Mike Konczal and I have a piece in the New York Times arguing that the next few years could see a historic boom for the US economy, if policy makers recognize that strong demand and rising wages are good things, and don’t get panicked into turning toward austerity.
Mike and I and our colleagues at the Roosevelt Institute are planning a series of papers on “planning for the boom” over the coming year. The first, asking how high employment could plausibly rise under conditions of sustained strong demand, will be coming out later this month. In the meantime, here are some things I’ve written over the past few years, making the case that there is much more space for demand-led growth in the US economy than conventional estimates suggest, and that the benefits from pursuing it are broader than just producing more stuff.
In my recent post on the economics of the Rescue Plan, I highlighted the way in which the expansive public spending of the Biden administration implicitly embraces a bigger role for aggregate demand in the longer term trajectory of the economy and not just in short-run fluctuations:
Overheating may have short-term costs in higher inflation, inflated asset prices and a redistribution of income toward relatively scarce factors (e.g. urban land), but it also is associated with a long-term increase in productive capacity — one that may eventually close the inflationary gap on its own. Shortfalls on the other hand lead to a reduction in potential output, and so may become self-perpetuating as potential GDP declines.
I’ve continued making this argument in an ongoing debate with the University of Chicago’s Harold Uhlig at this new site Pairagraph. I also discussed it with David Beckworth on his excellent macroeconomics podcast.
In many ways, this story starts from debates in the mid 2010s about the need for continued stimulus, which got a big impetus from Bernie Sanders first campaign in 2016. I tried to pull together those arguments in my 2017 Roosevelt paper What Recovery? There, I argued that the failure of per-capita GDP to return to its previous trend after 2009 was a striking departure from previous recessions; that an aging population could not explain the fall in labor fore participation; that slower productivity growth could be explained at least in part by weak demand; and the the balance of macroeconomic risks favored stimulus rather than austerity.
In a more recent post, I noted that the strong growth and low unemployment of the later part of the decade, while good news in themselves, implied an even bigger demand shortfall in the aftermath of the recession:
In 2014, the headline unemployment rate averaged 6.2 percent. At that time, the benchmark for full employment (technically, the non-accelerating inflation rate of unemployment, or NAIRU) used by the federal government was 4.8 percent, suggesting a 1.4 point shortfall, equivalent to 2.2 million excess people out of work. But let’s suppose that today’s unemployment rate of 3.6 percent is sustainable—which it certainly seems to be, given that it is, in fact, being sustained. Then the unemployment rate in 2014 wasn’t 1.4 points too high but 2.6 points too high, nearly twice as big of a gap as policymakers thought at the time.
I made a similar set of arguments for a more academic audience in a chapter for a book on economics in the wake of the global financial crisis,“Macroeconomic Lessons from the Past Decade”. There, I argue that
the effects of demand cannot be limited to “the short run”. The division between a long-run supply-side and a short-run demand-side, while it may be useful analytically, does not work as a description of real world developments. Both the size of the labor force and productivity growth are substantially endogenous to aggregate demand.
This set of arguments is especially relevant in the context of climate change; if there is substantial slack in the economy, then public spending on decarbonization can raise current living standards even in the short run. Anders Fremstad, Mark Paul and I made this argument in a 2019 Roosevelt report, Decarbonizing the US Economy: Pathways toward a Green New Deal. I made the case much more briefly in a roundtable on decarbonization in The International Economy:
The response to climate change is often conceived as a form of austerity—how much consumption must we give up today to avoid the costs of an uninhabitable planet tomorrow? … The economics of climate change look quite different from a Keynesian perspective, in which demand constraints are pervasive and the fundamental economic problem is not scarcity but coordination. In this view, the real resources for decarbonization will not have to be withdrawn from other uses. They can come from an expansion of society’s productive capabilities, thanks to the demand created by clean-energy investment itself.
If you like your economics in brief video form, I’ve made this same argument about aggregate demand and climate change for Now This.
The World War II experience, which Mike and I highlight in the Times piece, is discussed at length in a pair of papers that Andrew Bossie and I wrote for Roosevelt last year. (Most of what I know about the economics of the war mobilization is thanks to Andrew.) In the first paper, The Public Role in Economic Transformation: Lessons from World War II, we look at the specific ways in which the US built a war economy practically overnight; the key takeaway is that while private contractors generally handled production itself, most investment, and almost all the financing of investment, came from the public sector. The second paper, Public Spending as an Engine of Growth and Equality: Lessons from World War II, looks at the macroeconomic side of the war mobilization.
Among the key points we make here are that potential output is much more elastic in response to demand than we usually assume; that both the labor force and productivity respond strongly to the level of spending; that the inflation associated with rapid growth often is a sign of temporary shortfalls or bottlenecks, which can be addressed in better ways than simply reducing aggregate spending; and that strong demand is a powerful force for equalizing the distribution of income. The lessons for the present are clear:
The wartime experience suggests that the chronic weak demand the US has suffered from for at least the past decade is even more costly than we had realized. Not only does inadequate spending lead to slower growth, it leads to lower wage gains particularly for those at the bottom and reinforces hierarchies of race and sex. Conversely, a massive public investment program in decarbonization or public health would not only directly address those crises, but could also be an important step toward reversing the concentration of income and wealth that is one of the great failures of economic policymaking over the past generation.
I also discuss the war experience in this earlier Dissent review of Mark Wilson’s book Destructive Creation, and in a talk I delivered at the University of Massachusetts in early 2020.
Alternative approaches to inflation control isn’t something I’ve written a lot about —until recently, the question hasn’t seemed very urgent. But Mike, me and our Roosevelt colleague Lauren Melodia did write a blog post last month about why it’s a mistake to worry about somewhat higher inflation numbers this year. One aspect of this is the “base effect” which is artificially increasing measured inflation, but it’s also important to stress that genuinely higher inflation is both a predictable result of a rapid recovery from the pandemic and not necessarily a bad thing.
A few years ago, Mike and I wrote a paper arguing for a broader toolkit at the Fed. Our focus at the time was on finding more ways to boost demand. But many of the arguments also apply to a situation — which we are definitely not in today, but may be at some point — where you’d want to rein demand in. Whichever way the Fed is pushing, it would be better to have more than one tool to push with.
Another important background debate for the Times piece is the idea of secular stagnation, which enjoyed a brief vogue in the mid 2010s. Unfortunately, the most visible proponent of this idea was Larry Summers, who … well, let’s not get into that here. But despite its dubious provenance, there’s a lot to be said for the idea that recent decades have seen a persistent tendency for total spending to fall short of the economy’s productive potential. In this (somewhat wonkish) blog post, I discussed this idea in terms of Roy Harrod’s model of economic growth, and suggested a number of factors that might be at work:
for secular, long-term trends tending to raise desired saving relative to desired investment we have: (1) the progressive satiation of consumption demand; (2) slowing population growth; (3) increasing monopoly power; and (4) the end of the industrialization process. Factors that might either raise or lower desired savings relative to investment are: (5) changes in the profit share; (6) changes in the fraction of profits retained in the business sector; (7) changes in the distribution of income; (8) changes in net exports; (9) changes in government deficits; and (10) changes in the physical longevity of capital goods. Finally, there are factors that will tend to raise desired investment relative to desired saving. The include: (11) consumption as status competition (this may offset or even reverse the effect of greater inequality on consumption); (12) social protections (public pensions, etc.) that reduce the need for precautionary and lifecycle saving; (13) easier access to credit, for consumption and/or investment; and (14) major technological changes that render existing capital goods obsolete, increasing the effective depreciation rate. These final four factors will offset any tendency toward secular stagnation.
Hysteresis — the effect of demand conditions on potential output — and secular stagnation are two important considerations that suggest that big boost in spending, as we are looking at now, could permanently raise the economy’s growth path. A third, less discussed consideration is that demand itself may be persistent. I discuss that possibility in a recent blog post.
An important aspect of an economic boom which we unfortunately could not fit into the op-ed is the way that faster growth and moderately higher inflation reduce the burden of debt for both the private and public sector. Historically, growth rates, inflation and interest rates have had a bigger effect on the household debt ratio than household borrowing has. This is a major focus of my scholarly work — see here and here. The same thing goes for public debt, as I’ve discussed in a blog post here. The degree to which both the past year’s stimulus and a possible future boom has/will strengthen balance sheets across the economy is seriously underappreciated, in my view.
The question of public debt has moved away from center stage recently. Criticism of public spending lately seems more focused on inflation and supposed ”labor supply constraints.” But if the anti-boom contingent shifts back toward scare stories about public debt, I’ve got pre-rebuttals written here and here.
Finally, I want to highlight something I wrote about a year ago: The Coronavirus Recession Is Just Beginning. There, I argued that the exceptional reduction in activity due to the pandemic would probably be followed by a conventional recession. You will note that this is more or less the opposite of the argument in the Times piece. That’s because my post least year was wrong! But I don’t think it was unreasonable to make that prediction at the time. What I didn’t take into account, what almost no one took into account, was the extraordinary scale of the stimulus over the past year. Well ok! Now, let’s build on that.
Here’s the very short version of this very long post:
Hysteresis means that a change in GDP today has effects on GDP many years in the future. In principle, this could be because it affects either future aggregate demand or potential output. These two cases aren’t distinguished clearly in the literature, but they have very different implications. The fact that the Great Recession was followed by a period of low inflation, slow wage growth and low interest rates, rather than the opposite, suggests that the persistent-demand form of hysteresis is more important than potential-output hysteresis. The experience of the Great Recession is consistent with perhaps 20 percent of a shock to demand in this period carrying over to demand in future periods. This value in turn lets us estimate how much additional spending would be needed to permanently return GDP to the pre-2007 trend: 50-60 percent of GDP, or $10-12 trillion, spread out over a number of years.
Supply Hysteresis and Demand Hysteresis
The last few years have seen renewed interest in hysteresis – the idea that shifts in demand can have persistent effects on GDP, well beyond the period of the “shock” itself. But it seems to me that the discussion of hysteresis doesn’t distinguish clearly between two quite different forms it could take.
On the one hand, demand could have persistent effects on output because demand influences supply – this seems to be what people usually have in mind. But on the other hand, demand itself might be persistent. In time-series terms, in this second story aggregate spending behaves like a random walk with drift. If we just look at the behavior of GDP, the two stories are equivalent. But in other ways they are quite different.
Let’s say we have a period in which total spending in the economy is sharply reduced for whatever reason. Following this, output is lower than we think it otherwise would have been. Is this because (a) the economy’s productive potential was permanently reduced by the period of reduced spending? Or is it (b) because the level of spending in the economy was permanently reduced? I will call the first case supply hysteresis and the second demand hysteresis.
On the left, supply hysteresis. On the right, demand hysteresis.
It might seem like a semantic distinction, but it’s not. The critical thing to remember is that what matters for much of macroeconomic policy is not the absolute level of output but the output gap — the difference between actual and potential output. If current output is above potential, then we expect to see rising inflation. (Depending on how “potential” is understood, this is more or less definitional.) We also expect to see rising wages and asset prices, shrinking inventories, longer delivery times, and other signs of an economy pushing against supply constraints. If current output is below potential, we expect the opposite — lower inflation or deflation, slower wage growth, markets in general that favor buyers over sellers. So while lower aggregate supply and lower aggregate demand may both translate into lower GDP, in other respects their effects are quite different. As you can see in my scribbles above, the two forms of hysteresis imply opposite output gaps in the period following a deep recession.
Imagine a hypothetical case where there is large fall in public spending for a few years, after which spending returns to its old level. For purposes of this thought experiment, assume there is no change in monetary policy – we’re at the ZLB the whole time, if you like. In the period after the depressed spending ends, will we have (1) lower unemployment and higher inflation than before, as the new income created during the period of high public spending leads to permanently higher demand. Or will we have (2) higher unemployment and lower inflation than if the spending had not occurred, because the period of high spending permanently raised labor force participation and productivity, while demand returns to its old level?
Supply hysteresis implies (1), that a temporary negative demand shock will lead to persistently higher inflation and lower unemployment (because the labor force will be smaller). Demand hysteresis implies (2), that a temporary negative demand shock will lead to permanently lower inflation and higher unemployment. Since the two forms of hysteresis make diametrically opposite predictions in this case, seems important to be clear which one we are imagining. Of course in the real world, could see a combination of both, but they are still logically distinct.
Most people reading this have probably seen a versions of the picture below. On the eve of the pandemic, real per-capita GDP was about 15 percent below where you’d expect it to be based on the pre-2007 trend. (Or based on pre-2007 forecasts, which largely followed the trend.) Let’s say we agree that the deviation is in some large part due to the financial crisis: Are we imagining that output has persistently fallen short of potential, or that potential has fallen below trend? Or again, it might be a combination of both.
