business cycles – J. W. Mason

Negative Nowcast

In recent days, there has been a good deal of discussion in the business press and on economics Bluesky about the Atlanta Federal Reserve Bank’s “nowcast” of GDP for the first quarter of 2025. The suggestion is that the US may already be entering a recession.

The first quarter of 2025 is, of course, ongoing; strictly speaking, 2025Q1 GDP has not happened yet. But the Atlanta Fed’s GDPNow series tries to estimate what GDP for the quarter will turn out to be, based on data that is available before the official first release of GDP numbers at the start of the following month.

The Atlanta Fed has been producing these estimates since 2011. The reason this one got so much notice is that it shows “real” (inflation-adjusted) GDP this quarter declining at an annual rate of -2.8 percent, the second lowest value its shown since they started producing it. (The lowest, of course, was for 2020Q2.)

This is obviously significant as an indicator. I think that it does incorporate genuine information about what’s going in the world, and means broadly what it seems to mean. But I want to point out an important caveat, which both suggests we shouldn’t take this number at face value and raises some interesting questions about how we measure the economy.

The Atlanta Fed’s forecast implies a decline in growth of 5.1 points relative to the 2.3 points of inflation-adjusted growth in the fourth quarter of 2024.¹ If you dig into the Atlanta Fed’s numbers a bit, you’ll find that a large part of this is consumption spending, which is projected to be essentially flat this quarter, after contributing 1.5-2 points of growth in each recent quarter. An even larger contribution, however, comes from imports, which added 0.17 points to GDP growth last quarter but are projected to subtract 3.27 points this quarter.

You can see this below, showing the contribution of each component to “real” growth in recent quarters. The last column is the Atlanta Fed’s estimate for the current quarter.

Annualized contributions to real GDP growth

The fall in consumption spending, and the zero real growth in investment spending, represent, I think genuine developments in the world. But I find it impossible to take the imports number at face value.

By the conventions of the national accounts, imports are a subtraction from GDP. So the big negative bar on the right of the figure represents a rapid growth in imports – close to the fastest import growth, in fact, in US history. But in real economies, imports almost always rise when GDP growth is strong, and fall when GDP growth is weak. The prediction that we will have an almost-unprecedented slowdown in growth alongside and almost-unprecedented rise in imports doesn’t fit the historical experience.

Here, for example, is another version of Figure 1, but covering the period of the last major recession in the US, in 2008-2009. Notice how when investment spending (and GDP, though it’s not shown) fall through the floor in the second half of 2008, the contribution of imports turns sharply positive, indicating lower imports. Then when consumption and investment spending begin to rise again, making a positive contribution to growth, the import contribution turns negative. This is the usual historical pattern.

The strong relationship between expenditure growth and imports is, I think, one of the most basic and reliable Keynesian facts about the world. Countries import more when they grow faster, and import less when they grow more slowly or shrink. In the long run, yes, relative prices and competitiveness more broadly may be important. But in the short run of a few years or quarters, income is what matters.

Given this strong Keynesian prior, I have a lot of trouble accepting the Atlanta Fed’s nowcast that we are seeing very weak GDP growth but very rapid import growth. It’s not impossible, but it’s certainly very strange.

Here’s a figure, going back to 1947, showing annualized quarterly “real” GDP growth rates and the contribution of imports. The Atlanta Fed’s estimate for the current quarter is the large red dot in the lower left. As you can see, it’s not entirely out of line with the historical experience. But it would certainly be an outlier. The great majority of quarters with import growth even close to this saw exceptionally strong GDP growth.

An accounting point: When we teach the national income identity — Y = C + I + G + X – M — we present it as if M was a distinct category of spending. But it really isn’t. Final spending by every unit in the economy falls into one of the other four categories. -M is there to subtract the imported component of the other spending categories. This matters here, because it means it is impossible for anyone to simply import more, without also doing more of one of the other categories. Even if imported materials are just stockpiled in a warehouse, that is inventory investment, at least from the point of view of the national accounts.

Over time, of course, imports might rise independently of other components, if the fraction of imported inputs used to produce consumption or investment or export goods changed. But these are changes that happen only gradually. In the short run, it’s impossible for anyone to spend more on imports without also spending more on something else. And in practice, again, import spending reliably rises when total spending rises, and falls when total spending falls. (The relationship in the figure would look much closer if I used annual data.) A deep recession with a dramatic rise in import spending — what the Atlanta Fed’s numbers imply — is well outside the historic experience.

So what is really going on?

The Atlanta Fed is looking at genuine data. The high import numbers reflect more stuff being declared at US ports; the consumption numbers reflect lower grocery store receipts.

One natural way to make sense of it is that this is a surge of imports as businesses try to get ahead of Trump’s tariffs. Normally, imports are a reasonably stable share of current spending. But in this case, the imported part of future spending has been moved forward to this quarter.

Now, in principle, if this what’s going on, then the higher imports should be balanced by an increase in inventory investment — accumulation of raw materials and goods in process — with no effect on GDP. But the Atlanta Fed is assembling its data from a variety of different sources; there’s no reason to expect it to conform to the accounting relationships that final GDP has to. If, let’s say, trade data comes in sooner than inventory data — which seems very plausible — then it will look instead like the import share of other categories of spending is increasing. Which would be a subtraction from GDP.

To be clear: I think this is fine. Consistency and transparency are very valuable qualities in public data; they shouldn’t be lightly sacrificed even where some one-off adjustment will clearly yield a better point estimate. I think the Atlanta Fed is right to apply their methods consistently, even if they result in implausible results in this particular case.

There is, though, another intriguing possibility.

A research report from Goldman Sachs² suggests that the apparent rise in imports is to some significant extent due to a rise in imports of monetary gold. The Goldman Sachs analysts write:

most of the widening in the trade deficit since November has been driven by higher gold imports … as participants in the gold market sought to insure themselves against potential tariffs on gold. Although this may seem like a frontloading effect ahead of potential tariffs, these imports are for the most part … being shipped to the US on the off-chance that physical delivery of the gold is required,… Importantly, the Bureau of Economic Analysis (BEA) excludes most gold imports when calculating the imports component of GDP. ….

The same reasoning applies more generally to front-loading by retailers, wholesalers, and producers ahead of tariff increases. Because these developments are unrelated to US production, they should have little net effect on US GDP. In the case of non-gold goods, higher imports should be offset by higher inventories in the national accounts. In practice, it is possible that front-loading exerts a modest drag on reported GDP because imports… tend to be measured more accurately than inventories. We suspect this dynamic is playing out now to some extent… But because front-loading these imports now implies fewer imports later, we think the net effect on 2025 GDP growth should be small.

Again: in the conventions of the national accounts, if businesses buy extra foreign inputs today in order to avoid higher costs later, that should, in principle, be recorded in the national accounts as equal increases in imports and inventory investment, with no net effect on GDP. But if the rise in imports is observed earlier or more accurately that the rise in inventory investment, we will see a spurious decline in GDP.

But what about the point about gold specifically, that the BEA excludes gold imports when calculating the import component of GDP? This is not something I’d ever really thought about or even been aware of. But having now poked around a bit, yes, this is correct. Gold imports show up in the trade data because, of course they do. It’s a good crossing the international border. But monetary gold, gold held as an asset, does not show up in the imports (M) shown in the National Income and Product Accounts, because the NIPAs are organized to track production, and gold held as an asset is not being used in production.

