The Slack Wire – Page 32

New Keynesians Don’t Believe Their Models

Here’s the thing about about saltwater, New Keynesian economists: They don’t believe their own theory.

Via John Cochrane, here is a great example. In the NBER Macroeconomics Annual a couple years ago, Gauti Eggertson laid out the canonical New Keynesian case for the effectiveness of fiscal policy when interest rates are at the Zero Lower Bound. In the model Eggertson describes there — the model that is supposed to provide the intellectual underpinnings for fiscal stimulus — the multiplier on government spending at the ZLB is indeed much larger than in normal conditions, 2.3 rather than 0.48. But the same model says that at the ZLB, cuts in taxes on labor are contractionary, with a multiplier of -1. Every dollar of “stimulus” from the Making Work Pay tax credit, in other words, actually reduced GDP by a dollar. Or as Eggertson puts it, “Cutting taxes on labor … is contractionary under the circumstances the United States is experiencing today. “

Now, obviously there are reasons why one might believe this. For instance, maybe lower payroll taxes just allow employers to reduce wages by the same amount, and then in response to their lower costs they reduce prices, which is deflationary. There’s nothing wrong with that story in principle. No, the point isn’t that the New Keynesian claim that payroll tax cuts reduce demand is wrong — though I think that it is. The point is that nobody actually believes it.

In the debates over the stimulus bill back at the beginning of 2009, everyone agreed that payroll tax cuts were stimulus just as much as spending increases. The CBO certainly did. There were plenty of “New Keynesian” economists involved in that debate, and while they may have said that tax cuts would boost demand less than direct government spending, I’m pretty sure that not one of them said that payroll tax cuts would actually reduce demand. And when the payroll tax cuts were allowed to expire at the end of 2012, did anyone make the case that this was actually expansionary? Of course not. The conventional wisdom was that the payroll tax cuts had a large, positive effect on demand, with a multiplier around positive 1. Regardless of good New Keynesian theory.

As a matter of fact, even Eggertson doesn’t seem to believe that raising taxes on labor will boost demand, whether or not it’s what the math says. The “natural result” of his model, he admits, is that any increase in government spending should be financed by higher taxes. But:

There may, however, be important reasons outside the model that suggest that an increase in labor and capital taxes may be unwise and/or impractical. For these reasons I am not ready to suggest, based on this analysis alone, that raising capital and labor taxes is a good idea at zero interest rates. Indeed, my conjecture is that a reasonable case can be made for a temporary budget deficit to finance a stimulus plan…

Well, yeah. I think most of us can agree that raising payroll taxes in a recession is probably not the best idea. But at this point, what are we even doing here? If you’re going to defer to arguments “outside the model” whenever the model says something inconvenient or surprising, why are you even doing it?

EDIT: I put this post up a few days ago, then took it down because it seemed a little thin and I thought I would add another example or two of the same kind of thing. But I’m feeling now that more criticism of mainstream economics is not a good use of my time. If that’s what you want, you should check out this great post by Noah Smith. Noah is so effective here for the same reason that he’s sometimes so irritatingly wrong — he’s writing from inside the mainstream. The truth is, to properly criticize these models, you have to have a deep knowledge of them, which he has and I do not.

Arjun and I have a piece in an upcoming Economics and Politics Weekly on how liberal, “saltwater” economists share the blame for creating an intellectual environment favorable to austerian arguments, however much they oppose them in particular cases. I feel pretty good about it — will link here when it comes out — I think for me, that’s enough criticism of modern macro. In general, the problem with radical economists is they spend too much time on negative criticism of the economics profession, and not enough making a positive case for an alternative. This criticism applies to me too. My comparative advantage in econblogging is presenting interesting Keynesian and Marxist work.

One thing one learns working at a place like Working Families, the hard thing is not convincing people that shit is fucked up and bullshit, the hard thing is convincing them there’s anything they can do about it. Same deal here: The real challenge isn’t showing the other guys are wrong, it’s showing that we have something better.

That Safe Asset Shortage, Continued

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

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

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

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

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

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

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

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

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

Tell Me About that “Safe Asset Shortage” Again

From today’s FT:

US Junk Debt Yield Hits Historic Low

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

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

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

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

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

Difference between CCC- and AAA bond yields

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

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

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

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

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

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

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

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

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

Don’t Touch the Yield

There’s a widespread idea in finance and economics land that there’s something wrong, dangerous, even unnatural about persistently low interest rates.