In the first case, we would expect monetary policy to be generally looser in the period after a negative demand shock, in the second case tighter. In the first case we’d expect lower inflation in period after shock, in the second case higher.
It seems to me that most of the literature on hysteresis does not really distinguish these cases. This recent IMF paper by Antonio Fatas and coauthors, for example, defines hysteresis as a persistent effect of demand shocks on GDP. This could be either of the two cases. In the text of the paper,they generally assume hysteresis means an effect of demand on supply, and not a persistence of demand itself, but they don’t explicitly spell this out or make an argument for why the latter is not important.
It is clear that the original use of the term hysteresis was understood strictly as what I am calling supply hysteresis. (So perhaps it would be better to reserve the word for that, and make ups new name for the other thing.) If you read the early literature on hysteresis, like these widely-cited Laurence Ballpapers, the focus was on the European experience of the 1980s and 1990s; hysteresis is described as a change in the NAIRU, not as an effect on employment itself. The mechanism is supposed to be a specific labor-market phenomenon: the long term unemployed are no longer really available for work, even if they are counted in the statistics. In other words, sustained unemployment effectively shrinks the labor force, which means that in the absence of policy actions to reduce demand, the period following a deep recession will see faster wage growth and higher inflation than we would have expected.
(This specific form of supply hysteresis implies a persistent rise in unemployment following a downturn, just as demand hysteresis does. The other distinctions above still apply, and other forms of supply hysteresis would not have this implication.)
Set aside for now whether supply-hysteresis was a reasonable description of Europe in the 1980s and 1990s. Certainly it was a welcome alternative to the then-dominant view that Europe needed high unemployment because of over-protective labor market institutions. But whether or not thinking of hysteresis in terms of the NAIRU made sense in that context, it does not make sense for either Europe or the US (or Japan) in the past decade. Everything we’ve seen has been consistent with a negative output gap — with actual output below potential — with a depressed level of demand, not of supply. Wage growth has been unexpectedly weak, not strong; inflation has been below target; and central banks have been making extra efforts to boost spending rather than to rein it in.
Assuming we think that all this is at least partly the result of the 2007-2009 financial crisis — and thinking that is pretty much the price of entry to this conversation — that suggests we should be thinking primarily about demand-hysteresis rather than supply-hysteresis. We should be asking not, or not only, how much and how durably the Great Recession reduced the country’s productive potential, but how how durably it reduced the flow of money through the economy.
It’s weird, once you think about it, how unexplored this possibility is in the literature. It seems to be taken for granted that if demand shocks have a lasting effect on GDP, that must be because they affect aggregate supply. I suspect one reason for this is the assumption — which profoundly shapes modern macroeconomics — that the level of spending in the economy is directly under the control of the central bank. As Peter Dorman observes, it’s a very odd feature of modern macroeconomic modeling that the central bank is inside the model — the reaction of the monetary authorities to, say, rising inflation is treated as a basic fact about the economy, like the degree to which investment responds to changes in the interest rate, rather than as a policy choice. In an intermediate macroeconomics textbook like Carlin and Soskice (a good one as far as they go), students are taught to think about the path of unemployment and inflation as coming out of a “central bank preference function,” which is taken as a fundamental parameter of the economy. Obviously there is no place for demand hysteresis in this framework. To the extent that we think of the actual path of spending in the economy as being chosen by the central bank as part of some kind of optimizing process, past spending in itself will have no effect on current spending.
Be that as it may, it seems hard to deny that in real economies, the level of spending today is strongly influenced by the level of spending in the recent past. This is the whole reason we see booms and depressions as discrete events rather than just random fluctuations, and why they’re described with metaphors of positive-feedback process like “stall speed” or “pump-priming.”1
How Persistent Is Demand?
Let’s say demand is at least somewhat persistent. That brings us to the next question: How persistent? If we were to get extra spending of 1 percent of GDP in one year, how much higher would we now expect demand to be several years later?
We can formalize this question if we write a simple model like:
Zt = Z*t + Xt
Z*t = (1+g) Z*t-1 + a(Zt-1 – Z*t-1)
Here Z is total spending or demand, Z* is the trend, what we might think of as normal or expected demand, g is the normal growth rate, and X is the influence of transitory influences outside of normal growth.
With a = 0, then, we have the familiar story where demand is a trend plus random fluctuations. If we see periods of above- and below-trend demand, that’s because the X influences are themselves extended over time. If a boom year is followed by another boom year, in this story, that’s because whatever forces generated it in the first year are still operating, not because the initial boom itself was persistent.
Alternatively, with a = 1, demand shocks are permanent. Anything that increases spending this year, should be expected to lead to just as much additional spending next year, the year after that, and so on.
Or, of course, a can have any intermediate value.
Think back to 2015, in the debate over the first Sanders’ campaign’s spending plans that was an important starting point for current discussions of hysteresis. The basic mistake Jerry Friedman was accused of making was assuming that changes in demand were persistent — that is, if the multiplier was, say 1.5, that an increase in spending of $500 billion would raise output by $750 billion not only in that year and but in all subsequent years. As his critics correctly pointed out, that is not how conventional multipliers work. In terms of my equations above, he was setting a=1, while the conventional models have a=0.
He didn’t spell this out, and I didn’t think of it that way at the time. I don’t think anyone did. But once you do, it seems to me that while Friedman was wrong in terms of the standard multiplier, he was not wrong about the economy — or at least, no more wrong than the critics. It seems to me that both sides were using unrealistically extreme values. Demand shocks aren’t entirely permanent, but they also aren’t entirely transitory. Arealistic model should have 0 < a < 1.
Demand Persistence and Fiscal Policy
There’s no point in refighting those old battles now. But the same question is very relevant for the future. Most obviously, if demand shocks are persistent to some significant degree, it becomes much more plausible that the economy has been well below potential for the past decade-plus. Which means there is correspondingly greater space for faster growth before we encounter supply constraints in the form of rising inflation.
Both forms of hysteresis should make us less worried about inflation. If we are mainly dealing with supply hysteresis, then rapid growth might well lead to inflation, but it would be a transitory phenomenon as supply catches up to the new higher level of demand.On the other hand, to the extent we are dealing with demand hysteresis, it will take much more growth before we even have to worry about inflation.
Of course, both forms of hysteresis may exist. In which case, both reason for worrying less about inflation would be valid. But we still need to be clear which we are talking about at any given moment.
A slightly trickier point is that the degree of demand persistence is critical for assessing how much spending it will take to get back to the pre-2007 trend.
If the failure to return to the pre-2007 is the lasting effect of the negative demand shock of the Great Recession, it follows thatsufficient spending should be able to reverse the damage and return GDP to its earlier trend. The obvious next question is, how much? The answer really depends on your preferred value for a. In the extreme (but traditional) case of a=0, each year we need enough spending to fill the entire gap, every year, forever. Given a gap of around 12 percent, if we assume a multiplier of 1.5 or so, that implies additional public spending of $1.6 trillion. In the opposite extreme case, where a=1, we just need enough total spending to fill the gap, spread out over however many years. In general, if we want to get close a permanent (as opposed to transitory) output gap of W, we need W/(a μ) total spending, where μ is the conventional multiplier.2
If you project forward the pre-2007 trend in real per-capita GDP to the end of 2019, you are going to get a number that is about 15% higher than the actual figure, implying an output gap on the order of $3.5 trillion. In the absence of demand persistence, that’s the gap that would need to be filled each year. But with persistent demand, a period of elevated public spending would gradually pull private spending up to the old trend, after which it would remain there without further stimulus.
What Does the Great Recession Tell Us about Demand Persistence?
At this point, it might seem that we need to turn to time-series econometrics and try to estimate a value for a, using whatever methods we prefer for such things. And I think that would be a great exercise!
But it seems to me we can actually put some fairly tight limits on a without any econometrics, simple by looking back to the Great Recession. Keep in mind, once we pick an output gap for a starting year, then given the actual path of GDP, each possible value of a implies a corresponding sequence of shocks Xt. (“Shock” here just means anything that causes a deviation of demand from its trend, that is not influenced by demand in the previous period.) In other words, whatever belief we may hold about the persistence of demand, that implies a corresponding belief about the size and duration of the initial fall in demand during the recession. And since we know a fair amount about the causes of the recession, some of these sequences are going to be more plausible than others.
The following figures are an attempt to do this. I start by assuming that the output gap was zero in the fourth quarter of 2004. We can debate this, of course,, but there’s nothing heterodox about this assumption — the CBO says the same thing. Then I assume that in the absence of exogenous disturbances, real GDP per capita would have subsequently grown at 1.4 percent per year. This is the growth rate during the expansion between the Great Recession and the pandemic; it’s a bit slower than the pre-recession trend.3 I then take the gap between this trend and actual GDP in each subsequent quarter and divide it into the part predictable from the previous quarter’s gap, given an assumed value for a, and the part that represents a new disturbance in that period. So each possible value of a, implies a corresponding series of disturbances. Those are what are shown in the figures.
If you’re not used to this kind of reasoning, this is probably a bit confusing. So let me put it a different way. The points in the graphs above show where real GDP would have been relative to the long-term trend if there had been no Great Recession. For example, if you think a = 0, then GDP in 2015 would have been just the same in the absence of the recession, so the values there are just the actual deviation from trend. So you can think of the different figures here as showing the exogenous shocks that would be required under different assumptions about persistence, to explain the actual deviation from trend. They are answering this question: Given your beliefs about how persistent demand is, what must you think GDP would have been in subsequent years in a world where the Great Recession did not take place? (Or maybe better, where the fall in demand form the housing bubble was fully offset by stimulus.)
The first graph, with persistence = 0, is easiest to understand. If there is no carryover of demand shocks from one period to the next, then there must be some factor reducing demand in each later period by the full extent of the gap from trend. If we move on to, say, the persistence=0.1 figure, that is saying that, if you think 10 percent of a demand shock is normally carried over into future periods, that means that there was something happening in 2012 that would have depressed demand by 2 percent relative to the earlier trend, even if there had been no Great Recession.
Because people are used to overcomplicated economics models, I want to stress again. What I am showing you here is what you definitionally believe, if you think that in the absence of the Great Recession, growth in the 2010s would have been at about the same rate it was, just from a higher base, and you think that whatever fraction of a change in spending in one year is carried over to the next year. There are no additional assumptions. I’m just showing what the logical corollary of those beliefs would be for the pattern of demand shocks,
Another important feature of these figures is how large the initial fall in demand is. Logically, if you think demand is very persistent, you must also think the initial shock was smaller. If most of the fall in spending in the first half of 2008, say, was carried over to the second half of 2008, then it takes little additional fall in spending in that period to match the observed path of GDP. Conversely, if you think that very little of a change in demand in one period carries over to the next one then the autonomous fall in demand in 2009 must have been larger.
The question now is, given what we know about the forces impacting demand a decade ago, which of these figures is most plausible? If there had been sufficient stimulus to completely eliminate the fall in demand in 2007-2009, how strong would the headwinds have been a few years late?
Based on what we know about the Great Recession, I think demand persistence in the 0.15 – 0.25 range most plausible. This suggests that a reasonable baseline guess for total spending required to return to the pre-2007 would be around 50 percent of GDP, spread out over a number of years. With an output gap of 15 percent of GDP, a multiplier of 1.5, and demand persistence of 0.2, we have 15 / (1.5 * 0.2) = 50 percent of GDP. This is, obviously, a very rough guess, but if you put me on the spot and asked how much spending over ten years it would take to get GDP permanently back to the pre-2007 trend, $10-12 trillion would be my best guess.
How do we arrive at persistence in the 0.15 – 0.25 range?
On the lower end, we can ask: What are the factors that would have pushed down demand in the mid 2010s, even in the absence of the Great Recession Remember, if we use demand persistence of 0.1, that implies there were factors operating in 2014 that would have reduced demand by 2 percent of GDP, even if the recession had not taken place. What would those be?
I don’t think it makes sense to say housing — housing prices had basically recovered by then. State and local spending is a better candidate — it remained quite depressed and I think it’s hard to see this as a direct effect of the recession. Relative to trend, state and local investment was down about 1 percent of GDP in 2014, while the federal stimulus was basically over. On the other hand, unless we think that monetary policy is totally ineffective, we have to include the stimulative effect of a zero policy rate and QE in our demand shocks. This makes me think that by 2014, the gap between actual GDP and the earlier trend was probably almost all overhang from the recession. And this implies a persistence of at least 0.15. (If you look back at the figures, you’ll see that with persistence=0.15, the implied shock reaches zero in 2014.)
