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.
More posts on Greece, coming right up. But first I want to revisit the relationship between finance and nonfinancial business in the US.
Most readers of this blog are probably familiar with Tobin’s q. The idea is that if investment decisions are being made to maximize the wealth of shareholders, as theory and, sometimes, the law say they should be, then there should be a relationship between the value of financial claims on the firm and the value of its assets. Specifically, the former should be at least as great as the latter, since if investing another dollar in the firm does not increase its value to shareholders by at least a dollar, then that money would better have been returned to them instead.
As usual with anything interesting in macroeconomics, the idea goes back to Keynes, specifically Chapter 12 of the General Theory:
the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur.
It was this kind of reasoning that led Hyman Minsky to describe Keynes as having “an investment theory of the business cycle, and a financial theory of investment.” Axel Leijonhufvud, on the other hand, would warn us against taking the dramatis personae of this story too literally; the important point, he would argue, is the way in which investment responds to the shifts in the expected return on fixed investment versus the long-term interest rate. For better or worse, postwar Keynesians including the eponymous Tobin followed Keynes here in thinking of one group of decisionmakers whose expectations are embodied in share prices and another group setting investment within the firm. If shareholders are optimistic about the prospects for a business, or for business in general, the value of shares relative to the cost of capital goods will rise, a signal for firms to invest more; if they are pessimistic, share prices will fall relative to the cost of capital goods, a signal that further investment would be, from the point of view of shareholders, value-subtracting, and the cash should be disgorged instead.
There are various specifications of this relationship; for aggregate data, the usual one is the ratio of the value corporate equity to corporate net worth, that is, to total assets minus total liabilities. In any case, q fails rather miserably, both in the aggregate and the firm level, in its original purpose, predicting investment decisions. Here is q for nonfinancial corporations in the US over the past 60 years, along with corporate investment.
The orange line is the standard specification of q; the dotted line is equity over fixed assets, which behaves almost identically. The black line shows nonfinancial corporations’ nonresidential fixed investment as a share of GDP. As you can see, apart from the late 90s tech boom, there’s no sign that high q is associated with high investment, or low q with low investment. In fact, the biggest investment boom in postwar history, in the late 1970s, comes when q was at its low point. [*]
The obvious way of looking at this is that, contra Tobin and (at least some readings of) Keynes, stock prices don’t seem to have much to do with fixed investment. Which is not so strange, when you think about it — it’s never been clear why managers and entrepreneurs should substitute the stock market’s beliefs about the profitability of some new investment for their own, presumably better-informed, one. Just as well, given the unanchored gyrations of the stock market.
This is true as far as it goes, but there’s another way of looking at it. Because, q isn’t just uncorrelated with investment; for most of the period, at least until the 1990s, it’s almost always well below 1. This is even more surprising when you consider that a well-run firm with an established market ought to have a q above one, since it will presumably have intangible assets — corporate culture, loyal customers and so on — that don’t show up on the balance sheet. In other words, measured assets should seem to be “too low”. But in fact, they’re almost always too high. For most of the postwar period, it seems that corporations were systematically investing too much, at least from the point of view maximizing shareholder value.
I was talking with Suresh the other day about labor, and about the way labor organizing can be seen as a kind of assertion of a property right. Whether shareholders are “the” residual claimants of a firm’s earnings is ultimately a political question, and in times and places where labor is strong, they are not. Same with tenant organizing — you could see it as an assertion that long-time tenants have a property right in their homes, which I think fits most people’s moral intuitions.
Seen from this angle, the fact that businesses were investing “too much” during much of the postwar decades no longer is a sign they were being irrational or made a mistake; it just suggests that they were considering the returns to claimants other than shareholders. Though one wouldn’t what to read too much into it, it’s interesting in this light that for the past dozen years aggregate q has been sitting at one, exactly where loyal agents for shareholders would try to keep it. In liberal circles, the relatively low business investment of the past decade is often considered a sign of something seriously wrong with the economy. But maybe it’s just a sign that corporations have learned to obey their masters.
EDIT: In retrospect, the idea of labor as residual claimant does not really belong in this argument, it just confuses things. I am not suggesting that labor was ever able to compel capitalist firms to invest more than they wanted, but rather that “capitalists” were more divided sociologically before the shareholder revolution and that mangers of firms chose a higher level of investment than was optimal from the point of view of owners of financial assets. Another, maybe more straightforward way of looking at this is that q is higher — financial claims on a firm are more valuable relative to the cost of its assets — because it really is better to own financial claims on a productive enterprise today than in the pr-1980 period. You can reliably expect to receive a greater share of its surplus now than you could then.
[*] One of these days I really want to write something abut the investment boom of the 1970s. Nobody seems to realize that the highest levels of business investment in modern US history came in 1978-1981, supposedly the last terrible days of stagflation. Given the general consensus that fixed capital formation is at the heart of economic growth, why don’t people ask what was going right then?