This idea takes its perhaps most reasonable form in arguments that the fundamental cause of the Great Financial Crisis was rates that were “far too low for far too long,” and that continued low interest rates, going forward, will only encourage speculation and new asset bubbles. Behind, or anyway alongside, these kinds of claims is a more fundamentally ideological view, that owners of financial assets are morally entitled to their accustomed returns, and woe betide the society or central banker that deprives them of the fruit of their non-labor. You hear this when certain well-known economists describe low rates as the “rape and plunder” of bondowners, or when Jim Grant says that the real victims of the recession are investors in money-market funds.

I want to look today at the “reaching for yield” version of this argument, which Brad Delong flagged as PRIORITY #1 RED FLAG OMEGA for the econosphere after it was endorsed by the Federal Reserve’s Jeremy Stein. [1] In DeLong’s summary:

Bankers want profits. … And a bank has costs above and beyond the returns on its portfolio. For each dollar of deposits it collects, a bank must spend 2.5 cents per year servicing those deposits. In normal times, when interest rates are well above 2.5 percent per year, banks have a normal, sensible attitude to risk and return. They will accept greater risk only if they come with returns higher enough to actually diminish the chances of reporting a loss. But when interest rates fall low enough that even the most sensible portfolio cannot reliably deliver a return on the portfolio high enough to cover the 2.5 cent per year cost of managing deposits, a bank will “reach for yield” and start writing correlated unhedged out-of-the-money puts so that it covers its 2.5 percent per year hurdle unless its little world blows up. Banks stop reducing their risk as falling returns mean that diversification and margin can no longer be counted on to manage them but instead embrace risks.

It is Stein’s judgment that right now whatever benefits are being provided to employment and production by the Federal Reserve’s super-sub-normal interest rate policy and aggressive quantitative easing are outweighed by the risks being run by banks that are reaching for yield.

Now on one level, this just seems like a non-sequitur. “Banks holding more risky assets” is, after all, just another way of saying “banks making more loans.” In fact, it’s hard to see how monetary policy is ever supposed to work if we rule out the possibility of shifting banks’ demand for risky private assets. [1] An Austrian, I suppose, might follow this logic to its conclusion and reject the idea of monetary policy in general; but presumably not an Obama appointee to the Fed.

But there’s an even more fundamental problem, not only with the argument here but with the broader idea — shared even by people who should know better — that low interest rates hurt bank profits. It’s natural to think that banks receive interest payments, so lower interest means less money for the bankers. But that is wrong.

Banks are the biggest borrowers as well as the biggest lenders in the economy, so what matters is not the absolute level of interest rates, but the spread — the difference between the rate at which banks borrow and the rate at which they lend. A bank covers its costs as reliably borrowing at 1 percent and lending at 4, as it does borrowing at 3 percent and lending at 6. So if we want to argue that monetary policy affects the profitability of bank lending, we have to argue that it has a differential effect on banks funding costs and lending rates.

For many people making the low-rates-are-bad-for-banks argument, this differential effect may come from a mental model in which the main bank liabilities are non-interest-bearing deposits. Look at the DeLong quote again — in the world it’s describing, banks pay a fixed rate on their liabilities. And at one point that is what the real world looked like too.

In 1960, non-interest-bearing deposits made up over two-thirds of total bank liabilities. In a system like that, it’s natural to see the effect of monetary policy as mainly on the asset side of bank balance sheets. But today’s bank balance sheets look very different: commercial banks now pay interest on around 80 percent of their liabilities. So it’s much less clear, a priori, why policy changes should affect banks interest income more than their funding costs. Since banks borrow short and lend long (that’s sort of what it means to be a bank), and since monetary policy has its strongest effects at shorter maturities, one might even expect the effect on spreads to go the other way.

And in fact, when we look at the data, that is what we see.

Average interest rate paid (red) and received (blue) by commercial banks. Source: FDIC

The black line with diamonds is the Federal Funds rate, set by monetary policy. The blue line is the average interest rate charged by commercial banks on all loans and leases; the solid red line is their average funding cost; and the dotted red line is the average interest rate on commercial banks’ interest-bearing liabilities. [3] As the figure shows, in the 1950s and ’60s changes in the federal funds rate didn’t move banks’ funding costs at all, while they did have some effect on loan rates; the reach-for-yield story might have made sense then. But in recent decades, as banks’ pool of cheap deposit funding has dried up, bank funding costs have become increasingly sensitive to the policy rate.