Meanwhile, on the high end, a persistence of 0.5 would mean that the demand shock maxed out at a bit over 3 percent of GDP, and was essentially over by the second half of 2009. This seems implausibly small and implausibly brief. Residential investment fell from 6.5 percent of GDP in 2004 to less than 2.5 percent by 2010. And that is leaving aside housing wealth-driven consumption. Meanwhile, the ARRA stimulus didn’t really come online until the second half of 2009. I don’t believe monetary policy is totally ineffective, but I do think it operates slowly, especially on loosening side. So I find it hard to believe that the autonomous fall in demand in early 2009 was much less than 5 percent of GDP. That implies a demand persistence of no more than 0.25.
Within the 0.15 to 0.25 range, probably the most important variable is your judgement of the effectiveness of monetary policy and the ARRA stimulus. If you think that one or both was very effective, you might think that by mid-2010, they were fully offsetting the fall in demand from the housing bust. This would be consistent withpersistence around 0.25. Conversely, if you’re doubtful about the effectiveness of monetary policy and the ARRA (too little direct spending), you should prefer a value of 0.2 or 0.15.
In any case, it seems to me that the implied shocks with persistence in the 0.15 – 0.25 range look much more plausible than for values outside that range. I don’t believe that the underlying forces that reduced demand in the Great Recession had ceased to operate by the second half of 2009. I also don’t think that they were autonomously reducing demand by as much as 2 points still in early 2014.
You will have your own priors, of course. My fundamental point is that your priors on this stuff have wider implications. I have not seen anyone spell out the question of the persistence of demand in the way I have done here. But the idea is implicit in the way we talk about business cycles. Logically, a demand shortfall in any given period can be described as a mix of forces pulling down spending in that period, and the the ongoing effect of weak demand in earlier periods. And whatever opinion you have about the proportions of each, this can be quantified. What I am doing in this post, in other words, is not proposing a new theory, but trying to make explicit a theory that’s already present in these debates, but not normally spelled out.
Why Is Demand Persistent?
The history of real economies should be enough to convince us that demand can be persistent. Deep downturns — not only in the US after 2007, but in much of Europe, in Japan after 1990, and of course the Great Depression — show clearly that if the level of spending in an economy falls sharply for whatever reason, it is likely to remain low years later, even after the precipitating factor is removed. But why should economies behave this way?
I can think of a couple of reasons.
First, there’s the pure coordination story. Businesses pay wages to workers in order to carry out production. Production is carried out for sale. Sales are generated by spending. And spending depends on incomes, most of which are generated from production. This is the familiar reasoning of the multiplier, where it is used to show how an autonomous change in spending can lead to a larger (or smaller) change in output. The way the multiplier is taught, there is one unique level of output for each level of autonomous demand. But if we formalized the same intuition differently, we could imagine a system with multiple equilibria. Each would have a different level of income, expenditure and production, but in each one people would be making the “right” expenditure choices given their income.
We can make this more concrete in two ways. First, balance sheets. One reason that there is a link from current income to current expenditure is that most economic units are financially constrained to some degree. Even if you knew your lifetime income with great precision, you wouldn’t be able to make your spending decisions on that basis because, in general, you can’t spend the money you will receive in the distant future today.
Now obviously there is some capacity to shift spending around in time, both through credit and through spending down liquid assets. The degree to which this is possible depends on the state of the balance sheet. To the extent a period of depressed demand leaves households and businesses with weaker balance sheets and tighter financial constraints, it will result in lower spending for an extended period. A version of this idea was put forward by Richard Koo as a “balance sheet recession,” in a rather boldly titled book.
Finally there is expectations. There is not, after all, a true lifetime income out there for you to know. All you can do is extrapolate from the past, and from the experiences of other people like you. Businesses similarly must make decisions about how much investment to carry out based on extrapolation from the past – on what other basis could they do it?
A short period of unusually high or low demand may not move expectations much, but a sustained one almost certainly will. A business that has seen demand fall short of what they were counting on is going to make more conservative forecasts for the future. Again, how could they not? With the balance sheet channel, one could plausibly agree that demand shocks will be persistent but not permanent. But with expectations, once they have been adjusted, the resulting behavior will in general make them self-confirming, so there is no reason spending should ever return to its old path.
This, to me, is the critical point. Mainstream economists and policy makers worry a great deal about inflation expectations, and whether they are becoming “unanchored.” But expectations of inflation are not the only ones that can slip their moorings. Households and businesses make decisions based on expectations of future income and sales, and if those expectations turn out to be wrong, they will be adjusted accordingly. And, as with inflation, the outcomes of which people form expectations themselves largely depend on expectations.
This was a point emphasized by Keynes:
It is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent in conditions of full employment are made in the expectation of a yield of, say, 6 per cent, and are valued accordingly.
When the disillusion comes, this expectation is replaced by a contrary ‘error of pessimism’, with the result that the investments, which would in fact yield 2 per cent in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent in conditions of full employment, in fact yield less than nothing. We reach a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses that there are.
He continues the thought in terms that are very relevant today:
Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.
Here is a roundtable hosted by the Jain Family Institute on finance and decarbonization.
What’s the best way to fund the massive investments the green transition will require? Saule Omarova and Bob Hockett make the case for a specialized National Investment Authority (NIA), which would issue various kinds of new liabilities as well as lend to both the public and private sector. Anusar Farooqui and Tim Sahay present their proposal for a green ratings agency, to encourage private investment in decarbonization. I speak for the Green New Deal approach, which favors direct public spending. Yakov Feygin and Daniela Gabor also take part. Yakov is another voice for the NIA, while Daniela criticizes a private finance-based approach to decarbonization, which effectively puts her with me on team Green New Deal. The panel is moderated by Adam Tooze.
My part starts at around 38:00, if you want to skip to that, but the whole thing is worth watching.
Finance and its derivatives like financialization, are like many political economy categories: they’re a widely used term but lack an agreed-upon definition. One often encounters formulations like “financialization means the increasing role of financial motives, financial markets, financial actors and financial institutions.” That isn’t very helpful!
Let me offer a simple definition of finance, which I think corresponds to its sense both for Marx and in everyday business settings. Finance is the treatment of a payment itselfas a commodity, independent of the transaction or relationship that initially gave rise to it.
The most straightforward and, I think, oldest, form of finance in this sense is the invoice. Very few commercial transactions are in cash; much more common is an invoice payable in 30 or 60 or 90 days. This is financing; the payment obligation now appears as a distinct asset, recorded on the books of the seller as accounts receivable, and on the books of the buyer as accounts payable.
The distinct accounting existence of the payment itself, apart from the sale it was one side of, is a fundamental feature, it seems to me, of both day-to-day accounting and capitalism in a larger sense. In any case, it develops naturally into a distinct existence of payments, apart from the underlying transaction, in a substantive economic sense. Accounts payable can be sold to a third party, or (perhaps more often) borrowed against, or otherwise treated just like any other asset.
So far we’re talking about dealer finance; the next step is a third party who manages payments. Rather than A receiving a commodity from C in return for a promise of payment in 30 or 60 or 90 days, A receives the commodity and makes that promise to B, who makes immediate payment to C. Until the point of settlement, A has a debt to B, which is recorded on a balance sheet and therefore is an asset (for B) and a liability (for A.) During thins time the payment has a concrete reality as an asset that not only has a notional existence on a balance sheet, but can be traded, has a market price, etc.
If the same intermediary stands between the two sides of enough transactions, another step happens. The liabilities of the third party, B, can become generally accepted as payment by others. As Minsky famously put it, the fundamental function of a bank is acceptance — accepting the promises of various payors to the various payees. Yes, the B stands for Bank.
Arriving at banks by this route has two advantages. First, it puts credit ahead of money. The initial situation is a disparate set of promises, which come to take the form of a uniform asset only insofar as some trusted counterparts comes to stand between the various parties. Second, it puts payments ahead of intermediation in thinking about banks
But now we must pause for a moment, and signal a turn in the argument. What we’ve described so far implicitly leans on a reality outside money world.
As money payments, A —> C and A —> B —> C are exactly equivalent. The outcomes, described in money, are the same. The only reason the second one exists, is because they are not in reality equivalent. They are not in reality only money payments. There is always the question of, why should you pay? Why do you expect a promise to be fulfilled? There are norms, there are expectations, there are authorities who stand outside of the system of money payments and therefore are capable of enforcing them. There is an organization of concrete human activity that money payments may alter or constrain or structure, but that always remain distinct from them. When I show up to clean your house, it’s on one level because you are paying me to do it; but it’s also because I as a human person have made a promise to you as another person.
This, it seems to me, is the rational core of chartalism. The world, we’re told, is not the totality of things, but of facts. The economic world similarly is not the totality of things, but of payments and balance sheets. The economic world however is not the world. Something has to exist outside of and prior to the network of money payments.
This could, ok, be the state, as we imagine it today. This is arguably the situation in a colonial setting. The problem is that chartalism thinks the state, specifically in the form of its tax authority, is uniquely able to play this role of validating money commitments. Whereas from my point of view there are many kind of social relationships that have an existence independent of the network of money payments and might potentially be able to validate them.
Within the perspective of law, everything is law; just as within the perspective of finance, everything is finance. If you start from the law, then how can money be anything but a creature of the state? But if we start instead from concrete historical reality, we find that tax authority is just one of various kinds of social relations that have underwritten the promises of finance.
Stefano Ugolino’s Evolution of Central Banking describes a fascinating variety of routes by which generalized payments systems evolved in Western Europe. The overwhelming impression one takes away from the book is that there is no general rule for what kinds of social relationships give rise to a centralized system of payments. Any commitment that can be commuted to cash can, in principle, backstop a currency.
In the medieval Kingdom of Naples payments were ultimately based on the transfer of claims tokens at the network pawnbrokers operated by the Catholic Church. The Kingdom of Naples, writes Ugolino, “is the only country with a central bank that was founded by a saint.”
A somewhat parallel example is found in Knibbe and Borghaerts’ “Capital market without banks.” There they describe an early modern setting in the Low Countries where the central entity that monetizes private debt contracts is not the tax-collecting state, but the local pastor.
The general point is made with characteristic eloquence by Perry Mehrling in “Modern Money:Credit of Fiat”:
For monetary theory, so it seems to me, the significant point about the modern state is not its coercive power but the fact that it is the one entity with which every one of us does ongoing business.We all buy from it a variety of services, and the price we pay for those services is our taxes. … It is the universality of our dealings with the government that gives government credit its currency. The point is that the public “pay community” …is larger than most any private pay community, not that the state s more powerful than any other private entity.
There are different kinds of recipients of money payments and the social consequences they can call on if the payments aren’t made vary widely both in severity and in kind. The logic of the system in which payments are automatically made is the same in any case. But all the interesting parts of the system are the places where it doesn’t work like that.
Let me end with a little parable that I wrote many years ago and stuck in a drawer, but which now seems somehow relevant in this new age of NFTs.
Once upon a time there was a game called cow clicker. In this game, you click on a cow. Then you can’t click it again for a certain period of time. That’s it. That is the game.
How much is a cow click? Asked in isolation, the question is meaningless. You can’t compare it to anything. It is just an action in a game that has no other significance or effect.How much is a soccer goal, in terms of baseball runs?
On one level, you cannot answer the question. They exist in different games. You could add up the average score per game as a conversion factor … but then should you also take into account the number of games in a season… ? But you can’t even do that with cow clicker, there is no outcome in the game that corresponds to winning or losing. There is no point to it at all — the game was created as a joke, and that is the point of the joke.
Nonetheless, and to the surprise of the guy who created it, people did play cow clicker. They liked clicking cows. They wanted more cows. They wanted to know if there was any way to shorten the timeline before they could click their cow again.
Now suppose it was possible to get extra cow clicks by getting other people to also click a cow. These people, who wanted to click their cows more, now could persuade their friends to click cows for them. Any relationship now is a potential source of cow clicks.
For example, if you exercise any kind of coercive power over someone — a subordinate, a student, a child — you might use it to compel them to click cows for you. Or if you have anything of value, you might offer it in return for clicking cows. Clicking cows is still inherently valueless. And your relationship with your friends, kids, spouse, are valuable but not quantifiable in themselves. But now they can be expressed in terms of cow clicks.
Imagine this went further. If enough cow-clicker obsessives are willing to make real-life sacrifices — or use real-life authority — to get other people to click cows, then a capacity to click cows (some token in the game) becomes worth having for its own sake. Since you can offer it to the obsessives in return for something they have that you want. Even people who think the game is pointless and stupid now have an interest in figuring out exactly how many cows they can click in a day, and if there is any way to click more.
As more and more of social life became organized around enticing or coercing people into clicking cows, more and more relationships would take on a quantitative character, and be expressible in as a certain number of cow-clicks. These quantities would be real — they would arise impersonally, unintentionally, based on the number of clicks people were making. For instance, if a husband or wife can be convinced to click 10 times a day, while a work friend can only be convinced to click once a day on average, then a spouse really is worth 10 co-workers. No one participating in the system set the value, it is an objective fact from the point of view of participants. And, in this case, it doe express a qualitative relationship that exists outside of the game — marriage involves a stronger social bond than the workplace. But the specific quantitative ratio did not exist until now, it does not point to anything outside the game.