This is a very interesting accounting issue — in fact it’s what motivated me to write this post.

National accounting always faces the fundamental question of the production boundary. Which activities are part of production, and which ones aren’t? GDP (and its subsidiary components, like M) is supposed to be a sum of payments for new production. It’s not supposed to include payments for transfer of ownership of existing assets. But this is not always a clean distinction.

Gold is a weird commodity in this context, because it is both an important input to production (of both industrial equipment and jewelry) and an asset held for its own sake. In principle, when gold is unloaded from a ship and put into a warehouse, there’s no way to know whether it is destined to be an input to the production of some consumption good or piece of industrial equipment, or if it is being held as an asset. Maybe at that moment it hasn’t even been determined.Gold is gold.³

What the BEA does — this is interesting — is to take the difference between US use of gold as a production input and US production of gold, and call that imports of gold for purposes of the NIPAs. The difference between the actual net imports of gold and this number is assumed to be monetary gold. In practice, domestic production and use seem to be pretty close, so NIPA gold imports stay close to zero regardless of what the trade figures show. This procedure seems reasonable enough.

It’s not clear to me if monetary gold imports explain the whole story of the Atlanta Fed’s strange rise in imports, or just a part of it. The way the data is presented the Goldman Sachs report makes it hard to compare magnitudes. But it is true, on the one hand, that a surge in imports ahead of the tariffs not informative about GDP growth this quarter. And on the other hand, the treatment of gold imports in the national accounts raises some profound issues, whether or not it fully explains the apparent import surge.

The fundamental challenge with gold is that is both an important input to production, and an important asset in its own right. This is a challenge for our accounting framework that relies on a sharp line between payments related to production and asset sales. Gold is hardly unique in that respect.

A very analogous and more generally important case is housing. When a family buys a home, they are buying both a flow of consumption (the use value of living in that house) and an asset (the exchange value they can receive by selling the house, or borrowing against it).

Conceptually, these are two different purchase. But in reality, the homeowner is writing only one check. This is a big problem both substantively and for data. Substantively — well, this goes beyond the scope of this post, but the fact that people’s providing for their own housing needs also involves taking a position in a speculative asset has some pretty far-reaching effects on our society. From a data standpoint: How are we going to split the one payment of the homeowner into the part that is paying for the use of the hoser right now, and the part that is paying for the chance to profit from the appreciation of the house? It’s not an easy question.

Returning to the Atlanta Fed GDPNow estimates. It’s worth emphasizing that the estimate of zero real growth inc consumption spending, which doesn’t have any practical or conceptual problems as far as I can tell. So even if we set aside the import question, there is reason to say that real-time economic data suggest a sharp slowdown in spending — and therefore output, income and employment — relative to the recent trend. I think we should take that forecast seriously directionally, even if there is reason to be skeptical of the dramatic fall in GDP that they forecast.

If we set aside the import numbers, the estimate is real growth for the quarter of close to zero. Which would still be a sharp slowdown, and lead us to expect a significant rise in unemployment.

At the same time, we should keep in mind — always, and perhaps even more now — that numbers like GDP are not material facts existing out there in he world. They are the result of aggregating an enormous number of private payments in a specific way, which involve a great number of more or less arbitrary choices. If we don’t understand how the numbers are constructed, we will not be able to say much about what they mean.

At Barron’s: Do Interest Rates Really Drive the Economy?

(I write a more-or-less monthly opinion piece for Barron’s. This is my contribution for March 2023; you can find the earlier ones here.)

When interest rates go up, businesses spend less on new buildings and equipment. Right?

That’s how it’s supposed to work, anyway. To be worth doing, after all, a project has to return more than the cost of financing it. Since capital expenditure is often funded with debt, the hurdle rate, or minimum return, for capital spending ought to go up and down with the interest rate. In textbook accounts of monetary policy, this is a critical step in turning rate increases into slower activity.

Real economies don’t always match the textbook, though. One problem: market interest rates don’t always follow the Federal Reserve. Another, perhaps even more serious problem, is that changes in interest rates may not matter much for capital spending.

A fascinating new study raises new doubts about how much of a role interest rates play in business investment.

To clarify the interest-investment link, Niels Gormsen and Kilian Huber — both professors at the University of Chicago Booth School of Business — did something unusual for economists. Instead of relying on economic theory, they listened to what businesses themselves say. Specifically, they (or their research assistants) went through the transcripts of thousands of earnings calls with analysts, and flagged any mention of the hurdle rate or required return on new capital projects.

What they found was that quoted hurdle rates were consistently quite high — typically in the 15-20% range, and often higher. They also bore no relationship to current interest rates. The federal funds rate fell from 5.25% in mid-2007 to zero by the end of 2008, and remained there through 2015. But you’d never guess it from the hurdle rates reported to analysts. Required returns on new projects were sharply elevated over 2008-2011 (while the Fed’s rate was already at zero) and remained above their mid-2000s level as late as 2015. The same lack of relationship between interest rates and investment spending is found at the level of individual firms, suggesting, in Gormsen and Huber’s words, that “fluctuations in the financial cost of capital are largely irrelevant for [business] investment.”

While this picture offers a striking rejection of the conventional view of interest rates and investment spending, it’s consistent with other research on how managers make investment decisions. These typically find that changes in the interest rate play little or no role in capital spending.

If businesses don’t look at interest rates when making investment decisions, what do they look at? The obvious answer is demand. After all, low interest rates are not much of an incentive to increase capacity if existing capacity is not being used. In practice, business investment seems to depend much more on demand growth than on the cost of capital.

(The big exception is housing. Demand matters here too, of course, but interest rates also have a clear and direct effect, both because the ultimate buyers of the house will need a mortgage, and because builders themselves are more dependent on debt financing than most businesses are. If the Fed set the total number of housing permits to be issued across the country instead of a benchmark interest rate, the effects of routine monetary policy might not look that different.)

If business investment spending is insensitive to interest rates, but does respond to demand, that has implications for more than the transmission of monetary policy. It helps explain both why growth is so steady most of the time, and why it can abruptly stall out.

As long as demand is growing, business investment spending won’t be very sensitive to interest rates or other prices. And that spending in turn sustains demand. When one business carries out a capital project, that creates demand for other businesses, encouraging them to expand as well. This creates further demand growth in turn, and more capital spending. This virtuous cycle helps explain why economic booms can continue in the face of all kinds of adverse shocks — including, sometimes, efforts by the Fed to cut them off.

On the other hand, once demand falls, investment spending will fall even more steeply. Then the virtuous cycle turns into a vicious one. It’s hard to convince businesses to resume capital spending when existing capacity is sitting idle. Each choice to hold back on investment, while individually rational, contributes to an environment where investment looks like a bad idea.

This interplay between business investment and demand was an important part of Joseph Schumpeter’s theory of business cycles. It played a critical role in John Maynard Keynes’ analysis of the Great Depression. Under the label multiplier-accelerator models, it was developed by economists in the decades after World War II. (The multiplier is the link from investment to demand, while the accelerator is the link from demand growth to investment.) These theories have since fallen out of fashion among economists. But as the Gormsen and Huber study suggests, they may fit the facts better than today’s models that give decisive importance to the interest rate controlled by the Fed.