Part of it, presumably, must have been the kind of sociological factors pointed to here — this was just before the Revolt of the Rentiers got going, when businesses could still pursue growth, market share and innovation for their own sakes, without worrying much about what shareholders thought. Part must have been that the US was still able to successfully export in a range of industries that would become uncompetitive when the dollar appreciated in the 1980s. But I suspect the biggest factor may have been inflation. We always talk about investment being encouraged by stuff that makes it more profitable for capitalists to hold their wealth in the form of capital goods. But logically it should be just as effective to reduce the returns and/or safety of financial assets. Since neither nominal interest rates nor stock prices tracked inflation in the 1970s, wealthholders had no choice but to accept holding a greater part of their wealth in the form of productive business assets. The distributional case for tolerating inflation is a bit less off-limits in polite conversation than it was a few years ago, but the taboo on discussing its macroeconomic benefits is still strong. Would be nice to try violating that.
Krugman says that Friedman-style monetarism is really just a special case of postwar Keynesian analysis. I agree. (New Keynesianism in turn is just another name for monetarism.) To get monetarist conclusions out of an ISLM-type model, all you need is an income-elasticity of money demand that is both (a) stable and (b) large relative to the interest-elasticity of money demand.
Of course, for this to work the “money” that’s demanded has to be the same as the “money” that the central bank supplies, which requires a particular, and now largely vanished, kind of financial structure, as we’ve been discussing below. But that’s not what I want to talk about here. Rather, it’s this other bit:
This time the Fed did all that Friedman denounced it for not doing in the 1930s. The fact that this wasn’t enough amounts to a refutation of Friedman’s claim that adequate Fed action could have prevented the Depression.
Do we think this is right? It doesn’t seem right to me. If unemployment in the 1930s had peaked at below 10%, instead of 25%; if industrial production had fallen by one eighth, instead of by over half; if fixed investment had fallen by 20%, instead of by 80% (yes, business investment halted almost entirely in the early 30s); if we’d had one or two quarters of deflation, instead of four years; — then I think we would say that the Depression had indeed been prevented. Krugman is implicitly assuming here today’s economy couldn’t collapse the way it did in the 1930s, but how do we know that’s true?
We always ask, why was the Great Recession so deep? But you could just as well turn the question around and ask why, despite initial appearances, did it turn out to be not nearly as deep as the Depression?
I can think of four families of answers. One is the one that Krugman is implicitly rejecting — that policy was better this time. I think most people who tell this story — including some on the left — would emphasize the rescue of the banking system. Disgusting as it is to see the same smug assholes who caused the crisis handed truckloads of money, if nature had taken its course and the big banks had been allowed to fail, we might really have had a Depression. That’s one story. You might also mention fiscal policy, which, while inadequate, has clearly helped, but it’s hard to see that explaining more than a few points of the difference.
The second answer would be that the sheer size of government makes a Depression-scale collapse of demand impossible, regardless of policy. In 1929, with government final demand only a couple percent of GDP, autonomous spending basically was investment spending, especially if we think at the global level so exports wash out. Today, by contrast, G is significantly larger than I (about 20 vs 15 percent of GDP), so even if private investment had collapsed at the same scale as in 1929-1933, the percentage fall in autonomous demand would have been much less. (And of course that fact alone helped keep private investment from collapsing.) Interestingly, despite Hyman Minsky’s association with stories about finance, this, and not anything to do with the financial system, was why his answer to the question Can “It” Happen Again was, No. Policy is secondary; big government itself is the ballast that stabilizes the economy.
Third would be that the shock in 1929 was greater than the shock in 2007. Of course that would require that you specify the shock, and assumes that you think the causes of the crises were basically exogenous. We could compare a story of the 1920s about radically changed trade patterns as a result of WWI, or about the transition agriculture to industry, to a story for the more recent crisis about the housing bubble, or global imbalances, or the transition from industry to services. If you believe a story like that, there’s no reason you couldn’t argue that their exogenous shock was bigger than our exogenous shock, and that’s the real difference.
Last, you could argue that private demand is inherently more stable today than it was before WWII. Price stickiness, say, usually cast as a villain in macroeconomic stories, could have prevented outright deflation; and greater debt-financing of consumption, again usually seen as part of the problem, could have helped stabilize consumption demand in the face of falling incomes. Or financial markets are less subject to short-term fluctuations in sentiment. (Haha. I crack myself up.)
Personally, I would lean toward door number two. But the important thing is just to reframe the question — not why was the recession so bad, but why wasn’t it worse? If someone ever did an IGM-style survey of economists, but of the good guys, it would be a good thing to ask.
Hey you guys! You know how unemployment has been, like, real high for years now, and nobody knows why? Noah Smith has figured it out:
an economic principle often overlooked by progressives: There is sometimes a tradeoff between wages and employment levels (which is another way of saying that labor supply curves slope up and labor demand curves slope down). If economic “frictions” or the actions of policymakers hold wages up when economic forces are trying to push wages down, unemployment will often result.
I think he learned it in an economics class!
You remember how there were these economic forces in 2007 that decided wages had to go down, but we got all these new policies to raise wages like, you know, all those wage-raising things that Bush did? Well, that’s why unemployment went up by 5 points in less than two years.
I mean, it’s so simple when you think about it. “Labor demand curves slope down,” that’s all you need to know. We learn that the first year of micro, supply curves slope up, demand curves slope down. Demand for labor, demand for cottage cheese, doesn’t matter, they’re just the same. Why do they even bother offering courses in macro?
