Tag: anatomy of DeLongism

Links for October 6

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

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

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

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

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

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

 

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

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

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

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

 

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

 

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

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

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

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

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

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

 

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

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

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

 

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

 

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

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

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

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

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

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

 

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

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

Media advisory with synopsis is here.

 

On other blogs, other wonders

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

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

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

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

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

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

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

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

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

How Strong Is Business Investment, Really?

DeLong rises to defend Ben Bernanke, against claims that unconventional monetary policy in recent years has discouraged businesses from investing. Business investment is doing just fine, he says:

As I see it, the Fed’s open-market operations have produced more spending–hence higher capacity utilization–and lower interest rates–has more advantageous costs of finance–and we are supposed to believe that its policies “have hurt business investment”?!?! … As I have said before and say again, weakness in overall investment is 100% due to weakness in housing investment. Is there an argument here that QE has reduced housing investment? No. Is nonresidential fixed investment below where one would expect it to be given that the overall recovery has been disappointing and capacity utilization is not high?

As evidence, DeLong points to the fact that nonresidential investment as a share of GDP is back where it was at the last two business cycle peaks.

As it happens, I agree with DeLong that it’s hard to make a convincing case that unconventional monetary policy is holding back business investment. Arguments about the awfulness of low interest rates seem more political or ideological, based on the real or imagined interests of interest-receivers than any identifiable economic analysis. But there’s a danger of overselling the opposite case.

It is certainly true that, as a share of potential GDP, nonresidential investment is not low by historical standards. But is this the right measure to be looking at? I think not, for a couple of reasons, one relatively minor and one major. The minor reason is that the recent redefinition of investment by the BEA to include various IP spending makes historical comparisons problematic. If we define investment as the BEA did until 2013, and as businesses still do under GAAP accounting standards, the investment share of GDP remains quite low compared to previous expansions. The major reason is that it’s misleading to evaluate investment relative to (actual or potential GDP), since weak investment will itself lead to slower GDP growth. [1]

On the first point: In 2013, the BEA redefined investment to include a variety of IP-related spending, including the commercial development of movies, books, music, etc. as well as research and development. We can debate whether, conceptually, Sony making Steve Jobs is the same kind of thing as Steve Jobs and his crew making the iPhone. But it’s important to realize that the apparent strength of investment spending in recent expansions is more about the former kind of activity than the latter.  [2] More relevant for present purposes, since this kind of spending was not counted as investment — or even broken out separately, in many cases — prior to 2013, the older data are contemporary imputations. We should be skeptical of comparing today’s investment-cum-IP-and-R&D to the levels of 10 or 20 years ago, since 10 or 20 years ago it wasn’t even being measured. This means that historical comparisons are considerably more treacherous than usual. And if you count just traditional (GAAP) investment, or even traditional investment plus R&D, then investment has not, in fact, returned to its 2007 share of GDP, and remains well below long-run average levels. [3]

investment

More importantly, using potential GDP as the yardstick is misleading because potential GDP is calculated simply as a trend of actual GDP, with a heavier weight on more recent observations. By construction, it is impossible for actual GDP to remain below potential for an extended period. So the fact that the current recovery is weak by historical standards automatically pulls down potential GDP, and makes the relative performance of investment look good.

We usually think that investment spending the single most important factor in business-cycle fluctuations. If weak investment growth results in a lower overall level of economic activity, investment as a share of GDP will look higher. Conversely, an investment boom that leads to rapid growth of the economy may not show up as an especially high investment share of GDP. So to get a clear sense of the performance of business investment, its better to look at the real growth of investment spending over a full business cycle, measured in inflation-adjusted dollars, not in percent of GDP. And when we do this, we see that the investment performance of the most recent cycle is the weakest on record — even using the BEA’s newer, more generous definition of investment.

investmentcycles_broad
Real investment growth, BEA definition

The figure above shows the cumulative change in real investment spending since the previous business-cycle peak, using the current (broad) BEA definition. The next figure shows the same thing, but for the older, narrower GAAP definition. Data for both figures is taken from the aggregates published by the BEA, so it includes closely held corporations as well as publicly-traded ones. As the figures show, the most recent cycle is a clear outlier, both for the depth and duration of the fall in investment during the downturn itself, and even more for the slowness of the subsequent recovery.

investmentcycles_narrow
Real investment growth, plant and equipment only

Even using the BEA’s more generous definition, it took over 5 years for inflation-adjusted investment spending to recover its previous peak. (By the narrower GAAP definition, it took six years.) Five years after the average postwar business cycle peak, BEA investment spending had already risen 20 percent in real terms. As of the second quarter of 2015 — seven-and-a-half years after the most recent peak, and six years into the recovery — broad investment spending was up only 10 percent from its previous peak. (GAAP investment spending was up just 8.5 percent.) In the four previous postwar recoveries that lasted this long, real investment spending was up 63, 24, 56, and 21 percent respectively. So the current cycle has had less than half the investment growth of the weakest previous cycle. And it’s worth noting that the next two weakest investment performances of the ten postwar cycles came in the 1980s and the 2000s. In recent years, only the tech-boom period of the 1990s has matched the consistent investment growth of the 1950s, 1960s and 1970s.

So I don’t think it’s time to hang the “Mission Accomplished” banner up on Maiden Lane quite yet.

As DeLong says, it’s not surprising that business investment is weak given how far output is below trend. But the whole point of monetary policy is to stabilize output. For monetary policy to work, it needs to able to reliably offset lower than normal spending in other areas with stronger than normal investment spending. If after six years of extraordinarily stimulative monetary policy (and extraordinarily high corporate profits), business investment is just “where one would expect given that the overall recovery has been disappointing,” that’s a sign of failure, not success.

 

[1] Another minor issue, which I can’t discuss now, is DeLong’s choice to compare “real” (inflation-adjusted) spending to “real” GDP, rather than the more usual ratio of nominal values. Since the price index for investment goods consistent rises more slowly than the index for GDP as a whole, this makes current investment spending look higher relative to past investment spending.