Indeed, we may have exaggerated the role played in business cycles not just of monetary policy, but of money and finance in general. The instability that matters most may be in the real economy. The Fed worries a great deal about the danger that expectations of higher inflation may become self-confirming. But expectations about real activity can also become unanchored, with even greater consequences. Just look at the “jobless recoveries” that followed each of the three pre-pandemic recessions. Weak demand remained stubbornly locked in place, even as the Fed did everything it could to reignite growth.

In the exceptionally strong post-pandemic recovery, the Fed has so far been unable to disrupt the positive feedback between rising incomes and capital spending. Despite the rate hikes, labor markets remain tighter than any time in the past 20 years, if not the past 50. Growth in nonresidential investment remains fairly strong. Housing starts have fallen sharply since rates began rising, but construction employment has not – at least not yet. The National Federation of Independent Business’s survey of small business owners gives a sharply contradictory picture. Most of the respondents describe this as a very poor moment for expansion, yet a large proportion say that they themselves plan to expand and increase hiring. Presumably at some point this gap between what business owners are saying and what they are doing is going to close – one way or the other.

If investment responded strongly to interest rates, it might be possible for the Fed to precisely steer the economy, boosting demand a little when it’s weak, cooling it off when it gets too hot. But in a world where investment and demand respond mainly to each other, there’s less room for fine-tuning. Rather than a thermostat that can be turned up or down a degree or two, it might be closer to the truth to say that the economy has just two settings: boom and bust.

At its most recent meeting, the Fed’s forecast was for the unemployment rate to rise one point over the next year, and then stabilize. Anything is possible, of course. But in the seven decades since World War Two, there is no precedent for this. Every increase in the unemployment rate of a half a point has been followed by a substantial further rise, usually of two points or more, and a recession. (A version of this pattern is known as the Sahm rule.) Maybe we will have a soft landing this time. But it would be the first one.

A C-Shaped Recovery?

The coronavirus crisis has been different from normal recessions in many ways, but one of the most important is the scale of the macroeconomic response to it.

Thanks to the stimulus payments, the pandemic unemployment insurance, the child tax credit, and a raft of other income support measures, this is the first recession in history in which household income actually rose rather than fell, and households ended up in a stronger financial position than before — with bankruptcies, for instance, running at half their pre-pandemic rates. It’s this that’s allowed spending to come back so quickly as the pandemic recedes. It wasn’t written in stone that the economic problem at the end of 2021 would be labor “shortages” and inflation, rather than double-digit unemployment and mass immiseration. The rising wave of hunger, homelessness and bankruptcies that people feared at the start of the pandemic hasn’t shown up. But that doesn’t mean that it couldn’t have. Without the stimulus measures of the past year and a half, it most likely would have.

This extraordinary success story is the missing context for today’s macroeconomic debates. It’s somehow becoming conventional wisdom that the economy is “overstimulated,” as if the economic disruptions of the pandemic could have been managed some other way. As Claudia Sahm observed last week, the choice facing policymakerswas either to repeat the mistakes of the Great Recession or to go big. Fortunately, they went big.

The aggregate dimension of this story is familiar, even it’s sometimes forgotten these days. But I’ve seen much less discussion of the distributional side. Disposable income has held up overall, but what about for people at different income ranges?

For detailed statistics on this, we will have to wait for the American Community Survey produced by the Census. The ACS comes out annually; the first data from 2020 will be released in a month or so, and 2021 numbers will take another year. For real-time data we depend on the Current Population Survey, from the Bureau of Labor Statistics. This is the source for all the headline numbers on unemployment, wages and so on.

The CPS is mainly focused on labor-market outcomes, but it does have one question about income: “What was the total combined income of all members of your family over the past 12 months?”⁴ The answer is given as one of 15 ranges, topping out at $150,000 or higher.

Compared with what we get from the ACS (or other more specialized surveys like the Survey of Consumer Finances or the Survey of Income and Program Participation) that’s not very much information. But it’s enough to get the big picture, and it has the major advantage of being available in close to real time.

I have not seen anyone use the CPS to look at how real (inflation-adjusted) income changed across the distribution during the pandemic, compared with in the previous recession. So I decided to look at it myself. The results are shown in the figure nearby.

What I’ve done here is construct a household income measure by distributing households evenly within their buckets. Then I adjusted that income for inflation using the CPI. Then I compared family income at each point in the distribution in September 2021 — the most recent available — with September 2019, and then did the same thing for September 2009 and September 2007. I used the CPI for the inflation adjustment because the PCE index isn’t available yet for September.⁵ Using two-year periods ending in September seemed like the best way to make an apples-to-apples comparison and avoid seasonal effects.⁶ The idea is to see what happened to income across the distribution during the pandemic as compared to a similar time period during the Great Recession.

What you see here, for instance, is that a household at the 10th percentile — that is, whose income was higher than 10 percent of households and lower than 90 percent — had an income 4 percent higher in September 2021 than in September 2019. Over the 2007-2009 period, by contrast, real income at the 10th percentile fell by 8 percent. Real income the 80th percentile, on the other hand, fell by about 3 percent in both periods.⁷

As the figure makes clear, the difference between this recession and the previous one is not not just that disposable income fell last time but has been stable this time. The two crises saw very different patterns across income levels. The overall stability of personal income over the past two years is the result of substantial gains at the bottom combined with modest falls in the upper two-thirds. Whereas the fall in aggregate income during the Great Recession — as in most recessions — combines a much larger fall at the bottom with relative stability at the top.

This seems to me like a very important and very under-appreciated fact about the past two years. This is not just the first recession in which household income didn’t fall. It’s the first recession — in modern times, if not ever — that hit higher income families harder than low-income ones. So far, it looks less like a K-shaped recovery than a C-shaped one.

Let’s look at it another way. Between December 2007 and December 2009 — the period of the Great Recession — the share of households who reported a total income under $30,000 rose from 26.3 percent to 28.6 percent. Incomes rose over the next decade, so that by December 2019, a similar roughly one-quarter share of households reported total income of under $35,000. But over the next two years, this share fell by almost two points, from 25.7 to 23.9 percent. The fraction reporting incomes under $30,000 fell from 20.5 to 18.8 percent, while the fraction reporting incomes under $20,000 fell from 16.3 percent to 14.6 percent. This suggests a substantial decline in the number of families facing serious material hardship.

You might say: But real income did fall across most of the distribution. That is true.⁸ But think about it: We have just lived through a pandemic that, among other things, caused the most rapid fall in economic activity in US history. 20 million jobs disappeared overnight, and millions of them still have not come back. Of course income fell! What’s surprising is that it didn’t fall by more — that the short-term disruption was followed by a rapid bounce back rather than the long jobless recovery we’ve had after previous crises. What’s also a departure from previous downturns is whose incomes fell and whose didn’t.

Because the CPS income data is top-coded at $150,000 — about 15% of US households are above this — and the bucket below that is quite wide, the CPS isn’t informative about income at the top end. That’s why the figures cut off at the 80th percentile. I don’t see any obvious reason why high-income families should have had very different experiences in the two recessions, but we will have to wait for other data to be released to find out for sure.