Looking at the most recent cycle, the decline in the Fed Funds rate from around 5 percent in 2006-2007 to the zero of today has been associated with a 2.5 point fall in bank funding costs but only a 1.5 point fall in bank lending rates — in other words, a one point increase in spreads. The same relationship, though weaker, is present in the previous two cycles, but not before. More generally, the correlation of changes in the federal funds rate and changes in bank spreads is 0.49 for 1955-1980, but negative 0.38 for the years 1991-2001. So Stein’s argument fails at the first step. If low bank margins are the problem, then “super-sub-normal interest rate policy” is the solution.

Let’s walk through this again. The thing that banks care about is the difference between what it costs them to borrow, and what they can charge to lend. Wider spreads mean lending is more profitable, narrower spreads mean it’s less so. And if banks need a minimum return on their lending — to cover fixed costs, or to pay executives expected bonuses or whatever — then when spreads get too narrow, banks may be tempted to take underprice risk. That’s “reaching for yield.” So turning to the figure, the spread is the space between the solid red line and the solid blue one. As we can see, in the 1950s and ’60s, when banks funded themselves mostly with deposits, the red line — their borrowing costs — doesn’t move at all with the federal funds rate. So for instance the sharp tightening at the end of the 1960s raises average bank lending rates by several points, but doesn’t move bank borrowing rates at all. So in that period, a high federal funds rate means wide bank spreads, and a low federal funds rate means narrower spreads. In that context the “reaching for yield” story has a certain logic (which is not to say it would be true, or important.) But since the 1980s, the red line — bank funding costs — has become much more responsive to the federal funds rate, so this relationship between monetary policy and bank spreads no longer exists. If anything, as I said, the correlation runs in the opposite direction.

Short version: When banks are funded by non-interest bearing deposits, low interest rates can hurt their profits, which makes them have a sad face. But when banks pay interest on almost all their liabilities, as today, low rates make them have a happy face. [4] In which case there’s no reason for them to reach for yield.

Now, it is true that the Fed has also intervened directly in the long end, where one might expect the impact on bank lending rates to be stronger. This is specifically the focus of a speech by Stein last October, where he explicitly said that if the policy rate were currently 3 percent he would have no objection to lowering it, but that he was more worried about unconventional policy to directly target long rates. [5] He offers a number of reasons why a fall in long rates due an expectation of lower short rates in the future would be expansionary, but a fall in long rates due to a lower term premium might not be. Frankly I find all these explanations ad-hoc and hand-wavey. But the key point for present purposes is that unconventional policy does not involve the central bank setting some kind of regulatory ceiling on long rates; rather, it involves lowering long rates via voluntary transactions with lenders. The way the Fed lowers rates on long bonds is by raising their price; the way it raises their price is by buying them. It is true, simply as a matter of logic, that the only way that QE can lower the market rate on a loan from, say, 4 percent to 3.9 percent, is by buying up enough loans (or rather, assets that are substitutes for loans) that the marginal lender now values a 3.9 percent loan the same as the marginal lender valued a 4 percent loan before. If a lender who previously would have considered a loan at 4 percent just worth making, does not now consider a loan at 3.9 percent worth making, then the interest rate on loans will not fall. Despite what John Taylor imagines, the Fed does not reduce interest rates by imposing a ceiling by fiat. So the statement, “if the Fed lowers long rates, bank won’t want to lend” is incoherent: the only way the Fed can lower long rates is by making banks want to lend more.

Stein’s argument is, to be honest, a bit puzzling. If it were true that banks respond to lower rates not by reducing lending or accepting lower profit margins, but by redoubling their efforts to fraudulently inflate returns, that would seem to be an argument for radically reforming the bank industry, or at least sending a bunch of bankers to jail. Stein, weirdly, wants it to be an argument for keeping rates perpetually high. But we don’t even need to have that conversation. Because what matters to banks is not the absolute level of rates, but the spread between their borrowing rate and their lending rate. And in the current institutional setting, expansionary policy implies higher spreads. Nobody needs to be reaching for yield.

[1] The DeLong post doesn’t give a link, but I think he’s responding to this February 7 speech.