It’s funny, though: Wasn’t there some guy who wrote a whole book about why lower wages don’t raise employment? Maynard, or some weird name like that? Well, Noah’s never heard of him, or of his book (the General Theory of something?) but he can’t be worth bothering with, can he? after all, he didn’t even realize that demand curves slope down! Which is all you need to know.
Of course, lower wages won’t help employment if there is already an excess supply of labor. If people are already willing to work for less than the going wage, telling them they should accept less than the going wage can’t be the solution. What would we call a situation like that? How about … “involuntary unemployment”? But Noah Smith is too smart for that, he knows that could never happen. He knows that markets always clear, employment is always at the intersection of the labor supply curve and the labor demand curve, so the only way to raise employment must be to move the labor supply curve downward. It’s just Econ 101, and Econ 101 is never wrong.
Of course, if you think that wages are equal to the marginal product of labor, the demand curve for labor will only slope downward when the marginal product of labor is falling — which might not be the case when output is far from potential. But Noah Smith knows that demand curves always slope downward, so there can’t be any range of output over which the mpl is more or less constant.
But wait, what if labor markets are monopsonistic? Then the observed labor demand curve can slope upward. And monopsony in labor markets doesn’t require a company town, all it requires is that a firm’s labor costs are rising in employment. Or in other words that if a firm cuts wages moderately, it will lose some but not all of its workers. (Crazy talk, I know.) Which is the natural result of labor market models with search frictions. This is one reason why the most rigorous empirical studies of legislated wage changes show no sign of a downward sloping labor demand curve. But Noah Smith doesn’t need to trouble his beautiful mind with empirical evidence, or learn any of that silly labor economics stuff, because he knows that labor demand curves slope downward. He learned it in introductory micro!
And then there’s that little difference between labor and cottage cheese, that wages make up the large majority of producers’ variable costs. So we have to think general equilibrium here, not just partial. Prices, in the first instance, are set as a markup over marginal costs. [1] So if you reduce money wages, you don’t reduce real wages by as much, because you reduce the price level as well. That means deflation, which is … let’s see, not always super great for employment. That Maynard dude wrote something about that too, I think, and so did some other old guy, Hunter or Trapper or something. Apparently there was this crazy idea that falling wages and prices were a problem back in Ancient Rome, or maybe the 1930s (same thing). But Noah goes to a good graduate school, so he knows that no real economist bothers with dusty old stuff like that. After all it’s not like there are any lessons we could learn from the Great Depression, or the Punic Wars or whatever it was. Not when we know that labor demand curves slope down!
Oh and hey, there’s another difference between labor and cottage cheese! (Who’d have thought?) Wages are also a source of demand. Pop quiz for Noah Smith: Which is a more important component of final demand, consumption out of wages, or net exports? Yeah, that would be door number one. So maybe, just maybe, whatever competitive advantage lower wages yield in lower unit labor costs might be offset by lower consumption demand by wage-earners? And that’s assuming that changes in wages are fully passed through into the relative price of tradables, and that trade flows are price-elastic. [2] But hey, you know what happens when you assume: it makes you an … economist. Now, if it were the case that wages were an important source of final demand, and if output is demand-constrained, then lowering wages might not raise demand for labor, even if labor markets were fully competitive and if changes in nominal wages translated one for one into changes in real wages. But that’s unpossible! because, as we all know, the demand curve for labor slopes down.
Well, but demand doesn’t matter, since Noah knows — he learned it in school — the economy is always at full employment. If we observe fewer people working, it can’t be because aggregate demand has fallen, it can only be because an artificially high price of labor has led to substitution away from labor to other factors of production. It couldn’t possibly be the case that when unemployment is high, capital is underutilized as well too, could it? Because that would mean that the wage share and the profit share were both too high, which is like saying that x>y and y>x. So no, we couldn’t possibly observe anything like this:
Because we know — it’s economics 101 — that high unemployment can only ever be the result of substitution away from labor because of changes in relative prices, not a lower level of output for the economy as a whole. Altho, gosh, it sure looks like capacity utilization falls in recessions just like employment does, which would suggest that cyclical unemployment has nothing to do with the relative price of labor.
So, ok, we can forget Keynes and all that old nonsense. And let’s ignore the effect of nominal wage changes on prices. And put out of our mind any question about whether the marginal product of labor is really declining over current levels of output, or about imperfect competition in labor markets. And we’ll ignore the role of wages as a source of demand. And we’ll unlearn any information we might have accidentally picked up about the empirical relationship between wages and employment, or about the Great Depression. And we’ll stick our fingers in our ears if anyone suggests that unemployment today is associated with demand constraints on output rather than substitution away from labor. And then we can be as smart as Noah Smith! And we’ll know how to fix unemployment:
In Germany, labor unions often negotiate wage cuts in order to preserve long-term employment levels. I think we should look at doing something similar.
You guys, wage concessions! Has anybody in the US labor movement ever thought of that? I bet it will work great! It’s pretty ballsy of Noah Smith to stand up against Big Labor, but someone’s got to, right? I mean, unions represent almost 7 percent of the private workforce. If someone is holding wages above the level that Economic Forces want them to be at, who else could it be?