[2] This IP spending is not generally counted as investment in the GAAP accounting rules followed by private businesses. As I’ve mentioned before, it’s problematic that national accounts diverge from private accounts this way. It seems to be part of a troubling trend of national accounts being colonized by economic theory.

[3] R&D spending is at least reported in financial statements, though I’m not sure how consistently. But with the other new types of IP investment — which account for the majority of it — the BEA has invented a category that doesn’t exist in business accounts at all. So the historical numbers must involve more than usual amount degree of guesswork.

That Safe Asset Shortage, Continued

Regular readers of the blog will know that we have been having a contradiction with Brad DeLong and the rest of the monetarist mainstream of modern macroeconomics.

They think that demand constraints imply, by definition, an excess demand for money or “safe assets.” Unemployment implies disequilibrium, for them; if everyone can achieve their desired transactions at the prevailing prices, then society’s productive capacity will always be fully utilized. Whereas I think that the interdependence of income and expenditure means that all markets can clear at a range of different levels of output and employment.

What does this mean in practice? I am pretty sure that no one thinks the desire to accumulate safe assets  directly reduces demand for current goods from households and nonfinancial businesses. If a safe asset shortage is restricting demand for real goods and services, it must be via an unwillingness of banks to hold the liabilities of nonfinancial units. Somebody has to be credit constrained.

So then: What spending is more credit constrained now, than before the crisis?

It’s natural to say, business investment. But in fact, nonresidential investment is recovering nicely. And as I pointed out last week, by any obvious measure credit conditions for business are exceptionally favorable. Risky business debt is trading at historically low yields, while the volume of new issues of high-risk corporate debt is more than twice what it was on the eve of the crisis. There’s some evidence that credit constraints were important for businesses in the immediate post-Lehmann period, if not more recently; but even for the acute crisis period it’s hard to explain the majority of the decline in business investment that way. And today, it certainly looks like the supply of business credit is higher, not lower, than before 2008.

Similarly, if a lack of safe assets has reduced intermediaries’ willingness to hold household liabilities, it’s hard to see it in the data. We know that interest rates are low. We know that most household deleveraging has taken place via default, as opposed to reduced borrowing. We know the applications for mortgages and new credit cards have continued to be accepted at the same rate as before the crisis. And this week’s new Household Credit and Debt Report confirms that people are coming no closer than before the crisis, to exhausting their credit-card credit. Here’s a graph I just made of credit card balances and limits, from the report:

Ratio of total credit card balances to total limits (blue bars) on left scale; indexes of actual and trend consumption (orange lines) on right scale. Source: New York Fed.

The blue bars show total credit card debt outstanding, divided by total credit card limits. As you can see, borrowers did significantly draw down their credit in the immediate crisis period, with balances rising from about 23% to about 28% of total credit available. This is just as one would expect in a situation where more people were pushing up against liquidity constraints. But for the past year and a half, the ratio of credit card balances to limits has been no higher than before the crisis. Yet, as the orange lines show, consumption hasn’t returned to the pre-crisis trend; if anything, it continues to fall further behind. So it looks like a large number of household were pressing against their credit limit during the recession itself (as during the previous one), but not since 2011. One more reason to think that, while the financial crisis may have helped trigger the downturn, household consumption today is not being held back a lack of available credit, or a safe asset shortage.

If it’s credit constraints holding back real expenditure, who or what exactly is constrained?

Tell Me About that “Safe Asset Shortage” Again

From today’s FT:

US Junk Debt Yield Hits Historic Low

The average yield on US junk-rated debt fell below 5 per cent for the first time on Monday, setting yet another milestone in a multiyear rally and illustrating the massive demand for fixed income returns as central banks suppress interest rates. 

Junk bonds and equities often move in tandem, and with the S&P 500 rising above 1,600 points for the first time and sitting on a double digit gain this year, speculative rated corporate bonds are also on a tear. … With corporate default rates below historical averages, investors are willing to overlook the weaker credit quality in exchange for higher returns on the securities, analysts said. … The demand for yield has become the major driver of investor behaviour this year, as they downplay high valuations for junk bonds and dividend paying stocks. 

“Maybe the hurdles of 6 per cent and now 5 per cent on high-yield bonds are less relevant given the insatiable demand for income,” said Jim Sarni, managing principal at Payden & Rygel. “People need income and they are less concerned about valuations.”

In other words, the demand for risky assets is exceptionally high, and this has driven up their price. Or to put it the other way, if you are a high-risk corporate borrower, now is a very good time to be looking for a loan.

Here’s the same thing in a figure. Instead of their absolute yield, this shows the spread of junk bonds over AAA:

Difference between CCC- and AAA bond yields

See how high it is now, over on the far right? Yeah, me neither. But if the premium for safe assets is currently quite low, how can you say that it is a shortage of safe assets that is holding back the recovery? If financial markets are willing to lend money to risky borrowers on exceptionally generous terms, how can you say the problem is a shortage of risk-bearing capacity?

Now, the shortage-of-safe-assets story does fit the acute financial crisis period. There was a period in late 2008 and early 2009 when banks were very wary of holding risky assets, and this may have had real effects. (I say “may” because some large part of the apparent fall in the supply of credit in the crisis was limited to banks’ unwillingness to lend to each other.) But by the end of 2009, the disruptions in the financial markets were over, and by all the obvious measures credit was as available as before the crisis. The difference is that now households and firms wished to borrow less. So, yes, there was excess demand for safe assets in the crisis itself; but since then, it seems to me, we are in a situation where all markets clear, just at a lower level of activity.

This is a perfect illustration of the importance of the difference between the intertemporal optimization vision of modern macro, and the income-expenditure vision of older Keynesian macro. In modern macro, it is necessarily true that a shortfall of demand for currently produced goods and services is equivalent to an excess demand for money or some other asset that the private sector can’t produce. Or as DeLong puts it:

If you relieve the excess demand for financial assets, you also cure the excess supply of goods and services (the shortfall of aggregate demand) and the excess supply of labor (mass unemployment).

