Author: JW Mason

Inflation for Whom?

A point I’ve been emphasizing about inflation (see here and here) is that it is just an average of price changes; it doesn’t have any independent existence.

One implication of this is that there is not, even in principle, a true inflation rate. Pick any basket of goods and measure their prices over time; that is an inflation rate. The “all urban consumers” basket used by the BLS for the headline CPI inflation rate is a useful benchmark, but it’s just one basket among others. Any individual household or subgroup of households will have its own consumption basket and corresponding inflation rate.

Because a small number of items have gone up in price a lot recently, the average price increase in the CPI basket is greater than increase in wages over the past year. In this sense, real wages have gone down. I am not convinced this is a meaningful statistic. For one thing, car prices are almost certain to come back down over the next year, once the current semiconductor bottleneck is relieved and manufacturers ramp up output. Wage gains, on the other hand, have a lot of inertia. This year’s wage gains are likely to continue; certainly they will not be given back.

But there’s another reason the “falling real wage” claim is misleading. When price increases are concentrated in a few areas, the inflation rate facing people who are buying stuff in those areas will be very different from the rate facing those who are not. Most Americans do buy a car every few years, but relatively few need to buy a car right now.1 And even averaged over time, different groups of people spend more or less on cars relative to other things. The same goes for other categories of spending.

The BLS’s Consumer Expenditure Survey (CEX) tries to measure the distribution of consumption spending by different demographic groups. In principle, you could construct a separate CPI for each group, like CPI-E the BLS reports for elderly households. (For what it’s worth the CPI-E increased by 4.8 percent over the past year, a bit slower than the headline rate.) In practice the challenges in doing this are formidable — for the headline measure weights can be based on retail sales, but the weights for demographic group have to be based on household surveys, which are slower and much less reliable. (I have some discussion of these issues in Section 7 of this paper.) Still, the CEX can give us at least a rough sense of the difference in consumption baskets and inflation rates across different groups.

It’s particularly interesting to look at consumption baskets across income groups. One of the central arguments for running the economy hot is that it tends to compress wages. From this point of view, an increase in prices paid disproportionately by lower income households is more concerning than a similar aggregate increase in prices paid more by the better off.

For this post, I chose to focus on the consumption basket of households with pre-tax income below $30,000 a year — about one quarter of the population.

In the table below, I show 20 items, accounting for almost 95% of the CPI basket. The first column shows its share of the CPI-U basket, taken from the most recent CPI Table 2. The second column shows the difference between the weight of the item in consumption by households earning less than $30,000 and its weight in total consumption.2 So a positive value means something that makes up a larger share of consumption for households with incomes under $30,000 than of consumption for the population as a whole. This comes from the most recent Consumer Expenditure Survey, covering July 2019 through June 2020. The third column shows the price change of that item from July 2020 to July 2021, again from CPI Table 2. The items are ordered from the ones that make up the largest relative share of the consumption basket for low-income households to the ones that make up the smallest relative share. So it gives at least a rough sense of the different inflations experienced by lower versus higher income families.

Expenditure Category Overall share (CPI) Relative share, income <$30k (CEX) Inflation, July 2020-July 2021 (CPI)
Rent of primary residence 7.6 8.3 1.9
Food at home 7.6 2.4 2.6
Electricity 2.5 1.5 4
Medical care services 7.1 1 0.8
Medical care commodities 1.5 0.35 -2.1
Recreation commodities 2.0 0.35 3.2
Water and sewer and trash collection 1.1 0.3 3.7
Education and communication services 6.1 0.2 1.2
Motor fuel 3.8 0.2 41.6
Utility (piped) gas service 0.7 0.2 19
Apparel 2.7 0.2 4.2
Motor vehicle parts and equipment 0.4 0.05 4.3
Fuel oil and other fuels 0.2 0.05 30.9
New vehicles 3.7 -0.15 6.4
Transportation services 5.3 -0.15 6.4
Lodging away from home 1.0 -0.3 21.5
Used cars and trucks 3.5 -0.3 41.7
Alcoholic beverages 1.0 -0.3 2.4
Food away from home 6.2 -0.35 4.6
Recreation services 3.7 -0.6 3.7
Household furnishings and supplies 3.7 -0.7 3
Owners’ equivalent rent 22.4 n/a3 2.4

As you can see, the items that are increasing at less than 2 percent a year — highlighted in blue — are all things disproportionately consumed by lower-income households. Rent, in particular, makes up a much higher share of spending for low-income households. Rent growth slowed sharply during the pandemic and, unlike many other prices, it has not so far accelerated again. Rent growth over the past year is about half the average rate in the three years before the pandemic.

Medical goods and services also make up a larger share of spending for lower-income households; prices there have grown slowly or income cases actually fallen over the past year. Prescription drug prices, for example, fell by 2 percent over the past year. Finally, education services, including childcare, have pulled inflation down over the past year, rising by about 1 percent (college tuition was flat.) Education inflation has been slowing for a long time — a trend I don’t recall seeing discussed much — but it slowed even more during the pandemic. Education and childcare make up a slightly higher fraction of spending for low-income households than for others.

On the other side, almost all the sectors where inflation is notably high — highlighted in red — make up a larger share of spending for higher-income households. Lodging away from home, for example, where prices are up over 20 percent, makes up less than 1 percent of the consumption basket for households with incomes under $30,000, but 2.5 percent of the basket for households with incomes over $200,000. Transportation services, food away from home, and new and used cars, which account for  the majority of non-energy inflation, are also disproportionately consumed by higher income households.

In general, it seems clear that lower-income households are facing less inflation than higher income ones. The biggest price increases are in areas that are disproportionately consumed by higher-income families, while several of the most important consumption categories for lower-income families are seeing prices rise more slowly than before the pandemic. Any discussion of “falling real incomes” that ignores this fact is at best incomplete.

There is, of course, one big exception: energy. Gasoline especially, but also electricity and heating gas, are seeing big price increases and make up a larger share of consumption for lower-income families. And unlike auto purchases, energy consumption can’t be postponed. If you want to tell a story about higher prices eating up wage gains, it seems to me that energy is your best bet.

Except, of course, that these are prices that we want to see rise, if we are serious about climate change. Many of the same people fretting about inflation eroding real wages, are strong supporters of carbon taxes or permits. If you think a goal of policy is to raise the relative price of fossil fuels, why object when it happens via the market?

At the end of the day, perhaps the current debate about inflation and real wages doesn’t belong in the macroeconomics box at all, but in the climate box. The difficult problem here is not how to keep demand strong enough to raise wages without also raising prices. The price spikes we’re seeing right now are mainly about short-term supply constraints. I am confident that prices for autos and many other goods will  come back down or at least stabilize over the next year, even if demand remains strong. The really difficult problem is how we make the transition away from fossil fuels without unacceptably burdening the people who are currently dependent on them.

UPDATE: I am getting some very confused readers, who note that historically rent, education and health care have historically risen in price faster than most goods, while in this post I’m saying they are rising more slowly. The original post, should have, but did not, make clear that the pattern of price changes over the past year or so is quite different from what we are used to. That said, this is not all about the pandemic. As I did note, inflation in education has been slowing for a long time; health care inflation has fallen dramatically during the pandemic but was also slowing before that, arguably thanks to the ACA. But the key point is that I am not saying that poor people face lower inflation in general; I’m saying this is a distinct feature of the inflation we’re experiencing now.

Alternative Visions of Inflation

Like many people, I’ve been thinking a bit about inflation lately. One source of confusion, it seems to me, is that underlying concept has shifted in a rather fundamental way, but the full implications of this shift haven’t been taken on board.

I was talking with my Roosevelt colleague Lauren Melodia about inflation and alternative policies to manage it, which is a topic I hope Roosevelt will be engaging in more in the later part of this year. In the course of our conversation, it occurred to me that there’s a basic source of confusion about inflation. 

Many of our ideas about inflation originated in the context of a fixed quantity money. The original meaning of the term “inflation” was an increase in the stock of money, not a general increase in the price level. Over there you’ve got a quantity of stuff; over here you’ve got a quantity of money. When the stock of money grows rapidly and outpaces the growth of stuff, that’s inflation.

 In recent decades, even mainstream economists have largely abandoned the idea of the money stock as a meaningful economic quantity, and especially the idea that there is a straightforward relationship between money and inflation.

Here is what a typical mainstream macroeconomics textbook — Olivier Blanchard’s, in this case; but most are similar — says about inflation today. (You can just read the lines in italics.) 

There are three stories about inflation here: one based on expected inflation, one based on markup pricing, and one based on unemployment. We can think of these as corresponding to three kinds of inflation in the real world — inertial, supply-driven, and demand-driven. What there is not, is any mention of money. Money comes into the story only in the way that it did for Keynes: as an influence on the interest rate. 

To be fair, the book does eventually bring up the idea of a direct link between the money supply and inflation, but only to explain why it is obsolete and irrelevant for the modern world:

Until the 1980s, the strategy was to choose a target rate of money growth and to allow for deviations from that target rate as a function of activity. The rationale was simple. A low target rate of money growth implied a low average rate of inflation. … 

That strategy did not work well.

