mitzvah moment. While we’re reading Damodaran, here’s another well-aimed shoe, this one at Uber. As he says, pushing down costs is not enough to make profits. You also need some way of charging more than costs. You need some kind of monopoly power, some source of rents: network externalities; increasing returns, and the financing to take advantage of them; proprietary technology; brand loyalty; explicit or implicit collusion with your competitors. Which of these does Uber have? maybe not any? Uber’s foray into self-driving cars is perhaps a way to generate rents, though they’re more likely to accrue to the companies that actually own the technology; I think it’s better seen as a ploy to convince investors for another quarter or two that there are rents there to be sought.

Izabella Kaminska covers some of the same territory in what may be the definitive Uber takedown at FT Alphaville. Though perhaps she focuses overmuch on how awful it would be if Uber’s model worked, and not enough on how unlikely it is to.


On other blogs, other wonders. 

San Francisco Fed president John Williams writes, “during a downturn, countercyclical fiscal policy should be our equivalent of a first responder to recessions.” Does this mean that MMT has won?

Mike Konczal: Trump is full of policy.

My friend Sarah Jaffe interviews my friend Vamsi, on the massive strikes going on in India.

The Harry Potter books are bad books and and have a bad, childish, reactionary view of the world. So does J. K. Rowling.

The Mason-Tanebaum household has its first byline in the New York Times this week, with Laura’s review of the novel Black Wave in the Sunday books section.