There are certainly problems with measuring income with a single question. It’s not always clear what households are counting as income, especially at the low end where transfers make up a higher portion of the total. But it’s the same question in all four years. I find it hard to believe that the contrasting shifts in the numbers don’t reflect a genuine difference in the experience of low-income families over the two periods.

After all, this is consistent with what we know from other sources. Wage gains have been stronger at the bottom than at the top, by a growing margin. In the Household Pulse survey that the Census has been conducting regularly since the start of the pandemic, the dog that didn’t bark is the lack of any increase in most measures of material deprivation. In the most recent survey, for example, 9 percent of families reported that in the past week, they sometimes or often didn’t have enough to eat. That’s a shockingly high number — but it is a somewhat lower number than in April 2020. And of course, what’s all the talk about labor shortages but complaints — sometimes in so many words — that people no longer feel they have to accept underpaid drudge work out of sheer desperation?

Maintaining or improving access to necessities for the most vulnerable through an economic catastrophe is a major accomplishment. Yet what’s striking about the current moment is how little anyone is taking credit for it.

Of course there are reasons why the focus is where it is. It’s easier to talk about the problems we are actually facing than the much worse crisis we didn’t have. (There ought to be a name for the fallacy where a timely response to head off some danger is retroactively treated as a sign there was no danger in the first place.) Conservatives obviously don’t want to acknowledge the success of a massive public spending program, especially when Democrats are in office (and don’t necessarily approve of making poor people less poor in the first place.) Progressives are more comfortable criticizing bailouts than celebrating economic success stories. (And of course there is plenty to criticize.) And with the Build Back Better agenda on the line, one might worry that talking about how the measures of the past year and a half have raised up the bottom will feed a dangerous complacency, a sense that we’ve done enough already.

As it happens, I’m not sure that last worry is justified. Back when I did political work, one of things that came though most clearly talking to organizers, and to people at doors myself, is that for most people the biggest obstacle to political engagement isn’t satisfaction with the way things are, but doubt that collective action can change them. Most people,I think, are quite aware that, as we used to say, “Shit is fucked up and bullshit.” What they lack is a sense of the connection of politics and policy with the concrete problems they face. Even among political professionals, I suspect, doubt that things can be very different is often a more powerful conservative force than a positive attachment to things as they are. Remembering how policymakers made the choice go big during the pandemic might, then, strengthen, rather than undermine, the case for going big today.

Be that as it may, if it is in fact the case that during a period when unemployment spiked to 15 percent, incomes at the bottom end actually rose, that seems like an important fact about the world that someone ought to be talking about.

UPDATE:

Some people have asked whether the apparent rise in incomes at the bottom might be due to changes in family size — maybe more people moved in together and pooled their income during the pandemic? To address that, here’s another version of the figure, this one showing the change in real income divided by household size.

As it turns out, average household size actually shrank slightly over 2019-2021. This was not the case in 2007-2009, so adjusting for household size makes the recent performance look a bit better relative to the previous one. But as you can see, the broad picture is essentially the same.

The Coronavirus Recession Is Just Beginning

(A couple days ago I gave a talk — virtually, of course — to a group of activists about the state of the economy. This is an edied and somewha expanded version of what I said.)

The US economy has officially been in recession since February. But what we’ve seen so far looks very different from the kind of recessions we’re used to, both because of the unique nature of the coronavirus shock and because of the government response to it. In some ways, the real recession is only beginning now. And if federal stimulus is not restored, it’s likely to be a very deep and prolonged one.

In a normal recession, the fundamental problem is an interruption in the flow of money through the economy. People or businesses reduce their spending for whatever reason. But since your spending is someone else’s income, lower spending here reduces incomes and employment over there — this is what we call a fall in aggregate demand. Businesses that sell less need fewer workers and generate less profits for their owners. That lost income causes other people to reduce their spending, which reduces income even more, and so on.

Now, a small reduction in spending may not have any lasting effects — people and businesses have financial cushions, so they won’t have to cut spending the instant their income falls, especially if they expect the fall in income to be temporary. So if there’s just a small fall in demand, the economy can return to its old growth path quickly. But if the fall in spending is big enough to cause many workers and businesses to cut back their own spending, then it can perpetuate itself and grow larger instead of dying out. This downward spiral is what we call a recession. Usually it’s amplified by the financial system, as people who lose income can’t pay their debts, which makes banks less willing or able to lend, which forces people and businesses that needed to borrow to cut back on their spending. New housing and business investment in particular are very dependent on borrowed money, so they can fall steeply if loans become less available. That creates another spiral on top of the first. Or in recent recessions, often it’s the financial problems that come first.

But none of that is what happened in this case. Businesses didn’t close because there wasn’t enough money flowing through the economy, or because they couldn’t get loans. They closed because under conditions of pandemic and lockdown they couldn’t do specific things — serve food, offer live entertainment, etc. And to a surprising extent, the stimulus and unemployment benefits meant that people who stopped working did not lose income. So you could imagine that once the pandemic was controlled, we could return to normal much quicker than in a normal recession.

That was the situation as recently as August.

The problem is that much of the federal spending dried up at the end of July. And that is shifting the economy from a temporary lockdown toward a self-perpetuating fall in incomes and employment.

One way we see the difference between the lockdown and a recession is the industries affected. The biggest falls in employment were in entertainment and recreation and food service, which are industries that normally weather downturns pretty well, while construction and manufacturing, normally the most cyclical industries, have been largely unaffected. Meanwhile, employment in health and education, which in previous recessions has not fallen at all, this time has declined quite a bit.⁹

If we look at employment, for instance which is normally our best measure of business-cycle conditions, we again see something very different from past recessions. Total employment fell by 20 million in April and May of this year. In just two months, 15 percent of American workers lost their jobs. There’s nothing remotely comparable historically — more jobs were lost in the Depression, but that was a slow process over years not just two months. The post-World War II demobilization was the closest, but that only involved about half the fall in employment. So this is a job loss without precedent.

Since May, about half of those 20 million people have gone back to work. We’re about 10 million jobs down from a year ago. Still, that might look like a fairly strong recovery.

But in the spring, the vast majority of unemployed people described themselves as on temporary layoff — they expected to go back to their jobs. The recovery in employment has almost all come from that group. If we look at people who say they have lost their jobs permanently, that number has continued to grow. Back in May, almost 90 percent of the people out of work described it as temporary. Today, it’s less than half. Business closings and layoffs that were expected to be temporary in the spring are now becoming permanent. So in a certain sense, even though unemployment is officially much lower than it was a few months ago, unemployment as we usually think of it is still rising.

We can see this even more dramatically if we look at income. Most people don’t realize how large and effective the stimulus and pandemic unemployment insurance programs were. Back in the spring, most people — me included — thought there was no way the federal government would spend on the scale required to offset the hob losses. The history of stimulus in this country — definitely including the ARRA under Obama — has always been too little, too late. Unemployment insurance in particular has historically had such tight eligibility requirements that the majority of people who lose their jobs never get it.