First, the relation between money growth and inflation turned out to be far from tight, even in the medium run. … Second, the relation between the money supply and the interest rate in the short run also turned out also to be unreliable. …

Throughout the 1970s and 1980s, frequent and large shifts in money demand created serious problems for central banks. … Starting in the early 1990s, a dramatic rethinking of monetary policy took place based on targeting inflation rather than money growth, and the use of an interest rate rule.

Obviously, I don’t endorse everything in the textbook.4 (The idea of a tight link between unemployment and inflation is not looking much better than the idea of a tight link between inflation and the money supply.) I bring it up here just to establish that the absence of a link between money growth and inflation is not radical or heterodox, but literally the textbook view.

One way of thinking about the first Blanchard passage above is that the three stories about inflation correspond to three stories about price setting. Prices may be set based on expectations of where prices will be, or prices may be set based on market power (the markup), or prices may be set based on costs of production. 

This seems to me to be the beginning of wisdom with respect to inflation: Inflation is just an increase in prices, so for every theory of price setting there’s a corresponding theory of inflation. There is wide variation in how prices get set across periods, countries and markets, so there must be a corresponding variety of inflations. 

Besides the three mentioned by Blanchard, there’s one other story that inflation is perhaps even more widespread. We could call this too much spending chasing too little production. 

The too-much-spending view of inflation corresponds to a ceiling on output, rather than a floor on unemployment, as the inflationary barrier. As the NAIRU has given way to potential output as the operational form of supply constraints on macroeconomic policy, this understanding of inflation has arguably become the dominant one, even if without formalization in textbooks. It overlaps with the unemployment story in making current demand conditions a key driver of inflation, even if the transmission mechanism is different. 

Superfically “too much spending relative to production” sounds a lot like “too money relative to goods.” (As to a lesser extent does “too much wage growth relative to productivity growth.”) But while these formulations sound similar, they have quite different implications. Intuitions formed by the old quantity-of-money view don’t work for the new stories.

The older understanding of inflation, which runs more or less unchanged from David Hume through Irving Fisher to Milton Friedman and contemporary monetarists, goes like this. There’s a stock of goods, which people can exchange for their mutual benefit. For whatever reasons, goods don’t exchange directly for other goods, but only for money. Money in turn is only used for purchasing goods. When someone receives money in exchange for a good, they turn around and spend it on some good themselves — not instantly, but after some delay determined by the practical requirements of exchange. (Imagine you’ve collected your earnings from your market stall today, and can take them to spend at a different market tomorrow.) The total amount of money, meanwhile, is fixed exogenously — the quantity of gold in circulation, or equivalently the amount of fiat tokens created by the government via its central bank.

Under these assumptions, we can write the familiar equation

MV = PY

If Y, the level of output, is determined by resources, technology and other “real” factors, and V is a function of the technical process of exchange — how long must pass between the receipt of money and it spending — then we’re left with a direct relationship between the change in M and the change in P. “Inflation is always and everywhere a monetary phenomenon.”5

I think something like this underlies most folk wisdom about inflation. And as is often the case, the folk wisdom has outlived whatever basis in reality it may once have had.6

Below, I want to sketch out some ways in which the implications of the excessive-spending-relative-to-production vision of inflation are importantly different from those of the excessive-money-relative-to-goods vision. But first, a couple of caveats.

First, the idea of a given or exogenous quantity of money isn’t wrong a priori, as a matter of logic; it’s an approximation that happens not to fit the economy in which we live. Exactly what range of historical settings it does fit is a tricky question, which I would love to see someone try to answer. But I think it’s safe to say that many important historical inflations, both under metallic and fiat regimes, fit comfortably enough in a monetarist framework. 

Second, the fact that the monetarist understanding of inflation is wrong (at least for contemporary advanced economies) doesn’t mean that the modern mainstream view is right. There is no reason to think there is one general theory of inflation, any more than there is one general etiology of a fever. Lots of conditions can produce the same symptom. In general, inflation is a persistent, widespread rise in prices, so for any theory of price-setting there’s a corresponding theory of inflation. And the expectations-based propagation mechanism of inertial inflation — where prices are raised in the expectation that prices will rise — is compatible with many different initial inflationary impulses. 

That said — here are some important cleavages between the two visions.

1. Money vs spending. More money is just more money, but more spending is always more spending on something in particular. This is probably the most fundamental difference. When we think of inflation in terms of money chasing a given quantity of goods, there is no connection between a change in the quantity of money and a change in individual spending decisions. But when we think of it in terms of spending, that’s no longer true — a decision to spend more is a decision to spend more on some specific thing. People try to carry over intuitions from the former case to the latter, but it doesn’t work. In the modern version, you can’t tell a story about inflation rising that doesn’t say who is trying to buy more of what; and you can’t tell a story about controlling inflation without saying whose spending will be reduced. Spending, unlike money, is not a simple scalar.

The same goes for the wages-markup story of the textbook. In the model, there is a single wage and a single production process. But in reality, a fall in unemployment or any other process that “raises the wage” is raising the wages of somebody in particular.

2. Money vs prices. There is one stock of money, but there are many prices, and many price indices. Which means there are many ways to measure inflation. As I mentioned above, inflation was originally conceived of as definitionally an increase in the quantity of money. Closely related to this is the idea of a decrease in the purchasing power of money, a definition which is still sometimes used. But a decrease in the value of money is not the same as an increase in the prices of goods and services, since money is used for things other than purchasing goods and services.  (Merijn Knibbe is very good on this.7) Even more problematically, there are many different goods and services, whose prices don’t move in unison. 

This wasn’t such a big deal for the old concept of inflation, since one could say that all else equal, a one percent increase in the stock of money would imply an additional point of inflation, without worrying too much about which specific prices that showed up in. But in the new concept, there’s no stock of money, only the price changes themselves. So picking the right index is very important. The problem is, there are many possible price indexes, and they don’t all move in unison. It’s no secret that inflation as measured by the CPI averages about half a point higher than that measured by the PCE. But why stop there? Those are just two of the infinitely many possible baskets of goods one could construct price indexes for. Every individual household, every business, every unit of government has their own price index and corresponding inflation rate. If you’ve bought a used car recently, your personal inflation rate is substantially higher than that of people who haven’t. We can average these individual rates together in various ways, but that doesn’t change the fact that there is no true inflation rate out there, only the many different price changes of different commodities.

3. Inflation and relative prices. In the old conception, money is like water in a pool. Regardless of where you pour it in, you get the same rise in the overall level of the pool.

Inflation conceived of in terms of spending doesn’t have that property. First, for the reason above — more spending is always more spending on something. If, let’s say for sake of argument, over-generous stimulus payments are to blame for rising inflation, then the inflation must show up in the particular goods and services that those payments are being used to purchase — which will not be a cross-section of output in general. Second, in the new concept, we are comparing desired spending not to a fixed stock of commodities, but to the productive capacity of the economy. So it matters how elastic output is — how easily production of different goods can be increased in response to stronger demand. Prices of goods in inelastic supply — rental housing, let’s say — will rise more in response to stronger demand, while prices of goods supplied elastically — online services, say — will rise less. It follows that inflation, as a concrete phenomenon, will involve not an across-the-board increase in prices, but a characteristic shift in relative prices.

This is a different point than the familiar one that motivates the use of “core” inflation — that some prices (traditionally, food and energy) are more volatile or noisy, and thus less informative about sustained trends. It’s that  when spending increases, some goods systematically rise in price faster than others.

This recent paper by Stock and Watson, for example, suggests that housing, consumer durables and food have historically seen prices vary strongly with the degree of macroeconomic slack, while prices for gasoline, health care, financial services, clothing and motor vehicles do not, or even move the opposite way. They suggest that the lack of a cyclical component in health care and finance reflect the distinct ways that prices are set (or imputed) in those sectors, while the lack of a cyclical component in gas, clothing and autos reflects the fact that these are heavily traded goods whose prices are set internationally. This interpretation seems plausible enough, but if you believe these numbers they have a broader implication: We should not think of cyclical inflation as an across the board increase in prices, but rather as an increase in the price of a fairly small set of market-priced, inelastically supplied goods relative to others.

4. Inflation and wages. As I discussed earlier in the post, the main story about inflation in today’s textbooks is the Phillips curve relationship where low unemployment leads to accelerating inflation. Here it’s particularly clear that today’s orthodoxy has abandoned the quantity-of-money view without giving up the policy conclusions that followed from it.

In the old monetarist view, there was no particular reason that lower unemployment or faster wage growth should be associated with higher inflation. Wages were just one relative price among others. A scarcity of labor would lead to higher real wages, while an exogenous increase in wages would lead to lower employment. But absent a change in the money supply, neither should have any effect on the overall price level. 