In this world, the originalcontentless motivation of the obsessives becomes less and less important. The answer to “why are you clicking cows” becomes less anything to do with the cows, and more because someone asked me to. Or someone will reward me if I do, or someone will punish me if I don’t. And — once cow-clicks are transferable — this motivation applies just as much to the askers, rewarders and publishers. The original reason for clicking was trivially feeble but now it can even disappear entirely. Once a click can reliably be traded for real social activity, that is sufficient reason for trading one’s own social existence for clicks.
EDIT: The idea of finance as intermediation as an object in itself comes, like everything interesting in economics, from Marx. Here’s one of my favorite passages from the Grundrisse:
Bourgeois wealth, is always expressed to the highest power as exchange value, where it is posited as mediator, as the mediation of the extremes of exchange value and use value themselves. This intermediary situation always appears as the economic relation in its completeness…
Thus, in the religious sphere, Christ, the mediator between God and humanity – a mere instrument of circulation between the two – becomes their unity, God-man, and, as such, becomes more important than God; the saints more important than Christ; the popes more important than the saints.
Where it is posited as middle link, exchange value is always the total economic expression… Within capital itself, one form of it in turn takes up the position of use value against the other as exchange value. Thus e.g. does industrial capital appear as producer as against the merchant, who appears as circulation. … At the same time, mercantile capital is itself in turn the mediator between production (industrial capital) and circulation (the consuming public) or between exchange value and use value… Similarly within commerce itself: the wholesaler as mediator between manufacturer and retailer, or between manufacturer and agriculturalist…
Then the banker as against the industrialists and merchants; the joint-stock company as against simple production; the financier as mediator between the state and bourgeois society, on the highest level. Wealth as such presents itself more distinctly and broadly the further it is removed from direct production and is itself mediated between poles, each of which, considered for itself, is already posited as economic form. Money becomes an end rather than a means; and the higher form of mediation, as capital, everywhere posits the lower as itself, in turn, labour, as merely a source of surplus value. For example, the bill-broker, banker etc. as against the manufacturers and farmers, which are posited in relation to him in the role of labour (of use value); while he posits himself toward them as capital, extraction of surplus value; the wildest form of this, the financier.
You read this stuff and you think — how can you not? — that Marx was a smart guy,
(Earlier this week, I gave a virtual presentation at an event organized by the Roosevelt Institute and the Green New Deal Network. Virtual events are inferior to live ones in many, many ways. But one way they are better, is that they are necessarily on video, and can be shared. Anyway, here is 25 minutes on why the economic situation calls for even more spending than the (surprisingly ambitious) proposals from the Biden administration, and also on why full employment shouldn’t be seen as an alternative to social justice and equity goals but as the best way of advancing them.)
The previous post got quite a bit of attention — more, I think, than anything I’ve written on this blog in the dozen years I’ve been doing it.
I would like to do a followup post replying to some of the comments and criticisms, but I haven’t had time and realistically may not any time soon, or ever. In the meantime, though, here is some existing content that might be relevant to people who would like to see the arguments in that post drawn out more fully.
Here is a podcast interview I did with some folks from Current Affairs a month or so ago. The ostensible topic is Modern Mone(tar)y Theory, but the conversation gave me space to talk more broadly about how to think about macroeconomic questions.
Here is a piece I wrote a couple years ago on Macroeconomic Lessons from the Past Decade. Bidenomics could be seen as a sort of deferred learning of the lessons from the Great Recession. So even though this was written before the pandemic and the election, there’s a lot of overlap here.
This report from Roosevelt, What Recovery? is an earlier stab at learning those lessons. I hope to be revisiting a lot of the topics here (and doing a better job with them, hopefully) in a new Roosevelt report that should be out in a couple of months.
If you like podcast interviews, here’s one I did with David Beckworth of Macro Musings following the What Recovery report, where we talked quite a bit about hysteresis and the limits of monetary policy, among other topics.
And here are some relevant previous past posts on this blog:
Some people are frustrated about the surrender on the minimum wage, the scaled-back unemployment insurance, the child tax credit that should have been a universal child allowance, the fact that most of the good things phase out over the next year or two.
On the other side are those who see it as a decisive break with neoliberalism. Both the Clinton and Obama administrations entered office with ambitious spending plans, only to abandon or sharply curtail them (respectively), and instead embrace a politics of austerity and deficit reduction. From this point of view, the fact that the Biden administration not only managed to push through an increase in public spending of close to 10 percent of GDP, but did so without any promises of longer-term deficit reduction, suggests a fundamental shift.
Personally, I share this second perspective. I am less surprised by the ways in which the bill was trimmed back, than by the extent that it breaks with the Clinton-Obama model. The fact that people like Lawrence Summers have been ignored in favor of progressives like Heather Boushey and Jared Bernstein, and deficit hawks like the Committee for a Responsible Federal Budget have been left screeching irrelevantly from the sidelines, isn’t just gratifying as spectacle. It suggests a big move in the center of gravity of economic policy debates.
It really does seem that on the big macroeconomic questions, our side is winning.
To be clear, the bill did not pass because some economists out-argued other economists. It was a political outcome that was driven by political conditions and political work. Most obviously, it’s hard to imagine this Biden administration without the two Sanders campaigns that preceded it. (In the president’s speech after signing the bill, Bernie was the first second person credited.) If it’s true, as reported, that Schumer kept expanded unemployment benefits in the bill only by threatening Manchin that the thing would not pass the House without them, then the Squad also deserves a lot of credit.
Still, from my parochial corner, it’s interesting to think about the economic theory implied by the bill. Implicitly, it seems to me, it represents a big break with prevailing orthodoxy.
Over the past generation, macroeconomic policy discussions have been based on a kind of textbook catechism that goes something like this: Over the long run, potential GDP grows at a rate based on supply-side factors — demographics, technological growth, and whatever institutions we think influence investment and labor force participation. Over the short run, there are random events that can cause actual spending to deviate from potential, which will be reflected in a higher or lower rate of inflation. These fluctuations are more or less symmetrical, both in frequency and in cost. The job of the central bank is to adjust interest rates to minimize the size of these deviations. The best short-term measure of how close the economy is to potential is the unemployment rate; at any given moment, there’s a minimum level of unemployment consistent with price stability. Smoothing out these fluctuations has real short run benefits, but no effects on long-term growth. The government budget balance, meanwhile, should not be used to stabilize demand, but rather should be kept at a level that ensures a stable or falling debt ratio; large fiscal deficits may be very costly. Finally, while it may be necessary to stabilize overall spending in the economy, this should be done in a way that minimizes “distortions” of the pattern of economic activity and, in particular, does not reduce the incentive to work.
Policy debates — though not textbooks — have been moving away from this catechism for a while. Jason Furman’s New View of Fiscal Policy is an example I often point to; you can also see it in many statements from Powell and other Fed officials, as I’ve discussed here and here. But these are, obviously, just statements. The size and design of ARPA is a more consequential rejection of this catechism. Without being described as such, it’s a decisive recognition of half a dozen points that those of us on the left side of the macroeconomic debate have been making for years.
1. The official unemployment rate is an unreliable guide to the true degree of labor market slack, all the time and especially in downturns. Most of the movement into and out of employment is from people who are not officially counted as unemployed. To assess labor market slack, we should also look at the employment-population ratio, and also at more direct measures of workers’ bargaining power like quit rates and wage increases. By these measures, the US pre-pandemic was still well short of the late 1990s.More broadly, there is not a well defined labor force, but asmooth gradient of proximity to employment. The short-term unemployed are the closest, followed by the longer-term unemployed, employed people seeking additional work, discouraged workers, workers disfavored by employers due to ethnicity, credentials, etc. Beyond this are people whose claim on the social product is not normally exercised by paid labor – retired people, the disabled, full-time caregivers – but might come to be if labor market conditions were sufficiently favorable.
2. The balance of macroeconomic risks is not symmetrical. We don’t live in an economy that fluctuates around a long-term growth path, but one that periodically falls into recessions or depressions. These downturns are a distinct category of events, not a random “shock” to production or desired spending. Economic activity is a complex coordination problem; there are many ways it can break down or be interrupted that result in a fall inspending, but not really any way it can abruptly accelerate. (There are no “positive shocks” for the same reason that there are lots of poisons but no wonder drugs.) It’s easy to imagine real-world developments that could causes businesses to abruptly cut back their investment plans, but not that would cause them to suddenly and unexpectedly scale them up. In real economies, demand shortfalls are much more frequent, persistent and damaging than is overheating. And to the extent the latter is a problem, it is much easier to interrupt the flow of spending than to restart it.
3. The existence of hysteresis is one important reason that demand shortfalls are much more costly than overshooting. Overheating may have short-term costs in higher inflation, inflated asset prices and a redistribution of income toward relatively scarce factors (e.g. urban land), but it also is associated with a long-term increase in productive capacity — one that may eventually close the inflationary gap on its own. Shortfalls on the other hand lead to a reduction in potential output, and so may become self-perpetuating as potential GDP declines. Hysteresis also means that we cannot count on the economy returning to its long-term trend on its own — big falls in demand may persist indefinitely unless they are offset by some large exogenous boost to demand. Which in turn means that standard estimates of potential output understate the capacity of output to respond to higher spending.
4. A full employment or high pressure economy has benefits that go well beyond the direct benefits of higher incomes and output. Hysteresis is part of this — full employment is a spur to innovation and faster productivity growth. But there are also major implications for the distribution of income. Those who are most disadvantaged in the labor market, are the ones who benefit most from very low unemployment. The World War II experience, and the subsequent evolution of the racial wage gap, suggests that historically, sustained tight labor markets have been the most powerful force for closing the gap between black and white wages.
I’m not sure how much people in the administration and Congress were actually making arguments like these in framing the bill. But even if they weren’t explicitly argued for, some mix of them logically follows from the willingness to pass something so much larger than the conventional estimates of the output gap would imply. Some mix of them also must underly the repeated statements that we can’t do too much, only too little, and from the recognition that the costs of an inadequate stimulus in 2009 were not just lower output for a year or two, butan extended period of slow growth and stagnant wages. When Schumer says that in 2009, “we cut back on the stimulus dramatically and we stayed in recession for five years,” he is espousing a model of hysteresis, even if he doesn’t use the word.
On other points, there’s a more direct link between the debate over the bill and the shift in economic vision it implies.
5. Public debt doesn’t matter. Maybe I missed it, but as far as I can tell, in the push for the Rescue Plan neither the administration nor the Congressional leadership made even a gesture toward deficit reduction, not even a pro forma comment that it might be desirable in principle or in the indefinite long run. The word “deficit” does not seem to have occurred in any official statement from the president since early February — and even then it was in the form of “it’s a mistake to worry about the deficit.” Your guide to being a savvy political insider suggests appropriate “yes, buts” to the Rescue Plan — too much demand will cause inflation, or alternatively that demand will collapse once the spending ends. Nothing about the debt. Things may change, of course, but at the moment it’s astonishing how completely we have won on this one.
6. Work incentives don’t matter. For decades, welfare measures in the US have been carefully tailored to ensure that they did not broaden people’s choices other than wage labor. The commitment to maintaining work incentives was strong enough to justify effectively cutting off all cash assistance to families without anyone in paid employment — which of course includes the poorest.The flat $600 pandemic unemployment insurance was a radical departure from this — reaching everyone who was out of work took priority over ensuring that no one was left better off than they would be with a job. The empirical evidence that this had no effect on employment is informative about income-support programs in general. Obviously $300 is less than $600, but it maintains the priority of broad eligibility. Similarly, by allowing families with no wages to get the full benefit, making the child tax credit full refundable effectively abandons work incentives as a design principle (even if it would be better at that point to just make it a universal child allowance.) As many people have pointed out, this is at least directionally 180 degrees from Clinton-era “welfare reform.”
7.Direct, visible spending is better than indirect spending or spending aimed at altering incentives. For anyone who remembers the debates over the ARRA at the start of the Obama administration, it’s striking how much the Rescue Plan leans into direct, visible payments to households. The plan to allow the child tax credit to be paid out in monthly installments may have some issues (and, again, would certainly work better if it were a flat allowance rather than a tax credit) but what’s interesting here is that it reflects a view that making the payments more salient is a good thing, not a bad thing.