But this time, surprisingly, the federal stimulus was actually big enough to fill the hole of lost incomes. The across-the-board $600 per week unemployment benefit reached a large share of people who had lost their jobs, including gig workers and others who would not have been able to get conventional UI. And of course the stimulus checks reached nearly everyone. As a result, if we look at household income, we see that as late as July, it was substantially above pre-recession levels. This is a far more effective response than the US has made to any previous downturn. And it’s nearly certain that the biggest beneficiaries were lower-wage workers.

We can see the effects of this in the Household Pulse surveys conducted by the Census. Every week since Mach, they’ve been asking a sample of households questions about their economic situation, including whether they have enough money to meet their basic needs. And the remarkable thing is that over that period, there has been no increase in the number of people who say they can’t pay their rent or their mortgage or can’t get enough to eat. About 9 percent of families said they sometimes or often couldn’t afford enough to eat, and about 20 percent of renters said they were unable to pay the last month’s rent in full. Those numbers are shockingly high. But they are no higher than they were before the pandemic.

To be clear – there are millions of people facing serious deprivation in this country, far more than in other rich countries. But this is a longstanding fact about the United States. It doesn’t seem to be any worse than it was a year ago. And given the scale of the job loss, that is powerful testimony to how effective the stimulus has been.

But the stimulus checks were one-off, and the pandemic unemployment insurance expired at end of July. Fortunately there are other federal unemployment supplements, but they are nowhere as generous. So we are now seeing the steep fall in income that we did not see in the first five months of the crisis.

That means we may now be about to see the deep recession that we did not really get in the spring and summer. And history suggests that recovery from that will be much slower. If we look at the last downturn, it took five full years after the official end of the recession for employment to just get back to its pre-recession level. And in many ways, the economy had still not fully recovered when the pandemic hit.

One thing we may not see, though, is a financial crisis. The Fed is in some ways one of the few parts of our macroeconomic policy apparatus that works well, and it’s become even more creative and aggressive as a result of the last crisis. In the spring, people were talking about a collapse in credit, businesses unable to get loans, people unable to borrow. But this really has not happened. And there’s good reason to think that the Fed has all the tools they need if a credit crunch did develop, if some financial institutions to end up in distress. Even if we look at state and local governments, where austerity is already starting and is going to be a big part of what makes this recession severe, all the evidence is that they aren’t willing to borrow, not that they can’t borrow.

Similarly with the stock market — people think it’s strange that it’s doing well, that it’s delinked from the real economy, or that it’s somehow an artificial result of Fed intervention. To be clear, there’s no question that low interest rates are good for stock prices, but that’s not artificial — there’s no such thing as a natural interest rate.

More to the point, by and large, stocks are doing well because profits are doing well. Stock market indexes dominated by a small number of large companies, and many of those have seen sales hold up or grow. Again, so far we haven’t seen a big fall in total income. So businesses in general are not losing sales. What we have seen is a division of businesses into winners and losers. The businesses most affected by the pandemic have seen big losses of sales and profits and their share prices have gone down. But the businesses that can continue to operate have done well. So there’s nothing mysterious in the fact that Amazon’s stock price, for instance, has risen, and there’s no reason to think it’s going to fall. If you look at specific stocks, you see that by and large the ones that are doing well, the underlying business is doing well.

This doesn’t mean that what’s good for the stock market is good for ordinary workers. But again, that’s always been true. Shareholders don’t care about workers, they only care about the flow of profits their shares entitle them to. And if you’re a shareholder in a company that makes most of its sales online, that flow of profits is looking reasonably healthy right now.

So going forward, I think the critical question is whether we see any kind of renewed stimulus. If we do, it’s still possible that the downward income-expenditure spiral can be halted. At some point soon that will be much harder.

The Cash and I

Martin Wolf in the FT the other day:

The third challenge is over the longer-term sources of demand. I look at this issue in terms of the sectoral financial balances – the balances between income and spending – in the household, business, external and government sectors. The question, then, is where expansion will come from. In the first quarter of this year the principal offset to fiscal contraction was the declining household surplus.

What is needed, as well, is a big swing towards surplus in the US current account or a jump in corporate investment, relative to retained profits. Neither seems imminent, though the second seems more likely than the first. The worry is that the only way to balance the economy will be via big new bubbles. If so, this is not the fault of the Fed. It is the fault of structural features of the domestic and global economies…

This is a good point, which should be made more. If we compare aggregate expenditure today to expenditure just before the recession, it is clear that the lower level of demand today is all about lower consumption. But maybe that’s not the best comparison, because during the housing boom period, consumption was historically high. If we take a somewhat longer view, what’s unusually low today is not household consumption, but business investment. Weak demand is about I, not C.

This is especially clear when we compare investment by businesses to what they are receiving in the form of profits, or, better cashflow from operations — after-tax profits plus depreciation. [1] Here is the relationship over the past 40 years:

Corporate Investment and Cashflow from Operations as Fraction of Total Assets, 1970-2012

The graph shows annualized corporate investment and cashflow, normalized by total assets. Each dot is data from one quarter; to keep the thing legible, I’ve only labeled the fourth quarter of each year. As you can see, there used to be a clear relationship between corporate profitability and corporate investment. For every additional $150, more or less, that a corporation took in from operations, it would increase capital expenditures by $100. This relationship held consistently through the 1960s (not shown), the 1970s, the 1980s and 1990s.

But now look at the past ten years, the period after 2001Q4. Corporate investment rates are substantially lower throughout this period than at any earlier time (averaging around 3.5% of total assets, compared with 5% of assets for 1960-2001). And the relationship between aggregate profit and investment rates has simply disappeared.

Some people might say that the problem is in the financial system, that even profitable businesses can’t borrow because of a breakdown in intermediation, a shortage of liquidity, an unwillingness of risk-averse investors to hold their debt, etc. I don’t buy this story for a number of reasons, some of which I’ve laid out in recent posts here. But it at least has some certain prima facie plausibility for the period following the great financial crisis. Not for for the whole decade-plus since 2001. Saying that investment is low today because businesses can’t find anyone to buy their bonds is merely wrong. Saying that’s why investment was low in 2005 is absurd.

(And remember, these are aggregates, so they mainly reflect the largest corporations, the ones that should have the least problems borrowing.)

So what’s a better story?

I am going to save my full answer for another post. But regular readers will not be surprised that I think the key is a shift in the relationship between corporations and shareholders. I think there’s a sense in which the binding constraint on investment has changed from the terms on which management can get funds into the corporation, from profits or borrowing, to the terms are on which they can keep them from going out, to investors. But the specific story doesn’t matter so much here. You can certainly imagine other explanations. Like, “the China price” — even additional capacity that would be profitable today won’t be added if it there’s a danger of lower-cost imports entering that market.

The point of this post is just that corporate investment is historically low, both in absolute terms and relative to profitability. And because this has been true for a decade, it is hard to attribute this weakness to credit constraints, or believe that it will be responsive to monetary policy. (This is even more true when you recall that the link between corporate borrowing and investment has also essentially disappeared.) By contrast, household consumption remains high. I have the highest respect for Steve Fazzari, and agree that high income inequality is a key metric of the fucked-upness of our economy. But I don’t think it makes sense to think of the current situation in terms of a story where high inequality reduces demand by holding down consumption.

Consumption is red, on the right scale; investment is blue, on the left. Both as shares of GDP.