Hey, I wonder if any other countries are getting advice from smart economists like Noah Smith, and are fixing all their problems by cutting wages? You know, I think there are some. How about Latvia? The authorities there were all, like, wages are going down. And guess what? While in the US unemployment has gone from 5% in 2007 to over 8% today, in Latvia it went from 5% to … 14%? Well, who cares about some little Baltic country, let’s talk about the UK. They got real wages down by 2.7 percent last years (2.1 percent nominal growth less 4.8 percent inflation.) And hey, look at employment — it’s skyrocketing continuing to fall, and now the lowest it’s been since 2003.
You know what? I’m beginning to think that “labor demand curves slope down” might not be the best way to think about unemployment. Maybe it is helpful to know something about macroeconomics, after all.
[1] Or equal to marginal costs if you like; the point is the same.
[2] I’ve presented some evidence on whether trade flows are responsive to relative costs in practice in these posts.
There sure are a lot of ways to not say aggregate demand.
Here’s the estimable Joseph Stiglitz, not saying aggregate demand in Vanity Fair:
The parallels between the story of the origin of the Great Depression and that of our Long Slump are strong. Back then we were moving from agriculture to manufacturing. Today we are moving from manufacturing to a service economy. The decline in manufacturing jobs has been dramatic—from about a third of the workforce 60 years ago to less than a tenth of it today. … There are two reasons for the decline. One is greater productivity—the same dynamic that revolutionized agriculture and forced a majority of American farmers to look for work elsewhere. The other is globalization… (As Greenwald has pointed out, most of the job loss in the 1990s was related to productivity increases, not to globalization.) Whatever the specific cause, the inevitable result is precisely the same as it was 80 years ago: a decline in income and jobs. The millions of jobless former factory workers once employed in cities such as Youngstown and Birmingham and Gary and Detroit are the modern-day equivalent of the Depression’s doomed farmers.
This sounds reasonable, but is it? Nick Rowe doesn’t think so. Let’s leave aside globalization for another post — as Stieglitz says, it’s less important anyway. It’s certainly true that manufacturing employment has fallen steeply, even while the US — despite what you sometimes here — continues to produce plenty of manufactured goods. But does it make sense to say that the rise in manufacturing productivity be responsible for mass unemployment in the country as a whole?
There’s certainly an argument in principle for the existence of technological unemployment, caused by rapid productivity growth. Lance Taylor has a good discussion in chapter 5 of his superb new book Maynard’s Revenge (and a more technical version in Reconstructing Macroeconomics.) The idea is that with the real wage fixed, an increase in labor productivity will have two effects. First, it reduces the amount of labor required to produce a given level of output, and second, it redistributes income from labor to capital. Insofar as the marginal propensity to consume out of profit income is lower than the marginal propensity to consume out of wage income, this redistribution tends to reduce consumption demand. But insofar as investment demand is driven by profitability, it tends to increase investment demand. There’s no a priori reason to think that one of these effects is stronger than the other. If the former is stronger — if demand is wage-led — then yes, productivity increases will tend to lower demand. But if the latter is stronger — if demand is profit-led — then productivity increases will tend to raise demand, though perhaps not by enough to offset the reduced labor input required for a given level of output. For what it’s worth, Taylor thinks the US economy has profit-led demand, but not necessarily enough so to avoid a Luddite outcome.
Taylor is a structuralist. (The label I think I’m going to start wearing myself.) You would be unlikely to find this story in the mainstream because technological unemployment is impossible if wages equal the marginal product of labor, and because it requires that output to be normally, and not just exceptionally, demand-constrained.
It’s a good story but I have trouble seeing it having much to do with the current situation. Because, where’s the productivity acceleration? Underlying hourly labor productivity growth just keeps bumping along at 2 percent and change a year. Over the whole postwar period, it averages 2.3 percent. Over the past twenty years, 2.2 percent. Over the past decade, 2.3 percent. Where’s the technological revolution?
Just do the math. If underlying productivity rises at 2 percent a year, and demand constraints cause output to stay flat for four years [1], then we would expect employment to fall by 8 percent. In other words, lack of demand explains the whole fall in employment. [2] There’s no need to bring in structural shifts or anything else happening on the supply side. A fall in demand, plus a stable rate of productivity increase, gets you exactly what we’ve seen.
It’s important to understand why demand fell, but from a policy standpoint, no actually it isn’t. As the saying goes, you don’t refill a flat tire through the hole. The important point is that we don’t need to know anything about the composition of output to understand why unemployment is so high, because the relationship between the level of output and employment is no different than it’s always been.
But isn’t it true that since the end of the recession we’ve seen a recovery in output but no recovery in employment? Yes, it is. So doesn’t that suggest there’s something different happening in the labor market this time? No, it doesn’t. Here’s why.
There’s a well-established empirical relationship in macroeconomics called Okun’s law, which says that, roughly, a one percentage point change in output relative to potential changes employment by one a third to a half a percentage point. There are two straightforward reasons for this: first, a significant fraction of employment is overhead labor, which firms need an equal amount of whether their current production levels are high or low. And second, if hiring and training employees is costly, firms will be reluctant to lay off workers in the face of declines in output that are believe to be temporary. For both these reasons (and directly contrary to the predictions of a “sticky wages” theory of recessions) employment invariably falls by less than output in recessions. Let’s look at some pictures.
These graphs show the quarter by quarter annualized change in output (vertical axis) and employment (horizontal axis) over recent US business cycles. The diagonal line is the regression line for the postwar period as a whole; as you would expect, it passes through zero employment growth around two percent output growth, corresponding to the long-run rate of labor productivity growth.