[2] As Daniel Davies puts it in comments to the DeLong post:

If the Federal Reserve sets out on a policy of lowering interest rates in order to encourage banks to make loans to the real economy, it is a bit weird for someone’s main critique of the policy to be that it is encouraging banks to make loans. If Jeremy Stein worked for McDonalds, he would be warning that their latest ad campaign carried a risk that it might increase sales of delicious hamburgers.

[3] Specifically, these are commercial banks’ total interest payments from loans and leases divided by the total stock of loans and leases, and total interest payments divided by total liabilities and interest-bearing liabilities respectively.

[4] Why yes, I have been hanging around with a toddler lately.

[5] Interesting historical aside: Keynes’ conclusion in the 1930s that central bank intereventions could not restore full employment and that fiscal policy was therefore necessary, was not — pace the postwar Keynesian mainstream — based on any skepticism about the responsiveness of economic activity to interest rates in principle. It was, rather, based on his long-standing doubts about the reliability of the link from short rates to long rates, plus a new conviction that central banks would be politically unable or unwilling to target long rates directly.

Planned Service Changes

[Edit, 4-30-14: I put this post up a week ago and then took it down after a few hours because, seriously, there is no way I am going on hiatus. But apparently it’s bad form to put a post up and then delete it, so in the interests of historical integrity I’m putting it back.]

This blog has never had a high volume of posts, but it’s going to drop to zero for the next few months.

As some of you know, I’m in the final stages of my PhD at UMass-Amherst (the Gondor of the austerity wars). I’ve been working on this thing for quite a few years, and could happily work on it quite a few more — except, damn it, I went and got a job. Starting next fall, I’ll be an assistant professor in the economics department at Roosevelt University in Chicago.

It’s a good job. I like the department a lot: it’s unapologetically heterodox and serves mostly working-class students; I like my new colleagues and I don’t mind moving back to Chicago, where I lived for most of the ’90s. Of course my mother thinks I should be at Harvard, and I do harbor fantasies of teaching at the PhD level. But that’s not going to happen, and short of that, Roosevelt is about ideal for me. So I’m happy.

But! I do have to get the dissertation done and defended before then. So, rewarding as this blog is — and it really is rewarding; I think I have the best readers in the econosphere — I need to ~~shut it down. Next post you see from me, will be after the thesis is submitted.~~ slow the pace of posting, from its already low levels.

Honestly, you probably won’t even notice the difference.

Aggregate Demand and Modern Macro

Start with a point on language.

People often talk about aggregate demand as if it were a quantity. But this is not exactly right. There’s no number or set of numbers in the national accounts labeled “aggregate demand”. Rather, aggregate demand is a way of interpreting the numbers in the national accounts. (Admittedly, it’s the way of interpreting them that guided their creation in the first place). It’s a statement about a relationship between economic quantities. Specifically, it’s a statement that we should think about current income and current expenditure as mutually determining each other.

This way of thinking is logically incompatible with the way macroeconomics is taught in (almost) all graduate programs today, which is in terms of optimization under an intertemporal budget constraint. I’ll avoid semi-pejorative terms like mainstream and neoclassical, and instead follow Robert Gordon and call this approach modern macro.

In the Keynesian income-expenditure vision — which today survives only, as Leijonhufvud put it, “in the Hades of undergraduate instruction” — we think of economic actors as making decisions about current spending in terms of current receipts. If I earn $X, I will spend $Y; if I earn one dollar more, I’ll spend so many additional cents. We can add detail by breaking these income and expenditure flows in various ways — income from dividends vs. incomes from wages, income to someone at the top decile vs someone at the bottom, income to urban households vs income to rural ones; and expenditures on services, durable goods, taxes, etc., which generate income in their turn. This is the way macro forecasting models used by business and government were traditionally constructed, and may still be for all I know.

Again, these are relationships; they tell us that for any given level of aggregate money income, there is a corresponding level of aggregate expenditure. The level of income that is actually realized, is the one for which desired expenditure just equals income. And if someone for whatever reason adjusts their desired level of expenditure at that income, the realized level of income will change in the same direction, by a greater or lesser extent. (This is the multiplier.)

I should stress that while this way of thinking may imply or suggest concrete predictions, these are not themselves empirical claims, but logical relationships.