Because what else can people spend their (given, lifetime) income on, except currently produced stuff or assets? If they want less of one, that must mean they want more of the other.

In the Keynesian vision, by contrast, there’s no fixed budget — no endowment — to be allocated. People don’t know their lifetime income; indeed, there is no true expected value of future income out there for them to know. So households and businesses adjust current spending based on current income. Which means that all markets can clear at a various different levels of aggregate activity. Or in other words, people can rationally believe they are on their budget constraint at different levels of expenditure, so there is no reason that a decline in desired expenditure in one direction (currently produced stuff) has to be accompanied by an increase in some other direction (safe assets or money).

(This is one reason why fundamental uncertainty is important to the Keynesian system.)

For income-expenditure Keynesians, it may well be true that the financial meltdown triggered the recession. But that doesn’t mean that an ongoing depression implies an ongoing credit crisis. Once underway, a low level of activity is self-reinforcing, even if financial markets return to a pristine state and asset markets all clear perfectly. Modern macro, on the other hand, does need a continued failure in financial markets to explain output continuing to fall short of potential. So they imagine a “safe asset shortage” even when the markets are shouting “safe asset glut.”

EDIT: I made this same case, more convincingly I think, in this post from December about credit card debt. The key points are (1) current low demand is much more a matter of depressed consumption than depressed investment; (2) it’s nonsense to say that households suffer from a shortage of safe assets since they face an infinitely-elastic supply of government-guaranteed bank deposits, the safest, most liquid asset there is; (3) while it’s possible in principle for a safe-asset shortage to show up as an unwillingness of financial intermediaries to hold household debt, the evidence is overwhelming that the fall in household borrowing is driven by demand, not supply. The entire fall in credit card debt is accounted for by defaults and reduced applications; the proportion of credit card applications accepted, and the average balance per card, have not fallen at all.

Credit Cards and the Corridor

I don’t know if most people realize how much credit card debt fell during and after the Great Recession. It fell by a lot! Credit card debt outstanding today is about $180 billion, or 21 percent, lower than it was at the end of 2007. This is a 50 percent larger fall than in mortgage debt in percentage terms — though the fall in mortgages is of course much bigger in absolute dollars.
This fall in credit card debt is entirely explained by the drop in the number of credit card accounts, from about 500 million to 380 million. The average balance on open credit card accounts is about the same today as it was when the recession began.

The obvious question is, is this fall in consumer credit due to supply, or demand? Are banks less willing to lend, or are households less eager to borrow?

Here’s some interesting data that helps shed light on this question, from the Fed’s most recent Quarterly Report on Household Credit and Finance.

The red line shows the number of credit card accounts closed over the preceding 12 months, while the blue line shows the number opened. So the gap between the blue and red lines equals the change in the number of accounts. The spike in the red line is mostly write-offs, or defaults. I’ll return to those in a subsequent post; for now let’s look at the blue and green lines. The green line shows the number of inquiries, that is, applications for new cards by consumers. The blue line, again, shows the number issued. As we can see, the number of new accounts tracks the number of inquiries almost exactly. [1] What do we conclude from this? That the fall in the rate at which new credit cards are issued is entirely a matter of reduced demand, not supply. And given that balances on outstanding credit cards have not fallen, it’s hard to avoid the conclusion that banks’ reduced willingness to lend played little or no role in the fall in consumer credit.

Of course one figure isn’t dispositive, and mortgage debt is much more important quantitatively than credit card debt. But Dean Baker has been making a similar argument about mortgages for several years now:

the ratio of applications to [home] sales has not risen notably in this slump, indicating that the inability of potential homebuyers to get mortgages has not been a big factor in the housing downturn.

As a matter of fact, after reading that post (or one of Dean’s many others making the same point), I tried to construct a similar ratio for credit cards, but I wasn’t able to find the data. I didn’t realize then that the Fed publishes it regularly in the household credit report.

Needless to say, the ratio of applications to contracts is hardly the last word on this question, and needless to say there are plenty of more sophisticated attempts out there to disentangle the roles of supply and demand in the fall in borrowing. Rather than get into the data issues in more detail right now, I want to talk about what is at stake. Does it matter whether a fall in borrowing is more driven by the supply of credit or the demand for it? I think it does, both for theory and for policy.

One important question, of course, is the historical one: Did the financial crisis straightforwardly cause the recession by cutting off the supply of credit for nonfinancial borrowers, or were other factors more important? I admit to being agnostic on this question — I do think that credit constraints were dragging down fixed investment in the year or so before the recession officially began, but I’m not sure how important this was quantitatively. But setting aside the historical question, we also need to ask, is the availability of credit the binding constraint on real activity today?

For monetarists and New Keynesians, the answer has to be Yes almost by definition. Here’s DeLong:

There is indeed a “fundamental” configuration of asset prices–one that produces full employment, the optimal level of investment given the time preference of economic agents and the expected future growth of the economy, and the optimal division of investment between safe, moderately risky, and blue-sky projects. 

However, right now the private market cannot deliver this “fundamental” configuration of asset prices. The aftermath of the financial crisis has left us without sufficient trusted financial intermediaries … no private-sector agent can create the safe securities that patient and prudent investors wish to hold. The overleverage left in the aftermath of the financial crisis has left a good many investors and financial intermediaries petrified of losing all their money and being forced to exit the game–hence the risk tolerance of the private sector is depressed far below levels that are appropriate given the fundamentals… Until this overleverage is worked off, the private marketplace left to its own will deliver a price of safe assets far above fundamentals  … and a level of investment and thus of employment far below the economy’s sustainable and optimal equilibrium.

In such a situation, by issuing safe assets–and thus raising their supply–the government pushes the price of safe assets down and thus closer to its proper fundamental equilibrium value.