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| 1960 recession |
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| 1969 recession |
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| 1980 and 1981 recessions |
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| 1990 recession |
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| 2001 recession |
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| 2007 recession |
What you see is that in every case, there’s the same clockwise motion. The initial phase of the recession (1960:2 to 1961:1, 1969:1 to 1970:4, etc.) is below the line, meaning growth has fallen more than employment. This is the period when firms are reducing output but not reducing employment proportionately. Then there’s a vertical upward movement at the left, when growth is accelerating and employment is not; this is the period when, because of their excess staffing at the bottom of the recession, firms are able to increase output without much new hiring. Finally there’s a movement toward the right as labor hoards are exhausted and overhead employment starts to increase, which brings the economy back to the long-term relationship between employment and output. [3] As the figures show, this cycle is found in every recession; it’s the inevitable outcome when an economy experiences negative demand shocks and employment is costly to adjust. (It’s a bit harder to see in the 1980-1981 graph because of the double-dip recession of 1980-1981; the first cycle is only halfway finished in 1981:2 when the second cycle begins.)
There’s nothing exceptional, in these pictures, about the most recent recession. Indeed, the accumulated deviations to the right of the long-term trend (i.e., higher employment than one would expect based on output) are somewhat greater than the accumulated deviations to the left of it. Nothing exceptional, that is, except how big it is, and how far it lies to the lower-left. In terms of the labor market, in other words, the Great Recession was qualitatively no different from other postwar recessions; it was just much deeper.
I understand the intellectual temptation to look for a more interesting story. And of course there are obviously structural explanations for why demand fell so far in 2007, and why conventional remedies have been relatively ineffective in boosting it. (Tho I suspect those explanations have more to do with the absence of major technological change, than an excess of it.) But if you want to know the proximate reason why unemployment is so high today, there’s a recession on still looks like a sufficiently good working hypothesis.
[1] Real GDP is currently less than 0.1 percent above its level at the end of 2007.
[2] Actually employment is down by only about 5 percent, suggesting that if anything we need a structural story for why it hasn’t fallen more. But there’s no real mystery here, productivity growth is not really independent of demand conditions and always decelerates in recessions.
[3] Changes in hours worked per employee are also part of the story, in both downturn and recovery.
Let’s start from the top.
What is monetarism? As I see it, it’s a set of three claims. (1) There is a stable relationship between base money and the economically-relevant stock of money. [1] That is, there’s a stable relationship between outside money and inside money. (2) There is a stable velocity of money, so we can interpret the equation of exchange MV = PY (or MV = PT) as a behavioral relationship and not just an accounting identity. Since the first claim says that M is set exogenously by the monetary authority, causality in the equation runs from left to right. And (3), the LM aggregate supply curve is shaped like a backward L, so that changes in PY show up entire in Y when the economy is below capacity, and entirely in changes in P when it is at capacity.
In other words, (1) the central bank can control the supply of money; (2) the supply of money determines the level of nominal output; and (3) there is a single strictly optimal level of nominal output, without any tradeoffs. The implication is that monetary policy should be guided by a simple rule, that the money supply should grow at a fixed rate equal to (what we think is) the growth rate of potential output. Which is indeed, exactly what Friedman and other monetarists said.
You can relax (3) if you want — most monetarists would probably agree that in practice, disinflation is going to involve a period of depressed output. (Altho on the other hand, I’m pretty sure that when monetarism was officially adopted as the doctrine of the bank of England under Thatcher, it was claimed that slowing the growth of the money supply would control inflation without affecting growth at all. And the hedge-monetarism you run into today, that insists the huge growth in base money over the past few years could show up as hyperinflation without warning, seems to be implicitly assuming a backward-L shaped LM AS curve as well.) But basically, that’s the monetarist package.
So what’s wrong with this story? Here’s what:
The red line is base money, the blue line is broad money (M2), and the green line is nominal GDP. The monetarist story is that red moves blue, and blue moves green. Between 1990 and 2008, this story isn’t glaringly incompatible with the evidence. But since then? It’s clear that the money multiplier, as we normally talk about it, no longer has any economic reality. There might still be tools out there to control the money supply. But changing the stock of base money — the instrument of central banks, at least in theory, since the early 20th century — is no longer one of them. Monetary policy as we knew it is dead. The divergence between the blue and green lines is less dramatic in this graph, but if anything it’s even more damning. While output and prices lurched downward in the great Recession, the money supply just kept chugging along. Milton Friedman’s idea that stable growth of the money supply is a sufficient condition for stable growth of nominal GDP looks pretty definitively refuted.
So that’s monetarism, and what’s the matter with it. How about quasi-monetarism? What’s the difference from the unprefixed kind?
Some people would say, There is no difference. Quasi-monetarist is just what we call a New Keynesian who’s taken off his Keynes mask and admitted he was a Friedmanite all along. And let’s be honest, that’s sort of true. But it’s like one of those episodes in religious history where at some point the disciples have to acknowledge that, ok, the prophecies don’t seem to have exactly worked out. Which means we have to figure out what they really meant.
