Aggregate Demand and Modern Macro

Start with a point on language.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  what do you think? is this kind of critique valid/useful?
11:17 AM him: its totally true
11:18 AM and you wouldn’t know what was getting baked into the cake unless you were trained in the literature
  I only started understanding the New Keynsian models a little while ago
  and just had the lazy “they are too complicated” criticism
11:19 AM now I understand that they are stupidly too complicated (as Noah’s post points out)
11:20 AM me: so what is one supposed to do?
  if this is the state of macro
 him: i dunno. I think participating in this literature is a fucking horror show
 me: but you don’t like heterodox people either, so….?
11:21 AM him: maybe become a historian
  or figure out some simple variant of the DSGEmodels that you can make your point and publish empirical stuff

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

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

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

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

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

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

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

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

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

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

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

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

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

Toward a Unified Theory of Anti-Krugmanism

You know, there’s a fundamental parallel between what’s wrong with Krugman’s takes on monetary policy and on trade.

In the first case, his argument is that the interest rate (a price, administered to be sure) would normally equilibrate savings and investment at something like full employment. It’s the barrier to that price’s adjustment in the form of the zero lower bound that causes income to adjust instead, leading to the Great Recession (and the need for fiscal policy). Similarly trade flows are normally equilibrated by the adjustment of the exchange rate, a price. It’s barriers to that price’s adjustment, in the form of the Euro and the RMB-dollar peg, that cause income to adjust instead, leading to austerity in peripheral Europe and unemployment in the United States.

From a Post Keynesian perspective, these are kludges that get good conclusions from bad premises.

From a Post Keynesian (or for that matter Keynesian straight-up) perspective, flexible interest rates and exchange rates have never reliably delivered macroeconomic balance. Income adjustments aren’t a once-in-a-lifetime feature of the current conjuncture, they’re a routine and central feature of capitalism.

New Keynesian economists like Krugman can see that macroeconomic reality today doesn’t conform to the textbook, where prices smoothly converging to market-clearing levels. (Well, maybe to the 1978 edition.) But they’re not going to throw the textbook away, so the departures are explained as a series of ad hoc special cases. And so the textbook has a way of sneaking back in whenever their attention is elsewhere. That’s why Krugman insists something big changed when the federal funds rate hit zero, even though the federal funds rate has been more or less disconnected from most longer rates for a decade or more. And that’s why he insists that the Asian crisis countries were better off than Greece, etc. because they could devalue their currencies instead of resorting to austerity, when it seems clear that devaluations contributed little to Asian countries’ improved current account balances after 1997; they drastically cut domestic spending, just as peripheral Europe is being forced to. When he’s looking right at a non-price adjustment mechanism, he can see it; but wherever he’s not looking, he assumes that prices are doing their thing.

Or at least that’s how it looks to me.

Net and Gross, or What We Can and Cannot Learn from Balance Sheets

One of the less acknowledged of the secret sins of economists, it seems to me, is the failure to distinguish between net and gross quantities, or to treat the net numbers if they were all that mattered. Case in point, the issue of deleveraging, where the good guys — the anti-austerians — are trying to get an accounting-identity argument to do more work than it it’s capable of. A good example is this post from Peter Dorman (which Krugman liked), which points out that in a closed economy one agent’s debt is always another agent’s asset, and total consumption must equal total income. So the only way that one agent can reduce its net liabilities is for another’s to increase, just as the only way some agents can spend less than their income is for others to spend more. In this sense increased public debt is just the flipside of private-sector deleveraging; arguments that the public sector should reduce its debt along with the private sector are incoherent. QED, right? Except, this argument proves too much. It’s true that one agent’s net financial position can’t improve unless another’s gets worse. But the same accounting logic also means that financial claims across the whole economy always sum to zero. Total net worth is always equal to the sum of tangible assets, no matter what happens on the financial side. [1] So it’s not clear what leveraging and develeraging could even mean in these terms. So, since the words evidently do mean something, it seems they’re not being used in those terms. It seems to me that when people talk about (de)leveraging, they are almost always talking about gross financial claims, not net, relative to income. A unit that adds $1,000 in debt and acquires a financial asset valued at $1,000 is more leveraged than it was before. And in this gross sense, it is perfectly possible for the public and private sector to simultaneously deleverage. Consider the following very simple economy, with just two agents:

Income Assets Liabilities Net Worth
A 1 4 3 1
B 1 5 2 3
Total 2 9 5 4
Income Assets Liabilities Net Worth
A 1 3 2 1
B 1 4 1 3
Total 2 7 3 4