In other words, there is a unique, stable, optimal equilibrium for the macroeconomy. All agents know their expected lifetime income and preferred expenditures in that equilibrium. The only reason we are not there, is if some market fails to clear. If there is a shortfall of demand for currently produced output, then there must be excess demand for some asset the private sector cannot produce. In the monetarist version of the story, that asset is money. [2] In DeLong’s version, it’s “safe assets” more generally. But the logic is the same.

This is why DeLong is so confident that continued zero interest rates and QE must work — that it is literally impossible for output to remain below potential if the Fed follows its stated policy for the next three years. If the only reason for the economy to be off its unique, optimal growth path is excess demand for safe assets, then a sufficient increase in the supply of safe assets has to be able to get us back onto it.

But is this right?

Note that in the passage above, DeLong refers to a depressed “level of investment and thus of employment.” That’s how we’re accustomed to think about demand shortfalls, and most of the time it’s a reasonable shorthand — investment (business and residential) generally does drive fluctuations in demand. But it’s not so clear that this is true of the current situation. Here, check this out:

We’re looking at output relative to potential for GDP and its components; I’ve defined potential as 2.5 percent real annual growth from the 2007Q4 peak. [3] What we see here is investment and consumption both fell during the recession proper, but since 2010, investment has recovered strongly and is almost back to trend. The continued output gap is mainly accounted for by the failure of consumption to show any signs of returning to trend — if anything, consumption growth has decelerated further in the recovery.

You can’t explain low household consumption demand in terms of a shortage of safe assets. The safest, most liquid asset available to households is bank deposits, and the supply of these is perfectly elastic. I should note that it is possible (though not necessarily correct) to explain falling consumption this way for the early 1930s, when people were trying to withdraw their savings from banks and convert them into cash. The private sector cannot print bills or mint coins. But classical bank runs are no longer a thing; people are not trying to literally hoard cash; it is impossible that a lack of safe savings vehicles for households is what’s holding down consumption today.

So if we are going to explain the continued consumption shortfall in DeLong’s preferred terms, households must be credit-constrained. It is not plausible that households are restricting consumption in order to bid up the price of some money-like asset in fixed supply. But it is plausible that the lack of trusted financial intermediaries makes investors less willing to hold households’ debt, and that this is limiting some households’ ability to borrow and thus their consumption. In that case, it could be that increasing the supply of safe assets will provide enough of a cushion that investors are again willing to hold risky assets like household debt, and this will allow households to return to their optimal consumption path. That’s the only way DeLong’s story works.

It’s plausible, yes; but is it true? The credit card data is evidence that, no, it is not. If you believe the evidence of that first figure, the fall in consumer borrowing is driven by demand, not supply; continued weakness in consumption is not the result of unwillingness of investors to hold household debt due to excess demand for safe assets. If you believe the figure, investors are no less willing to hold consumer debt than they were before the recession; it’s households that are less willing to borrow.

Again, one figure isn’t dispositive. But what I really want to establish is the logical point: The shortage-of-safe-assets explanation of the continued output gap, and the corollary belief in the efficacy of monetary policy, only makes sense if the weakness in nonfinancial units’ expenditure is due to continued tightness of credit constraints. So every additional piece of evidence that low consumption (and investment, though again investment is not especially low) is not due to credit constraints, is another nail in the coffin of the shortage-of-safe-assets story.

So what’s the alternative? Well, that’s beyond the scope of this post. But basically, it’s this. Rather than assume there is a unique, stable, optimal equilibrium, we say that the macroeconomy has multiple equilibria and/or divergent adjustment dynamics. More specifically, we emphasize the positive feedback between current income and expenditure. For small deviations in income, people and businesses don’t adjust their expenditure, but use credit and and/or liquid assets to maintain it at its normal level. But for large deviations, this buffering no longer takes place, both because of financing constraints and because true lifetime income is uncertain, so people’s beliefs about it change in response to changes in current income.

In other word’s Axel Leijonhufvud’s “corridor of stability”. Within certain bounds (the corridor), the economy experiences stabilizing feedback, based on relative prices; beyond them, it experiences destabilizing feedback based on the income-expenditure link. Within these bounds, the multiplier is weak; outside them, it is “strong enough for effects of shocks to be endogenously amplified. Within the corridor, the prescription is in favor of ‘monetarist,’ outside in favor of ‘fiscalist’, policy prescriptions.”
I’m going to break that thought off here. The important point for now is that if you think that the continued depressed level of real economic activity is due to excess demand for safe assets, you really need evidence that the expenditure of households and businesses is limited by the unwillingness of investors to hold their liabilities, i.e. that they face credit constraints. And this credit card data is one more piece of evidence that they don’t. Which, among other things, makes it less likely that central bank interventions to remove risk from the balance sheets of the financial system will meaningfully boost  output and employment.

[1] For some reason, inquiries are given over the past six months while the other two series are given over the past year. This implies that about half of all inquiries result in a new account being opened. The important point for our purposes is that this fraction did not change at all during the financial crisis and recession.

[2] To be fair, you can also find this story in the General Theory — “unemployment develops because people want the moon,” etc. But it’s not the only story you can find there. And, I would argue, Keynes really intends this as a story of how downturns begin, and not why they persist.

[3] Yes, it would be more “correct” to use the BEA’s measure of potential output. But the results would be qualitatively very similar, and I don’t think there’s nearly enough precision in measures of potential output to make the few tenths of a point difference meaningful.

LATE UPDATE: Here is a similar graph for the previous recession & recovery.

Does the Fed Control Interest Rates?

Casey Mulligan goes to the New York Times to say that monetary policy doesn’t work. This annoys Brad DeLong:

THE NEW YORK TIMES PUBLISHES CASEY MULLIGAN AS A JOKE, DOESN’T IT? 