In this case, the core commitment is the idea that if PY is too low (we’re experiencing a recession and/or deflation) that means M is too low; if PY is too high (we’re experiencing inflation) that means M is too high. In other words, when we talk about insufficient aggregate demand, what we’re really talking about is just excess demand for money. And therefore, when we talk about policies to boost demand, we’re really just talking about policies to boost the money stock. (Nick Rowe, as usual, is admirably straightforward on this point.) But how to reconcile this with the graph above? You just have to replace some material entities with spiritual ones: The true M, or V, or both, is not visible to mortal eyes. Let’s say that velocity is exogenous but not stable. Then there is still a unique path of M that would guarantee both full employment and stable prices, but it can’t be characterized as a simple growth rate as Friedman hoped. Alternatively, maybe the problem is that the monetary authority can only control M clumsily, and can’t directly observe how far off it is. (This is the DeLong version of quasi-monetarism. The assets that count as M are always changing.) Then, there may still be the One True Growth Rate of M just as Friedman promised, but the monetary authority can’t reliably implement it. Or sublunary M and V could both depart from their platonic ideals. In any case, the answer is clear: Since it’s hard to get MV right, your rule should be to target a steady growth rate of PY (nominal GDP). Which is, indeed, exactly what the quasi-monetarists say. [2]
So what’s the alternative? I’ve been arguing that one alternative is to think of recessions as coordination failures, which could happen even in an economy without money. I’m honestly not sure if that’s going to turn out to be a productive direction to go in, or not. But in terms of the monetarist framework, the alternative is clear. Say that V is not only unstable, but endogenous. Specifically, say that it varies inversely with M. In this case, it remains true — as it must; it’s an accounting identity — that MV = PY. But nonetheless there is nothing you can do to M, that will affect P or Y. (This situation, by the way, is what Keynes meant by a liquidity trap. It wasn’t about the zero lower bound.)
This, I think, is what we actually observe, not just right now, but in general. “The” interest rate is the price of liquidity, that is, the price of money. [3] And what kinds of activity are sensitive to interest rates? Well, uh … none of them. None, anyway, except for housing. When an economic unit is deciding on the division of its income between currently-produced goods and services vs. money, the price at which they exchange just doesn’t seem to be much of a consideration. (Again, except — and it’s an important exception — when the decision takes the form of purchasing housing services from either an existing home, or a new one.) Which means that changes in M don’t have any good channel to produce changes in P or Y. In general, increases or decreases in M will just result in pro rata decreases or increases in V. Yes, it may be formally true that insufficient demand for goods equals excess demand for money; but it doesn’t matter if there’s no well-defined money demand function. A traditional Keynesian expenditure function (Z = A + cY) cannot be usefully simplified, as the quasi-monetarists would like, by thinking of it as a problem of maximizing the flow of consumption subject to some real balance constraint.
So, monetarism made some strong predictions. Quasi-monetarism admits that those predictions don’t hold up, but argues that the monetarist model is still the right one, we just can’t observe the variables in it as directly as early monetarists hoped. On some level, they may be right! But at some point, when the model gets too loosely coupled with reality, you’ll want to stop using it. Even if, in some sense, it isn’t wrong.
Which is all to say that, even if I can’t find a way to disprove it analytically, I just can’t accept the idea that the question of aggregate demand can be usefully reduced to the question of the supply of money.
[1] The simplest form of the first claim would be that the money multiplier is equal to one: Outside money is all the money there is. Something like this was supposed to be true under the gold standard, tho as the great Robert Triffin points out, it wasn’t really. Over at Windyanabasis, rsj claims that Krugman, a closet quasi-monetarist, implicitly makes this assumption.
[2] In practice, despite the tone of this post, I’m not entirely sure they’re wrong. More generally, Nick Rowe’s clear and thorough posts on this set of questions are essential reading.
[3] I’ve learned from Bob Pollin never to write that phrase without the quotes. There are lots of interest rates, and it matters.
Today Paul Krugman takes up the question of the post below, are recessions all about (excess demand for) money? The post is in response to an interesting criticism by Henry Kaspar of what Kaspar calls “quasi-monetarists,” a useful term. Let me rephrase Kaspar’s summary of the quasi-monetarist position [1]:
1. Logically, insufficient demand for goods implies excess demand for money, and vice versa.
2. Causally, excess demand for money (i.e. an increase in liquidity preference or a fall in the money supply) is what leads to insufficient demand for goods.
3. The solution is for the monetary authority to increase the supply of money.
Quasi-monetarists say that 2 is true and 3 follows from it. Kaspar says that 2 doesn’t imply 3, and anyway both are false. And Krugman says that 3 is false because of the zero lower bound, and it doesn’t matter if 2 is true, since asking for “the” cause of the crisis is a fool’s errand. But everyone agrees on 1.
Me, though, I have doubts.
Krugman:
An overall shortfall of demand, in which people just don’t want to buy enough goods to maintain full employment, can only happen in a monetary economy; it’s correct to say that what’s happening in such a situation is that people are trying to hoard money instead (which is the moral of the story of the baby-sitting coop). And this problem can ordinarily be solved by simply providing more money.
