How State Budgets Adjust

Here is a figure from the paper I’m presenting at the Eastern Economics Association meetings next weekend, on state and local government balance sheets:

State Government Finances 1999-2013. Source: Census of Governments, author’s analysis

This figure is just for aggregate state governments. It shows total borrowing (red), net acquisition of financial assets (blue), and the overall fiscal balance (black, with surplus as positive). It also shows the year over year change in the ratio of state debt to GDP (the gray dotted line). A number of interesting points come out here:

  • Despite statutory balanced-budget requirements, state budgets do show significant cyclical movement, from aggregate deficits of around 0.5 percent of GDP in recent recessions to surpluses as high as 0.5 percent of GDP in the expansions of the 1980s and 1990s (not shown here). Individual state governments show larger movements.
  • Shifts in state government fiscal balances are accommodated almost entirely on the asset side of the balance sheet. When state government revenue exceeds current expenditure, they buy financial assets; when revenue falls or expenditure rises, they sell financial assets (or buy less). State governments borrow in order to finance specific capital projects; unlike the federal government, they do not use credit-market borrowing to close gaps between current expenditure and revenue. (As I show in the paper, this is still true when we look at state governments cross-sectionally rather than aggregate data.) Between 2005 and 2009, state budgets moved from an aggregate surplus of around 0.3 percent of GDP to an aggregate deficit of around 0.5 percent. But borrowing over this period was completely flat – the entire shortfall was made up by reduced acquisition of financial assets.
  • The ratio of state government debt to GDP rose over the Great Recession period, by a total of about 2 points. While this is small compared with the increase in federal debt over the same period, it is certainly not trivial. Among other things, rising state debt ratios have been used as arguments for austerity and attacks on pubic-sector unions in a number of states. But as we see here, the entire rise in state debt-GDP ratios over this period is explained by slower growth. The ratio rose because of a smaller denominator, not a bigger numerator.
  • State debt ratios rose around the same time that state budgets moved into deficit. But there is no direct relationship between these two developments. Deficits were financed entirely through a reduction in assets. Simultaneously, the drastic slowdown in growth mean that even though state governments significantly reduced their borrowing, in dollar terms, during the recession, the ratio of debt to income rose. It is true, of course, that both the deficits and the growth slowdown were the result of the recession. But the increase in state debt ratios would have been exactly the same if state budgets had not moved to deficit at all.
  • Since 2010 there has been a simultaneous fall in state government borrowing and acquisition of assets. When these two variables vary together (as they also do across governments in some periods) it suggests that there is some autonomous balance sheet adjustment going on that can’t be reduced to the net financial position changing to accommodate real flows. (The fact that offsetting financial positions cannot in general be netted out is one of the main planks of Bezemer’s accounting view of economics.)

The pattern is similar in the previous recession. Although there was some increase in borrowing as state governments moved into deficit in 2002-2003, the large majority of the financing was on the asset side.

The larger significance of all this, and the data underlying it, is discussed more in the paper.  I will post that here next week. In the meantime, the two big takeaways are, first, that a lot of historical variation in debt ratios are driven by the effect of different nominal growth rates on the existing debt stock rather than by new borrowing; and that state governments don’t finance budget imbalances on the liability side of their balance sheets, but on the asset side.

(Earlier posts based on the same work here and here.)

Links and Thoughts for Feb. 17

Minimum wages are good for poor people. Here is an important paper from Arin Dube on the impact of minimum wage increases on family income. Using a variety of approaches, he asks what the record of minimum wage changes tells us about how the effects of the minimum at different points in the income distribution. The core finding is that, in his preferred specification, the elasticity of income at the 10th percentile with respect to the minimum wage is around 0.4 – that is, a one percent increase in the minimum wage will raise income for poor families by close to half a percent. This is, to my mind, a really big number – it suggests that pay at most low-wage jobs is tightly linked to the minimum wage, and that criticism of minimum wages as being badly targeted at low income households is off the mark. Tho to be fair, he also finds that minimum wage increases don’t do much for the very bottom of the distribution, where there is not much wage income to begin with. But beyond whatever this ammo this gives for minimum wage supporters, this is a great example of how you should approach this kind of question as a social scientist. The paper gets out of the box of qualitative debates about job loss that have dominated this debate and makes a positive, quantitative claim about what minimum wages actually do.

This is the effect of a doubling of the state minimum wage on family income, per Dube.

 

Why prefund? I’m still trying to finish this interminable paper on state and local government balance sheets. But one of the big things I’ve learned is that the biggest constraint these governments face is not the terms on which they can borrow, but the extent to which they are required to prefund future expenses. The idea that pensions should be fully funded has a solid basis for private employers but it’s not at all clear that the same arguments apply for governments. It’s good to see that some professionals in state and local finance have come to the same conclusion. Here is a new paper from the Haas Institute on exactly this question. It makes a strong case that the requirement to fully fund public employee pensions is costly and unnecessary, and is an important factor in local government budget crises.

 

Privilege: still exorbitant. Here’s a nice analysis of the international role of the dollar. This is the same argument I tried to make in my Roosevelt Institute piece on trade policy last summer. The Economist says it better:

Unlike other aspects of American hegemony, the dollar has grown more important as the world has globalised, not less. … As economies opened their capital markets in the 1980s and 1990s, global capital flows surged. Yet most governments sought exchange-rate stability amid the sloshing tides of money. They managed their exchange rates using massive piles of foreign-exchange reserves … Global reserves have grown from under $1trn in the 1980s to more than $10trn today.

Dollar-denominated assets account for much of those reserves. Governments worry more about big swings in the dollar than in other currencies; trade is often conducted in dollar terms; and firms and governments owe roughly $10trn in dollar-denominated debt. … the dollar is, on some measures, more central to the global system now than it was immediately after the second world war. …

America wields enormous financial power as a result. It can wreak havoc by withholding supplies of dollars in a crisis. When the Federal Reserve tweaks monetary policy, the effects ripple across the global economy. Hélène Rey of the London Business School argues that, despite their reserve holdings, many economies have lost full control over their domestic monetary policy, because of the effect of Fed policy on global appetite for risk.

… During the heyday of Bretton Woods, Valéry Giscard d’Estaing, a French finance minister (later president), complained about the “exorbitant privilege” enjoyed by the issuer of the world’s reserve currency. America’s return on its foreign assets is markedly higher than the return foreign investors earn on their American assets…  That flow of investment income allows America to run persistent current-account deficits—to buy more than it produces year after year, decade after decade.

Exactly right. You can have free capital mobility, or you can have a balanced trade for the US. But you can’t have both, as long as the world depends on dollar reserves.