It’s worth noting here that altho Milton Friedman’s “natural rate of unemployment” is often conflated with the modern NAIRU, the causal logic is completely different. In Friedman’s story, high inflation caused low unemployment, not the reverse. In the modern story, causality runs from lower unemployment to faster wage growth to higher inflation. In the modern story, prices are set as a markup over marginal costs. If the markup is constant, and all wages are part of marginal cost, and all marginal costs are wages, then a change in wages will just be passed through one to one to inflation.

We can ignore the stable markup assumption for now — not because it is necessarily reasonable, but because it’s not obvious in which direction it’s wrong. But if we relax the other assumptions, and allow for non-wage costs of production and fixed wage costs, that unambiguously implies that wage changes are passed through less than one for one to prices. If production inputs include anything other than current labor, then low unemployment should lead to a mix of faster inflation and faster real wage growth. And why on earth should we expect anything else? Why shouldn’t the 101 logic of “reduced supply of X leads to a higher relative price of X” be uniquely inapplicable to labor?8

There’s an obvious political-ideological reason why textbooks should teach that low unemployment can’t actually make workers better off. But I think it gets a critical boost in plausibility — a papering-over of the extreme assumptions it rests on — from intuitions held over from the old monetarist view. If inflation really was just about faster money growth, then the claim that it leaves real incomes unchanged could work as a reasonable first approximation. Whereas in the markup-pricing story it really doesn’t. 

5. Inflation and the central bank.  In the quantity-of-money vision, it’s obvious why inflation is the special responsibility of the central bank. In the textbooks, managing the supply of money is often given as the first defining feature of a central bank. Clearly, if inflation is a function of the quantity of money, then primary responsibility for controlling it needs to be in the hands of whoever is in charge of the money supply, whether directly, or indirectly via bank lending. 

But here again, it seems, to me, the policy conclusion is being asked to bear weight even after the logical scaffolding supporting it has been removed. 

Even if we concede for the sake of argument that the central bank has a special relationship with the quantity of money, it’s still just one of many influences on the level of spending. Indeed, when we think about all the spending decisions made across the economy, “at one interest rate will I borrow the funds for it” is going to be a central consideration in only a few of them. Whether our vision of inflation is too much spending relative to the productive capacity of the economy, or wages increasing faster than productivity, many factors are going to play a role beyond interest rates or central bank actions more broadly. 

One might believe that compared with other macro variables, the policy interest rate has a uniquely strong and reliable link to the level of spending and/or wage growth; but almost no one, I think, does believe this. The distinct responsibility of the central bank for inflation gets justified not on economic grounds but political-institutional ones: the central bank can act more quickly than the legislature, it is free of undue political influence, and so on. These claims may or may not be true, but they have nothing in particular to do with inflation. One could justify authority over almost any area of macroeconomic policy on similar grounds.

Conversely, once we fully take on board the idea that the central bank’s control over inflation runs through to the volume of credit creation to the level of spending (and then perhaps via unemployment to wage growth), there is no basis for the distinction between monetary policy proper and other central bank actions. All kinds of regulation and lender-of-last-resort operations equally change the volume and direction of credit creation, and so influenced aggregate spending just as monetary policy in the narrow sense does.

6. The costs of inflation. If inflation is a specifically monetary phenomenon, the costs of inflation presumably involve the use of money. The convenience of quoting relative prices in money becomes a problem when the value of money is changing.

An obvious example is the fixed denominations of currency — monetarists used to talk with about “shoe leather costs” — the costs of needing to go more frequently to the bank (as one then did) to restock on cash. A more consequential example is public incomes or payments fixed in money terms. As recently as the 1990s, one could find FOMC members talking about bracket creep and eroded Social Security payments as possible costs of higher inflation — albeit with some embarrassment, since the schedules of both were already indexed by then. More broadly, in an economy organized around money payments, changes in what a given flow of money can buy will create problems. Here’s one way to think about these problems:

Social coordination requires a mix of certainty and flexibility. It requires economic units to make all kinds of decisions in anticipation of the choices of other units — we are working together; my plans won’t work out if you can change yours too freely. But at the same time, you need to have enough space to adapt to new developments — as with train cars, there needs to be some slack in the coupling between economic unit for things to run smoothly. One dimension of this slack is the treatment of some extended period as if it were a single instant.

This is such a basic, practical requirements of contracting and management that we hardly think about it. For example, budgets — most organizations budget for periods no shorter than a quarter, which means that as far as internal controls and reporting are concerned, anything that happens within that quarter happens at the same time.9Similarly, invoices normally require payment in 30 or 60 days, thus treating shorter durations as instantaneous. Contracts of all kinds are signed for extended periods on fixed money terms. All these arrangements assume that the changes in prices over a few months or a year are small enough that they can be safely ignored.can be modified when inflation is high enough to make the fiction untenable that 30, 60 or 90 days is an instant. Social coordination strongly benefits from the convention that shorter durations can be ignored for most periods, which means people behave in practice as if they expect inflation over such shorter periods to be zero.

Axel Leijonhufvud’s mid-70s piece on inflation is one of the most compelling accounts of this kinds of cost of inflation — the breakdown of social coordination — that I have seen. For him, the stability of money prices is the sine qua non of decentralized coordination through markets. 

In largely nonmonetary economies, important economic rights and obligations will be inseparable from particularized relationships of social status and political allegiance and will be in some measure permanent, inalienable and irrevocable. … In monetary exchange systems, in contrast, the value to the owner of an asset derives from rights, privileges, powers and immunities against society generally rather than from the obligation of some particular person. …

Neoclassical theories rest on a set of abstractions that separate “economic” transactions from the totality of social and political interactions in the system. For a very large set of problems, this separation “works”… But it assumes that the events that we make the subject of … the neoclassical model of the “economic system” do not affect the “social-political system” so as … to invalidate the institutional ceteris paribus clauses of that model. …

 Double-digit inflation may label a class of events for which this assumption is a bad one. … It may be that … before the “near-neutral” adjustments can all be smoothly achieved, society unlearns to use money confidently and reacts by restrictions on “the circles people shall serve, the prices they shall charge, and the goods they can buy.”

One important point here is that inflation has a much greater impact than in conventional theory because of the price-stability assumption incorporated into any contract that is denominated in money terms and not settled instantly — which is to say, pretty much any contract. So whatever expectations of inflation people actually hold, the whole legal-economic system is constructed in a way that makes it behave as if inflation expectations were biased toward zero:

The price stability fiction — a dollar is a dollar is a dollar — is as ingrained in our laws as if it were a constitutional principle. Indeed, it may be that no real constitutional principle permeates the Law as completely as does this manifest fiction.

The market-prices-or-feudalism tone of this seems more than a little overheated from today’s perspective, and when Arjun and I asked him about this piece a few years ago, he seemed a bit embarrassed by it. But I still think there is something to it. Market coordination, market rationality, the organization of productive activity through money payments and commitments, really does require the fiction of a fixed relationship between quantities of money and real things. There is some level of inflation at which this is no longer tenable.

So I have no problem with the conventional view that really high inflations — triple digits and above — can cause far-reaching breakdowns in social coordination. But this is not relevant to the question of inflation of 1 or 2 or 5 or probably even 10 percent. 

In this sense, I think the mainstream paradoxically both understates and overstates the real costs of inflation. They exaggerate the importances of small differences in inflation. But at the same time, because they completely naturalize the organization of life through markets, they are unable to talk about the possibility that it could break down.

But again, this kind of breakdown of market coordination is not relevant for the sorts of inflation seen in the United States or other rich countries in modern times. 

It’s easier to talk about the costs (and benefits) of inflation when we see it as a change in relative prices, and redistribution of income and wealth. If inflation is typically a change in relative prices, then the costs are experienced by those whose incomes rise more slowly than their payments. Keynes emphasized this point in an early article on “Social Consequences of a Change in the Value of Money.”10

A change in the value of money, that is to say in the level of prices, is important to Society only in so far as its incidence is unequal. Such changes have produced in the past, and are producing now, the vastest social consequences, because, as we all know, when the value of money changes, it does not change equally for all persons or for all purposes. … 

Keynes sees the losers from inflation as passive wealth owners, while the winners are active businesses and farmers; workers may gain or lose depending on the degree to which they are organized. For this reason, he sees moderate inflation as being preferable to moderate deflation, though both as evils to be avoided — until well after World War II, the goal of price stability meant what it said.

Let’s return for a minute to the question of wages. As far as I can tell, the experience in modern inflations is that wage changes typically lag behind prices. If you plot nominal wage growth against inflation, you’ll see a clear positive relationship, but with a slope well below 1. This might seem to contradict what I said under point 4. But my point there was that insofar as inflation is driven by increased worker bargaining power, it should be associated with faster real wage growth. In fact, the textbook is wrong not just on logic but on facts. In principle, a wage-driven inflation would see a rise in real wage. But most real inflations are not wage-driven.

In practice, the political costs of inflation are probably mostly due to a relatively small number of highly salient prices. 