For those who don’t know it, Krugman’s baby-sitting co-op story is about a group that let members “sell” baby-sitting services to each other in return for tokens, which they could redeem later when they needed baby-sitting themselves. The problem was, too many people wanted to save up tokens, meaning nobody would use them to buy baby-sitting and the system was falling apart. Then someone realizes the answer is to increase the number of tokens, and the whole system runs smoothly again. It’s a great story, one of the rare cases where Keynesian conclusions can be drawn by analogizing the macroeconomy to everyday experience. But I’m not convinced that the fact that demand constraints can arise from money-hoarding, means that they always necessarily do.
Let’s think of the baby-sitting co-op again, but now as a barter economy. Every baby-sitting contract involves two households [2] committing to baby-sit for each other (on different nights, obviously). Unlike in Krugman’s case, there’s no scrip; the only way to consume baby-sitting services is to simultaneously agree to produce them at a given date. Can there be a problem of aggregate demand in this barter economy. Krugman says no; there are plenty of passages where Keynes seems to say no too. But I say, sure, why not?
Let’s assume that participants in the co-op decide each period whether or not to submit an offer, consisting of the nights they’d like to go out and the nights they’re available to baby-sit. Whether or not a transaction takes place depends, of course, on whether some other participant has submitted an offer with corresponding nights to baby-sit and go out. Let’s call the expected probability of an offer succeeding p. However, there’s a cost to submitting an offer: because it takes time, because it’s inconvenient, or just because, as Janet Malcolm says, it isn’t pleasant for a grown man or woman to ask for something when there’s a possibility of being refused. Call the cost c. And, the net benefit from fulfilling a contract — that is, the enjoyment of going out baby-free less the annoyance of a night babysitting — we’ll call U.
So someone will make an offer only when U > c/p. (If say, there is a fifty-fifty chance that an offer will result in a deal, then the benefit from a contract must be at least twice the cost of an offer, since on average you will make two offers for eve contract.) But the problem is, p depends on the behavior of other participants. The more people who are making offers, the greater the chance that any given offer will encounter a matching one and a deal will take place.
It’s easy to show that this system can have multiple, demand-determined equilibria, even though it is a pure barter economy. Let’s call p* the true probability of an offer succeeding; p* isn’t known to the participants, who instead form p by some kind of backward-looking expectations looking at the proportion of their own offers that have succeeded or failed recently. Let’s assume for simplicity that p* is simply equal to the proportion of participants who make offers in any given week. Let’s set c = 2. And let’s say that every week, participants are interested in a sitter one night. In half those weeks, they really want it (U = 6) and in the other half, they’d kind of like it (U = 3). If everybody makes offers only when they really need a sitter, then p = 0.5, meaning half the contracts are fulfilled, giving an expected utility per offer of 2. Since the expected utility from making an offer on a night you only kind of want a sitter is – 1, nobody tries to make offers for those nights, and the equilibrium is stable. On the other hand, if people make offers on both the must-go-out and could-go-out nights, then p = 1, so all the offers have positive expected utility. That equilibrium is stable too. In the first equilibrium, total output is 1 util per participant per week, in the second it’s 2.5.
Now suppose you are stuck in the low equilibrium. How can you get to the high one? Not by increasing the supply of money — there’s no money in the system. And not by changing prices — the price of a night of baby-sitting, in units of nights of baby-sitting, can’t be anything but one. But suppose half the population decided they really wanted to go out every week. Now p* rises to 3/4, and over time, as people observe more of their offers succeeding, p rises toward 3/4 as well. And once p crosses 2/3, offers on the kind-of-want-to-go-out nights have positive expected utility, so people start making offers for those nights as well, so p* rises further, toward one. At that point, even if the underlying demand functions go back to their original form, with a must-go-out night only every other week, the new high-output equilibrium will be stable.
As with any model, of course, the formal properties are less interesting in themselves than for what they illuminate in the real world. Is the Krugman token-shortage model or my pure coordination failure model a better heuristic for understanding recessions in the real world? That’s a hard question!
Hopefully I’ll offer some arguments on that question soon. But I do want to make one logical point first, the same as in the last post but perhaps clearer now. The statement “if there is insufficient demand for currently produced goods, there must excess be demand for money” may look quite similar to the statement “if current output is limited by demand, there must be excess demand for money.” But they’re really quite different; and while the first must be true in some sense, the second, as my hypothetical babysitting co-op shows, is not true at all. As Bruce Wilder suggests in comments, the first version is relevant to acute crises, while the second may be more relevant to prolonged periods of depressed output. But I don’t think either Krugman, Kaspar or the quasi-monetarists make the distinction clearly.
EDIT: Thanks to anonymous commenter for a couple typo corrections, one of them important. Crowd-sourced editing is the best.
Also, you could think of my babysitting example as similar to a Keynesian Cross, which we normally think of as the accounting identity that expenditure equals output, Z = Y, plus the behavioral equation for expenditure, Z = A + cY, except here with A = 0 and c = 1. In that case any level of output is an equilibrium. This is quasi-monetarist Nick Rowe’s idea, but he seems to be OK with my interpretation of it.
FURTHER EDIT: Nick Rowe has a very thoughtful response here. And my new favorite econ blogger, the mysterious rsj, has a very good discussion of these same questions here. Hopefully there’ll be some responses here to both, soonish.
[1] Something about typing this sentence reminds me unavoidably of Lucky Jim. This what neglected topic? This strangely what topic? Summary of the quasi-what?