 

Greece: still a catastrophe. Over at Alphaville, Matthew Klein makes a strong case that Greece’s experience in the euro has been uniquely catastrophic – no modern balance of payments crisis elsewhere has led to anything like as large and as sustained a fall in output and employment. Martin Sandbu objects, arguing that the Greek catastrophe is the result of austerity, not of the single currency per se. Which is true, but also, it seems to me, misses the point. The problem with the euro — as Klein more or less says — isn’t mainly that it precludes devaluation, but that it surrenders authority over the basic tools of macroeconomic policy to a foreign authority — an authority, as it turns out, that has been happy to see Greece burn pour encourager les autres.

 

The myth of capital strike. I was more on Team Streeck than Team Tooze in their great LRB showdown. But this followup post by Tooze is very smart. Mostly he’s just trying to bring some much-needed order to a complicated set of debates about the role of private finance, credit markets, central banks and the state. But he also scores, I think, a stronger point against Streeck than in the LRB review: Streeck exaggerates the threat of capital strike in modern “managed-money” economies. As Tooze says:

Greece, Spain, Portugal, Ireland even Italy and France all experienced bond market attacks. But this is because they were left by the ECB in a situation which was as though they had borrowed their entire sovereign debt in a foreign currency with no central bank support. … That peculiarity is the result of deliberate political construction. To generalize and reify it into a general theory of capitalist democracy in crisis is highly misleading.

I think Tooze is right: behind the apparent power of the bondholders there’s always either a hostile central bank, or else other, stronger countries.

 

Things are speeding up here at the end. From Credit Suisse, here is an interesting discussion of longevity of firms in the S&P 500.

There is a general sense that the rate of change is accelerating and that corporate longevity is shrinking. This assertion appears frequently in the business press. Our research shows a more nuanced picture. Indeed, a common measure of corporate longevity, turnover of the companies in the S&P 500, shows that longevity has lengthened in recent years.

 

A hell of a way to run a railroad. For New Yorkers who are bored of the things they are mad about and want something new to be mad about: The Port Authority capital plan approved this week includes $1.5 billion for Cuomo’s pointless LaGuardia AirTrain. Of course it would be too much to ask that we extend the existing transit system, we have to create a special new system for airport travelers only. But Cuomo’s plan is useless even for them.

 

Strikes: still declining. Various people have been sharing a graph of strikes “involving 1000 or more workers” on Facebook. I expressed some doubts about this – it’s obviously true that the US has seen a drastic decline in strikes and in worker militance in general, but how well is this captured by a series that only includes the largest strikes? Andrew Bossie replies, showing that for the earlier period where we have more comprehensive strike data, it matches the 1000+ series pretty well. Fair enough.

 

Welfare is not only for whites. Here is a useful corrective from Matt Bruenig to claims that the welfare state disproportionately serves white Americans.  I assume the idea behind these arguments is to disarm claim that welfare is just for “them.” But the politics could cut other way – it’s equally easy to see “welfare goes to whites” as a move to advance the idea that racial justice and economic justice are unrelated, even conflicting, goals. Anyway, whatever it rhetorical uses, we still need a clear and honest assessment of how things work. Which Matt as usual provides.

 

TPP is dead … or is it? My collaborator Arjun Jayadev has a nice piece in The Hindu (circulation 1.4 million, not far off the New York Times) on the legacy of the late, unlamented Trans-Pacific Partnership. It can be hard to rememebr, amid the shrieks and shudders and foul smells coming from the Oval Office, how destructive and, in its own way, insane, was the pre-Trump liberal consensus for free trade and endless war.

 

Just give people nice things is a sound basis for policy. When we decided peoples’ houses shouldn’t burn down, we didn’t provide savings accounts for private fire insurance, we hired firefighters and built fire stations. If the broad left takes power again, enough with too-clever-by-half social engineering. Help people and take credit.”

What Exactly Does Mexico Export to the US?

One of the many ways conventional economic theory hinders our discussions of trade is it gets us thinking about goods “produced” in one country and “consumed” in another. Mexicans grow tomatoes, drill oil, sew shirts, and assemble cars; Americans eat, burn, wear and drive them.

Most trade in the real world does not look like this. What you have, rather, are commodity chains, where different parts of the production process take place in different countries. In most cross-border transactions, the buyers are not consumers, or even distributors, but producers who use the imported goods as inputs. And in many cases, the relevant transactions are not arm’s-length market exchanges, but transfers within a single corporate structure. Even the final purchasers may not be consumers: In general, investment goods and exports have higher imported content than consumption goods do.

Case in point: US-Mexico trade. What with the latest eruption from DC, I was curious what US imports from Mexico actually look like. [1] Here’s what the Census says:

$ millions % of total
Consumer goods 84,572 26.6
   food 22,432 7.0
   autos 23,434 7.4
   clothing 5,257 1.7
   others 33,448 10.5
Industrial inputs 89,583 28.1
   oil 13,689 4.3
   other raw materials 7,568 2.4
   auto parts 53,175 16.7
   other intermediate goods 15,152 4.8
Investment goods 113,312 35.6
   computers 41,778 13.1
   vehicles 31,943 10.0
   other machinery/equipment 39,590 12.4
Services and other 30,872 9.7
Total 318,338 100

As you can see, consumer goods account for only about a quarter of US imports from Mexico. Given that a large fraction of the service imports are tourism, the total share of consumption in US imports from Mexico will be a bit higher, between 30 and 35 percent. [2] (But presumably tourism would not be affected by a tariff.) The remainder is divided about evenly between industrial inputs (raw materials plus intermediate goods like cloth, steel, auto parts, etc.) and investment goods. Machinery and equipment, including computers, account for an impressive 25 percent of Mexican exports to the US. Petroleum products, despite the widespread perception of Mexico as an oil exporter, account for less than 5 percent.

OK, so why does this matter?

Well, it’s enough, to begin with, that most of us have a distorted idea of what “trade” involves. It’s always dangerous to talk about something at a high level of abstraction without a clear sense of the concrete reality involved — even if, in a given case, the abstract description works fine.

But in this case I don’t think it works fine. I think our model of one country and producing and the other consuming, misleads us in some important ways about the likely impact of something like Trump’s tariff.