7. Inflation and production. The old monetarist view had a fixed quantity of money confronting a fixed quantity of goods, with the price level ending up at whatever equated them. As I mentioned above, the fixed-quantity-of-money part of this has been largely abandoned by modern mainstream as well as heterodox economists. But what about the other side? Why doesn’t more spending call forth more production?

The contemporary mainstream has, it seems to me, a couple ways of answering the question. One is the approach of a textbook like Blanchard’s. There, higher spending does lead to to higher employment and output and lower unemployment. But unless unemployment is at a single unique level — the NAIRU — inflation will rise or fall without limit. It’s exceedingly hard to find anything that looks like a NAIRU in the data, as critics have been pointing out for a long time. Even Blanchard himself rejects it when he’s writing for central bankers rather than undergraduates. 

There’s a deeper conceptual problem as well. In this story, there is a tradeoff between unemployment and inflation. Unemployment below the NAIRU does mean higher real output and income. The cost of this higher output is an inflation rate that rises steadily from year to year. But even if we believed this, we might ask, how much inflation acceleration is too much? Can we rule out that a permanently higher level of output might be worth a slowly accelerating inflation rate?

Think about it: In the old days, the idea that the price level could increase without limit was considered crazy. After World War II, the British government imposed immense costs on the country not just to stabilize inflation, but to bring the price level back to its prewar level. In the modern view, this was crazy — the level of prices is completely irrelevant. The first derivative of prices — the inflation rate — is also inconsequential, as long as it is stable and predictable. But the second derivative — the change in the rate of inflation — is apparently so consequential that it must be kept at exactly zero at all costs. It’s hard to find a good answer, or indeed any answer, for why this should be so.

The more practical mainstream answer is to say, rather than that there is a tradeoff between unemployment and inflation with one unambiguously best choice, but that there is no tradeoff. In this story, there is a unique level of potential output (not a feature of the textbook model) at which the relationship between demand, unemployment and inflation changes. Below potential, more spending calls forth more production and employment; above potential, more spending only calls forth higher inflation. This looks better as a description of real economies, particular given that the recent experience of long periods of elevated unemployment that have not, contrary to the NAIRU prediction, resulted in ever-accelerating deflation. But it begs the question of why should be such a sharp line.

The alternative view would be that investment, technological change, and other determinants of “potential output” also respond to demand. Supply constraints, in this view, are better thought of in terms of the speed with which supply can respond to demand, rather than an absolute ceiling on output.

Well, this post has gotten too long, and has been sitting in the virtual drawer for quite a while as I keep adding to it. So I am going to break off here. But it seems to me that this is where the most interesting conversations around inflation are going right now — the idea that supply constraints are not absolute but respond to demand with varying lags — that inflation should be seen as often a temporary cost of adjustment to a new higher level of capacity. And the corollary, that anti-inflation policy should aim at identifying supply constraints as much as, or more than, restraining demand. 

At Age of Economics: How Should an Economist Be?

The website Age of Economics has been carrying out a series of interviews with economists about what the purpose of the discipline it is, and what its relationship is to capitalism as a historical social system. I believe there will be 52 of these interviews, one each week over the course of 2021. Earlier this spring, they interviewed Arjun Jayadev and myself. You can watch video of the interview here. I’ve pasted the transcript below.

 

Q: Why does economics matter?

JWM: The most obvious way that economics matters is that it has an enormous prestige in our society. Economists have a level of respect and authority that no other social scientist, arguably no other academic discipline possesses. An enormous number of policy debates are conducted in the language of economics. There’s an ability of an economist to speak directly in policy settings, in political settings in a way that most academics simply can’t. And so Joan Robinson has that famous line that the reason you study economics is to avoid being fooled by economists.

And there’s some truth to that. Even if you think that the discipline is completely vacuous, it’s worth learning its language and techniques just in order to be able to at least criticize the arguments that other economists are making. But I would say we don’t think that economics is completely worthless and vacuous because we think it does bring some positive ways of thinking to the larger conversation. One thing that is defining of economics is the insistence on formalizing ideas, expressing your thoughts in some highly abstract way, either as a system of equations or a system of diagrams in a way where you’re explicitly stating all of the causal relationships that you think exist in the story that you’re trying to tell.

And that’s a useful habit of thinking that is not necessarily as widespread outside the economics profession. Sometimes you can learn new things just by writing down your assumptions and working through them. The whole debate in the heterodox field about wage led growth versus profit led growth, what are the circumstances where redistribution from profits to wages is likely to boost demand? And what are the situations where it’s likely to reduce demand? There are real insights that come out of trying to write down your vision of the economy as a system of equations.

The notion of balance of payments-constrained growth, where we think that maybe for a lot of countries, the thing that’s fundamentally driving the rate of growth that they can sustain is how responsive, how income-elastic, their exports are versus their imports is another set of ideas that comes out of writing down a formal model in the first case.

So this is a useful discipline that training as an economist gives you, that people with other kinds of backgrounds don’t have. This effort to make explicit the causal connections that you have in mind.

AJ:  It’s also important to realize that economics has come up with some very useful concepts, to make sense of this world around us: concepts like GDP or employment. These are concepts which are well defined and measured, and help us to have an understanding of the system as a whole.

Admittedly, lots of economics education doesn’t pay as much attention to this side of economics as it should. And maybe the question was an implicit critique — when you ask why does economics matter, there are some people who feel that it doesn’t matter because of what’s happened to the discipline. Josh and I both like this particular quote by the economist Trygve Haavelmo. He said that the reason that you learn economics is to – I believe the phrase is – “to be a master of the happenings of real life”.

And that that’s why one should be doing economics, not as an exercise in and of itself, but to understand what’s happening in the world.

JWM: That’s right. The real secret to doing good economics is to start from somewhere other than economics. You may come into economics with a set of political commitments as Arjun and I both did, but you may also come in with a desire to make money in the business world and you’re associating with people who do that, or you come in because you’re focused on a particular set of public debates that you want to clarify your thinking about. If you come in with some other set of concerns that are going to guide you in terms of what’s important, what’s relevant, what’s reasonable, then you’ll find a lot of useful tools within economics.

The problem arises with people – and, unfortunately, this I’d say is the majority of professional economists – who don’t have any independent intellectual or personal base, their intellectual development is entirely within academic economics. And then it becomes very easy to lose sight of the happenings of real life that this field is supposed to be illuminating.

Q: What are the differences between economic science (academic economics) and economic engineering (policymaking)?

JWM: Today there’s a very wide gap between academic economics and what we might call policy economics, particularly in macro. If you’re a labor economist, maybe the terms that are used in academic studies and the terms that are used in policy debates might be might be closer to each other. But there’s a long standing divide between the questions that academic macroeconomists ask and the questions that come in policy debates which has gotten much wider since the crisis.

The unfortunate fact – and people are going to say this is not fair, but I can tell you, I’ve looked at qualifying exams, recent ones from graduate programs in macroeconomics, and this is a fair characterization, what I’m about to say – that the way academic macroeconomics trains people to think is to imagine a representative agent with perfect knowledge of the probabilities of all future events, who is then choosing the best possible outcome for them in terms of maximizing utility over infinite future time under a given set of constraints. That is literally what you are trained to think about if you are getting an academic training in macroeconomics. For people who are not economists listening to this, you have to study this stuff to understand how weird it is.

Unfortunately that aspect of the profession has not changed very much since the financial crisis of a decade ago. On the other hand, the public debate on macroeconomic questions has moved a lot. So there’s a much wider range of perspectives if you look at people in the policy world or the financial press or even in the business world. So in some ways the public debate has gotten much better over the past decade, but that’s widening the gap between the public debate and academic macroeconomics. I don’t know how exactly this will come about, but at some point we’re going to have to essentially throw out the existing graduate macroeconomics curriculum and start fresh, roll back the clock to 1979 or start from somewhere else, because it does seem like the dominant approach in academic macroeconomics is an intellectual dead end.

AJ: We have friends who are doing a lot of good work in labor economics. People like Arin Dube at UMass Amherst, which is one of these places which takes these things seriously, or my colleague Amit Basole where I am at Azim Premji University. And in some fields there is back and forth between the world that exists and policymaking and the craft of economics and academic economics.

It requires also talking to people from outside the discipline to see how far academic economics and macroeconomics has drifted away from policymaking. And this is why I come back to the Haavalmo point. The reason for us to be doing many of the things we are doing is academic macroeconomist is to try to see if we can have an effect on the world, understand the world. And this distinction has become so sharp right now to make it dysfunctional.

Now, the additional problem that comes with it is that because this kind of theory is hard, it’s complex and it’s weird, people spend a lot of time invested in this activity. When I say this activity, I mean basically solving equations, but for some imaginary state. That’s not only limited to macro, but it’s the worst in macro. And as a result, it becomes very hard for people to pull away from that, and say that there’s something wrong. The emperor’s new clothes moment is extremely painful to face.

But it is interesting that one of the advantages of studying macroeconomics is there are always people who want to understand what’s happening in the world. And what you might call concrete policy macroeconomics has got much more open, much more interesting than in the past. There’s an economic science aspect in concrete policy macroeconomics. I wouldn’t want to separate them so sharply as you might have done in the question.