As I say, I’ll come back in a future post to my on preferred explanation for why a comparably profitable firm, facing comparable credit conditions, will invest less today than 20 or 30 years ago.

In the meantime, one other thing. That first graph is a nice tool for showing how a Marxist thinks about business cycles.

If you look at the graph carefully, you’ll see the points follow counterclockwise loops. It’s natural to see this as cycles. Like this:

Start from the bottom of a cycle, at a point like 1992. A rise in profits from whatever source leads to higher investment, mainly as a source of funds and but also because it raises expectations of future profitability. That’s the lower right segment of the cycle. High investment eventually runs into supply constraints, typically in the form of a rising wage share.[1] At that point profits begin to fall. Investment, however, continues high for a while, as the credit system allows firms to bridge a growing financing gap. That’s the upper right segment of the cycle. Eventually, though, if profits don’t recover, investment will follow them downward. This turning point often involves a financial crisis and/or abrupt fall in asset values, like the collapse of tech stocks in 2000. This is the upper left segment of the cycle. Finally, in the lower left, both profits and investment are low. But after some time the conditions for profitability are restored, and we move toward the right and begin a new cycle. This last step is less reliable than the others. It’s quite possible for the economy to come to rest at the lower left and wobble there for a while without any sustained change in either profits or investment. We see this in 2002-2003 and in 1988-1991.

(I think the investment boom of the late 70s and the persistent slump of the early 1990s are two of the more neglected episodes in recent economic history. The period around 1990, in particular, seems to have all the features that are supposed to be distinctive to the current macroeconomic conjuncture. At the time, people even called it a balance-sheet recession!)

For now, though, we’re not interested in the general properties of cycles. We’re interested in how flat and low the most recent two are, compared with earlier ones. That is the structural feature that Martin Wolf is pointing to. And it’s not a new feature of the post financial crisis period, it’s been the case for a dozen years at least, only temporarily obscured by the housing bubble.

UPDATE: In comments, Seth Ackerman asks if maybe using total assets to normalize investment and profits is distorting the picture. It’s a good question, but the answer is no. Here’s the same thing, with trend GDP in the denominator instead:

As you can see, the picture is basically the same. Investment in the 200s is still visibly depressed compared with earlier decades, and the relationship between profits and investment is much weaker. Of course, it’s always possible that current high profits will lead an investment boom in the next few years…

[1] Cash from operations is better than profits for at least two reasons. First, from the point of view of aggregate demand, we are interested in gross not net investment. A dollar of investment stimulates demand just as much whether it’s replacing old equipment or adding new. So our measure of income should also be gross of depreciation. Second, there are major practical and conceptual issues with measuring depreciation. Changes in accounting standards may result in very different official depreciation numbers in economically identical situations. By combining depreciation and profits, we avoid the problem of the fuzzy and shifting line between them, making it more likely that we are comparing equivalent quantities.

[2] A rising wage share need not, and often does not, take the form of rising real wages. In recent cycles especially, it’s more likely to combine flat real wages with a rising relative cost of wage goods.

Reviving the Knife-Edge: Aggregate Demand in the Long Run

The second issue of the new Review of Keynesian Economics is out, this one focused on growth. [1] There’s a bunch of interesting contributions, but I especially like the piece by Steve Fazzari, Pietro Ferri, Edward Greenberg and Anna Maria Variato, on growth and aggregate demand.

The starting point is the familiar puzzle that we have a clear short-run story in which changes in output [2] on the scale of the business cycle are determined by aggregate demand — that is, by changes in desired expenditure relative to income. But we don’t have a story about what role, if any, aggregate demand plays in the longer run.

The dominant answer — unquestioned in the mainstream [3], but also widespread among heterodox writers — is, it doesn’t. Economic growth is supposed to depend on a different set of factors — technological change, population growth and capital accumulation — than those that influence demand in the short run. But it’s not obvious how you get from the short-run to the long — what mechanism, if any, that ensures that the various demand-driven fluctuations will converge to the long-run path dictated by these “fundamentals”?

This is the question posed by Fazzari et al., building on Roy Harrod’s famous 1939 article. As Harrod noted, there are two relations between investment and output: investment influences output as a source of demand in the short run, and in the longer run higher output induces investment in order to maintain a stable capital-output ratio. More investment boosts growth, for the first channel, the multiplier; growth induces investment, through the second, the accelerator. With appropriate assumptions you can figure out what combinations of growth and investment satisfy both conditions. Harrod called the corresponding growth paths the “warranted” rate of growth. The problem is, as Harrod discovered, these combinations are dynamically unstable — if growth strays just a bit above the warranted level, it will accelerate without limit; if falls a little below the warranted rate, it will keep falling til output is zero

This is Harrod’s famous “knife-edge.” It’s been almost entirely displaced from the mainstream by Solow type growth models. Solow argued that the dynamic instability of Harrod’s model was due to the assumption of a fixed target capital-output ratio, and that the instability goes away if capital and labor are smoothly substitutible. In fact, Harrod makes no such assumption — his 1939 article explicitly considers the possibility that capitalists might target different capital-output ratios based on factors like interest rates. More generally, Solow didn’t resolve the problem of how short-run demand dynamics converge to the long-run supply-determined growth path, he just assumed it away.

The old textbook solution was price flexibility. Demand constraints are supposed to only exist because prices are slow to adjust, so given enough time for prices to reach market-clearing levels, aggregate demand should cease to exist. The obvious problem with this, as Keynes already observed, is that while flexible prices may help to restore equilibrium in individual markets, they operate in the wrong direction for output as a whole. A severe demand shortfall tends to produce deflation, which further reduces demand for goods and services; similarly, excessive demand leads to inflation, which tends — though less certainly — to further increase demand. As Leijonhufvud notes, it’s a weird irony that sticky wages and/or prices are held to be the condition of effective demand failures, when the biggest demand failure of them all, the Depression, saw the sharpest falls in both wages and prices on record.

The idea that if it just runs its course, deflation — via the real balance effect or some such — will eventually restore full employment is too much even for most economists to swallow. So the new consensus replaces price level adjustment with central bank following a policy rule. In textbooks, this is glossed as just hastening an adjustment that would have happened on its own via the price level, but that’s obviously backward. When an economy actually does develop high inflation or deflation, central banks consider their jobs more urgent, not less so. It’s worth pausing a moment to think about this. While the central bank policy rule is blandly presented as just another equation in a macroeconomic model, the implications are actually quite radical. Making monetary policy the sole mechanism by which the economy converges to full employment (or the NAIRU) implicitly concedes that on its own, the capitalist economy is fundamentally unstable.

While the question of how, or whether, aggregate demand dynamics converge to a long-run growth path has been ignored or papered over by the mainstream, it gets plenty of attention from heterodox macro. Even in this one issue of ROKE, there are several articles that engage with it in one way or another. The usual answer, among those who do at least ask the question, is that the knife-edge result must be wrong, and indicates some flaw in the way Harrod posed the problem. After all, in real-world capitalist economies, output appears only moderately unstable. Many different adjustments have been proposed to his model to make demand converge to a stable path.