First of all, the fact that trade is normally part of a longer commodity chain helps explain why trade flows are often insensitive to changes in relative prices. Notice, for instance, the $50 billion auto parts imported from Mexico — about one-seventh of total Mexican exports to the US. Some of these parts may be generic but most presumably represent investment by the parent company in a specialized supply chain. There’s little or no short-run possibility of substituting components from elsewhere in response to changes in relative prices. In any case, insofar as the importer and exporter are part of the same corporate structure, the relevant price is an administered one that presumably has more to do with internal accounting practices than with exchange rates, tariffs or other macro phenomena. This kind of trade is the excluded category in orthodox trade theory — it doesn’t responds rapidly to changes in prices, but neither does it reflect any fundamental differences in natural resources or other “endowments” between countries.

The second reason the composition of trade matters is when we look at the distributional impact. If Mexican exports were just corn tortillas, as some people seem to imagine, it would be relatively easy to answer “who pays” for a tariff. You just estimate the price elasticities of supply and demand and do the math. (OK, maybe not that easy.) But with a high proportion of intermediate and investment goods it’s much trickier. Especially since there are profits collected at a number of points along the commodity chain, so an increase in the price of Mexican imports at the border is not necessarily passed on to ultimate consumers. Some fraction will presumably come out of the various rents along the way. Even the broad claim that it must ultimately be Americans who pay doesn’t hold, since a large fraction of imports are inputs for export industries.

The third reason follows directly. Insofar as the final users of imports are exporters, tariffs and other relative-price changes will have less of an effect on the trade balance. In the old days of import-substitution industrialization people took this problem seriously — they recognized that the effective rate of protection  for a given industry might be quite different from the statutory rate, depending on how dependent the industry was on imported inputs. In this case, if a large fraction of Mexican imports are destined for US export industries — and they are — then a tariff on Mexican goods will improve US competitiveness less than the textbook analysis would predict.

Finally,  the disproportionately large share of intermediate and investment goods in international  trade should factor into how we think about trade in general. The more I study this stuff, the more I get the sense of international trade and finance as a world unto itself — sitting on top of, dependent on, the rest of the economy, but irrelevant to most of the routine activity of extracting human labor to meet human needs. Imports are purchased to make exports, which will be purchased to make more exports to somewhere else.

An exaggeration? Yes, but maybe not an extreme one. Somewhere in Civilization and Capitalism, Fernand Braudel describes the early modern world as an archipelago of towns scattered around the margins of an interior world — whether in France or India — that remained focused on immediate, local needs. The boundary regions were more connected to each other than to their own hinterlands perhaps only a few miles away. Mutatis mutandis (and there’s a lot of mutatis!) I think something like this applies today. Traders and producers for trade are mostly much more integrated with each other than with the rest of us. Your t-shirt is a valid counterexample, but not necessarily a representative one.

In summary: Most US imports from Mexico are intermediate and investment goods, not consumer goods. A tariff on Mexican goods is more likely to raise costs for US businesses — including for US exporters — than to lead people to substitute American-made goods for Mexican ones.

 

[1] This is my own categorization of the more detailed breakdown given by the census. I’ve included computers with investment goods because most computer expenditure in the US is by businesses, not households. Yes, some computers are purchased by households, but on the other hand some autos are purchased by businesses, so it probably balances out.

[2] Under the conventions of the national accounts, when someone from country A visits country B as a tourist, their spending there counts as a service export from country B to A.

 

 

UPDATE: I feel obliged to point out that I anticipated the latest iteration of “Mexico will pay for the wall’ towards the end of this post from last summer.

UPDATE 2: As Peter K. points out in comments, my line about trade within corporate supply chains not responding to relative costs doesn’t really make sense as written. As he reasonably asks, in that case why would they relocate production to lower-cost areas in the first place? What I should have said is that intra-corporate trade (1) isn’t responsive to *short-run* changes in relative prices and (2) is responsive to long-run changes, but on the supply side, not the demand side. I.e. if there were a large persistent rise in prices in Mexico relative to the US, that might well eventually reduce Mexican exports, but the main way this would happen would be firms disinvesting in production capacity there. Not expenditure switching by consumers in response to higher prices.

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.

2016 Books

Here’s what I read in 2016. There’s probably a couple books I’m forgetting.

 

Munif – Cities of Salt. Munif was a dissident Saudi writer who spent his later life in exile in Syria. I happened to pick up this book on a recent visit to hi son Yasser’s house (we went to grad school together) and couldn’t put it down. It’s set in the 1930s in an unnamed Arabian country, and tells the stories of ordinary people who are variously enriched, displaced, and wrecked by the establishment of the oil industry. It has a bit of the structure of something like One Hundred Years of Solitude, though without the magic. One unusual thing about it is its use of collective protagonists — various individuals drift in and out, but a great deal of the narration is from the point of view of “the villagers,” “the pipeline workers,” “the townspeople,” etc. Munif’s sympathies are obviously with those uprooted by the alliance of American business and indigenous royalty, and with their overt and covert resistance to it, but he’s also clear-eyed about the limits to their capacity for collective action and their lack of any usable political language for what is happening to them. It’s the first book in a series. Two others are available in English, beautifully translated by Peter Theroux; the remaining two sadly are not, apparently because Theroux has been occupied translating books by Naguib Mahfouz.

 

Mantel – The Assassination of Margaret Thatcher. These stories were mostly just ok. I picked them up because, like everybody, I loved the Thomas Cromwell novels Wolf Hall and Bring Up the Bodies. (The tv miniseries was also quite good.) But what she’s doing here doesn’t work as well. What she’s doing is mostly something very specific: writing realistic fiction with the conventions of the gothic. Almost all of them are written from the perspective of subordinates and outsiders, and almost all of them involve a building sense of unease and dislocation. Sometimes this mix of social realism and horror succeeds, as in the title story and in The School of English, about a servant who was raped by her employer under circumstances that never quite come into focus. But more often it doesn’t, like in the embarrassing misfire Harley Street, where the shocking revelation is that two of a woman’s coworkers are lesbians. Oh well. I hope she’s working on the third Cromwell book.

 

Beckert – Empire of Cotton: A Global History. This magnificent book is certainly the best nonfiction I read this year. Perhaps the best way to show the concrete reality of capitalism is by following the chain of a single commodity from start to end — Mardi Gras Made in China s a classic example. With cotton Beckert has picked the ur-commodity. It’s all here: from the rise of Europe and the origins of wage labor, through imperialism and emancipation, the changing organization and financing of trade, to the developmental state. He’s especially good on two points. First, that the organization of production always comes down to control of labor. Second, that incorporation into the global economy didn’t simply mean swapping one mix of commodities produced and consumed for another, but a thorough reorganization of society, not just once but continuously as people’s life choices and circumstances became increasingly dependent on developments in distant markets. And he has an almost miraculous ability to produce exactly the right quote, the perfectly telling anecdote, at every point in the story. I’d love to know how he organizes his files.