JWM: And to be fair, there are plenty of prominent mainstream macroeconomists who have a lot of interesting and insightful things to say about real economies. The thing is that when they’re talking about the real world, they ignore what they do in their scholarly work. They’re smart enough and they’ve got time and energy that they can they can follow both tracks at once, but they’re still two separate tracks.

But for most people, that’s not practical. And if you get sucked into the theory, then you stop thinking about the real questions. And the other thing, just to be fair, is that in the world of empirical macroeconomics, there’s more interesting work being done. The problem is that there isn’t a body of theory that the empirical work can link up with.

Q: What role does economics play in society? Does it serve the common good?

JWM: You can certainly criticize economists for being ideological. There are very specific assumptions about how the world works that are baked into the theory in a way that is not even visible to the people who are educated in that theory.

But it’s almost impossible to imagine a non-ideological economics. In principle we could study the economy scientifically in the way we study other areas of existence scientifically. But we can’t do it as long as we live in a capitalist economy because the questions are too close to the basic structures of authority and hierarchy of our society. They are too close to the ways that all the inequalities, all the sources of power in our society are legitimated.

They can’t just be scrutinised in a neutral way from the outside. So as long as we live under capitalism, we are never going to have an established scientific study of capitalism. That’s just not possible. In a way, you could even say that the function of a lot of academic economics is not so much to instill a particular ideological view of capitalism, but just to stop people from thinking about it systematically at all. It gives you something else to think about instead.

That doesn’t mean that on an individual level we should not aspire to be scientific in a broad sense in our approach. We should expose our ideas to critical scrutiny. We should systematically consider alternatives and formulate hypotheses and see if the world is giving us reason to think our hypotheses are right or wrong. we should follow that.

But we should also recognize that you’re going to be on the margins as you do this. That’s OK, because the life of a professional economist is pretty good. So the margins of the profession is still a perfectly fine place to be. But that’s where you’re going to be. Or occasionally in moments of deep crisis, when the survival of the system is at stake, then there will be periods where a more rational perspective on it is tolerated.

But the notion that we’re going to persuade people in the economics profession that we have a better set of ideas and we’re going to win out that way, it misses that there is a deep political reason why economics is the way it is. So again, as we were saying at the beginning, if you want to do good scientific work, you have to have a foot outside the profession to give you a base somewhere else.

Hayek is probably not somebody that neither of us agrees with on very much, but he has a nice line about this, he says, “no one can be a great economist who is only an economist.” And that’s very true.

AJ: The question reminds me of the famous story about Keynes when he finishes being the editor of the Economic Journal, where he raises a toast to the economists who are the trustees of the possibility of civilization. There’s a belief among economists that  they are standing apart and guiding the forces of history.

Well, that sounds a little pompous. Keynes could get away with it. Nowadays we wouldn’t say that, but we’d say that we maximizing social welfare, which is in some ways the same thing. One of the things that you ask is, is it serving the common good? One of the things that economics does in its training is posit a common good. And that immediately takes you away from the space of politics. Because there are many situations in the economy in which there are conflicts of interest.

These are not just conflicts of opinions. It’s conflicts around things like the distribution of income and so on. And these questions become unavoidably political. It’s pulling away from that, which, by the way, the Classical economists never did, that allows you to talk about something abstract like social welfare. So I would say the economics can play a role in trying to understand what we would want to have from a democratic, open, egalitarian society. But positing something like the common good can sometimes obscure that.

Q: Economics provides answers to problems related to markets, efficiency, profits, consumption and economic growth. Does economics do a good job in addressing the other issues people care about: climate change and the wider environment, the role of technology in society, issues of race and class, pandemics, etc.?

JWM: We might turn this question around a little bit. Economics does best when it’s focused on urgent questions like climate change. We do better economics when we’re oriented towards towards real urgent live political questions like around race and class. This is what we’re saying: Economics when it’s focused on questions of markets and efficiency in the abstract, doesn’t contribute very much to the conversation. It quickly loses contact with the real phenomena that it’s supposed to be dealing with.

And what focuses our attention is precisely that second set of questions that you raise. Those are the questions that create enough urgency to force people to adopt a more realistic economics. So in that sense, we do a better job talking about markets, we give a better, more useful definition of things like efficiency when we’re focused on concrete questions like climate change. There’s a good reason that modern macroeconomics begins with the Great Depression, because this is a moment when you do need to look at the economy as it is.

Today, it’s obvious that the existing models aren’t working, and there’s a political urgency to coming up with a better set of stories, a better set of tools. The climate crisis has a good chance to be a similar clarifying moment as the 1930s, more so than the financial crisis of a decade ago or whatever the next financial crisis is.

Climate change may force us to rethink some of our broader economic ideas in a more fundamental way. The truth is established economic theory does not give good answers in general to the problems of profits, economic growth and so on. And a focus on climate change can improve the field in that way.

The other thing you bring up is race, class, and gender. The problem here is that nobody has a God’s eye view of the world. Nobody can step out of their own skin and see things from a perfectly objective view. As a middle class white man in the United States, I have a particular way of looking at the world, which is in some ways a limiting one. Economics as a field would be better if we had more diversity, a broader range of backgrounds and perspectives.

AJ: I’d like to add, there is no reason why a particular set of tools that you use in one sphere should automatically be something that you can use in another sphere. The way that modern economics is set up is just a set of maximization problems, it allows people to seamlessly say that they are studying on the one hand buying oranges and apples, and on the other side solving the problems of climate change.

So there is an issue in the way that you posit, that  it is using tools which it may be – I agree with Josh, it’s not very good at – but it may be better than its applications in other spheres. A famous example is the choice of discount rate for climate change. And that’s been such a long-standing disaster in the amount of time we’ve spent to think about this particular issue for which that analysis is completely inappropriate.

So, yes, there are places when it may be more appropriate, but maybe it’s not even very appropriate in those spheres. I would agree with Josh that this current moment and other moments of crisis – you mentioned 2008 – has opened up the space to think much more carefully about specific issues. And when you have a crisis that confronts you, it forces you to come up with a different economics or use other traditions of economics which have better answers than the ones that are there presently.

Q: As we live in an age of economics and economists – in which economic developments feature prominently in our lives and economists have major influence over a wide range of policy and people – should economists be held accountable for their advice?

JWM: As Arjun was saying earlier, this question is almost giving economics as a field too much credit, in the sense that it suggests that a lot of economic outcomes are directly dependent on the advice given by economists. Economics, as we’ve said, has an enormous prestige in terms of the presence of economists in all sorts of public debates. But a lot of times if you look at how views change, it’s not the economists who are leading the way. It’s the politicians or the broader public who’ve shifted. And then the economist come in to justify this after the fact.

There’s a certain sense, as a concrete example, where a lot of the development in macroeconomic theory over the past generation has been an after-the-fact effort to justify the policies that central banks were already following. Like a way of demonstrating that what central banks were already doing in terms of inflation target, using something like the Taylor Rule was the socially optimal thing. And that generalizes pretty widely.

So I’m not sure that we should be blaming or crediting economists for policy outcomes that they probably do more to legitimate or help with the execution of than to shift. The other reason I don’t personally see this as a particularly productive direction to go in is: who’s going to impose the accountability, who’s going to step in and say, all right, you were wrong and that had consequences and now you’re going to pay a penalty.

There’s no consensus position from which to do that. So we all just have to go on making our arguments the best we can and we’re not going to reach agreement. And so we try to shift the debate our way and somebody else shifts it their way, and there’s never going to be an impartial referee who’s going to come in and say that one side was right and the other was wrong.

AJ: Having been practicing economist for 10-15 years, broadly one has to realize that whatever you say and whatever you think and whatever you do, is strictly circumscribed by what the world is open to at that point of time. That’s something that’s sometimes hard for us to accept. There are many people who for years made the argument that we shouldn’t be so concerned about supply constraints, and it was only after 2012, 13, 14, 15- when the world started to move away from austerity or the costs of austerity became well known, that space was made for these arguments. And it’s always like that.

Spaces are there in some moments and not in other moments. And there are those people who for whatever reason in some universities, in some spaces, seem to capture elite opinion. They’re the ones who you see again and again and again. It doesn’t matter if they’re right or wrong, they’re the ones who are opinion makers.

I don’t think this is distinct from any other kind of marketing. There are always going to be a few people who are opinion and market leaders. Having said that, it would be good to have a list of when people were wrong. And sometimes it would be good to take people down a peg or two.

But again, I don’t think it’s an important thing. I don’t think that we should necessarily valorise economics and economists one way or the other.

6. Does economics explain Capitalism? How would you define Capitalism?

AJ: If you want to think about capitalism as a system, you need to go back to Karl Marx. You don’t have to call yourself a Marxist, but if you want to think about the questions like the ones that you just posed, you have to take him very seriously because his work is the foundation of many of the ways that we think about capitalism. Josh and I are working on a book and we take up this question about what capitalism means, and in our minds it has a clear definition. It has three elements, or three phases.