… The third joke is the entire third paragraph: since the long government bond rate is made up of the sum of (a) an average of present and future short-term rates and (b) term and risk premia, if Federal Reserve policy affects short rates then–unless you want to throw every single vestige of efficient markets overboard and argue that there are huge profit opportunities left on the table by financiers in the bond market–Federal Reserve policy affects long rates as well. 

Casey B. Mulligan: Who Cares About Fed Funds?: New research confirms that the Federal Reserve’s monetary policy has little effect on a number of financial markets, let alone the wider economy…. Eugene Fama of the University of Chicago recently studied the relationship between the markets for overnight loans and the markets for long-term bonds…. Professor Fama found the yields on long-term government bonds to be largely immune from Fed policy changes…

Krugman piles on [1]; the only problem with DeLong’s post, he says, is that

it fails to convey the sheer numbskull quality of Mulligan’s argument. Mulligan tries to refute people like, well, me, who say that the zero lower bound makes the case for fiscal policy. … Mulligan’s answer is that this is foolish, because monetary policy is never effective. Huh? 

… we have overwhelming empirical evidence that monetary policy does in fact “work”; but Mulligan apparently doesn’t know anything about that.

Overwhelming evidence? Citation needed, as the Wikipedians say.

Anyway, I don’t want to defend Mulligan — I haven’t even read the column in question — but on this point, he’s got a point. Not only that: He’s got the more authentic Keynesian position.

Textbook macro models, including the IS-LM that Krugman is so fond of, feature a single interest rate, set by the Federal Reserve. The actual existence of many different interest rates in real economies is hand-waved away with “risk premia” — market rates are just equal to “the” interest rate plus a prmium for the expected probability of default of that particular borrower. Since the risk premia depnd on real factors, they should be reasonably stable, or at least independent of monetary policy. So when the Fed Funds rate goes up or down, the whole rate structure should go up and down with it. In which case, speaking of “the” interest rate as set by the central bank is a reasonable short hand.

How’s that hold up in practice? Let’s see:

The figure above shows the Federal Funds rate and various market rates over the past 25 years. Notice how every time the Fed changes its policy rate (the heavy black line) the market rates move right along with it?

Yeah, not so much.

In the two years after June 2007, the Fed lowered its rate by a full five points. In this same period, the rate on Aaa bonds fell by less 0.2 points, and rates for Baa and state and local bonds actually rose. In a naive look at the evidence, the “overwhelming” evidence for the effectiveness of monetary policy is not immediately obvious.

Ah but it’s not current short rates that long rates are supposed to follow, but expected short rates. This is what our orthodox New Keynesians would say. My first response is, So what? Bringing expectations in might solve the theoretical problem but it doesn’t help with the practical one. “Monetary policy doesn’t work because it doesn’t change expectations” is just a particular case of “monetary policy doesn’t work.”

But it’s not at all obvious that long rates follow expected short rates either. Here’s another figure. This one shows the spreads between the 10-Year Treasury and the Baa corporate bond rates, respectively, and the (geometric) average Fed Funds rate over the following 10 years.

If DeLong were right that “the long government bond rate is made up of the sum of (a) an average of present and future short-term rates and (b) term and risk premia” then the blue bars should be roughly constant at zero, or slightly above it. [2] Not what we see at all. It certainly looks as though the markets have been systematically overestimating the future level of the Federal Funds rate for decades now. But hey, who are you going to believe, the efficient markets theory or your lying eyes? Efficient markets plus rational expectations say that long rates must be governed by the future course of short rates, just as stock prices must be governed by future flows of dividends. Both claims must be true in theory, which means they are true, no matter how stubbornly they insist on looking false.

Of course if you want to believe that the inherent risk premium on long bonds is four points higher today than it was in the 1950s, 60s and 70s (despite the fact that the default rate on Treasuries, now as then, is zero) and that the risk premium just happens to rise whenever the short rate falls, well, there’s nothing I can do to stop you.

But what’s the alternative? Am I really saying that players in the bond market are leaving huge profit opportunities on the table? Well, sometimes, maybe. But there’s a better story, the one I was telling the other day.

DeLong says that if rates are set by rational, profit-maximizing agents, then — setting aside default risk — long rates should be equal to the average of short rates over their term. This is a standard view, everyone learns it. but it’s not strictly correct. What profit-maximizing bond traders do, is set long rates equal to the expected future value of long rates.

I went through this in that other post, but let’s do it again. Take a long bond — we’ll call it a perpetuity to keep the math simple, but the basic argument applies to any reasonably long bond. Say it has a coupon (annual payment) of $40 per year. If that bond is currently trading at $1000, that implies an interest rate of 4 percent. Meanwhile, suppose the current short rate is 2 percent, and you expect that short rate to be maintained indefinitely. Then the long bond is a good deal — you’ll want to buy it. And as you and people like you buy long bonds, their price will rise. It will keep rising until it reaches $2000, at which point the long interest rate is 2 percent, meaning that the expected return on holding the long bond and rolling over short bonds is identical, so there’s no incentive to trade one for the other. This is the arbitrage that is supposed to keep long rates equal to the expected future value of short rates. If bond traders don’t behave this way, they are missing out on profitable trades, right?

Not necessarily. Suppose the situation is as described above — 4 percent long rate, 2 percent short rate which you expect to continue indefinitely. So buying a long bond is a no-brainer, right? But suppose you also believe that the normal or usual long rate is 5 percent, and that it is likely to return to that level soon. Maybe you think other market participants have different expectations of short rates, maybe you think other market participants are irrational, maybe you think… something else, which we’ll come back to in a second. For whatever reason, you think that short rates will be 2 percent forever, but that long rates, currently 4 percent, might well rise back to 5 percent. If that happens, the long bond currently trading for $1000 will fall in price to $800. (Remember, the coupon is fixed at $40, and 5% = 40/800.) You definitely don’t want to be holding a long bond when that happens. That would be a capital loss of 20 percent. Of course every year that you hold short bonds rather than buying the long bond at its current price of $1000, you’re missing out on $20 of interest; but if you think there’s even a moderate chance of the long bond falling in value by $200, giving up $20 of interest to avoid that risk might not look like a bad deal.