The transition from T1 to T2 involves simultaneous deleveraging — in the economically meaningful sense — by both the agents in the economy, and no national accounting identities are violated. What would this look like in practice? To some extent, it could simply mean netting out offsetting financial claims, but that only really works within the financial sector; nonfinancial actors don’t generally hold financial assets and liabilities at the same time without some good institutional reason. (A firm may both receive and extend trade credit, but those two lines on the balance sheet can’t be netted out unless we want to go back to a cash-on-the-barrelhead economy. A typical middle-class household has both retirement savings and a mortgage and student-loan debt; both the borrowing and saving are sufficiently subsidized and tax-favored that it makes sense to add to the IRA rather than paying off the debt. [2]) To the extent that this kind of deleveraging does take place within the nonfinancial sector, it requires that units reduce their gross saving, i.e. their acquisition of financial assets — a suggestion that will seem even more paradoxical to conventional wisdom than the claim that private-sector deleveraging requires increased public debt. [3] But there’s another approach. Most borrowing by households and nonfinancial firms and households is undertaken to finance the acquisition of a tangible asset — in the table above, we should really divide the assets column into tangible assets and financial assets. For the low net worth units, most assets are tangible; for middle-class households, the house is by far the biggest asset, while property, plant and equipment is generally the biggest item on the asset side of a nonfinancial firm’s balance sheet. So the most natural way for the private sector and the public sector to deleverage is through a transfer of tangible assets from debtor to creditor units, combined with the extinction of the debts associated with the assets. This is, in essence, what privatization of public assets is supposed to do, when the IMF imposes it as part of a structural adjustment program. And more to the point, it’s what the foreclosure process, in its herky-jerky way, is doing in the housing market. At the end of the road, there’s a lot less mortgage debt — and a lot more big suburban landlords. [4] And the private sector has reduced its leverage, without any increase in the public sector’s. (Of course, we could just extinguish the debt and skip the asset-transfer part. But that default could be a means of deleveraging is one of those thoughts you’re not allowed to have.) Now, all this said, I completely agree with Dorman’s conclusion, that reducing public debt would hinder rather than help deleveraging. (Or rather, what he thinks is his conclusion; the real logic of his argument is that nothing can help or hinder deleveraging, since — like motion — it does not exist.) But the reason has nothing to do with balance sheets. It is because I believe that fiscal consolidation will reduce aggregate income — the denominator in leverage. I reckon Dorman (and Krugman) would agree. But this an empirical claim, not one that can be deduced from national accounting identities.
[1] Or the sum of tangible assets and base money, if you don’t treat the latter as a liability of the government. This is a question that gets people remarkably worked up, but it’s not important to this argument. (Or to any other, as far as I can tell.) [2] Actually I suspect many middle-class households are saving more than is rational — they’re acquiring financial assets when paying down debt would have a higher return. But anyone who knows me knows how comically unsuited I am to have opinions on anyone else’s personal finances. [3] Reducing debt and and expenditure simultaneously doesn’t help, since one unit’s expenditure is another’s income. For financial deleveraging to work, people really do have to save less. [4] Who might or might not end up being the banks themselves.

What’s the Difference Between Money and Debt?

(An idea I’ve been playing with lately, just wanted to get something on virtual paper.)

Currency, dollar bills, are liabilities of the Federal Reserve. Federal debt is a liability of the US Treasury. Leaving aside some deliberate obscurity around the precise legal status of the Fed, both are liabilities of the US government. Of course there are various formal differences, but economically, wouldn’t it be simplest to regard them the same?

In other words, while we are taught that there are no close substitutes for money but that government and private debt are substitutes for each other, wouldn’t it be better to say that money and government debt are substitutes for each other and both are complements for private debt? More concretely, given lenders’ need for liquidity, an increase in their holding of government debt may make them more willing to hold private debt, i.e. under some circumstances, an increase in government debt could put downward rather than upward pressure on interest rates further out the yield curve.

The canonical case is the recent financial crisis. As I’ve discussed before, there’s an argument (which gets at least some support from non-crazies like Perry Mehrling and Brad DeLong) that insufficient federal debt contributed to the crisis, by creating demand for equivalently liquid but higher-return substitutes, thus fueling the financial innovation of the 1990s and 2000s. Of course this dynamic would have increased the availability of credit for private borrowers whose liabilities were (a) seen as implicitly enjoying a federal guarantee and (b) easily securitizable. But for borrowers that didn’t meet those criteria, the lack of enough new federal debt may have made banks less willing to lend to them, in exactly the same way a lack of reserves would have in the old days. And even if the restriction of credit to non-securitizable borrowers was not that big in the boom, the lack of federal debt certainly exacerbated the crash.

So far this is just thinking aloud. But a bunch of smart people seem to be heading in this direction. Take for instance Roger Farmer’s call for more quantitative easing (via DeLong). Says Farmer, “Even if the Bank of England were to buy the entire UK national debt, this policy would not be inflationary.” This is just a dramatic way of making the point that as government debt and money have become closer substitutes, the economic consequences of shifts between them have become smaller. As Farmer says, money no longer occupies a discrete, unique role. Instead, there is a continuum of assets: “At the safe end of the spectrum there is cash. At the risky end there is equity and low grade bonds.” And in a rich country like the US or UK, government debt is very close to the money end. Where Farmer is less convincing is his idea that the interchangeability of money and public debt came about all at once, when central banks began paying interest on reserves. Seems to me it was a longer process of institutional evolution.

One implication of this, again, is that a smoothly functioning financial system requires more public debt, indefinitely. (Another reason to agree with Davidson, Galbraith and Skidelsky that austerity tomorrow is no more desirable than austerity today.) But there’s a second implication: If money as a discrete category is obsolete, then so is monetary policy as we know it. If Treasuries are as liquid as so-called high-powered money, then monetary policy — which comes down to injecting and removing liquidity — must work on the former and not just the latter; but of course the volume of federal debt is orders of magnitude greater than the volume of reserves. Which suggests that quantitative easing may be the only kind of easing there is, from here on out, that is, no more distinction between monetary and fiscal policy.

EDIT: What’s the affinity between cranks and money? Everyone knows that discussions of monetary theory bring all the cranks to the yard. But am I the only one who finds that writing about this stuff, makes me feel like a crank?