The intertemporal optimization approach followed in modern macro is based on a different set of logical relationships. In this framework, agents know their endowments and tastes (and everyone else’s, though usually in these models agents are assumed to be identical) and the available production technology in all future periods. So they know all possible mixes of consumption and leisure available to them over the entire future and the utility each provides. Based on this knowledge they pick, for all periods simultaneously (“on the 8th day of creation” — that’s Leijonhufvud again) the optimal path of labor, output and consumption.

I realize that to non-economists this looks very strange. I want to stress, I’m not giving a dismissive or hostile summary. To anyone who’s done economics graduate work in the last 15 or 20 years (a few heterodox enclaves excepted) constructing models like this is just what “doing macroeconomics” means.

(For a concrete example, a first-year grad textbook offers as one of its first exercises in thinking like an economist the question of why countries often run current account deficits in wartime. The answer is entirely in terms of why countries would choose to allocate a greater share of consumption to periods when there is war, and how interest rates adjust to make this happen. The possibility that war leads to higher incomes and expenditure, some of which inevitably falls on imported goods — the natural answer in the income-expenditure framework — is not even mentioned. Incidentally, as this example suggests, thinking in terms of intertemporal allocation is not always necessarily wrong.)

In these models, there is no special relationship between income and expenditure flows just because they happen to take place at the same time or in any particular order. The choice between jam today and jam tomorrow is no different from the choice between blackberry and lingonberry jam, and the checks you get from your current job and from the job you’ll hold ten years from now are no more different than the checks from two different jobs that you hold right now are. Over one year or 50, the problem is simply the best allocation of your total income over your possible consumption baskets — subject, of course, to various constraints which may make the optimal allocation unachievable.

My point here is not that modern models are unrealistic. I am perfectly happy to stipulate that the realism of assumptions doesn’t matter. Models are tools for logical analysis, not toy train sets — they don’t have to look like real economies to be useful.

(Although I do have to point out that modern macroeconomics models are often defended precisely on the grounds of microfoundations — i.e. more realistic assumptions. But it is simply not true that modern models are more “microfounded” than income-expenditure ones in any normal English sense. Microfoundations does not mean, as you might imagine, that a model has an explicit story about the individual agents in the economy and how they make choices — the old Keynesian models do at least as well as the modern ones by that standard. Rather, microfoundations means that the agents’ choices consist of optimizing some quantity under true — i.e. model consistent — expectations.)

But again, I come not to bury or dispraise modern models. My point is just that they are logically incompatible with the concept of aggregate demand. It’s not that modern macroeconomists believe that aggregate demand is unimportant, it’s that within their framework those words don’t mean anything. Carefully written macro papers don’t even footnote it as a minor factor that can be ignored. Even something anodyne like “demand might also play a role” would come across like the guy in that comic who asks the engineers if they’ve “considered logarithms” to help with cooling.

The atomic units of one vision are flows — that is, money per time period — between economic units. The atomic units of the other are prices and quantities of different goods. Any particular empirical question can be addressed within either vision. But they generate very different intuitions, and ideas of what questions are most important.

Still, it is true that the same concrete phenomena can be described in either language. The IS curve is the obvious example. In the Hades of the undergraduate classroom we get the old Keynesian story of changes in interest rate changing desired aggregate expenditure at each given income. While in the sunlit Arcadia of graduate classes, the same relationship between interest rates and current expenditure is derived explicitly from intertemporal optimization.

So what’s the problem, you say. If either language can be used to describe the same phenomena, why not use the same language as the vast majority of other economists?

This is a serious question, and those of us who want to do macro without DSGE models need a real answer for it. My answer is that default assumptions matter. Yes, with the right tweaks the two models can be brought to a middle ground, with roughly the same mix of effects from the current state and expected future states of the world. But even if you can get agreement on certain concrete predictions, you won’t agree on what parts of them depend on the hard core of your theory and what on more or less ad hoc auxiliary assumptions. So Occam’s Razor will cut in opposite directions — a change that simplifies the story from one perspective, is adding complexity from the other.

For example, from the income-expenditure perspective, saying that future interest rates will have a similar effect on current activity as current interest rates do, is a strong additional assumption. Whereas from the modern perspective, it’s saying that they don’t have similar effects that is the additional assumption that needs to be explained. Or again, taking an example with concrete applications to teaching, the most natural way to think about interest rates and exchange rates in the income-expenditure vision is in terms of how the the flow of foreign investment responds to interest rates differentials. Whereas in the modern perspective — which is now infiltrating even the underworld — the most natural way is in terms of rational agents’ optimal asset mix, taking into account the true expected values of future exchange rates and interest rates.