In other areas, the conceptual framework hasn’t moved as far as I would have hoped, though we are making progress:
8. Means testing is costly and imprecise. As Claudia Sahm, Matt Bruenig and others have forcefully argued, there’s a big disconnect between the way means testing is discussed and the way it actually operates. When the merits of income-based spending are talked about in the abstract, it’s assumed that we know every household’s income and can assign spending precisely to different income groups. But when we come to implement it, we find that the main measure of income we use is based on tax records from one to two years earlier; there are many cases where the relevant income concept isn’t obvious; and the need to document income creates substantial costs and uncertainties for beneficiaries. Raising the income thresholds for things like the child tax credit is positive, but the other side of that is that once the threshold gets high enough it’s perverse to means-test at all: In order to exclude a relatively small number of high-income families you risk letting many lower-income families fall through the cracks.
9. Weak demand is an ongoing problem, not just a short-term one. The most serious criticism of the ARPA is, I think, that so many of its provisions are set to phase out at specific dates when they could be permanent (the child tax credit) or linked to economic conditions (the unemployment insurance provisions). This suggests an implicit view that the problems of weak demand and income insecurity are specific to the coronavirus, rather than acute forms of a chronic condition. This isn’t intended as a criticism of those who crafted the bill — it may well be true that a permanent child tax credit couldn’t be passed under current conditions.
Still, the arguments in support of many of the provisions are not specific to the pandemic, and clearly imply that these measures ought to be permanent. If the child tax credit will cut child poverty by half, why would you want to do that for only one year? If a substantial part of the Rescue Plan should on the merits be permanent, that implies a permanently larger flow of public spending. The case needs to be made for this.
10. The public sector has capacities the private sector lacks. While Biden’s ARPA is a big step forward from Obama’s ARRA in a lot of ways, one thing they have in common is a relative lack of direct public provision. The public health measures are an exception, of course, and the aid to state and local governments — a welcome contrast with ARRA — is public spending at one remove, but the great majority of the money is going to boost private spending. That’s not necessarily a bad thing in this specific context, but it does suggest that, unlike the case with public debt, theinstitutional and ideological obstacles to shifting activities from for-profit to public provision are still formidable.
My goal in listing these points isn’t, to be clear, to pass judgement on the bill one way or the other. Substantively, I do think it’s a big victory and a clear sign that elections matter. But my interest in this particular post is to think about what it says about how thinking about economic policy is shifting, and how those shifts might be projected back onto economic theory.
What would a macroeconomics look like that assumed that the economy was normally well short of supply constraints rather than at potential on average, or was agnostic about whether there was a meaningful level of potential output at all? What would it look like if we thought that demand-induced shifts in output are persistent, in both directions? Without the assumption of a supply-determined trend which output always converges to, it’s not clear there’s a meaningful long run at all. Can we have a macroeconomic theory that dispenses with that?
One idea that I find appealing is to think of supply as constraining the rate of growth of output, rather than its level. This would fit with some important observable facts about the world — not just that demand-induced changes in output are persistent, but also that employment tends to grow (and unemployment tends to fall) at a steady rate through expansions, rather than a quick recovery and then a return to long-run trend. The idea that there is a demographically fixed long-run employment-population ratio flies in the face of the major shifts of employment rates within demographic groups. A better story, it seems to me, is that there is a ceiling on the rate that employment can grow — say 1.5 or 2 percent a year — without any special adjustment process; faster growth requires drawing new people into the labor force, which typically requires faster wage growth and also involves various short run frictions. But, once strong growth does generate a larger labor force, there’s no reason for it to revert back to its old trend.
More broadly, thinking of supply constraints in terms of growth rates rather than levels would let us stop thinking about the supply side in terms of an abstract non monetary economy “endowed” with certain productive resources, and start thinking about it in terms of the coordination capabilities of markets. I feel sure this is the right direction to go. But a proper model needs to be worked out before it is ready for the textbooks.
The textbook model of labor markets that we still teach justifies a focus on “flexibility”, where real wages are determined by on productivity and a stronger position for labor can only lead to higher inflation or unemployment. Instead, we need a model where the relative position of labor affects real as well as nominal wages, andin which faster wage growth can be absorbed by faster productivity growth or a higher wage share as plausibly as by higher prices.
Or again, how do we think about public debt and deficits once we abandon the idea that a constant debt-GDP ratio is a hard constraint? One possibility is that we think the deficit matters, but debt does not, just as we now think think that the rate of inflation matters but the absolute price level does not.To earlier generations of economists, the idea that prices could just rise forever without limit, would have seemed insane. But today we find it perfectly reasonable, as long as the rise over any given period is not too great. Perhaps we’ll come to the same view of public debt. To the extent that we do care about the debt ratio, we need to foreground the fact that its growth over time depends as much on interest, inflation and growth rates as it does on new borrowing. For the moment, the fact that interest rates are much lower than growth rates is enough to convince people past concerns were overblown. But to regard that as a permanent rather than contingent solution, we need, at least, to get rid of the idea of a natural rate of interest.
In short, just as a generation of mainstream macroeconomic theory was retconned into an after-the-fact argument for an inflation-targeting central bank, what we need now is textbooks and theories that bring out, systematize and generalize the reasoning that justifies a great expansion of public spending, unconstrained by conventional estimates of potential output, public debt or the need to preserve labor-market incentives. The circumstances of the past year are obviously exceptional, but that doesn’t mean they can’t be made the basis of a general rule. For the past generation, macroeconomic theory has been largely an abstracted parable of the 1970s, when high interest rates (supposedly) saved us from inflation. With luck, perhaps the next generation will learn macroeconomics as a parable of our own time, when big deficits saved us from secular stagnation and the coronavirus.
(A year ago, I mentioned that Arjun Jayadev were writing a book about money. The project was then almost immediately derailed by covid, but we’ve recently picked it up again. I’ve decided to post some of what we’re writing here. Plucked from its context, it may be a bit unclear both where this piece is coming from and where it is going.)
The problem of interest rates is one of the key fissures between the vision of the economy in terms of the exchange of real stuff and and the reality of a web of money payments. Like a flat map laid over a globe, a rigid ideological vision can be made to lie reasonably smoothly over reality in some places only at the cost of ripping or crumpling elsewhere; the interest rate is one of the places that rips in the smooth fabric of economics most often occur. As such, it’s been a central problem since the emergence of economics as a distinct body of thought. How does the “real” rate determined by saving and investment demand get translated into the terms set for the exchange of IOUs between the bank and its customer?
One straightforward resolution to the problem is simply to deny that money plays a role in the determination of the interest rate. David Hume’s central argument in his essay “On Interest” (one of the first discussions within the genealogy of modern economics) was that changes in the supply of money do not affect the interest rate.4
High interest arises from three circumstances: A great demand for borrowing; little riches to supply that demand; and great profits arising from commerce: And these circumstances are a clear proof of the small advance of commerce and industry, not of the scarcity of gold and silver… Those who have asserted, that the plenty of money was the cause of low interest, seem to have taken a collateral effect for a cause…. though both these effects, plenty of money and low interest, naturally arise from commerce and industry, they are altogether independent of each other.
“Riches” here means real, material wealth, so this is an early statement of what we would today call the loanable-funds view of interest rates. Similar strong claims have been taken up by some of today’s more doctrinaire classical economists, in the form of what is known as neo-Fisherism. If the “real” rate, in the sense of the interest rate adjusted for inflation, is set by the fundamentals of preferences and technology, then central bank actions must change only the nominal rate. This implies that when the central bank raises the nominal interest rate, that must cause inflation to rise — not to fall, as almost everyone (including the central bankers!) believes. Or as Minneapolis Federal Reserve president Narayana Kocherlakota put it, if we believe that money is neutral, then “over the long run, a low fed funds rate must lead to … deflation.”5 This view is, not surprisingly, also popular among libertarians.
The idea that monetary influences on the interest rate are canceled out by changes in inflation had a superficial logic to it when those influences were imagined as a literal change in the quantity of money — of the relative “scarcity of gold and silver,” as Hume put it. If we imagine expansionary monetary policy as an increase in the fixed stock of money, then it might initially make money more available via loans, but over time as that money was spent, it would lead to a general rise in prices, leaving the real stock of money back where it started.
But in a world where the central bank, or the private banking system, is setting an interest rate rather than a stock of money, this mechanism no longer works. More money, plus higher prices, leaves the real stock of money unchanged. But low nominal rates, plus a higher rate of inflation, leaves the real interest rate even lower. In a world where there is a fixed, central bank-determined money stock, the inflation caused by over-loose policy will cancel out that policy. But when the central bank is setting an interest rate, the inflation caused by over-loose policy implies an even lower real rate, making the error even worse. For the real rate to be ultimately unaffected by monetary policy, low interest rates must somehow lead to lower inflation. But it’s never explained how this is supposed to come about.
Most modern economists are unwilling to outright deny that central banks or the financial system can affect the rate of interest.6 Among other things, the privileged role of the central bank as macroeconomic manager is a key prop of policy orthodoxy, essential to stave off the possibility of other more intrusive forms of intervention. Instead, the disjuncture between the monetary interest rate observable in credit markets and the intertemporal interest rate of theory is papered over by the notion of the “natural” interest rate.
This idea, first formulated around the turn of the 20th century by Swedish economist Knut Wicksell, is that while banks can set any interest rate they want, there is only one interest rate consistent with stable prices and, more broadly, appropriate use of society’s resources. It is this rate, and not necessarily the interest rate that obtains at any given moment, that is set by the nonmonetary fundamentals of the economy, and that corresponds to the intertemporal exchange rate of theory. In the classic formulation of Milton Friedman, the natural rate of interest, with its close cousin the natural rate of unemployment, correspond to the rates that would be “ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on.”
The natural rate of interest is exactly the rate that you would calculate from a model of a rational individual trading off present against future — provided that the model was actually a completely different one.
Despite its incoherence, Friedman’s concept of the natural rate has had a decisive influence on economic thinking about interest in the 50 years since. His 1968 Presidential Address to the American Economics Association introducing the concept (from which the quote above comes) has been called “very likely the most influential article ever published in an economics journal” (James Tobin); “the most influential article written in macroeconomics in the past two decades” (Robert Gordon); “one of the decisive intellectual achievements of postwar economics” (Paul Krugman); “easily the most influential paper on macroeconomics published in the post-war era” (Mark Blaug and Robert Skidelsky). 7 The appeal of the concept is clear: It provides a bridge between the nonmonetary world of intertemporal exchange of economic theory, and the monetary world of credit contracts in which we actually live. In so doing, it turns the intertemporal story from a descriptive one to a prescriptive one — from an account of how interest rates are determined, to a story about how central banks should conduct monetary policy.
To understand the ideological function of R*, it’s useful to look at a couple of typical examples of how it’s used in mediating between the needs of managing a monetary economy and the real-exchange vision through which that economy is imagined.
A 2018 speech by Fed Chair Jerome Powell is a nice example of how monetary policy practitioners think of the natural rate. He introduces the idea of R* with the statement that “In conventional models of the economy, major economic quantities such as inflation, unemployment, and the growth rate of gross domestic product (GDP) fluctuate around values that are considered ‘normal,’ or ‘natural,’ or ‘desired.’” The slippage between the three last quoted terms is a ubiquitous and essential feature of discussions of R*. Like the controlled slipping between the two disks of a clutch in a car, it allows systems moving in quite different ways to be joined up without either fracturing from the stress. The ambiguity between these meanings is itself normal, natural and desired.
In a monetary policy context, Powell continues, these values are operationalized as “views on the longer-run normal values for the growth rate of GDP, the unemployment rate, and the federal funds rate.” Powell immediately glosses this as “fundamental structural features of the economy … such as the ‘natural rate of unemployment’.” Here again, we see a move from something that is expected to be true on average, to something that is a “fundamental structural feature” presumably linked to things like technology and demographics, and then to the term “natural”, which implies that these fundamental structures are produced by some quite different process than the network of money payments managed by the Fed. The term “natural” of course also implies beyond human control, and indeed, Powell says that these values “are not … chosen by anyone”. In the conventions of modeling, such natural, neutral, long-run, unchosen values are denoted with stars, so along with R* there is U* and a bevy of starred Greek letters.
Powell, to be fair, goes on to talk about how difficult it is to navigate by these stars in practice, and criticizes his predecessors who were too quick to raise interest rates based on hazy, imprecise ideas of the natural rate of unemployment. But there’s a difference between saying the stars are hard to see, and that they are not there at all. He has not (or, plausibly, assumes his audience has not) escaped the scholastic and tautological habit of interpreting any failure of interest rate changes to deliver the expected result as a sign that the natural rate was different than expected.
It is, of course true, that if there is any stable relationship between the policy rate controlled by the Fed and a target like GDP or unemployment, then at any particular moment there is presumably some interest rate which would move that target to its desired level. But the fact that an action can produce a desired result doesn’t make it “natural” in any sense, or an unchanging structural feature of the world.