[2] Can’t help being bugged a little by the way Krugman always refers to the participants as “couples,” even if they mostly were. There are all kinds of families!
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.
It’s September of 2007. Though almost no one realizes it, the so-called Great Moderation is ending. The housing bubble has just peaked, a rolling financial conflagration has already started, and the US economy is descending into its steepest downturn since the 1930s.
And a well-known economist is saying:
One of the most striking facts about macropolicy is that we have progressed amazingly. … In my opinion, better policy, particularly on the part of the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle in the last 25 years. ..
The story of stabilization policy of the last quarter century is one of amazing success. We have seen the triumph of sensible ideas and have reaped the rewards in terms of macroeconomic performance. The costly wrong turn in ideas and macropolicy of the 1960s and 1970s has been righted and the future of stabilization looks bright.
Who is it?
Must be one of those smug right-wing Chicago types, right? Maybe Robert Lucas, whose claim that the “central problem of depression-prevention has been solved” was so widely mocked when the crisis broke out?
Nope. It’s Christina Romer, soon to be Obama’s top economist.
As Obama’s CEA chair, by all accounts Romer led the pro-stimulus forces in the administration against the forces of austerity. Yet there she is, in Berkeley in 2007, speaking without irony of the “glorious counterrevolution” against Keynes in the 1980s:
The 1960s represented the beginning of a long dark period for macroeconomic policy…. [But] since 1985, inflation has been below 4% every single year and has averaged just 2.5%. Real short-run macroeconomic performance has been similarly splendid. … As someone who started her career saying there had not been a stabilization of the postwar economy, I now have to admit there most certainly has been – it just started in 1985, not 1947. ..
What stops this story from being a good morality play is that good hasn’t triumphed entirely. At the same time that we have seen a glorious counterrevolution in the ideas and conduct of short-run stabilization policy, we have seen a remarkable lack of progress in long-run fiscal policy. In this area, the legacy of 1960s beliefs is still very much with us and may threaten the long-run stability of the American economy. … The revolutionary idea of the 1960s concerning long-run fiscal policy was that it was not important to balance the budget even over a period of several years. Rather, persistent budget deficits could actually be desirable because they would lower unemployment and move the economy toward a more desirable path for real output.
In other words, there is one flaw in the amazingly amazing progress in economic policy since the 1980s. It’s not rising private debt, financial deregulation, or stagnant wages and soaring income inequality, none of which she mentions. It’s that people need to worry more about the federal debt.
True, she admits, there’s no concrete evidence for any economic costs to public indebtedness over its historic range.[1] But that shouldn’t stop us worrying:
The consequences of persistent deficits may only be felt over a very long horizon. … It is also possible that the effects of persistent deficits are highly nonlinear. Perhaps over a wide range, deficits and the cumulative public debt really do have little impact on the economy. But, at some point, the debt burden reaches a level that threatens the confidence of investors. Such a meltdown and a sudden stop of lending would unquestionably have enormous real consequences.
Maybe. But ideas have consequences, too. For instance, Romer’s argument here is the same argument, almost verbatim, that would be used by her opponents in the administration just a year and a half later, when she was pushing for a larger stimulus:
Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be more than $1.2 trillion. The memo to Obama, however, detailed only two packages: a five-hundred-and-fifty-billion-dollar stimulus and an eight-hundred-and-ninety-billion-dollar stimulus. Summers … argued that the stimulus should not be used to fill the entire output gap; rather, it was “an insurance package against catastrophic failure.” … He believed that filling the output gap through deficit spending was important, but that a package that was too large could potentially shift fears from the current crisis to the long-term budget deficit, which would have an unwelcome effect on the bond market. In the end, Summers made the case for the eight-hundred-and-ninety-billion-dollar option.
That’s Ryan Lizza via Paul Krugman; in Krugman’s version, Romer is the hero. But what he doesn’t say is that the arguments being deployed against her here are ones she herself was making just a year or two earlier: Shortfalls in demand are less dangerous than policymakers think, but deficits are much more so; and thanks to nonlinearity you can’t wait until there’s some visible cost to deficit spending to curtail it.
Now, let’s be fair: We’d all be better off if Romer had won her debate with Orszag and Summers. (And if Summers had then been remanded to a job in chicken manure management.) Still, it’s important to remember how small is the gap between the wings of mainstream economics, despite the vitriol.
In her Berkeley address, Romer says
The reason that I have talked in some detail about the economic beliefs that policymakers held in the 1950s is that I believe the policies they undertook and the economic outcomes derived largely from those beliefs.
I agree. In 2007, Christina Romer was using her podium to say that we don’t need to worry about major recessions, that the greatest mistake in economic policy in recent decades was faith in fiscal policy, and that the most important intellectual task for macroeconomists is to convince policymakers of the dangers of budget deficits. Now, those same arguments are being used to tell us we should accept 9-10% unemployment as far as the eye can see. If we didn’t want to end up here, we should have started somewhere else.
[1] Here is, literally, the entirety of her argument on the costs of higher deficits: “On the idea that persistent deficits don’t matter, I think there is widespread consensus that that is not true. There may be differences in our estimates of the size of the eventual effects, but most economists agree that deficits over decades unquestionably reduce national saving and have consequences for long-run standards of living.” No names, no cites, no data, no examples. Just, “most economists agree.”