Of course, even if you think the long bond is likely to fall in value to $800, that doesn’t mean you won’t buy it for anything above that. if the current price is only a bit above $800 (the current interest rate is only a bit below the “normal” level of 5 percent) you might think the extra interest you get from buying a long bond is enough to compensate you for the modest risk of a capital loss. So in this situation, the equilibrium price of the long bond won’t be at the normal level, but slightly below it. And if the situation continues long enough, people will presumably adjust their views of the “normal” level of the long bond to this equilibrium, allowing the new equilibrium to fall further. In this way, if short rates are kept far enough from long rates for long enough, long rates will eventually follow. We are seeing a bit of this process now. But adjusting expectations in this way is too slow to be practical for countercyclical policy. Starting in 1998, the Fed reduced rates by 4.5 points, and maintained them at this low level for a full six years. Yet this was only enough to reduce Aaa bond rates (which shouldn’t include any substantial default risk premium) by slightly over one point.

In my previous post, I pointed out that for policy to affect long rates, it must include (or be believed to include) a substantial permanent component, so stabilizing the economy this way will involve a secular drift in interest rates — upward in an economy facing inflation, downward in one facing unemployment. (As Steve Randy Waldman recently noted, Michal Kalecki pointed this out long ago.) That’s important, but I want to make another point here.

If the primary influence on current long rates is the expected future value of long rates, then there is no sense in which long rates are set by fundamentals.  There are a potentially infinite number of self-fulfilling expected levels for long rates. And again, no one needs to behave irrationally for these conventions to sustain themselves. The more firmly anchored is the expected level of long rates, the more rational it is for individual market participants to act so as to maintain that level. That’s the “other thing” I suggested above. If people believe that long rates can’t fall below a certain level, then they have an incentive to trade bonds in a way that will in fact prevent rates from falling much below that level. Which means they are right to believe it. Just like driving on the right or left side of the street, if everyone else is doing it it is rational for you to do it as well, which ensures that everyone will keep doing it, even if it’s not the best response to the “fundamentals” in a particular context.

Needless to say, the idea that that long-term rate of interest is basically a convention straight from Keynes. As he puts it in Chapter 15 of The General Theory,

The rate of interest is a highly conventional … phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable; subject, of course, in a changing society to fluctuations for all kinds of reasons round the expected normal. 

You don’t have to take Keynes as gospel, of course. But if you’ve gotten as much mileage as Krugman has out of the particular extract of Keynes’ ideas embodied in the IS-LM mode, wouldn’t it make sense to at least wonder why the man thought this about interest rates, and if there might not be something to it.

Here’s one more piece of data. This table shows the average spread between various market rates and the Fed Funds rate.

Spreads over Fed Funds by decade
10-Year Treasuries Aaa Corporate Bonds Baa Corporate Bonds State & Local Bonds
1940s 2.2 3.3
1950s 1.0 1.3 2.0 0.7
1960s 0.5 0.8 1.5 -0.4
1970s 0.4 1.1 2.2 -1.1
1980s 0.6 1.4 2.9 -0.9
1990s 1.5 2.6 3.3 0.9
2000s 1.5 3.0 4.1 1.8

Treasuries carry no default risk; a given bond rating should imply a fixed level of default risk, with the default risk on Aaa bonds being practically negligible. [3] Yet the 10-year treasury spread has increased by a full point and the corporate bond rates by about two points, compared with the postwar era. (Municipal rates have risen by even more, but there may be an element of genuine increased risk there.) Brad DeLong might argue that society’s risk-bearing capacity has decline so catastrophically since the 1960s that even the tiny quantum of risk in Aaa bonds requires two full additional points of interest to compensate its quaking, terrified bearers. And that this has somehow happened without requiring any more compensation for the extra risk in Baa bonds relative to Aaa. I don’t think even DeLong would argue this, but when the honor of efficient markets is at stake, people have been known to do strange things.

Wouldn’t it be simpler to allow that maybe long rates are not, after all, set as “the sum of (a) an average of present and future short-term rates and (b) [relatively stable] term and risk premia,” but that they follow their own independent course, set by conventional beliefs that the central bank can only shift slowly, unreliably and against considerable resistance? That’s what Keynes thought. It’s what Alan Greenspan thinks. [4] And also it’s what seems to be true, so there’s that.

[1] Prof. T. asks what I’m working on. A blogpost, I say. “Let me guess — it says that Paul Krugman is great but he’s wrong about this one thing.” Um, as a matter of fact…

[2] There’s no risk premium on Treasuries, and it is not theoretically obvious why term premia should be positive on average, though in practice they generally are.

[3] Despite all the — highly deserved! — criticism the agencies got for their credulous ratings of mortgage-backed securities, they do seem to be good at assessing corporate default risk. The cumulative ten-year default rate for Baa bonds issued in the 1970s was 3.9 percent. Two decades later, the cumulative ten-year default rate for Baa bonds issued in the 1990s was … 3.9 percent. (From here, Exhibit 42.)

[4] Greenspan thinks that the economically important long rates “had clearly delinked from the fed funds rate in the early part of this decade.” I would only add that this was just the endpoint of a longer trend.

Adventures in Cognitive Dissonance

Brad DeLong, May 25:

WHAT ARE THE CORE COMPETENCES OF HIGH FINANCE? 

The core competences of high finance are supposed to be (a) assessing risk, and (b) matching people with risks to be carried with people with the risk-bearing capacity to carry them. Robert Waldmann has a different view:

I think their core competencies are (a) finding fools for counterparties and (b) evading regulations/disguising gambling as hedging.

Regulatory arbitrage, and persuading those who do not understand risks that they should bear them–those are not socially-valuable activities.

Brad DeLong, yesterday:

NEXT YEAR’S EXPECTED EQUITY RETURN PREMIUM IS 9% 

If you have any risk-bearing capacity at all, now is the time to use it.