Fazzari et al.’s answer to the puzzle, which I personally find persuasive, is that demand dynamics really are that unstable — that taken on their own the positive feedbacks between income, expenditure and investment would cause output to spiral toward infinity or fall to zero. The reasons this doesn’t happen is because of the ceiling imposed by supply constraints and the the floor set by autonomous expenditure (government spending, long-term investment, exports, etc.). But in general, the level of output is set by expenditure, and there is no reason to expect desired expenditure to converge to exactly full utilization of the economy’s resources. When rising demand hits supply constraints, it can’t settle at full employment, since in general full employment is only reached on the (unfulfillable) expectation of more-than-full employment.

Upward demand instability can drive demand to a level that fully employs labor resources. But the full employment path is not stable. … The system bounces off the ceiling onto an unstable declining growth path.

I won’t go through the math, which in any case isn’t complicated — is trivial, even, by the standards of “real” economics papers. The key assumptions are just a sufficiently strong link between income and consumption, and a target capital output ratio, which investment is set to maintain. These two assumptions together define the multiplier-accelerator model; because Fazzari et al explicitly incorporate short-term expectations, they need a third assumption, that unexpected changes in output growth cause expectations of future growth to adjust in the same direction — in other words, if growth is higher than expected this period, people adjust their estimates of next period’s growth upward. These three assumptions, regardless of specific parameter values, are enough to yield dynamic instability, where any deviation from the unique stable growth path tends to amplify over time.

The formal model here is not new. What’s more unusual is Fazzari et al.’s suggestion that this really is how capitalist economies behave. The great majority of the time, output is governed only by aggregate demand, and demand is either accelerating or decelerating. Only the existence of expenditure not linked to market income prevents output from falling to zero in recessions; supply constraints — the productive capacity of the economy — matters only occasionally, at the peaks of businesses cycles.

Still, one might say that if business-cycle peaks are growing along a supply-determined path, then isn’t the New Consensus right to say that the long run trajectory of the economy is governed only by the supply side, technology and all that? Well, maybe — but even if so,this would still be a useful contribution in giving a more realistic account of how short-term fluctuations add up to long-run path. It’s important here that the vision is not of fluctuations around the full-employment level of output, as in the mainstream, but at levels more or less below it, as in the older Keynesian vision. (DeLong at least has expressed doubts about whether the old Keynsians might not have been right on this point.) Moreover, there’s no guarantee that actual output will spend a fixed proportion of time at potential, or reach it at all. It’s perfectly possible for the inherent instability of the demand process to produce a downturn before supply constraints are ever reached. Financial instability can also lead to a recession before supply constraints are reached (altho more often, I think, the role of financial instability is to amplify a downturn that is triggered by something else.)

So: why do I like this paper so much?

First, most obviously, because I think it’s right. I think the vision of cycles and crises as endogenous to the growth process, indeed constitutive of it, is a better, more productive way to think about the evolution of output than a stable equilibrium growth path occasionally disturbed by exogenous shocks. The idea of accelerating demand growth that sooner or later hits supply constraints in a more or less violent crisis, is just how the macroeconomy looks. Consider the most obvious example, unemployment:

What we don’t see here, is a stable path with normally distributed disturbances around it. Rather, we see unemployment falling steadily in expansions and then abruptly reversing to large rises in recessions. To monetarists, the fact that short-run output changes are distributed bimodally, with the economy almost always in a clear expansion or clear recession with nothing in between, is a sign that the business cycle must be the Fed’s fault. To me, it’s more natural to think that the nonexistence of “mini-recessions” is telling us something about the dynamics of the economic process itself — that capitalist growth, like love,

is a growing, or full constant light,
And his first minute, after noon, is night.

Second, I like the argument that output is demand-constrained at almost all times. There is no equilibrium between “aggregate supply” and “aggregate demand”; rather, under normal conditions the supply side doesn’t play any role at all. Except for World War II, basically, supply constraints only come into play momentarily at the top of expansions, and not in the form of some kind of equilibration via prices, but as a more or less violent external interruption in the dynamics of aggregate demand. It is more or less always true, that if you ask why is output higher than it was last period, the answer is that someone decided to increase their expenditure.

Third, I like that the article is picking up the conversation from the postwar Keynesians like Harrod, Kaldor and Hicks, and more recent structural-Keynesian approaches. The fundamental units of the argument are the aggregate behavior of firms and households, without the usual crippling insistence on reducing everything to a problem of intertemporal optimization. (The question of microfoundations gets a one-sentence footnote, which is about what it deserves.) Without getting into these methodological debates here, I think this kind of structuralist approach is one of the most productive ways forward for positive macroeconomic theory. Admittedly, almost all the other papers in this issue of ROKE are coming from more or less the same place, but I single out Fazzari for praise here because he’s a legitimate big-name economist — his best known work was coauthored with Glenn Hubbard. (Yes, that Glenn Hubbard.)

Fourth, I like the paper’s notion of economies having different regimes, some of persistently excess demand, some persistent demand shortfalls. When I was talking about this paper with Arjun the other day he asked, very sensibly, what’s the relevance to our current situation. My first response was not much, it’s more theoretical. But it occurs to me now that the mainstream model (often implicit) of fluctuations around a supply-determined growth path is actually quite important to liberal ideas about fiscal policy. The idea that a deep recession now will be balanced by a big boom sometime in the future underwrites the idea that short-run stimulus should be combined with a commitment to long-run austerity. If, on the other hand, you think that the fundamental parameters of an economy can lead to demand either falling persistently behind, or running persistently ahead, of supply constraints, then you are more likely to think that a deep recession is a sign that fiscal policy is secularly too tight (or investment secularly too low, etc.) So the current relevance of the Fazzari paper is that if you prefer their vision to the mainstream’s, you are more likely to see the need for bigger deficits today as evidence of a need for bigger deficits forever.

Finally, on a more meta level, I share the implicit vision of capitalism not as a single system in (or perhaps out of) equilibrium, but involving a number of independent processes which sometimes happen to behave consistently with each other and sometimes don’t. In the Harrod story, it’s demand-driven output and the productive capacity of the economy, and population growth in particular; one could tell the same story about trade flows and financial flows, or about fixed costs and the degree of monopoly (as Bruce Wilder and I were discussing in comments). Or perhaps borrowing and interest rates. In all cases these are two distinct causal systems, which interact in various ways but are not automatically balanced by any kind of price or equivalent mechanism. The different systems may happen to move together in a way that facilitates smooth growth; or they may move inconsistently, which will bring various buffers into play and, when these are exhausted, lead to some kind of crisis whose resolution lies outside the model.

A few points, not so much of criticism, as suggestions for further development.

First, a minor point — the assumption that expectations adjust in the same direction as errors is a bit trickier than they acknowledge. I think it’s entirely reasonable here, but it’s clearly not always valid and the domain over which it applies isn’t obvious. If for instance the evolution of output is believed to follow a process like yt = c + alpha t + et, then unusually high growth in one period would lead to expectations of lower growth in the next period, not higher as Fazzari et al assume. And of course to the extent that such expectations would tend to stabilize the path of output, they would be self-fulfilling. (In other words, widespread belief in the mainstream view of growth will actually make the mainstream view more true — though evidently not true enough.) As I say, I don’t think it’s a problem here, but the existence of both kinds of expectations is important. The classic historical example is the gold standard: Before WWI, when there was a strong expectation that the gold link would be maintained, a fall in a country’s currency would lead to expectations of subsequent appreciation, which produced a capital inflow that in fact led to the appreciation; whereas after the war, when devaluations seemed more likely, speculative capital flows tended to be destabilizing.