Powell, a non-economist, doesn’t make any particular effort to associate his normal or natural values with any particular theoretical model. But the normal and natural next step is to identify “fundamental structural features” of the world with the parameters of a non monetary model of real exchange among rational agents. Indeed, in the world of macroeconomics theory, that is what “deep structural parameters” mean. In the usage of Robert Lucas and his followers, which has come to dominate academic macroeconomics, structural parameters are those that describe the rational choices of agents based only on their preferences and the given, objective production function describing the economy. There’s no reason to think Powell has this narrower meaning in mind, but it’s precisely the possibility of mapping these meanings onto each other that allows the “natural rate” and its cousins to perform their ideological role.
For an example of that next step, let’s turn to a recent report from the Centre for Economic Policy Research, which assembles work by leading European macroeconomists. As with Powell’s speech, the ideological understanding of the natural rate is especially striking here because much of the substantive policy argument being made is so reasonable — fiscal policy is important, raising interest rates makes public debt problems worse, the turn to austerity after great financial crisis was a mistake.
The CEPR economists begin with the key catechism of the real-exchange view of interest: “At its most basic level, the interest rate is the ‘price of time’ — the remuneration for postponing spending into the future.” R*, in other words, is a rate of interest determined by purely non monetary factors — it should be unaffected by developments in the financial system. This non monetary rate,
while unobservable … provides a useful guidepost for monetary policy as it captures the level of the interest rate at which monetary policy can be considered neutral … when the economy runs below potential, pushing actual real policy rates sufficiently below R* makes policy expansionary.
The notion of an unobservable guidepost doesn’t seem to have given the CEPR authors any pause, but it perfectly distills the contradiction embodied in the idea of R*. Yes, we can write down a model in which everyone has a known income over all future time, and with no liquidity constraints can freely trade future against present income without the need for specialized intermediaries. And we can then ask, given various parameters, what the going rate would be when trading goods at some future date for the same goods today. But given that we live in a world where the future is uncertain, where liquidity constraints are ubiquitous, and where a huge specialized financial system exists to overcome them, how do we pick one such model and say that it somehow corresponds to the real world?
And even if we somehow picked one, why would the intertemporal exchange rate in that world be informative for the appropriate level of interest rates in our own, given that the model abstracts away from the features that make monetary policy necessary and possible in the first place? In the world of the natural rate, there is no possibility for the economy to ever “run below potential” (or above it). Nor would there be any way for a single institution like a central bank to simultaneously change the terms of all those myriad private exchanges of present for future goods.
Michael Woodford, whose widely-used graduate textbook Interest and Prices is perhaps the most influential statement of this way of thinking about monetary policy is, unusually, at least conscious of this problem. He notes that most accounts of monetary policy treat it as if the central bank is simply able to fix the price of all loan transactions, but it’s not clear how it does this or where it gets the power to do so. His answers to this question are not very satisfactory. But at least he sees the problem; the vast majority of people using this framework breeze right past it.
The CEPR writers, for instance, arrive at a definition of the natural rate as
the real rate of interest that, averaged over the business cycle, balances the supply and demand of loanable funds, while keeping aggregate demand in line with potential output to prevent undue inflationary or deflationary pressure.
This definition simply jams together the intertemporal “interest rate” of the imagined non monetary world, with the interest rate target for monetary policy, without establishing any actual link between them. (Here again we see the natural rate as the clutch between theory and policy.) “Loanable funds” are supposed to be the real goods that their owners don’t currently want, which they agree to let someone else use. The “while” conjunction suggests that clearing the loanable-funds market and price stability are two different criteria — that there could in principle be an interest rate that keep output at potential and inflation on target, but failed to clear the market for loanable funds. But what could this mean? Are there any observable facts about the world that would lead a central bank to conclude “the policy rate we have chosen seems to be consistent with price stability, but the supply and demand for loanable funds are not balanced”? Where would this imbalance show up? The operational meaning of the natural rate is that any rate associated with the macroeconomic outcomes sought by the central bank is, by definition, the “natural” one. And as Keynes long ago pointed out — it is a key argument of The General Theory — the market for loanable funds always clears. There is no need for a market price balancing investment and saving, because any change in investment mechanically produces an exactly equal change in saving.
In practice, the natural rate means just this: We, the central bank, have set the interest rate under our control at a level that we hope will lead to our preferred outcomes for GDP, inflation, the unemployment rate, etc. Also, we can imagine a world in which rational agents trade present goods for future goods. Since in some such world the exchange rate between present and future goods would be the same as the policy rate we have chosen, our choice must be the optimal one.
(At the big economics conference earlier in January, I spoke on a virtual panel in response to Michael Hudon’s talk on the this topic. HIs paper isn’t yet available, but he has made similar arguments here and here. My comments were in part addressed to his specific paper, but were also a response to the broader discussion around financialization. A version of this post will appear in a forthcoming issue of the Review of Radical Political Economics.)
Michael Hudson argues that the industrial capitalism of a previous era has given way to a new form of financial capitalism. Unlike capitalists in Marx’s day, he argues, today’s financial capitalists claim their share of the surplus by passively extracting interest or economic rents broadly. They resemble landlords and other non-capitalist elites, whose pursuit of private wealth does not do anything to develop the forces of production, broaden the social division of labor, or prepare the ground for socialism.
Historically, the progressive character of capitalism comes from three dimensions on which capitalists differ from most elites. First, they do not merely claim the surplus from production, but control the production process itself; second, they do not use the surplus directly but must realize it by selling it on a market; and third, unlike most elites who acquire their status by inheritance or some similar political process, a capitalist’s continued existence as a capitalist depends on their ability to generate a large enough money income to acquire new means of production. This means that capitalists are under constant pressure to reduce the costs through technical improvements to the production process. In some cases the pressure to reduce costs may also lead to support for measures to socialize the reproduction costs of labor power via programs like public education, or for public provision of infrastructure and other public services.
In Hudson’s telling, financial claims on the surplus are essentially extractive; the pursuit of profit by finance generates pressure neither for technical improvements in the production process, nor for cost-reducing public investment. The transition from one to the other as the dominant form of surplus appropriation is associated with a great many negative social and political developments — lower wages, privatization of public goods, anti-democratic political reforms, tax favoritism and so on. (The timing of this transition is not entirely clear.)
Otherwritershavetold versions of this story, but Hudson’s is one of the more compelling I have seen. I am impressed by the breadth of his analysis, and agree with him on almost everything he finds objectionable in contemporary capitalism.
I am not, however, convinced. I do not think that “financial” and “industrial” capital can be separated in the way he proposes. I think it is better to consider them two moments of a single process. Connected with this, I am skeptical of the simple before and after periodization he proposes. Looking at the relationship between finance and production historically, we can see movements in both directions, with different rhythms in different places and sectors. Often, the growth of industrial capitalism in one industry or area has gone hand in hand with a move toward more financial or extractive capitalism somewhere else. I also think the paper gives a somewhat one-sided account of developments in the contemporary United States. Finally, I have concerns about the political program the analysis points to.
1.
Let’s start with idea that industrial capitalists support public investments in areas like education, health care or transportation because they lower the reproduction costs of labor. This is less important for owners of land, natural resources or money, whose claim on the social surplus doesn’t mainly come through employing labor.
I wouldn’t say this argument is wrong, exactly, but I was struck by the absence of any discussion of the other ways in which industrial capitalists can reduce the costs of labor — by lowering the subsistence level of workers, or reducing their bargaining power, or extracting more work effort, or shifting employment to lower-wage regions or populations. The idea that the normal or usual result of industrial capitalists’ pursuit of lower labor costs is public investment seems rather optimistic.
Conversely, public spending on social reproduction only reduces costs for capitalist class insofar as the subsistence level is fixed. As soon as we allow for some degree of conflict or bargaining over workers share of the social product, we introduce possibility that socializing reproduction costs does not lower the price of labor, but instead raises the living standards of the human beings who embody that labor. Indeed, that’s why many people support such public spending in the first place!
On the flip side, the case against landlords as a force for capitalist progress is not as straightforward as the paper suggests.
Ellen Meiksins Wood argues, convincingly, that the origins of what Hudson calls industrial capitalism should really be placed in the British countryside, where competition among tenants spurred productivity-boosting improvements in agricultural land. It may be true that these gains were mostly captured by landlords in the form of higher rents, but that does not mean they did not take place. Similarly, Gavin Wright argues that one of the key reasons for greater public investment in the ante-bellum North compared with the South was precisely the fact that the main form of wealth in the North was urban land. Land speculators had a strong interest in promoting canals, roads and other forms of public investment, because they could expect to capture gains from them in the form of land value appreciation.
In New York City, the first subways were built by a company controlled by August Belmont, who was also a major land speculator. In a number of cases, Belmont — and later the builders of the competing BMT system — would extend transit service into areas where they or their partners had assembled large landholdings, to be able to develop or sell off the land at a premium after transit made it more valuable. The possibility of these gains was probably a big factor in spurring private investment in transit service early in the 20th century.
Belmont can stand as synecdoche for the relationship of industrial and financial capital in general. As the organizer of the labor engaged in subway construction, as the one who used the authority acquired through control of money to direct social resources to the creation of new means of transportation, he appears as an industrial capitalist, contributing to the development of the forces of production as well as reducing reproduction costs by giving workers access to better, lower-cost housing in outlying areas. As the real estate speculator profiting by selling off land in those areas at inflated prices, he appears as a parasitic financial capitalist. But it’s the same person sitting in both chairs. And he only engaged in the first activity in the expectation of the second one.
None of this is to defend landlords. But it is to make the point that the private capture of the gains from the development of the forces of production is, under capitalism, a condition of that development occurring in the first place, as is the coercive control over labor in the production process. If we can acknowledge the contributions of a representative industrial capitalist like Henry Frick, author of the Homestead massacre, to the development of society’s productive forces, I think we can do the same for a swindler like August Belmont.
More broadly, it seems to me that the two modes of profit-seeking that Hudson calls industrial and financial are not the distinct activities they appear as at first glance.
It might seem obvious that profiting from a new, more efficient production process is very different from profiting by using the power of the state to get some legal monopoly or just compel people to pay you. It is true that the first involves real gains for society while the second does not. But how do those social gains come to be claimed as profit by the capitalist? First, by the exclusive access they have to the means of production that allows them to claim the product, to the exclusion of everyone else who helped produce it. And second, by their ability to sell it at a price above its cost of production that allows them to profit, rather than everyone who consumes the product. In that sense, the features that Hudson points to as defining financial capitalism are just as fundamental to industrial capitalism. Under capitalism, making a product is not a distinct goal from extracting a rent. Capturing rents is the whole point.
The development of industry may be socially progressive in a way that the development of finance is not. But that doesn’t mean that the income and authority of the industrial capitalist is different from that of the financial capitalist, or even that they are distinct people.
Hudson is aware of this, of course, and mentions that from a Marxist standpoint the capitalist is also a rentier. If he followed this thought further I think he would find it creates problems for the dichotomy he is arguing for.
Let’s take a step back.
Capital is a process, a circuit: M – C – P – C’ – M’. Money is laid out to gain control of commodities and labor power, which are the combined in a production process. The results of this process are then converted back into money through sale on the market.
At some points in this circuit, capital is embodied in money, at other points in labor power and means of production. We often think of this circuit as happening at the level of an individual commodity, but it applies just as much at larger scales. We can think of the growth of an industrial firm as the earlier part of the circuit where value comes to be embodied in a concrete production process, and payouts to shareholders as the last part where value returns to the money form.
This return to money form just as essential to the circuit of capital as production is. It’s true that payouts to shareholders absorb large fraction of profits, much larger than what they put in. We might see this as a sign that finance is a kind of parasite. But we could also see shareholder payouts as where the M movement is happening. Industrial production doesn’t require that its results be eventually realized as money. But industrial capitalism does. From that point of view, the financial engineers who optimize the movement of profits out of the firm are as integral a part of industrial capital as the engineer-engineers who optimize the production process.
2.
My second concern is with the historical dimension of the story. The sense one gets from the paper is that there used to be industrial capitalism, and now there is financial capitalism. But I don’t think history works like that.
It is certainly true that the forms in which a surplus is realized as money have changed over time. And it is also true that while capital is a single process, there are often different human beings and institutions embodying it at different points in the circuit.
In a small business, the same person may have legal ownership of the enterprise, directly manage the production process, and receive the profits it generates. Hudson is certainly right that this form of enterprise was more common in the 19th century, which among other things allowed Marx to write in Volume One about “the capitalist” without having to worry too much about exactly where this person was located within the circuit. In a modern corporation, by contrast, production is normally in the hands of professional managers, while the surplus flows out to owners of stock or other financial claims. This creates the possibility for the contradiction between the conditions of generating a surplus and of realizing it, which always exists under capitalism, to now appear as a conflict between distinct social actors.