The first is the conversion of all kinds of human activities and their products into commodities, this thing that you buy and sell, this alienated thing that is sold in markets. That’s the first. The second is the endless accumulation of money as an end to itself. That’s the drive of the system, which seems to be out of human control. And then finally, something which is very critical and which gives it some of its emotional heft, there is the hierarchy in the workplace where people work under the authority of the boss.

All three of these elements are there historically. But their fusion in this incredibly changeable system that we’ve had for 200 years, that has been unique. That’s the central aspect that we want to focus on, the combination of these three things. And it’s the fact that when combined it gives you this dynamism, this ability to transform society, in far reaching ways that seem out of human control. That’s what I would say capitalism is.

JWM: I agree, that’s the correct definition of capitalism as a system. The problem comes when you try to pull out one of those elements in isolation and think that’s what defines the system. It’s the fusion of the three of them.

The other piece, which maybe isn’t quite as defining but historically has been very important, is that the process of endless accumulation has this moment in the middle of it where money is tied up, locked up in long-lived means of production, that you’re not just buying commodity, working it up and then selling it again, but you’ve got machines, you’ve got buildings, you’ve got technology.

So there’s this long gap between the outlay and the final sale. And that’s one of the things that has made this a system that is dynamic and has transformed human productive capacities in ways that we would agree with Marx’s judgment that in the long run, expand the space for human freedom and possibilities because it’s broken up the old, local, simple ways of carrying out productive activity and allowed people to have a much more extensive division of labor, much wider scale cooperation and the development of all of these new ways of transforming the world through technology that didn’t exist before or that were much – let’s not say it didn’t exist, but developed much more slowly in limited ways before.

But this is also where a lot of the conflict comes up, because you build up a business and it exists for its own purposes, it has its own norms, it has its own internal logic. And then at some point, you have to turn the products of that back into money to keep the accumulation process going. And so a lot of the tensions around the system come from that.

The other part of your question is, can economics explain capitalism. From our point of view economics is part of the larger set of social phenomena that grow out of the generalisation of capitalism as a way of organizing human life and productive activity. In that sense, you can’t use the tools of economics to explain capitalism, because economics is within capitalism. The categories of economics are specific to capitalism. If you want to explain the origins of it, you need a different set of tools. It’s a historical question rather than one that you can answer with the tools of economics.

Q: Is Capitalism, or whatever we should call the current system, the best one to serve the needs of humanity, or can we imagine another one?

JWM: We don’t have to imagine other systems, they’re all around us. As Arjun was saying earlier, we all of us experience every day systems where productive activity is organized through some collective decision making process. An enormous amount of our productive work, our reproductive labor that keeps us going individually and collectively, is carried out in the family. Some families are more egalitarian, some families are more hierarchical, but no family is organized on the basis of the pursuit of profit – well, let’s not say none, but a trivially small fraction of them are.

So we all have firsthand experience that this is a way that we can organize our activity. We all know that within the workplace you personally don’t make decisions based on some profit maximizing criteria. And your immediate boss isn’t doing it that way either. Probably they’re just following orders and some bureaucratic system, or perhaps there’s an element of voluntary cooperation going on.

But either way, it’s a different way of organizing our activity than the notion of markets and the pursuit of profit. As academics, we’re fortunate enough to have a collective decision making process that covers a lot of the traditional roles of the capitalist employer. We collectively decide on hiring and we collectively organize our work schedules and so on. 

Obviously, very few workers in the world are as fortunate as academics in that way. But the point is that this is a model that exists. It works. Certainly here in the United States, higher education is one of our big industrial success stories. And it’s organized as a bunch of little worker co-ops!

In any workplace, there are moments when people sit down to make a decision together, where people do stuff because that’s just what makes sense and what they’ve agreed to do, as opposed to somebody making a calculation of self-interest. This is what David Graeber in his wonderful book, Debt, talks about as “everyday communism.” Even in the most traditional workplace if somebody says pass me that hammer or can you do some little favor for me, people do it just as a way of cooperating and not because they’ve been ordered to or because they’re calculating that it will pay off for them.

And then we have a huge public sector in the world as well. We have public schools and public libraries and public transit and fire and police services and so on. So we already have an enormous amount of non-capitalist organization of production around us. We don’t have to imagine it.

The challenge intellectually is to generalize from this stuff, to recognize how these principles can be applied more broadly. We don’t have to create something new, but we do have to bring in general principles. For people on the left, or people who support individual public sector programs or individual non- capitalist ways of organizing particular activities, there’s often a tendency to make the argument in terms of that specific activity: well, here’s why we want public schools and we want better funding for our public schools. As opposed to trying to articulate what is the general principle that makes markets and the pursuit of profit a bad way to organize that. What is the general principle that says teachers should have autonomy?

We want less authority of the boss in the classroom. That’s why we have civil service protection, that’s why we have professions, because we want workers to have autonomy. But we need to be able to say why.

We want to move away from the model of proletarian labor where you’re completely under the authority of the boss. We do that in a lot of specific cases already. The intellectual challenge is to generalize that and see how we can apply it more broadly to the areas of society where it’s not not currently organized that way.

AJ: The question is nicely posed, because most people would broadly agree that capitalism generates a lot of good. But there’s been a sense right from the beginning that it may not be serving the needs of humanity. That the only word that describes this is a drive, an alien drive which sometimes intersects with the need of human beings and very often doesn’t.

When we think about  what happens in farms, for example, and how so many people spend their entire lives working as drones, it’s very tragic history.  Yes, people are richer and healthier as well. But capitalism, the way that it’s developed, has not served the needs of humanity. 

We don’t have to look historically. Let’s look at what’s happening right now with vaccination. The belief that you needed intellectual property and you can only solve this by the genius of a few pharmaceutical companies when in fact, what happened in all of this innovation was that it was the public sector backing all of this, which made certainly some of the vaccines even viable in the first place. And so now you have this perverse situation where some people are prevented from access because we want to maintain whatever capitalist institutions that we’ve built up.

So it’s important to realize that capitalism, while it’s done many great things as Marx and others recognized, it’s never been a force which has very nicely dovetailed with human needs. But that what’s useful now to think about is, as Josh said, we don’t need to imagine an alternative – we have a model and a system that’s already there, that we’re going to replace it with.

This thing will happen incrementally. Maybe this is radical optimism, but we both believe that the domain organized around these arbitrary hierarchies – the market and so on, is shrinking. Maybe in the next few generations with the challenge of climate change, with more crises and with a truly global world, the responses to those will mean that the domain of collective freedom will be much greater in the future than now.

And the domain of capitalism will be smaller. 

JWM:  I want to amplify something Arjun just said — the vaccine is a perfect example of this dynamic. On the one hand, we have a urgent collective problem, this pandemic. And the solution is directed by the public. It’s a collective decision mediated by governments to devote our common resources to solving this problem.

And it’s incredibly effective when you want to solve this problem and you have a political decision to do it. You can work wonders. And it’s carried out by scientists who have a whole set of professional norms around the conduct of science, which is precisely in order to suppress market incentives. We don’t want scientists thinking about how to get rich. Now, we do get that because that’s ubiquitous in our society, but the reason we have a whole set of professional norms around science is precisely because we think that this is the activity that people carry out better when they’re insulated from market incentives.

And then we have a centralized public direction to mobilize their activity. But the problem is that the fruits of that still have to be squeezed into this box of private property. Somebody has to have a property right over all this collective labor and public resources in the form of a patent.

And that then limits the value of this work. It makes the success much less than it could have been. We already are seeing that conflict and we’re going to continue seeing it even more so as we deal with problems like the pandemic and climate change and so on.

When we urgently need to solve a problem, we find we do it by suppressing the logic of the market and making decisions collectively. But then as long as we still have this overarching insistence on organizing our claims on each other in the form of property rights, it creates a conflict, it gets in the way of that. And over time, again, just the necessity of solving our urgent problems is going to force us to move away from the private property model and away from the pursuit of profit, and towards more rational collective ways of dealing with the problems that face us.

At The International Economy: How Worried Should We Be about Asset Bubbles?

(I am an occasional contributor to roundtables of economists in the magazine The International Economy. This month’s topic was “What about the Risk of a Bursting Asset Bubble?”, with corporate debt and equity mentioned as possibilities. Contributors were asked to rank their level of concern from 1 to 10. My response is below.)

Any time you have an asset held primarily for capital gains, a story that allows people to extrapolate from recent price increases to future ones, and a reasonably elastic credit system, you have the ingredients for a bubble. The question is not whether there will be bubbles, but how damaging they will be, and what steps we should take if we think one is developing in a particular asset market.

Corporate debt is an unlikely asset for a bubble. Unlike with equity, real estate, or currency, there are clear limits to potential capital gains. High levels of stock buy- backs are problematic for a number of reasons, but they don’t particularly suggest a bubble. When a greater share of corporate value added is paid out to shareholders rather than retained and invested or paid to workers, that may be bad news for the economy in the long run. But it is good news for owners of corporate stock, and there’s nothing strange about it being priced accordingly.