 

Davis – Late Victorian Holocausts. I assigned it for a class – one of the best ways of finally getting to something you should have read years ago. It’s an extraordinary book — as suggested by the title, a comprehensive guide to Europe’s war against humanity in the 19th century, but also a timely exploration of the political and social consequences of climate change — a sort of prequel to my friend Christian Parenti’s Tropic of Chaos. Davis is a master of this kind of thing — he somehow combines the core historical narrative, the political-economic analysis, the key statistical information and the telling quotes in a completely organic way. (I happened to reread a bit of City of Quartz recently and it’s the same — holds up very well.) The Brazil, China and Africa chapters are powerful, but the stuff on India is just brutal. The name Richard Temple should have the same resonance as the name Josef Mengele.

 

Bagchi – Perilous Passage: Mankind and the Global Ascendancy of Capital. This is I’d planned to assign parts of this in my economics history class but in the end I didn’t use it. It’s a global history with a particular focus on assessing historical changes in wellbeing, especially in the periphery of the Europe-centered world system. In some ways it seems like an attempt to put Sen’s ideas about capabilities and functionings into a historical framework. It’s not a bad book, but the stories I wanted to use it for are told more vividly elsewhere, like the Beckert and Davis books.

 

Coates – Between the World and Me. I don’t have anything really to add to what everyone else has said about this book. It deserves the praise it’s gotten. If you haven’t read it, you should.

 

Isherwood – A Single Man. A lovely little novel about a bereaved gay academic in early-1960s California. Although all the specifics are captured very well, in some ways all these are beside the point. The real subject is the way our unitary self dissolves, on closer examination, into various roles we play, personae we adopt, based on the circumstances we find ourselves in. I suppose the bereaved part of the package is the most important for this purpose, since it removes the central, stabilizing social context of the narrator’s life. I guess the pre-stonewall gay part is important too, since it deprives him of a standard set of social forms and rituals that would make sense of his new condition. But the core idea is conveyed as well by the scene of him observing himself driving on an LA freeway: “an impassive anonymous chauffeur-figure with little will or individuality of its own, the very embodiment of muscular co-ordination, lack of anxiety, tactful silence, driving its master to work.” One other thing I like about this book: It’s one of the only campus novels that somehow manages to tip into neither nasty satire nor sententious harrumph. He conveys both that teaching is an almost religious vocation, standing intercessor between your students and a world that’s much bigger and older and deeper than them; and that it’s just a job. The Tom Ford movie entirely misses the point.

 

Hicks The Crisis in Keynesian Economics and Critical Essays in Monetary Theory. I read through quite a few essays in these collections after reading some fascinating pieces by Axel Leijonhufvud on Hicks and his work.  I didn’t get as much out of them as I had hoped. Hicks famously described his later work as a struggle to escape from the neoclassical framework of his best-known work, Value and Capital, but I don’t know how well he succeeded. I think I prefer Leijonhufvud’s Hicks to Hicks’ Hicks.

 

Reardon – Handbook of Pluralist Economic Education. I wrote a review of this, which should be coming out in the Review of Keynesian Economics at some point.

 

Diski – In Gratitude. I’ve been reading Diski’s essays and reviews for a while in the London Review of Books (which is objectively better than the NYRB, by the way). This is her memoir of, first, being semi-adopted by the novelist Doris Lessing as a teenager, and, later, dying of cancer. It’s a lovely book. It’s a playful but rigorous self-inventory; like a lot of the best memoirs, it conveys the the sense of being a spontaneous confession while benefiting from careful construction.

 

Lewin – The Soviet Century. I picked this up at a Verso event. I’m not sorry I read it, but I wouldn’t really recommend it. (Any ideas what one book you should you read on the history of the Soviet Union?) It’s chronological but not comprehensive — he’s really only interested here in how the system worked politically — how decisions were made, carried out, and justified.  There’s some interesting material here on the day to day realities of the Soviet administration. But there’s not enough context on what concrete outcomes resulted all this reshuffling of departments and reassignment of personnel. (The iconic red army soldier on the cover is a bit of a tease – there’s almost nothing here on World War II itself, only its repercussions for bureaucratic politics.) Lewin is evidently a Trotskyist of some sort — we are constantly being reminded of how stalin betrayed the promise of the revolution and the genuine accomplishments of the 1920s. As far as perspectives on the Soviet Union go, this is a respectable one, but it seems like at this point we should be aiming for a dispassionate account of how the system worked and what it did and did not do, without reenacting the debates of 100 years ago.

 

Hood – 722 Miles: The Building of the Subways and How They Transformed New York. I’d expected this classic history to be, you know, sandhogs battling the Manhattan schist. There is some of that, but much more about the political and financial aspects of the story which, to me, are even more interesting. It develops and complicates the vague — “private subways abetted real estate speculation but became unprofitable after WWI so the government took them over” story I’d vaguely had in my head before.

The book does support the idea that the economics of private subways only really make sense in conjunction when they’re built by large-scale real estate developers; no other private actor can internalize their positive externalities. But the private to public transition is more complicated. It is true that, thanks to inflation and the nickel fare, the private lines saw big losses in the 1920s and 1930s. But because of the long-term contracts signed before the war, under which the city owned the tracks on which the privately-owned trains ran, the losses were mostly borne by the public; the private companies were mostly profitable. So the private-public question was less economic, and more directly ideological, than I had realized. Early on, there was very strong resistance to the idea of government-operated subways — state legislation forbidding public operation was passed when proposals were first floated. Public subways were explicitly seen as a step toward socialism. But a bit later, in the Progressive era, there was a serious push for a government run subway as a sort of public option to compete with August Belmont’s monopoly, and the Public Service Commission briefly operated some short connecting lines. this early foray into public subways was abandoned, but only as a result of complex set of negotiations counterbalancing the goals of holding down fares through competition; extending the existing system in a rational way; and encouraging development of outlying areas. (The last goal also supported by the progressives in order to move workers out of dense immigrant neighborhoods in Manhattan.) As is often the case when you read history, what in retrospect looks like a logically unfolding inevitable development, on clsoer examination could easily have gone in other ways.

 

Saki – The Unrest Cure. Oscar Wilde’s wit without his weirdness (mostly) or his politics (at all). Kept me occupied for half a dozen subway rides.