The conversion of most large enterprises to publicly traded corporations took place in the US in a relatively short period starting in the 1890s. The exact timing is of course different elsewhere, but this separation of ownership and control is a fairly universal phenomenon. Even at the time this was perceived as a momentous change, and if we are looking for a historical break that I think this is where to locate it. Already by the early 20th century, the majority of great fortunes took the form of financial assets, rather than direct ownership of businesses. And we can find contemporary observers like Veblen describing “sabotage” of productive enterprises by finance (in The Price System and the Engineers) in terms very similar to the ones that someone like Michael Hudson uses today.
It’s not unreasonable to describe this change as financialization. But important to realize it’s not a one-way or uniform transition.
In 1930s, Keynes famously described American capital development as byproduct of a casino, again in terms similar to Hudson’s. In The General Theory, an important part of the argument is that stock markets have a decisive influence on real investment decisions. But the funny thing is that at that moment the trend was clearly in the opposite direction. The influence of financial markets on corporate managers diminished after the 1920s, and reached its low point a generation or so after Keynes wrote.
If we think of financialization as the influence of financial markets over the organization of production, what we see historically is an oscillation, a back and forth or push and pull, rather than a well-defined before and after. Again, the timing differs, but the general phenomenon of a back and forth movement between more and less financialized capitalism seems to be a general phenomenon. Postwar Japan is often pointed to, with reason, as an example of a capitalist economy with a greatly reduced role for financial markets. But this was not a survival from some earlier era of industrial capitalism, but rather the result of wartime economic management, which displaced financial markets from their earlier central role.
Historically, we also find that moves in one direction in one place can coexist with or even reinforce moves the other way elsewhere. For example, the paper talks about the 19th-century alliance of English bankers and proto-industrialists against landlords in the fight to overturn the corn laws. Marx of course agreed that this was an example of the progressive side of capitalist development. But we should add that the flip side of Britain specializing in industry within the global division of labor was that other places came to specialize more in primary production, with a concomitant increase in the power of landlords and reliance on bound labor. Something we should all have learned from the new historians of capitalism like Sven Beckert is how intimately linked were the development of wage labor and industry in Britain and the US North with he development of slavery and cotton production in the US South; indeed they were two sides of the same process. Similar arguments have been made linking the development of English industry to slave-produced sugar (Williams), and to the second serfdom and de-urbanization in Eastern Europe (Braudel).
Meanwhile, as theorists of underdevelopment like Raul Prebisch have pointed out, it’s precisely the greater market power enjoyed by industry relative to primary products that allows productivity gains in industry to be captured by the producers, while productivity gains in primary production are largely captured by the consumers. We could point to the same thing within the US, where tremendous productivity advances in agriculture have led to cheap food, not rich farmers. Here again, the relationship between the land-industry binary and the monopoly-competition binary is the opposite as Hudson’s story. This doesn’t mean that they always line up that way, either, but it does suggest that the relationship is at least historically contingent.
3.
Let’s turn now to the present. As we all know, since 1980 the holders of financial assets have reasserted their claims against productive enterprises, in the US and in much of the rest of the world. But I do not think this implies, as Hudson suggests, that today’s leading capitalists are the equivalent of feudal landowners. While pure rentiers do exist, the greatest accumulations of capital remain tied to control over the production process.
Even within the financial sector, extraction is only part of the story. A major development in finance over the past generation has been the growth of specialized venture capital and private equity funds. Though quite different in some ways — private equity specializing in acquisition of existing firms, venture capital in financing new ones — both can be seen as a kind of de-financialization, in the sense that both function to re-unite management and ownership. It is true of course, that private equity ownership is often quite destructive to the concrete production activities and social existence of a firm. But private equity looting happens not through the sort of arm’s length tribute collection of al landlord, but through direct control over the firm’s activity. The need for specialized venture capital funds to invest in money-losing startups, on the other hand, is certainly consistent with the view that strict imposition of financial criteria is inconsistent with development of production. But it runs against a simple story in which industry has been replaced by finance. (Instead, the growth of these sectors looks like an example of the way the capital looks different at different moments in its circuit. Venture capitalists willing to throw money at even far-fetched money-losing enterprises, are specialists in the M-C moment, while the vampires of private equity are specialists in C-M.)
It is true, of course, that finance as an industry has grown relative to the economy over the past 50 years, as have the payments made by corporations to shareholders. Hudson describes these trends as a “relapse back toward feudalism and debt peonage”, but I don’t think that’s right. The creditor and the landlord stand outside the production process. A debt peon has direct access to means of production, but is forced to hand over part of the product to the creditor or landlord. Capitalists by contrast get their authority and claim on surplus from control over the production process. This is as true today as when Marx wrote.
There is a widespread view that gains from ownership of financial assets have displaced profits from production even more many nonfinancial corporations, and that household debt service is a form of exploitation that now rivals the work place as a source of surplus, as households are forced to take on more debt to meet their subsistence needs. But these claims are mistaken — they confuse the temporary rise in interest rates after 1980 for a deeper structural shift.
As Joel Rabinovichconvincingly shows, the increased financial holdings of nonfinancial corporations mostly represent goodwill from mergers and stakes in subsidiaries, not financial assets in the usual sense, while the apparent rise in their financial income of in the 1980s is explained by the higher interest on their cash holdings. With respect to household debt, it continues to overwhelmingly finance home ownership, not consumption; is concentrated in the upper part of the income distribution; and rose as a result of the high interest rates after 1980, not any increase in household borrowing. (See my discussion here.) With the more recent decline in interest rates, much of this supposed finacialization has reversed. Contrary to Hudson’s picture of an ever-rising share of income going to debt service, interest payments in the US now total about 17 percent of GDP, the same as in 1975.
On the other side, the transformation of the production process remains the source of the biggest concentrations of wealth. Looking at the Forbes 400 list of richest Americans, it is striking how rare generalized financial wealth is, as opposed to claims on particular firms. Jeff Bezos (#1), Bill Gates (#2) and Mark Zuckerberg (#3) all gained their wealth through control over newly created production processes, not via financial claims on existing ones. Indeed, of the top 20 names on the list, all but one are founders and active managers of companies or their immediate families. (The lone exception is Warren Buffet.) Finance and real estate are the source of a somewhat greater share of the fortunes found further down the list, but nowhere near a majority.
Companies like Wal Mart and Google and Amazon are clearly examples of industrial capitalism. They sell products, they lower prices, they put strong downward pressure on costs. Cheap consumer goods at Wal Mart lower the costs of subsistence for workers today just as cheap imported food did for British workers in the 19th century.
Does this mean Amazon and Wal Mart are good? No, of course not. (Tho we shouldn’t deny that their logistical systems are genuine technological accomplishments that a socialist society could build on.) My point is that the greatest concentrations of wealth today still arise from the competition to sell more desirable goods at lower prices. This runs against the idea of dominance by rentiers or passive rent-extractors.
Finally, I have some concerns about the political implications of this analysis. If we take Hudson’s story seriously, we may see a political divide between industrial capital and finance capital, and the possibility of a popular movement seeking alliance with the former. I am doubtful about this. While finance is a distinct social actor, I do not think it is useful to think of it as a distinct type of capital, one that is antagonistic to productive capital. As I’ve written elsewhere, it’s better to see finance as weapon by which the claims of wealth holders are asserted against the rest of society.
Certainly I don’t think the human embodiments of industrial capital would agree that they are victims of finance. Many of the features of contemporary capitalism he objects would appear to them as positive developments. Low wages, weak labor and light taxes are desired by capitalists in general, not just landlords and bankers. The examples Hudson points to of industrial capitalists and their political representatives supporting measures to socialize the costs of reproduction are real and worth learning from, but as products of specific historical circumstances rather than as generic features of industrial capitalism. We would need a better account of the specific conditions under which capital turns to programs for reducing labor costs in this way — rather than, for example, simply forcing down wages — to assess to what extent, and in which areas, they exist today.
Even if it were feasible, I am not sure this kind of program does much to support a more transformative political project. Hudson quotes Simon Patten’s turn-of-the-last-century description of public services like education as a “fourth factor of production” that is necessary to boost industrial competitiveness, with the implication that similar arguments might be successful today. Frankly, this kind of language strikes me as more characteristic of our neoliberal era than a basis for an alternative to it. As a public university teacher, I reject the idea that my job is to raise the productive capacity of workers, or reduce the overhead costs of American capital. Nor do I think we will be successful in defending education and other public goods from defunding and austerity using this language. And of course, it is not the only language available to us. As Mike Konczal notes in his new book Freedom from the Market, historically the case for public provision has often been made in terms of removing certain areas of life from the market, as well as the kinds of arguments Hudson describes.
More fundamentally, the framing here suggests that the objectionable features of capitalism stem from it not being capitalist enough. The focus on monopolies and rents suggests that what is wanted is more vigorous market competition. It is a strikingly Proudhonian position to say that the injustice and waste of existing capitalism stem from the failure of prices to track costs of production. Surely from a Marxist perspective it is precisely the pressure to compete on the basis of lower costs that is the source of that injustice and waste.
There is a great deal that is interesting and insightful in this paper, as there always is in Michael Hudson’s work. But I remain unconvinced that financial and industrial capitalism can be usefully thought of as two opposed systems, or that we can tell a meaningful historical story about a transition between them. Industry and finance are better thought of, in my view, as two different sides of the same system, or two moments in the same circuit of capital.Capitalism is a system in which human creative activity is subordinated to the endless accumulation of money. In this sense, finance is as integral to it as production. A focus on on the industrial-financial divide risks attributing the objectionable effects of accumulation to someone else — a rentier or landlord — leaving a one-sided and idealized picture of productive capital as the residual.
This being URPE, many people here will have at one time or another sung “is there aught we have in common with the greedy parasites?” Do we think those words refer to the banker only, or to the boss?
UPDATE: My colleague Julio Huato made similar arguments in response to an earlier version of Hudson’s paper a few years ago, here.
In the five thousand years that interest rates have been recorded, they’ve never hit zero before.Today, there’s some $15 trillion in negative-yielding bonds — admittedly down from $17 trillion last year, but still a very substantial fraction of the global bond market outside the US. At first it was only shorter bonds that were negative, but today German bunds are negative all the way out to 30 years. What’s going on? Does this mean it would be profitable to bulldoze the Rockies for farmland? Will it cause the extinction of the banking system? And more fundamentally, if the interest rate reflects the cost of a good today in terms of the same good next year, why would it ever be negative? Why would people place a higher value on stuff in the future than on stuff today?
Personally, I don’t think they’re so weird. And the reason I think that is that interest rates are not, in fact, the price of goods today in terms of goods tomorrow. It is, rather, the price of a financial asset that promises a certain schedule of money payments. Negative rates are only a puzzle in the real-exchange perspective that dominates economics, where we can safely abstract from money when discussing interest rates. In the money view, where interest transactions are swap of assets, or of a stream of money payments, nothing particularly strange about them.
(I should say up front that this post is an attempt to clarify my own thinking. I think what I’m writing here is right, but I’m open to hearing why it’s wrong, or incomplete. It’s not a finished or settled position, and it’s not backed up by any larger body of work. At best, like most of what I wrote, it is informed by reading a lot of Keynes.)
The starting point for thinking about negative rates is to remember that these are market prices. Government is not setting a negative yield by decree, someone is voluntarily holding all those negative-yielding bonds. Or more precisely, someone is buying a bond at a price high enough, relative to the payments it promises, to imply a negative yield.
Take the simplest example — a government bond that promises a payment of $100 at some date in the future, with no other payments in between. (A zero-coupon bond, in other words.) If the bond sells today for less than $100, the interest rate on it is positive. If the bond sells today for more than $100, the interest rate is negative. Negative yields exist insofar market participants value such a bond at greater than $100.
So now we have to ask, what are the sources of demand for government bonds?
A lot of confusion is created, I think, by asking this question the wrong way. People think about saving, and about trading off spending today against spending tomorrow. This after all is the way an economics training encourages you to think about interest rates — as a shorthand for any exchange between present and future. Any transaction that involves getting less today in return for more tomorrow incorporates the interest rate as part of the price — at a high enough level of abstraction, they’re all the same thing. The college wage premium, say, is just as much an interest rate from this perspective as the yield on the bond.
If we insist on thinking of interest rates this way, we would have to explain negative yields in terms of a society-wide desire to defer spending, and/or the absence of any store of wealth that even maintains its value, let alone increases it. Either of those would indeed be pretty weird!
(Or, it would be the equivalent of people paying more for a college education than the total additional wages they could expect to earn from it, or people paying more for a house than the total cost of renting an identical one for the rest of their lives. Which are both things that might happen! But also, that would be generally seen as something going wrong in the economic system.)