So I guess last week’s doubts have been assuaged. Or did he really mean to write “If you have any capacity for being fooled into being a swindler’s counterparty, now is the time to use it”?

EDIT: Oh and then, the post just after that one argued — well, really, assumed — that the current value of Facebook shares gives an unbiased estimate of future Facebook earnings, and therefore of the net wealth that Facebook has created. (I guess not a single dollar of FB revenue comes at the expense of other firms, which must be a first in the history of capitalism.) Is there some way of consistently believing both that current stock values give an unbiased estimate of the present value of future earnings, and that stock values a year from now will be much higher than they are today? I can’t see one. But then I’ve never had the brain for theodicy.

UPDATE: Anyone reading this should immediately go and read rsj’s much better take on the same DeLong post over at Windyanabasis. He explains exactly why DeLong is confused here.

Are Recessions All About Money?

There is a view that seems to be hegemonic among liberal economists, that recessions are fundamentally about money or finance. Not just causally, not just in general, but always, by definition. In this view, the only sense in which one can speak about aggregate demand as a constraint on output, is if we can identify excess demand for some non-produced financial asset.

In the simplest case, people want to hold a stock of money in some proportion to their total income. Money is produced only by the government. Now suppose people’s demand for money rises, and the government fails to increase supply accordingly. You might expect the price of money to rise — that is, deflation. But deflation doesn’t restore equilibrium, either because prices are sticky (i.e., deflation can’t happen, or not fast enough), or because deflation itself further raises the demand for money. It might do this by raising precautionary demand, since falling prices make it likely that businesses and households won’t be able to meet obligations fixed in money terms and will face bankruptcy (Irving Fisher’s debt-deflation cycle). Or deflation might increase demand for money by because it redistributes income from net borrowers to net savers, and the latter have a higher marginal demand for money holdings. Or there could be other reasons. In any case, the price of money doesn’t adjust, so government has to keep its quantity growing at the appropriate rate instead. From this perspective,  if we ever see an economy operating bellow full capacity, it is true by definition that there is excess demand for some money-like asset.

This sounds like Milton Friedman. It is Milton Friedman! But it also seems to be most of the liberal macroeconomists who are usually called Keynesians. Here’s DeLong:

there was indeed a “general glut” of newly-produced commodities for sale and of workers to hire. But it was also the case that the excess supply of goods, services, and labor was balanced by an excess demand elsewhere in the economy. The excess demand was an excess demand not for any newly-produced commodity, but instead an excess demand for financial assets, for “money”…

How, exactly, should economists characterize the excess demand in financial markets? Where was it, exactly? That became a subject of running dispute, and the dispute has been running for more than 150 years, with different economists placing the cause of the “general glut” that was excess supply of newly-produced goods and of labor at the door of different parts of the financial system.

The contestants are:

Fisher-Friedman: monetarism: a depression is the result of an excess demand for money–for those liquid assets generally accepted as means of payment that people hold in their portfolios to grease their market transactions. You fix a depression by having the central bank boost the money stock…

Wicksell-Keynes (Keynes of the Treatise on Money, that is): a depression happens when there is an excess demand for bonds… You fix a depression by either reducing the market rate of interest (via expansionary monetary policy) or raising the natural rate of interest (via expansionary fiscal policy) in order to bring them back into equality….

Bagehot-Minsky-Kindleberger: a depression happens because of a panic and a flight to quality, as everybody tries to sell their risky assets and cuts back on their spending in order to try to shift their portfolio in the direction of safe, high-quality assets… You fix a depression by restoring market confidence and so shrinking demand for AAA assets and by increasing the supply of AAA assets….

From the perspective of this Malthus-Say-Mill framework Keynes’s General Theory is a not entirely consistent mixture of (1), (2), and (3)…Note that these financial market excess demands can have any of a wide variety of causes: episodes of irrational panic, the restoration of realistic expectations after a period of irrational exuberance, bad news about future profits and technology, bad news about the solvency of government or of private corporations, bad government policy that inappropriately shrinks asset stocks, et cetera. Nevertheless, in this Malthus-Say-Mill framework it seems as if there is always or almost always something that the government can do to affect asset supplies and demands that promises a welfare improvement

That’s an admirably clear statement. But is it right? I mean, first, is it right that demand constraints can always and only be usefully characterized as excess demand for some financial asset? And second, is that really what the General Theory says?

The first answer is No. Or rather, it’s true but misleading. It is hard to talk sensibly about a “general glut” of currently produced goods except in terms of an excess demand for some money-like financial asset. But recessions and depressions are not mainly characterized by a glut of currently produced goods. They are characterized by an excess of productive capacity. Markets for all currently-produced goods may clear. But there is still a demand constraint, in the sense that if desired expenditure were higher, aggregate output would be higher. The simple Keynesian cross we teach in the second week of undergrad macro is a model of just such an economy, which makes sense without money or any other financial asset. (And is probably more useful than most of what gets taught in graduate courses.) Arguably, this is the normal state of modern capitalist economies.

I’ll come back to this in a future post, hopefully. But it’s important to stress that the notion of aggregate demand limiting output, does not imply that any currently-produced good is in excess supply. [1]

Meanwhile, how about the second question — in the General Theory, did Keynes see demand constraints as being fundamentally about excess demand for money or some other financial asset, with the solution being to change the relative price of currently produced goods, and that asset? Again, the answer is No.

In his explanation of the instability of capitalist economies, Keynes always emphasizes the fluctuations in investment demand (or in his terms, the marginal efficiency of capital schedule). Investment demand is based on the expected returns of new capital goods over their lifetime. But the distribution of future states of the world relevant to those returns is not just stochastic but fundamentally unknown, so expectations about profits on long-lived fixed capital are essentially conventional and unanchored. It is these fluctuations in expectations, and not the demand for financial assets as expressed in liquidity preference, that drives booms and slumps. Keynes:

The fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the rate of interest may seriously aggravate the decline in investment. But the essence of the situation is to be found, nevertheless, in the collapse of the marginal efficiency of capital… Liquidity preference, except those manifestations which are associated with increasing trade and speculation, does not increase until after the collapse in the marginal efficiency of capital.  