 

Ferrante – My Brilliant Friend, The Story of a New Name, Those Who Leave and Those who Stay, and The Story of the Lost Child. These remarkable books deserve much more than I can write about them. Luckily, lots of other people have written about them! Purely as fiction, they are highly effective – they are the sort of novels you can’t stop reading, but that you constantly want to stop reading to make them last longer, and to think about what you’ve just read. As to the substance: Some people see the tragedy of the book that Lila, the central character, never leaves Naples — that her talent and energy and intelligence go to waste there, instead of developing into some useful and rewarding career as they would have elsewhere. I don’t agree. I don’t think we’re meant to imagine that anything important would have been better if she’d followed the narrator Elena to a middle-class, professional life in the North. I think we should take the narrator seriously in her reflections at the start of the third book. She says that she once saw the stasis, brutality and hopelessness of her childhood neighborhood as geographically specific. So she thought the solution was to

get away for good, settle in well-organized lands where everything really is possible. I had fled … Only to discover, in the decades to come, that I had been wrong… the neighborhood was connected to the city, the city to Italy, to Europe, Europe to the whole planet. And this is how I see it today: it’s not the neighborhood that’s sick, it’s not Naples, it’s the entire earth… And shrewdness means hiding from from oneself the true state of things.

I think if there’s a failure in the book, it’s the shrewd, practical Elana’s. I think Lila’s choice is the one we’re meant to admire — to keep trying to push through the immovable barriers of corrupt, violent Naples. To me, she comes across as almost Dostoyevskyan figure, a Myshkin unable to make the reasonable compromises we all make with an unreasonable world. In this reading, the radical political milieu of the middle books is more than just dramatic backdrop, though it certainly functions as that. The insurgent New Left of the 1970s, whatever its failures, was reacting to same basic problem as Lila — what do you do when you find the world you’ve been born unjust, nonsensical, and intolerable? Of course the usual answer is you do what you can to make things a bit better, incrementally — after all they are getting better — that way, with luck, lies a respected and remunerative career. This choice — which, again, almost all of us make — is represented in the books by the repulsive Nino. Whereas Lila (and the communist Pasquale, the books’ most purely admirable figure) represents the other choice, not to reconcile yourself. I feel like the books could have taken their epigraph from Mario Savio: “There is a time when the operation of the machine becomes so odious, makes you so sick at heart, that you can’t take part; you can’t even passively take part, and you’ve got to put your bodies upon the gears and upon the wheels, upon the levers, upon all the apparatus, and you’ve got to make it stop.”

 

Streeck – Buying Time: The Delayed Crisis of Democratic Capitalism. I originally read this hoping to write a review of it. But I took too long and now Streeck has another one. Still planning to write the review, which will now have to be of the two books, so will save my thoughts til then.

 

Eicher – The New Cosmos. I like reading about science and I loved Carl Sagan as a kid, so this was an easy sell. I enjoyed reading it — if it’s the sort of thing you like, you’d probably enjoy it too — but I wouldn’t say it’s anything special. He does make a strong case that demoting Pluto from planethood was the wrong call.

 

Ascher The Works and The Heights. I got these two books mainly to read to my son, who like many five-year-olds is very interested in public works, infrastructure and engineering. (Brian Hayes’ magnificent Infrastructure, with its gorgeous photos, has been preferred dinnertime reading for a while.) But they aren’t kids’ books — I learned quite a lot from them — especially from The Works, which is about all the normally unregarded machinery and labor that makes New York City, well, work. Did you know about the Sandy Hook pilots, who still guide freighters into New York Harbour? Did you know that New York is one of the few major cities where storm runoff and sewage flow together, and that until the 1980s, the upper west side of Manhattan had no sewage treatment facilities and dumped its raw waste right into the Hudson? Did you know that New York still has an operational steam-tunnel system, which provides the heat for many of Manhattan’s iconic buildings as well as steam for dry cleaners, hospitals, etc.? Did you know that six inches of snow is the cutoff for all the city’s garbage trucks to be converted to snowplow service? I didn’t know any of that, and it’s good stuff to know.

 

Johnson – The Making of Donald Trump. At my parents’ house at Christmastime, my father was reading this. Laura picked it up and started saying, “Wait! did you ever hear this…?”, so I started reading it too. It’s a page turner. Now personally, I think it’s a mistake to personalize the political situation; I think we’re better off talking about what “the Republicans will do” than what “Trump will do.” And of course the fundamental terms of politics don’t change with elections. Still, I hadn’t realized just how vile this person is. Did you know that he cut off the medical coverage of his newborn grandnephew in neonatal intensive care, to force the parents to settle an inheritance dispute? Good times.

Thoughts and Links for December 21, 2016

Aviation in the 21st century. I’m typing this sitting on a plane, en route to LA. The plane is a Boeing 737-800. The 737 is the best-selling commercial airliner on earth; reading its Wikipedia page should raise some serious doubts about the idea that we live in an era of accelerating technological change. I’m not sure how old the plane I’m sitting on is, but it could be 15 years; the 800-series was introduced in its present form in the late 1990s. With airplanes, unlike smartphones, a 20-year old machine is not dramatically — is not even noticeably — different from the latest version. The basic 737 model was first introduced in 1967. There have been upgrades since then, but to my far from expert eyes it’s striking how little changed tin 50 years. The original 737 carried 120 passengers, at speeds of 800 km/h on trips of up to 3,000 km, using 6 liters of fuel per kilometer; this model carries 160 passengers (it’s longer) at speeds of 840 km/h on trips of 5,500 km, using 5 liters of fuel per kilometer. Better, sure, but probably the main difference you’d actually notice from a flight 50 years ago is purely social: no smoking. In any case it’s pretty meager compared that with the change from 50 years earlier, when commercial air travel didn’t exist. The singularity is over; it happened on or about December 1910.

 

Unnatural rates. Here’s an interesting post on the New York Fed’s Liberty Street blog challenging the ideas of “natural rates” of interest and unemployment. good: These ideas, it seems to me, are among the biggest obstacles to thinking constructively about macroeconomic policy. Obviously it’s example of, well, naturalizing economic outcomes, and in particular it’s the key ideological element in presenting the planning by the central bank as simply reproducing the natural state of the economy. But more specifically, it’s one of the most important ways that economists paper over the disconnect between the the economic-theory world of rational exchange, and the real world of monetary production. Without the natural rate, it would be much hard to  pretend that the sort of models academic economists develop at their day jobs, have any connection to the real-world problems the rest of the world expects economists to solve. Good to see, then, some economists at the Fed acknowledging that the natural rate concepts (and its relatives like the natural rate of unemployment) is vacuous, for two related reasons. First, the interest rate that will bring output to potential depends on a whole range of contingent factors, including other policy choices and the current level of output; and second, that potential output itself depends on the path of demand. Neither potential output nor the natural rate reflects some deep, structural parameters. They conclude:

the risks associated with monetary easing are asymmetric. That is, excessive easing can be reversed, but excessive tightening may cause irreversible damage to the economy’s potential output.