Cryptocurrencies are a better candidate for a bubble. It’s safe to say they are mostly held in expectation of capital gains, since they pay no income and, despite the promises of their boosters, have limited utility for transactions. It wouldn’t be surprising if their value fell to a small fraction of what it is today.

But that brings us to the question of how damaging a bursting bubble will be. The housing bubble was exceptionally damaging because housing is the main asset owned by most middle-class families, housing purchases are mostly debt-financed, and mortgages are a major asset for the financial system. It’s hard to see how a collapse of bitcoin or its peers would have wider consequences for the economy.

The other question is what to do about a bubble if we have reason to believe one is forming. One common answer is to raise interest rates. The problem is that, historically, there’s no sign that low rates are more favorable to bubbles than high ones. The 1980s savings and loan crisis took place in an environment of—indeed was driven by—historically high interest rates. Similarly, Sweden’s great real estate bubble of the late 1980s took place when rates were high, not low.

And why not? While productive investment may be discouraged by high rates, expected capital gains at the height of a bubble are too high for them to have much effect. This was most famously illustrated in the late 1920s, when the Fed’s efforts to rein in stock prices by raising rates did a great deal to destabilize European banks by reversing U.S. capital outflows, but had little or no effect on Wall Street.

A better policy in the face of a developing bubble is to directly limit the use of credit to buy the appreciating asset. Tighter limits on mortgage lending would have done far more than higher rates to control the housing bubble of the 2000s.

In other cases, the best policy is to do nothing. As economists going back to John Maynard Keynes have observed, a chronic problem for our economy is an insufficient level of investment in long-lived capital goods and new technology. To the extent that inflated asset values encourage more risky investment—as in the late 1990s— they may be even be socially useful.

By all means, let’s take steps to insulate the core functions of the financial system from speculation in asset markets. But holding macroeconomic policy hostage to fears of asset bubbles is likely to do more harm than good.

Weighing the chance of a major bubble along with its likely consequences, I’d put my concern over asset bubbles at three out of ten. The biggest danger is not a bubble itself, but the possibility that a fear of bubbles will prompt a premature tightening of monetary policy.

At Roosevelt: Reimagining Full Employment

Mike Konczal, Lauren Melodia and I have a new report out from the Roosevelt Institute, on what true full employment might look like in the United States.

This is part of a larger project of imagining what an economic boom would look like. As Mike and I argued in our recent New York Times op-ed, there’s a real possibility that the coming years could see a historic boom, thanks to the exceptionally strong stimulus measures of the past year and, hopefully, the further expansions of public spending on the way. (Interestingly, the term “boom” is now making it into Biden’s speeches on the economy.) If the administration, Congress and the Fed don’t lose their nerve and stay on the path they’re currently on, we could soon be seeing economic growth and rising wages in a way that we haven’t since at least the late 1990s.

This is going to call for a new way of thinking about economic policy. Over the past decade or more, the macroeconomic policy debate has been dominated by a consensus that is more concerned with the supposed dangers of public debt than stagnation, and sees any uptick in growth or wages as worryingly inflationary. Meanwhile, the left knows how to criticize austerity and bailouts for business, and to make the case for specific forms of public spending, but has a harder time articulating the benefits of sustained growth and tight labor markets.

What we’re trying to do is move away from the old, defensive fights about public debt and austerity and make the positive case for a bigger more active public sector. There’s no reason the Right should have a monopoly on promises faster growth and improvements in peoples material living standards. Post-covid, we’re looking at a new “morning in America” moment, and progressives should be prepared to take credit.

One of the great appeals of the Green New Deal framing on climate change is that it turns decarbonization from a question of austerity and sacrifice into a promise to improve people’s material well being, not decades from now but right now, and in ways that go well beyond climate itself. I think this promise is not just politically useful but factually well-founded, and could just as well be made for other expansions of the public sector.

This is an argument that I and others have been making for years. Of course, any promise of faster growth and higher living standards has to confront the argument, enshrined in macroeconomics textbooks, that the economy is already operating close to potential, at least most of the time — that the Federal Reserve has taken care of the demand problem. In that case, the Keynesian promise that more spending can call forth more production would no longer apply.

We’ve tended to respond to this argument negatively — that there is no evidence that the US now was facing any kind of absolute supply constraint or labor shortage before the pandemic, let alone now. This is fine as far as it goes, and I think our side of the debate has won some major victories — Jay Powell and Janet Yellen both now seem to agree that as of 2019 the US was still well short of full employement. Still, I think it’s legitimate for people to ask, “If this isn’t full employment, then what would be?” We need a positive answer of our own, and not just a negative criticism of the textbook view.

This new paper is an attempt to do just that — to construct an estimate of full employment that doesn’t build in the assumption that recent labor market performance was close to it. One way to do this is to compare the US to other advanced countries, many of which have higher employment-population ratios than the US, even after adjusting for age differences. We chose to take a different approach, one that instead looks at differences in employment rates within the US population.

From the executive summary:

This issue brief argues that potential employment in the US is much higher than we have seen in recent years. In addition to those officially counted in the labor force, there is a large latent labor force, consisting of people who are not currently seeking work but who could reasonably be expected to do so given sustained strong labor demand. This implies much more labor market slack than conventional measures of unemployment suggest.

An important but less familiar sign of labor market slack is the difference in employment rates between groups with more- and less-privileged positions in the labor market. Because less-favored groups—Black workers, women, those with less formal education, those just entering the labor market—are generally last hired and first fired, the gaps between more- and less-favored groups vary systematically over the business cycle. When labor markets are weak and employers can pick and choose among potential employees, the gap between employment rates for more- and less-favored groups widens. When labor markets are tight, and workers have more bargaining power, the gap shrinks.

We use this systematic relationship between overall labor market conditions and employment rates across race, gender, education, and age to construct a new measure of potential employment. In effect, since more-favored workers will be hired before less-favored ones, the difference in outcomes between these groups is a measure of how close hiring has gotten to the true back of the line.

We construct our measure in stages. We start with the fact that changes in employment rates within a given age group cannot reflect the effect of population aging. Simply basing potential employment by age groups on employment rates that have been observed historically implies potential employment 1.7 points higher than the CBO estimates.

Next, we close the employment gaps by race and gender, on the assumption that women and Black Americans are no less able or willing to work than white men of a similar age. (When adjusting for gender, we make an allowance for lower employment rates among parents of young children). This raises potential employment by another 6.2 points.

Finally, reducing the employment gap between more- and less-educated workers in line with the lower gaps that have been observed historically adds another 1.8 points to the potential employment rate.

In total, these adjustments yield a potential employment-population ratio 10 points higher than the CBO estimates, equivalent to the addition of about 28 million more jobs over the next decade.

Adding these 28 million additional jobs over the next decade would require an average annual growth in employment of 2.1 percent. The employment growth that would fully mobilize the latent labor force, as estimated here, is in line with the rate of GDP growth required to repair the damage from the Great Recession of 2007–2009 and return GDP to its pre–2007 trend.

You can read the rest here.

A new macroeconomics?

UPDATE: The video of this panel is here.

[On Friday, July 2, I am taking part in a panel organized by Economics for Inclusive Prosperity on “A new macroeconomics?” This is my contribution.]

Jón Steinsson wrote up some thoughts about the current state of macroeconomics. He begins:

There is a narrative within our field that macroeconomics has lost its way. While I have some sympathy with this narrative, I think it is a better description of the field 10 years ago than of the field today. Today, macroeconomics is in the process of regaining its footing. Because of this, in my view, the state of macroeconomics is actually better than it has been for quite some time.

I can’t help but be reminded of Olivier Blanchard’s 2008 article on the state of macroeconomics, which opened with a flat assertion that “the state of macro is good.” I am not convinced today’s positive assessment is going to hold up better than that one. 

Where I do agree with Jón is that empirical work in macro is in better shape than theory. But I think theory is in much worse shape than he thinks. The problem is not some particular assumptions. It is the fundamental approach.

We need to be brutally honest: What is taught in today’s graduate programs as macroeconomics is entirely useless for the kinds of questions we are interested in. 

I have in front of me the macro comp from a well-regarded mainstream economics PhD program. The comp starts with the familiar Euler equation with a representative agent maximizing their utility from consumption over an infinite future. Then we introduce various complications — instead of a single good we have a final and intermediate good, we allow firms to have some market power, we introduce random variation in the production technology or markup. The problem at each stage is to find what is the optimal path chosen by the representative household under the new set of constraints.

This is what macroeconomics education looks like in 2021. I submit that it provides no preparation whatsoever for thinking about the substantive questions we are interested in. It’s not that this or that assumption is unrealistic. It is that there is no point of contact between the world of these models and the real economies that we live in.