It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and probably a necessary condition of it. But for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough [to offset it]. If the reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority. But in fact, this is not usually the case.

In this sense, Keynes agrees with the Real Business Cycle theorists that the cause of a decline in output is not fundamentally located in the financial system, but a fall in the expected profitability of new investment. The difference is that RBC thinks a decline in expected profitability must be due to genuine new information about the true value of future profits. Keynes on the other hand thinks there is no true expected value in that sense, and that our belief about the future are basically irrational. (“Enterprise only pretends to itself to be actuated by the statements in its prospectus … only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come.”) This is an important difference. But the key point here is the bolded sentences. Keynes considers DeLong’s view that the fundamental cause of a downturn is an autonomous increase in demand for safe or liquid assets, and explicitly rejects it.

The other thing to recognize is that Keynes never mentions the zero lower bound. He describes the liquidity trap as theoretical floor of the interest rate, which is above zero, but nothing in his argument depends on it. Rather, he says,

The most stable, and least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in the future, the minimum rate of interest acceptable to the generality of wealthowners. (Cf. the nineteenth-century saying quoted by Bagehot, that “John Bull can stand many things, but he cannot stand 2 percent.”) If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money.

This is an important part of the argument, but it tends to get ignored by mainstream Keynesians, who assume that monetary authority can reliably set “the” interest rate. But as we see clearly today, this is not a good assumption to make. Well before the policy rate reached zero, it had become effectively disconnected from the rates facing business borrowers. And of course the hurdle rate from the point of view of the decisionmakers at a firm considering new investment isn’t just the market interest rate, but that rate plus some additional premium reflecting what Keynes (and later Minsky) calls borrower’s risk.

So, Keynes thought that investment demand was subject to wide, unpredictable fluctuations, and probably also a secular downward trend. He doubted that very large movements in the interest rate could be achieved by monetary policy. And he didn’t think that the moderate movements that could be achieved, would have much effect on investment. [2] Where did that leave him? “Somewhat skeptical of the success of a merely monetary policy directed toward influencing the rate of interest” at stabilizing output and employment; instead, the government must “take an ever greater responsibility for directly organizing investment.”

Of course, DeLong could be misrepresenting Keynes and still be right about economic reality. But we need to at least recognize that aggregate demand is logically separate from the idea of a general glut; that the former, unlike the latter, does not necessarily involve excess demand for any financial asset; and that in practice supply and demand conditions in financial markets are not always the most important or reliable influences on aggregate demand. Keynes, at least, didn’t think so. And he was a smart guy.

[1] The other point, to anticipate a possible objection, is that the investment decision does not involve allocation of a fixed stock of savings between capital goods and financial assets.

[2] The undoubted effectiveness of monetary policy in the postwar decades might seem to argue against this point. But it’s important to recognize — though Keynes himself didn’t anticipate this — that in practice monetary policy has operated largely though its effect on the housing market, not on investment.

Political Economy 101

When he’s right, he’s right:

everything we’re seeing makes sense if you think of the Right as representing the interests of rentiers, of creditors who have claims from the past — bonds, loans, cash — as opposed to people actually trying to make a living through producing stuff. Deflation is hell for workers and business owners, but it’s heaven for creditors. … thinking of what’s happening as the rule of rentiers, who are getting their interests served at the expense of the real economy, helps make sense of the situation.

Or, almost right. Because it isn’t just the Right…

EDIT: It’s interesting to note how reflexively DeLong shied away from this thought when it occurred to him a while back, with the ludicrous-on-its-face argument that only “coupon-clippers with their portfolios 100% in government bonds” could have an interest in deflation. The existence of rentiers as a distinct social class is an unthought in respectable circles. Which shows how impressively disrespectable Krugman is becoming.

The Beatings Will Continue…

This may be the answer to this.

Shorter DeLong:

It is perfectly obvious that the cause of the Great Recession was an insufficient supply of government debt. And it is perfectly obvious that we need to reduce the supply of government debt.

Let me spoil the joke by explaining it.

The argument that the collapse in demand for currently produced goods and services in 2007-2009 was due to an excess demand for AAA assets, i.e. government debt, is a useful one, as far as it goes. But the strange thing is that the New Keynesians making it don’t seem to think it conveys any information about the long-term fiscal position. Presumably, if we’d known about the coming excess demand for government debt, we’d have wanted higher deficits throughout the 2000s, instead of having to ramp them up suddenly at the end of the decade. And presumably, the circumstances that led to higher demand for government debt in 2007-2009 can be expected to recur. So maybe we want to prepare for them going forward? But no, we still need the debt-GDP ratio to be “sustainable” — a term which is never defined, except it’s always lower than where we are now. The fact that the ratio was too low, rather than too high, in the recent past somehow fails to imply that it could be too low, rather than too high, in the future.

Let me come at this another way. Check out the entrants in the Peterson Institute budget beauty contest. All of them are considered by the judges to have rocked the swimsuit competition “put the federal debt on a sustainable trajectory through 2035.” But what does this mean? The fiscal positions at the end date range from a surplus of 0.8% of GDP to a deficit of 3.7%. Debt-GDP ratios range from 30% to 81.7%. The highest-deficit entrant (EPI’s, for what it’s worth) is near the very high end of the historical range, and essentially identical to the CBO’s current-policy baseline. If current policy is sustainable, why are we having this conversation? But of course, Peterson gives no indication how “sustainable” is being defined (or for that matter what they’re assuming about GDP growth and the interest rate on government debt, quite important for these exercises).

Mainstream discourse on budget deficits (as with inflation) combines an absolute conviction that the current debt-GDP ratio is too high, with a complete lack of principles for telling us what the optimal ratio might be.