In the research described in this blog, we focus on the effect of recessions on human capital. Recessions may affect potential output through other channels as well, such as lower capital accumulation, lower labor force participation, slow productivity growth, and so forth. Our research would suggest that to the extent that these mechanisms are operative, a monetary policy that seeks to track measured natural rates—of unemployment, interest rates, and so forth—might be insufficiently accommodative to engineer a full and quick recovery after a large recession. Such policies fall short because in a world with hysteresis, “natural” rates are endogenous. Policy should set these rates, not track them.

Also on a personal level, it’s nice to see that the phrases “potential output,” “other channels,” “lower labor force particiaption,” and “slow productivity growth” all link back to posts on this very blog. Maybe someone is listening.

 

More me being listened to: Here is a short interview I did with KCBS radio in the Bay area, on what’s wrong with economics. And here is a nice writeup by Cory Doctorow at BoingBoing of “Disgorge the Cash,” my Roosevelt paper on shareholder payouts and investment.

 

Still disgorging. Speaking of that: There were two new working papers out from the NBER last week on corporate finance, governance and investment. I’ve only glanced at them (end of semester crunch) but they both look like important steps forward for the larger disgorge the cash/short-termism argument. Here are the abstracts:

Lee, Shin and Stultz – Why Does Capital No Longer Flow More to the Industries with the Best Growth Opportunities?

With functionally efficient capital markets, we expect capital to flow more to the industries with the best growth opportunities. As a result, these industries should invest more and see their assets grow more relative to industries with the worst growth opportunities. We find that industries that receive more funds have a higher industry Tobin’s q until the mid-1990s, but not since then. Since industries with a higher funding rate grow more, there is a negative correlation not only between an industry’s funding rate and industry q but also between capital expenditures and industry q since the mid-1990s. We show that capital no longer flows more to the industries with the best growth opportunities because, since the middle of the 1990s, firms in high q industries increasingly repurchase shares rather than raise more funding from the capital markets.

And:

Gutierrez and Philippon – Investment-less Growth: An Empirical Investigation

We analyze private fixed investment in the U.S. over the past 30 years. We show that investment is weak relative to measures of profitability and valuation… We use industry-level and firm-level data to test whether under-investment relative to Q is driven by (i) financial frictions, (ii) measurement error (due to the rise of intangibles, globalization, etc), (iii) decreased competition (due to technology or regulation), or (iv) tightened governance and/or increased short-termism. We do not find support for theories based on risk premia, financial constraints, or safe asset scarcity, and only weak support for regulatory constraints. Globalization and intangibles explain some of the trends at the industry level, but their explanatory power is quantitatively limited. On the other hand, we find fairly strong support for the competition and short-termism/governance hypotheses. Industries with less entry and more concentration invest less, even after controlling for current market conditions. Within each industry-year, the investment gap is driven by firms that are owned by quasi-indexers and located in industries with less entry/more concentration. These firms spend a disproportionate amount of free cash flows buying back their shares.

I’m especially glad to see Philippon taking this question up. His Has Finance Become Less Efficient is kind of a classic, and in general he somehow seems to manages to be both a big-time mainstream finance guy and closely attuned to observable reality.  A full post on the two NBER papers soon, hopefully, once I’ve had time to read them properly.

 

 

“Sets” how, exactly? Here’s a super helpful piece  from the Bank of France on the changing mechanisms through which central banks — the Fed in particular — conduct monetary policy. It’s the first one in this collection — “Exiting low interest rates in a situation of excess liquidity: the experience of the Fed.” Textbooks tell us blandly that “the central bank sets the interest rate.” This ignores the fact that there are many interest rates in the economy, not all of which move with the central bank’s policy rate. It also ignores the concrete tools the central bank uses to set the policy rate, which are not trivial or transparent, and which periodically have to adapt to changes in the financial system. Post-2008 we’ve seen another of these adaptations. The BoF piece is one of the clearest guides I’ve seen to the new dispensation; I found it especially clarifying on the role of reverse repos. You could probably use it with advanced undergraduates.

Zoltan Pozsar’s discussion of the same issues is also very good — it adds more context but is a bit harder to follow than the BdF piece.

 

When he’s right, he’s right. I have my disagreements with Brad DeLong (doesn’t everyone?), but a lot of his recent stuff has been very good. Here are a couple of his recent posts that I’ve particularly liked. First, on “structural reform”:

The worst possible “structural reform” program is one that moves a worker from a low productivity job into unemployment, where they then lose their weak tie social network that allows them to get new jobs. … “Structural reforms” are extremely dangerous unless you have a high-pressure economy to pull resources out of low productivity into high productivity sectors.

The view in the high councils of Europe is that, when there is a high-pressure economy, politicians will not press for “structural reform”: there is no obvious need, and so why rock the boat? Politicians kick every can they can down the road, and you can only try “structural reform” when unemployment is high–and thus when it is likely to be ineffective if not destructive.

This gets both the substance and the politics right, I think. Although one might add that structural reform also often means reducing wages and worker power in high productivity sectors as well.

Second, criticizing Yellen’s opposition to more expansionary policy,which she says is no longer needed to get the economy back to full employment.

If the Federal Reserve wants to have the ammunition to fight the next recession when it happens, it needs the short-term safe nominal interest rate to be 5% or more when the recession hits. I believe that is very unlikely to happen without substantial fiscal expansion. … In the world that Janet Yellen sees, “fiscal policy is not needed to provide stimulus to get us back to full employment.” But fiscal stimulus is needed to create a situation in which full employment can be maintained…. if we do not shift to a more expansionary fiscal policy–and the higher neutral rate of interest that it brings–now, what do we envision will happen when the next recession arrives?

This is the central point of my WCEG working paper — that output is jointly determined by the interest rate and the fiscal balance, so the “natural rate” depends on the current stance of fiscal policy.  Plus the argument that, in a world where the zero lower bound is a potential constraint — or more broadly, where the expansionary effects of monetary policy are limited — what is sometimes called “crowding out” is a feature, not a bug. Totally right, but there’s one more step I wish DeLong would take. He writes a lot, and it’s quite possible I’ve missed it, but has he ever followed this argument to its next logical step and concluded that the fiscal surpluses of the 1990s were, in retrospect, a bad idea?