I don’t think that anyone in this conversation reasons this way when they are thinking about real economic questions. If you are asked how serious inflation is likely to be over the next year, or how much of a constraint public debt is on public spending, or how income distribution is likely to change based on labor market conditions, you will not base your answer on some kind of vaguely analogous questions about a world of rational households optimizing the tradeoff between labor and consumption over an infinite future. You will answer it based on your concrete institutional and historical knowledge of the world we live in today. 

To be sure, once you have come up with a plausible answer to a real world question, you can go back and construct a microfounded model that supports it. But so what? Yes, with some ingenuity you can get a plausible Keynesian multiplier out of a microfounded model. But in terms of what we actually know about real economies, we don’t learn anything from the exercise that the simple Keynesian multiplier didn’t already tell us.

The heterogenous agent models that Jón talks about are to me symptoms of the problem, not signs of progress. You start with a fact about the world that we already knew, that consumption spending is sensitive to current income. Then you backfill a set of microfoundations that lead to that conclusion. The model doesn’t add anything, it just gets you back to your starting point, with a lot of time and effort that you could have been using elsewhere. Why not just start from the existence of a marginal propensity to consume well above zero, and go forward from there?

Then on the other hand, think about what is not included in macroeconomics education at the graduate level. Nothing about national accounting. Nothing about about policy. Nothing about history. Nothing about the concrete institutions that structure real labor and product markets. 

My personal view is that we need to roll back the clock at least 40 years, and throw out the whole existing macroeconomics curriculum. It’s not going to happen tomorrow, of course. But if we want a macroeconomics that can contribute to public debates, that should be what we’re aiming for.

What should we be doing instead? There is no fully-fledged alternative to the mainstream, no heterodox theory that is ready to step in to replace the existing macro curriculum. Still, we don’t have to start from scratch. There are fragments, or building blocks, of a more scientific macroeconomics scattered around. We can find promising approaches in work from earlier generations, work in the margins of the profession, and work being done by people outside of economics, in the policy world, in finance, in other social sciences.  

This work, it seems to me, shares a number of characteristics.

First, it is in close contact with broader public debates. Macroeconomics exists not to study “the economy” in the abstract — there isn’t any such thing — but to help us address concrete problems with the economies that we live in. The questions of what topics are important, what assumptions are reasonable, what considerations are relevant, can only be answered from a perspective outside of theory itself. A useful macroeconomic theory cannot be an axiomatic system developed from first principles. It needs to start with the conversations among policymakers, business people, journalists, and so on, and then generalize and systematize them. 

A corollary of this is that we are looking not for a general model of the economy, but a lot of specialized models for particular questions. 

Second, it has national accounting at its center. Physical scientists spend an enormous amount of time refining and mastering their data collection tools. For macroeconomics, that means the national accounts, along with other sources of macro data. A major part of graduate education in economics should be gaining a deep understanding of existing accounting and data collection practices. If models are going to be relevant for policy or empirical work, they need to be built around the categories of macro data. One of the great vices of today’s macroeconomics is to treat a variable in a model as equivalent to a similarly-named item in the national accounts, even when they are defined quite differently.

Third, this work is fundamentally aggregative. The questions that macroeconomics asks involve aggregate variables like output, inflation, the wage share, the trade balance, etc. No matter how it is derived, the operational content of the theory is a set of causal relationships between these aggregate variables. You can certainly shed light on relationships between aggregates using micro data. But the questions we are asking always need to be posed in terms of observable aggregates. The disdain for “reduced form” models is something we have to rid ourselves of. 

Fourth, it is historical. There are few if any general laws for how “an economy” operates; what there are, are patterns that are more or less consistent over a certain span of time and space. Macroeconomics is also historical in a second sense: It deals with developments that unfold in historical time. (This, among other reasons, is why the intertemporal approach is fundamentally unsuitable.) We need fewer models of “the” business cycle, and more narrative descriptions of individual cycles. This requires a sort of figure-ground reversal in our thinking — instead of seeing concrete developments as case studies or tests of models, we need to see models as embedded in concrete stories. 

Fifth, it is monetary. The economies we live in are organized around money commitments and money flows, and most of the variables we are interested in are defined and measured in terms of money. These facts are not incidental. A model of a hypothetical non-monetary economy is not going to generate reliable intuitions about real economies. Of course it is sometimes useful to adjust money values for inflation, but it’s a bad habit to refer to the result quantities as “real” — it suggests that there is some objective quantity lying behind the monetary one, which is in no way the case.

In my ideal world, a macroeconomics education would proceed like this. First, here are the problems the external world is posing to us — the economic questions being asked by historians, policy makers, the business press. Second, here is the observable data relevant to those questions, here’s how the variables are defined and measured. Third, here are how those observables have evolved in some important historical cases. Fourth, here are some general patterns that seem to hold over a certain range  — and just as important, here is the range where they don’t. Finally, here are some stories that might explain those patterns, that are plausible given what we know about how economic activity is organized.

Well, that’s my vision. Does it have anything to do with a plausible future of macroeconomics?

I certainly don’t expect established macroeconomists to throw out the work they’ve been doing their whole careers. Among younger economists, at least those whose interest in the economy is not strictly professional, I do think there is a fairly widespread recognition that macroeconomic theory is at an intellectual dead end. But the response is usually to do basically atheoretical empirical work, or go into a different field, like labor, where the constraints on theory are not so rigid. Then there is the heterodox community, which I come out of. I think there has been a great deal of interesting and valuable work within heterodox economics, and I’m glad to be associated with it. But as a project to change the views of the rest of the economics profession, it is clearly a failure.

As far as I can see, orthodox macroeconomic theory is basically unchallenged on its home ground. Nonetheless, I am moderately hopeful for the future, for two reasons. 

First, academic macroeconomics has lost much of its hold on public debate. I have a fair amount of contact with policymakers, and in my experience, there is much less deference to mainstream economic theory than there used to be, and much more interest in alternative approaches. Strong deductive claims about the relationships between employment, inflation, wage growth, etc. are no longer taken seriously.

To be sure, there was always a gulf between macroeconomic theory and practical policymaking. But at one time, this could be papered over by a kind of folk wisdom — low unemployment leads to inflation, public deficits lead to higher interest rates, etc. — that both sides could accept. Under the pressure of the extraordinary developments of the past dozen years, the policy conversation has largely abandoned this folk wisdom — which, from my point of view, is real progress. At some point, I think, academic economics will recognize that it has lost contact with the policy conversation, and make a jump to catch up. 

Keynes got a lot of things right, but one thing I think he got wrong was that “practical men are slaves to some defunct economist.” The relationship is more often the other way round. When practical people come to think about economy in new ways, economic theory eventually follows.

I think this is often true even of people who in their day job do theory in the approved style. They don’t think in terms of their models when they are answering real world questions. And this in turn makes our problem easier. We don’t need to create a new body of macroeconomic theory out of whole cloth. We just need to take the implicit models that we already use in conversations like this one, and bring them into scholarship. 

That brings me to my second reason for optimism. Once people realize you don’t have to have microfoundations, that you don’t need to base your models on optimization by anyone, I think they will find that profoundly liberating. If you are wondering about, say, the effect of corporate taxation on productivity growth, there is absolutely no reason you need to model the labor supply decision of the representative household as some kind of intertemporal optimization. You can just, not do that. Whatever the story you’re telling, a simple aggregate relationship will capture it. 

The microfounded approach is not helping people answer the questions they’re interested in. It’s just a hoop they have to jump through if they want other people in the profession to take their work seriously. As Jón suggests, a lot of what people see as essential in theory, is really just sociological conventions within the discipline. These sorts of professional norms can be powerful, but they are also brittle. The strongest prop of the current orthodoxy is that it is the orthodoxy. Once people realize they don’t have to do theory this way, it’s going to open up enormous space for asking substantive questions about the real world. 

I think that once that dam breaks, it is going to sweep away most of what is now taught as macroeconomics. I hope that we’ll see something quite different in its place.  

Once we stop chasing the will-o-wisp of general equilibrium, we can focus on developing a toolkit of models addressed to particular questions. I hope in the years ahead we’ll see a more modest but useful body of theory, one that is oriented to the concrete questions that motivate public debates; that embeds its formal models in a historical narrative; that starts from the economy as we observe it, rather than a set of abstract first principles; that dispenses with utility and other unobservables; and that is ready to learn from historians and other social scientists.

The Roaring 2020s: Further Reading

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.

For the broader economic perspective I’m coming from, I haven’t done a better job laying it out than this interview with the Current Affairs podcast. The ostensible topic is Modern Monetary Theory, but it’s really a general conversation about how we should think about the economy. You could also look at the teaching materials on this website. On the more concrete debates about economic potential and the limits to public spending, Arjun Jayadev and I have written a couple of stock-taking pieces: Strange Defeat: How Austerity Economics Lost All the Intellectual Battles and Still Won the War, and more recently The Crash of Austerity Economics.

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.

The Persistence of Demand

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 Ball papers, 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.”11

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.  A realistic 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 that  sufficient 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.12

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.13 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 with  persistence 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.

 

Video: Finance and Decarbonization

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, Money and Cow Clicking

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 itself  as 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 original  contentless 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,