Since economists (and economics-influenced people) are so used to thinking of interest as reflecting a tradeoff between present and future, a kind of inter-temporal exchange rate, it’s worth an example to clarify why it isn’t. Imagine a typical household credit transaction, a car loan. The household acquires means to pay for the acquisition of a car, and commits to a schedule of payments to the bank; the bank gets the opposite positions. Is the household giving up future consumption in order to consume now? No. At every period, the value the household gets from the use of the car will exceed the payments the household is making for it — otherwise, they wouldn’t be doing it. If anything, since the typical term of a car loan is six or seven years while a new car should remain in service for a decade or more, the increased consumption comes in the future, when the car is paid off and still delivering transport services. Credit, in general, finances assets, not consumption. The reason car loans are needed is not to shift consumption from the future to the present, but because use of the transportation services provided by the car are tightly bound up with ownership of the car itself.
Nor, of course, is the lender shifting present consumption to the future. The lender itself, being a bank, does not consume. And no one else needs to forego or defer consumption for the banks to make the auto loan either. No one needs to deposit savings in a bank before it makes a loan; the lent money is endogenous, created by banks in the course of lending it. Whatever factors limit the willingness of the bank to extend additional auto loans — risk; liquidity; capital; regulation; transaction costs — a preference for current consumption is not among them.
The intertemporal-exchange way of looking at government bonds would make sense if the only way to acquire one was to forego an equal amount of consumption, so that bond purchases were equivalent to saving in an economic sense. Then understanding the demand for government bonds, would be the same as understanding the desire to save, or defer consumption. But of course government bonds are not part of some kind of economy-wide savings equilibrium like that. First of all, the purchasers of bonds are not households, but banks and other financial actors. Second, the purchase of the bond does not entail a reduction in current spending, but a swap of assets. And third, the owners of bonds do not hold them in order to finance some intended real expenditure in the future, but rather for some combination of benefits from owning them (liquidity, safety, regulation) and an expectation of monetary profit.
From the real-exchange perspective, there is one intertemporal price — the interest rate —just as there is one exchange rate between any given pair of countries. From the money view perspective, there are many different interest rates, corresponding to the different prices of different assets promising future payments. Many of the strong paradoxes people describe from negative rates only exist if rates are negative across the board. But in reality, rates do not move in lockstep. We will set aside for now the question of how strong the arbitrage link between different assets actually is.
We can pass over these questions because, again, government bonds are not held for income. They are not held by households or the generic private sector. They are overwhelmingly held by banks and bank-like entities for some combination of risk, liquidity and regulatory motives, or by a broader set of financial institutions for return. Note for later: Return is not the same as income!
Let’s take the first set of motivations first.
If you are a bank, you may want to hold some fraction of your assets as government bonds in order to reduce the chance your income will be very different from what you expected; reduce the chance that you will find yourself unable to make payments that you need or want to make (since it’s easy to sell the bonds as needed); and/or to reduce the chance that you’ll fall afoul of regulation(which presumably is there because you otherwise might neglect the previous two goals).
The key point here is that these are benefits of holding bonds that are in addition to whatever return those bonds may offer. And if the ownership of government bonds provides substantial benefits for financial institutions, it’s not surprising they would be willing to pay for those services.
This may be clearer if we think about checking accounts. Scare stories about negative rates often ask what happens when households have to pay for the privilege of lending money to the bank. Will they withdraw it all as cash and keep it under the mattress? But of course, paying the bank to lend it money is the situation most people have always been in. Even before the era of negative rates, lots of people held money in checking accounts that carried substantial fees (explicit and otherwise) and paid no interest, or less than the cost of the fees. And of course unbanked people have long paid exorbitant amounts to be able to make electronic payments. In general, banks have no problem getting people to hold negative-yield assets. And why would they? The payments services offered by banks are valuable. The negative yield just reflects people’s willingness to pay for them.
In the national accounts, the difference between the interest that bank depositors actually receive and a benchmark rate that they in some sense should receive is added to their income as “imputed interest”, which reflects the value of the services they are getting from their low- or no- or negative-interest bank accounts. In 2019, this imputed interest came to about $250 billion for households and another $300 billion for non financial corporations. These nonexistent interest payments are, to be honest, an odd and somewhat misleading thing to include in the national accounts. But their presence reflects the genuine fact that people hold negative and more broadly below-market yield assets in large quantities because of other benefits they provide.
Turned around this way, the puzzle is why government debt ever has a positive yield. The fundamental form of a bond sale is the creating of pair of offsetting assets and liabilities. The government acquires an asset in the form of a deposit, which is the liability of the bank; and the bank acquires an asset in the form of a bond, which is the liability of the government. Holding the bond has substantial benefits for the bank, while holding the deposit has negligible benefits for the government. So why shouldn’t the bank be the one that pays to make the transaction happen?
One possible answer is the cost of financing the holding. But, it is normally assumed that the interest rate paid by banks follows the policy rate. There’s no obvious reason for the downward shift in rates to affect spread between bank deposits and government bonds.Of course some bank liabilities will carry higher rates, but again, that was true In the past too.
Another possible answer is the opportunity cost of not holding positive-yield asset. Again, this assumes that other yields don’t move down too. More fundamentally, it assumes a fixed size of bank balance sheets, so that holding more of one asset means less of another. In a world with with a fixed or exogenous money stock, or where regulations and monetary policy create the simulacrum of one, there is a cost to the bank of holding government debt, namely the income from whatever other asset it might have held instead. Many people still have this kind of mental model in thinking about government debt. (It’s implicit in any analysis of interest rates in terms of saving.) But in a world of endogenous credit money, holding more government debt doesn’t reduce a bank’s ability to acquire other assets. Banks’ ability to expand their balance sheets isn’t unlimited, but what limits it is concerns about risk or liquidity, or regulatory constraints. All of these may be relaxed by government debt holdings, so holding more government bonds may increase the amount of other assets banks can hold, not reduce it. In this case the opportunity cost would be negative.
So why aren’t interest rates on government debt usually negative? As a historical matter, I suppose the reasons we haven’t seen negative yields in the past are, first, that under the gold standard, government bonds were not at the top of the hierarchy of money and credit, and governments had to pay to access higher-level money; in some contexts government debt may have been lower in the hierarchy than bank money as well. Second, in the postwar era the use of the interest rate for demand control has required central banks to ensure positive rates on publicas well as private debt. And third, the safety, liquidity and regulatory benefits of government debt holdings for the financial system weren’t as large or as salient before the great financial crisis of 2007-2009.
Even if negative yields aren’t such a puzzle when we think about the sources of bank demand for government debt, we still have the question of how low they can go. Analytically, we would have to ask, how much demand is there for the liquidity, safety and regulatory-compliance services provided by sovereign debt holdings, and to what extent are there substitute sources for them?
But wait, you may be saying, this isn’t the whole story. Bonds are held as assets, not just as reserves for banks and bank-like entities. Are there no bond funds, are there no bond traders?
These investors are the second source of demand for government bonds. For them, return does matter. The goal of making a profit from holding the bond is the second motivation mentioned earlier.
The key point to recognize here is that return and yield are two different things. Yield is one component of return. The other is capital gains. The market price of a bond changes if interest rates change during the life of the bond, which means that the overall return on a negative-yielding bond can be positive. This would be irrelevant if bonds were held to maturity for income, but of course that is not bond investment works.
For foreign holders, return also includes gains or losses from exchange rate changes, but we can ignore that here. Most foreign holders presumably hold government bonds as foreign exchange reserves, which is a subset of the safety/liquidity/regularity benefits discussed above.
To understand how negative yielding bonds could offer positive returns, we have to keep in mind what is actually going on with bond prices, including negative rates. The borrower promises one or more payments of specified amounts at specified dates in the future. The purchaser then offers a payment today in exchange for that stream of future payments. What we call an interest rate is a description of the relationship between the promised payments and the immediate payment. We normally think of interest as something paid over a period of time, but strictly speaking the interest rate is a price today for a contract today. So unlike in the checking account case, the normal negative-rates situation is not the lender paying the borrower.
Here’s an example. Suppose I offer to pay you $100 30 years from now. This is, formally, a zero-coupon 30-year bond. How much will you pay for this promse today?
If you will pay me $41 for the promise, that is the same as saying the interest rate on the loan is 3 percent. (41 * 1.03 ^ 30 = 100). So an interest rate of 3 percent is just another way of saying that the current market price of a promise of $100 30 years from now is $41.
If you will pay me $55 for the promise, that’s the same as an interest rate of 2 percent. If you’ll pay me $74, that’s the same as an interest rate of 1 percent.
If you’ll pay me $100 for the promise, that is of course equivalent to an interest rate of 0. And if you’ll pay me $135 for the promise of $100 30 years from now, that’s the equivalent of an interest of -1 percent.
When we look at things this way, there is nothing special about negative rates. There is just continuous range of prices for an asset. Negative rates refer to the upper part of the range but nothing in particular changes at the boundary between them. Nothing magical or even noticeable happens when the price of an asset (in this case that promise of $100) goes from $99 to $101, any different from when it went from $97 to $99. The creditor is still paying the borrower today, the borrower is still paying the creditor in the future.
Now the next step: Think about what happens when interest rates change.
Suppose I paid $135 for a promise of $100 thirty years from now, as in the example above. Again, this equivalent to an interest rate of -1 percent. Now it’s a year later, so I have a promise of $100 29 years from now. At an interest rate of -1 percent, that is worth $133.50. (The fact that the value of the bond declines over time is another way of seeing that it’s a negative interest rate.) But now suppose that, in the meantime, market interest rates have fallen to -2 percent. That means a promise of $100 29 years from now is now worth $178. (178 * 0.98 ^ 29 = 100.) So my bond has increased in value from $135 to $178, a capital gain of one-third! So if I think it is even modestly more likely that interest rates will fall than that they’ll rise over the next year, the expected return on that negative-yield bond is actually positive.
Suppose that it comes to be accepted that the normal, usual yield on say, German 10-year bunds is -1 percent. (Maybe people come to agree that the liquidity, risk and regulatory benefits of holding them are worth the payment of 1 percent of their value a year. That seems reasonable!) Now, suppose that the yield starts to move toward positive territory – for concreteness, say the current yield reaches 0, while people still expect the normal yield to be -1 percent. This implies that the rise to 0 is probably transitory. And if the ten-year bund returns to a yield of -1 percent, that implies a capital gain on the order of 10 percent for anyone who bought them at zero. This means that as soon as the price begins to rise toward zero, demand will rise rapidly. And the bidding-up of the price of the bund that happens in response to the expected capital gains, will ensure that the yield never in fact reaches zero, but stops rising before gets much above -1 percent.
Bond pricing is a technical field, which I have absolutely no expertise in. But this fundamental logic has to be an important factor in decisions by investors (as opposed to financial institutions) who hold negative-yielding bonds in their portfolios. The lower you expect bond yields to be in the future, the higher the expected return on a bond with a given yield today. If a given yield gets accepted as usual or normal, then expected capital gains will rise rapidly when the yield rises above that — a dynamic that will ensure that the actual yield does not in fact depart far from the normal one. Capital gains are a bigger part of the return the lower the current yield is. So while high-yielding bonds can see price moves in response to fundamentals (or at least beliefs about them), these self-confirming expectations (or conventions) are likely to dominate once yields fall to near zero.
These dynamics disappear when you think in terms of an intertemporal equilibrium where future yields are known and assets are held to maturity. When we think of trading off consumption today for consumption tomorrow, we are implicitly imagining something equivalent to holding bond to maturity. And of course if you have a model with interest rates determined by some kind of fundamentals by a process known to the agents in the model — what is called model-consistent or rational expectations — than it makes to sense to say that people could believe the normal or “correct” level of interest rates is anything other than what it is. So speculation is excluded by assumption.
Keynes understand all this clearly, and the fact that the long-term interest rate is conventionally determined in this way is quite important to his theory. But he seems never to have considered the possibility of negative yields. As a result he saw the possibility of capital gains as disappearing as interest rates got close to zero. This meant that for him, the conventional valuation was not symmetrical, but operated mainly as a floor. But once we allow the possibility of negative rates, conventional expectations can prevent a rise in interest rates just as easily as a fall.
In short, negative yields are a puzzle and a problem in the real exchange paradigm that dominates economic conversation, in which the “interest rate” is the terms on which goods today exchange for goods in the future. But from the money view, where the interest rate is the (inverse of) the price of an asset yielding a flow of money payments, there is nothing especially puzzling about negative rates. It just implies greater demand for the relevant assets. A corollary is that while there should be a single exchange rate between now and later, the prices of different assets may behave quite differently. So while many of the paradoxes people pose around negative rates assume that all rates go negative together, in the real world the average rate on US credit cards, for example, is still about 15 percent — the same as it was 20 years ago.
In the future, the question people may ask is not how interest rates could be negative, but why was it that the government for so long paid the banks for the valuable services its bonds offered them?