 

Farmer on government debt. Also on government budgets, here are some sensible observations on the UK’s, from Roger Farmer. First, the British public deficit is not especially high by historical standards; second, past reductions in debt-GDP ratios were achieved by growth raising the denominator, not surpluses reducing the numerator; and third, there is nothing particularly desirable about balanced budgets or lower debt ratios in principle. Anyone reading this blog has probably heard these arguments a thousand times, but it’s nice to get them from someone other than the usual suspects.

 

Deviation and trend. I was struck by this slide from the BIS. The content is familiar;  what’s interesting is that they take the deviation of GDP from the pre-criss trend as straightforward evidence of the costs of the crisis, and not a demographic-technological inevitability.

 

Cap and dividend. In Jacobin, James Boyce and Mark Paul make the case for carbon permits. I used to take the conventional view on carbon pricing — that taxes and permits were equivalent in principle, and that taxes were likely to work better in practice. But Boyce’s work on this has convinced me that there’s a strong case for preferring dividends. A critical part of his argument is that the permits don’t have to be tradable — short-term, non transferrable permits avoid a lot of the problems with “cap and trade” schemes.

 

 

Why teach the worst? In a post at Developing Economics, New School grad student Ingrid Harvold Kvangraven forthrightly makes the case for teaching “the worst of mainstream economics” to non-economists. As it happens, I don’t agree with her arguments here. I don’t think there’s a hard tradeoff between teaching heterodox material we think is true, and teaching orthodox material students will need in future classes or work. I think that with some effort, it is possible to teach material that is both genuinely useful and meaningful, and that will serve students well in future economics class. And except for students getting a PhD in economics themselves — and maybe not even them — I don’t think “learning to critique mainstream theories” is a very pressing need. But I like the post anyway. The important thing is that all of us — especially on the heterodox side — need to think more of teaching not as an unfortunate distraction, but as a core part of our work as economists. She takes teaching seriously, that’s the important thing.

 

 

Apple in the balance of payments. From Brad Setser, here’s a very nice example of critical reading of the national accounts. Perhaps even more than in other areas of accounts, the classification of different payments in the balance of payments is more or less arbitrary, contested, and frequently changed. It’s also shaped more directly by private interests — capital flight, tax avoidance and so on often involve moving cross-border payments from one part of the BoP to another. So we need to be even more scrupulously attentive with BoP statistics than with others to how concrete social reality gets reflected in the official numbers. The particular reality Setser is interested in is Apple’s research and development spending in the US, which ought to show up in the BoP as US service exports. But hardly any of it does, because — as he shows — Apple arranges for almost all its IP income to show up in low-tax Ireland instead. To me, the fundamental lesson here is about the relation between statistical map and economic territory. But as Setser notes, there’s also a more immediate policy implication:

Trade theory says that if the winners from globalization compensate the losers from globalization, everyone is better off. But I am not quite sure how that is supposed to happen if the winners are in some significant part able to structure their affairs so that a large share of their income is globally (almost) untaxed.

 

Capital Mobility as Trojan Horse

In my Jacobin piece on finance, I observed in passing that financial commitments across borders — what’s sometimes called capital mobility — enforce the logic of markets on national governments. This disciplining role has been on vivid display in the euro area over the past few years. Here, courtesy of yesterday’s Financial Times, is a great example of the obverse: If a state does want to resist liberal “reforms”, it needs to limit financial flows across the border.

The headline in the online edition spells it right out:

Renminbi stalls on road to being a global currency. New capital controls lead to doubt, especially over hopes of forcing economic reform.

The print edition is wordier but even clearer:

Renminbi reaches its high water mark. Fresh capital controls cast doubt over the push to increase the global use of its global currency. But what does that mean for the Chinese policymakers who saw it as a ‘Trojan horse’ to force through economic reform?

The whole article is fascinating. On the substance it’s really quite good — anyone who teaches international finance or open-economy macroeconomics should bookmark it to share with students. Along with the political-economy question I’m interested in here, it touches on almost all the most important points you’d want to make about what determines exchange rates. [1]

The article’s starting point is that for most of the past decade, international use of the Chinese renminbi (Rmb) has been steadily increasing. Some people even saw a future rival to the dollar. For most of the period, the renminbi was appreciating against the dollar, and the Chinese government was loosening restrictions on cross-border financial transactions. But recently those trends have reversed:

The share of China’s foreign trade settled in its own currency has shrunk from 26 per cent to 16 per cent over the past year while renminbi deposits in Hong Kong — the currency’s largest offshore centre — are down 30 per cent from a 2014 peak of Rmb1tn. Foreign ownership of Chinese domestic financial assets peaked at Rmb4.6tn in May 2015; it now stands at just Rmb3.3tn. In terms of turnover on global foreign exchange markets, the renminbi is only the world’s eighth most-traded currency — squeezed between the Swiss franc and Swedish krona — barely changed from ninth position in 2013.

What appeared to be structural drivers supporting greater international use of the Chinese currency now appear more like opportunism and speculation.

Large financial outflows — including capital flight by Chinese wealthholders and currency speculators reversing their bets — have led the renminbi to lose 10 percent of its value against the dollar over the past year or so. The Chinese central bank (the People’s Bank of China, or PBoC) has had to use a substantial part of its dollar reserves to keep the renminbi from depreciating even further.

… the PBoC remains active in the foreign exchange market as buyer and seller. Over the past 18 months, this has mostly meant selling dollars from foreign exchange reserves to counteract the depreciation pressure weighing on the renminbi.

This strategy has been expensive, contributing to a decline in reserves from $4tn in June 2014 to $3.1tn at the end of November. Defenders of the PBoC believe such aggressive action to curb depreciation has been worth the price because it prevented panic selling by global investors. Critics counter that costly forex intervention has merely delayed an inevitable exchange-rate adjustment.

For years, the IMF, US Treasury and other outside experts have urged China to embrace a floating exchange rate. In theory, such a step should eliminate the need to tighten capital controls or to spend precious foreign reserves on propping up the exchange rate. Instead, the currency would weaken until inflows and outflows balance.

In the age of Trump, it’s worth stressing this point: The Chinese central bank has been intervening to make the renminbi stronger, not weaker — to keep Chinese goods relatively expensive, not cheap. This has been true for a while, actually, although you can still find prominent liberals complaining about China boosting its exports through “currency manipulation”.  Also, as the article notes, the Washington Consensus line has been that China should end foreign-exchange interventions and abolish capital controls, allowing the renminbi to depreciate even further.

For most countries, continuing to spend down reserves would be the only alternative to uncontrolled depreciation. But China, unlike most countries, has maintained effective controls over cross-border financial flows, so it has another option: limiting the ability of households and businesses to trade renminbi claims for dollar ones.