Two more substantive points concern supply constraints. I think it’s a strength, not a weakness of the paper that it doesn’t try to represent supply constraints in any systematic way, but just leaves them exogenous. Models are tools for logical argument, not toy train sets; the goal is to clarify a particular set of causal relationships, not to construct a miniature replica of the whole economy. Still, there are a couple issues around the relationship between rising demand and supply constraints that one would like to develop further.

First, what concretely happens when aggregate expenditure exceeds supply? It’s not enough to just say “it can’t,” in part because expenditure is in dollar terms while supply constraints represent real physical or sociological limits. As Fazzari et al. acknowledge, we need some Marx with our Keynes here — we need to bring in falling profits as a key channel by which supply constraints bind. [4] As potential output is approached, there’s an increase in the share claimed by inelastically-supplied factors, especially labor, and a fall in the share going to capital. This is the classic Marxian cyclical profit squeeze, though in recent cycles it may be the rents claimed by suppliers of oil and “land” in general, as opposed to wages, that is doing much of the squeezing. But in any case, a natural next step for this work would be to give a more concrete account of the mechanisms by which supply constraints bind. This will also help clarify why the transitions from expansion to recession are so much more abrupt than the transitions the other way. (Just as there are no mini-recessions, neither are there anti-crises.) The pure demand story explains why output cannot rise stably on the full employment trajectory, but must either rise faster or else fall; but on its own it’s essentially symmetrical and can’t explain why recessions are so much steeper and shorter than expansions. Minsky-type dynamics, where a fall in output means financial commitments cannot be met, must also play a role here.

Second, how does demand-driven evolution of output affect growth of supply? They write,

while in our simple model the supply-side path is assumed exogenous, it is easy to posit realistic economic channels through which the actual demand-determined performance of the economy away from full employment affects conditions of supply. The quantity and productivity of labor and capital at occasional business-cycle peaks will likely depend on the demand-determined performance of the economy in the normal case in which the system is below full employment.

I think this is right, and a very important point to develop. There is increasing recognition in the mainstream of the importance of hysteresis — the negative effects on economic potential of prolonged unemployment. There’s little or no discussion of anti-hysteresis — the possibility that inflationary booms have long-term positive effects on aggregate supply. But I think it would be easy to defend the argument that a disproportionate share of innovation, new investment and laborforce broadening happens in periods when demand is persistently pushing against potential. In either case, the conventional relationship between demand and supply is reversed — in a world where (anti-)hysteresis is important, “excessive” demand may lead to only temporarily higher inflation but permanently higher employment and output, and conversely.

Finally, obsessive that I am, I’d like to link this argument to Leijonhufvud’s notion of a “corridor of stability” in capitalist economies, which — though Leijonhufvud isn’t cited — this article could be seen as a natural development of. His corridor is different from this one, though — it refers to the relative stability of growth between crises. The key factor in maintaining that stability is the weakness of the link between income and expenditure as long as changes in income remain small. Within some limits, changes in the income of households and firms do not cause them to revise their beliefs about future income (expectations are normally fairly inelastic), and can be buffered by stocks of liquid assets and the credit system. Only when income diverges too far from its prior trajectory do expectations change — often discontinuously — and, if the divergence is downward, do credit constraints being to bind. If it weren’t for these stabilizing factors, capitalist growth would always, and not just occasionally, take the form of explosive bubbles.

Combining Leijonhufvud and Fazzari et al., we could envision the capitalist growth path passing through concentric bands of stability and instability. The innermost band is Leijonhufvud’s corridor, where the income-expenditure link is weak. Outside of that is the band of Harrodian instability, where expectations are adjusting and credit constraints bind. That normal limits of that band are set, at least over most of the postwar era, by active stabilization measures by the state, meaning in recent decades monetary policy. (The signature of this is that recoveries from recessions are very rapid.) Beyond this is the broader zone of instability described by the Fazzari paper — though keeping the 1930s in mind, we might emphasize the zero lower bound on gross investment a bit more, and autonomous spending less, in setting the floor of this band. And beyond that must be a final zone of instability where the system blows itself to pieces.

Bottom line: If heterodox macroeconomic theory is going to move away from pure critique (and it really needs to) and focus on developing a positive alternative to the mainstream, articles like this are a very good start.

[1] It’s unfortunate that no effort has been made to make ROKE content available online. Since neither of the universities I’m affiliated with has a subscription yet, it’s literally impossible for me — and presumably you — to see most of the articles. I imagine this is a common problem for new journals. When I raised this issue with one of the editors, and asked if they’d considered an open-access model, he dismissed the idea and suggested I buy a subscription — hey, it’s only $80 for students. I admit this annoyed me some. Isn’t it self-defeating to go to the effort of starting a new journal and solicit lots of great work for it, and then shrug off responsibility for ensuring that people can actually read it?

[2] It’s not a straightforward question what exactly is growing in economic growth. When I talk about demand dynamics, I prefer to use the generic term “activity,” as proxied by a variety of measures like GDP, employment, capacity utilization, etc. (This is also how NBER business-cycle dating works.) But here I’ll follow Fazzari et al. and talk about output, presumably the stuff measured by GDP.

[3] See for instance this post from David Altig at the Atlanta Fed, from just yesterday:

Forecasters, no matter where they think that potential GDP line might be, all believe actual GDP will eventually move back to it. “Output gaps”—the shaded area representing the cumulative miss of actual GDP relative to its potential—simply won’t last forever. And if that means GDP growth has to accelerate in the future (as it does when GDP today is below its potential)—well, that’s just the way it is.

Here we have the consensus with no hedging. Everyone knows that long-run growth is independent of aggregate demand, so slower growth today means faster growth tomorrow. That’s “nature,” that’s just the way it is.

[4] This fits with the story in Capitalism Since 1945, still perhaps the first book I would recommend to anyone trying to understand the evolution of modern economies. From the book:

The basic idea of overaccumulation is that capitalism sometimes generates a higher rate of accumulation than can be sustained, and thus the rate of accumulation has eventually to fall. Towards the end of the postwar boom, an imbalance between accumulation and the labor supply led to increasingly severe labor shortage. … Real wages were pulled up and older machines rendered unprofitable, allowing a faster transfer of workers to new machines. This could in principle have occurred smoothly: as profitability slid down, accumulation could have declined gently to a sustainable rate. but the capitalist system has no mechanism guaranteeing a smooth transition in such circumstances. In the late sixties the initial effect of overaccumulation was a period of feverish growth with rapidly rising wages and prices and an enthusiasm for get-rich-quick schemes. These temporarily masked, but could not suppress, the deterioration in profitability. Confidence was undermined, investment collapsed and a spectacular crash occurred. Overaccumulation gave rise, not to a mild decline in the profit rate, but to a classic capitalist crisis.

I think the Marxist framework here, with its focus on profit rates, complements rather than contradicts the Keynesian frame of Fazzari et al. and its focus on demand. In particular, the concrete mechanisms by which supply constraints operate are much clearer here.