The State Administration of Foreign Exchange, the regulator, last week said it would continue to encourage outbound investment deals that support the country’s efforts to transform its economy… But the agency said it would apply tighter scrutiny to acquisitions of real estate, hotels, Hollywood studios and sport teams.

That will probably mean fewer food-additive tycoons buying second-tier UK football clubs. It also suggests a crackdown on fake trade invoices, Hong Kong insurance purchases and gambling losses in Macau — all channels used to spirit money out of China. …

“They are trying to squeeze out all the low quality or suspicious or fraudulent outbound investment. But they have also made it clear they support genuine high-quality investment,” says Mr Qu.

These moves come on top of other limits on financial outflows. This passage highlights a couple additional points. First, effective controls on financial flows require controls on cross-border transactions in general. Second, there’s no sharp line between macro policy aimed at the exchange rate or other monetary aggregates, and micro-interventions aimed at channeling credit in particular directions.

Now to the political economy point:

China’s recent moves to tighten approvals for foreign acquisitions by Chinese companies, as well as other transactions that require selling renminbi for foreign currency, cast further doubt on China’s commitment to currency internationalisation.

“There is a fundamental conflict between preserving stability and allowing the freedom and flexibility required of a global currency,” says Brad Setser, senior fellow at the Council on Foreign Relations and a former US Treasury official. “Now that the cost is becoming clear, Chinese policymakers may be realising they are not willing to do what it takes to maintain a global currency. Capital controls certainly set back the cause of renminbi internationalisation but they may well be the appropriate step given the outflow pressures.”

As a topic for banking conferences and think-tank seminars, renminbi internationalisation could not be beaten. It offered a way to express dissatisfaction with the US dollar-dominated monetary system, as laid bare by the 2008 financial crisis, while signalling an eagerness to do business with China’s large, fast-growing economy.

For China’s reform-minded central bank, however, renminbi internationalisation … offered something else: a Trojan horse that could be used to persuade Communist party leaders in Beijing and financial elites to accept reforms that were, in reality, more important for China’s domestic financial system than for the renminbi’s international status. Since 2010, when the internationalisation drive began, many of those reforms have been adopted…

This is the dynamic we’ve seen over and over. Real or imagined pressure from the outside — from international creditors , institutions like the IMF, “the markets” in general — is needed to push through a liberal agenda that would not be accepted on its own merits. This is true in China, with its multiple competing power centers and effective if disorganized popular protests, just as it is for countries with more formally democratic political systems. What’s unusual about China’s case is that the “reform” side may no longer be winning.

What’s  unusual about this article is that it’s spelled out so clearly. “Trojan horse”: Their words, not mine.

The article continues:

The totem of currency internationalisation also served as justification for China’s moves over the past half-decade to open up its domestic financial markets to foreign investment, a process known as capital account liberalisation, that has been crucial to the global push of the renminbi. If foreign investors are to hold large quantities of China’s currency, they must have access to a deep and diverse pool of renminbi assets — and the peace of mind of knowing that they are free to sell those assets and convert proceeds back into their home currency as needed.

Again, thinking of classroom use, this is a nice illustration of liquidity preference.

Until last week, regulators had also steadily loosened approval requirements for foreign direct investment, in to and out of the country.  But those reforms occurred at a time when capital inflows and outflows were roughly balanced, which meant that liberalisation did not create strong pressure on the exchange rate. Now, the situation is very different. Beijing faces a stark choice. Either row back on freeing up capital flows — as it has already begun to do this year — or relinquish control of the exchange rate and accept a hefty devaluation.

We used to talk about a trilemma: A country cannot simultaneously peg its currency, set interest rates at the level required by the domestic economy, and allow free financial flows across its borders. At most you can manage two of the three. But it’s becoming clear that for most countries it’s  more of a dilemma: If you allow free capital mobility, you can’t control either the exchange rate or domestic credit conditions. International financial shifts are so large, and so unpredictable, that for most central banks they’ll overwhelm anything that can be done with conventional tools.

And when you accept free capital mobility, with its dubious rewards, it’s not just control over interest rates and exchange rates you’re giving up. In the absence of  controls over international financial flows, the whole range of economic policy — of public decisions in general — is potentially subject to the veto of finance. If you need foreign wealth-owners to voluntarily hold your assets, the only way to keep them happy — so goes the approved catechism — is to adopt the full range of market-friendly reforms. The FT again:

Economists argue that the fate of renminbi internationalisation ultimately depends on far-reaching economic reforms rather than short-term responses to rising capital outflows.

The list of course starts with privatization of state-owned companies and continues with deregulating finance.

“When you reimpose capital controls after having rolled them back, it can sometimes have a perverse effect,” says Mr Prasad… “What they need to do is something much harder — actually to get started on the broader reform agenda and show that they are serious about it. Right now the sense is that there is very little happening on other reforms.”

This is what it comes down to: If China is going to reach the grail of international-currency status, it is going to have to focus on the “reform” agenda dictated by financial markets — it’s going to have to earn their trust and prove it is “serious.” What exactly are the benefits of that status for China? It’s far from clear. (Of course it’s an attractive prospect for Chinese individuals who own lots of renminbi-denominated assets.) But it doesn’t matter as long as it serves as a seemingly objective basis for continued liberalization, which otherwise might face serious resistance.

“The question is which is to be the master — that’s all.”

 


 

[1] It doesn’t, of course, mention uncovered interest parity, the idea that interest rate differences between currencies exactly offset expected exchange rate changes. This doctrine dominates textbook discussion of exchange rate movements but plays no role in any real-life discussion of them.

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.

Blogging in the Age of Trump

I haven’t written anything for this blog in the past month. Or rather, I’ve written quite a bit, but nothing I’ve felt comfortable posting. No surprise why.

On the one hand, I have — like everyone — opinions about the election, and the coming Trump presidency and broader Republican ascendancy. But none of those opinions seem especially insightful or original or coherent, and most of them I don’t hold with great confidence. I’m also not sure that this space is the right one for discussions of political strategy: Readers of this blog don’t constitute the kind of community for which the question “what should we do?” makes sense.

But on the other hand, it doesn’t feel right — it doesn’t feel possible — to just go on posting about the same economic questions as before, as if nothing has changed. Even if, in important ways, nothing has. And it still seems too soon to know where the terrains of struggle will be under the new administration, or to guess how the economic debates will reorient themselves along the new political field lines.

I’ve felt stuck. I know I’m not the only one who feels like they have nothing useful to say.

But you still have to get up in the morning, you still have to go to your job, you have to teach your classes, you have to write blog posts. So, back to work.