Or, what got me thinking about this in the first place. I’ve been reading a lot of empirical work on credit constraints and business investment in the Great Recession — I might do a post on it in the next week or so, though an academic style literature review seems a bit dull even for this blog — and three things have become clear.

First, the commitment to intertemporal optimization means that New Keynesians really need financial frictions. In a world where current output is an important factor in investment, where investment spending is linked to profit income, and where expectations are an independently adjusting variable, it’s no problem to have a slowdown in investment triggered by fall in demand in some other sector, by a fall in the profit share, or by beliefs about the future becoming more pessimistic. But in the modern consensus, the optimal capital stock is determined by the fundamental parameters of the model and known to all agents, so you need a more or less permanent fall in the return on investment, due presumably to some negative technological shock or bad government policy. Liberal economists hate this stuff, but in an important sense it’s just a logical application of the models they all teach. If in all your graduate classes you talk about investment and growth in terms of the technologically-determined marginal product of capital, you can hardly blame people when, faced with a slowdown in investment and growth, they figure that’s the first place to look. The alternative is some constraint that prevents firms from moving toward their desired capital stock, which really has to be a financial friction of some kind. For the older Keynesian perspective credit constraints are one possible reason among others for a non-supply-side determined fall in investment; for the modern perspective they’re the only game in town.

Second, the persistence of slumps is a problem for them in a way that it’s not in the income-expenditure approach. Like the previous point, this follows from the fundamental fact that in the modern approach, while there can be constraints that prevent desired expenditure from being achieved, there’s never causation from actual expenditure to desired expenditure. Businesses know, based on fundamentals, their optimal capital stock, and choose an investment path that gets them there while minimizing adjustment costs. Similarly, households know their lifetime income and utility-maximizing consumption path. Credit constraints may hold down investment or consumption in one period, but once they’re relaxed, desired expenditure will be as high or higher than before. So you need persistent constraints to explain persistently depressed spending. Whereas in the income-expenditure model there is no puzzle. Depressed investment in one period directly reduces investment demand in the next period, both by reducing capacity utilization and by reducing the flow of profit income. If your core vision of the economy is a market, optimizing the allocation of scare resources, then if that optimal allocation isn’t being achieved there must be some ongoing obstacle to trade. Whereas if you think of the economy in terms of income and expenditure flows, it seems perfectly natural that an interruption to some flow will will disrupt the pattern, and once the obstacle is removed the pattern will return to its only form only slowly if at all.

And third: Only conservative economists acknowledge this theoretical divide. You can find John Cochrane writing very clearly about alternative perspectives in macro. But saltwater economists — and the best ones are often the worst in this respect — are scrupulously atheoretical. I suspect this is because they know that if they wanted to describe their material in a more general way, they’d have to use the language of intertemporal optimization, and they are smart enough to know what a tar baby that is. So they become pure empiricists.

In Leon Fink’s wonderful history of the New York health care workers’ union 1199, Upheaval in the Quiet Zone, he talks about how the union’s early leaders and activists were disproportionately drawn from Communist Party members and sympathizers, and other leftists. Like other communist-led unions, 1199 was kicked out of the CIO in the 1940s, but unlike most of the others, it didn’t fade into obscurity. Originally a drugstore-employees union, it led the new wave of organizing of health care and public employees in the 1960s. Fink attributes a large part of its unusual commitment to organizing non-white and female workers, in an explicitly civil-rights framework, and its unusual lack of corruption and venality, to the continued solidarity of the generation of the 1930s. Their shared political commitments were a powerful source of coordination and discipline. But, says Fink, it was impossible for them to pass these commitments on to the next generation. Yes, in 1199, unlike most other unions, individual leftists were not purged; but there was still no organized left, either within the union or in connection to a broader movement. So there was no way for the first generation to reproduce themselves, and as they retired 1199 became exposed to the same pressures that produced conservative, self-serving leadership in so many other unions.

I feel there’s something similar going on in economics. There are plenty of people at mainstream departments with a basically Keynesian vision of the economy. But they write and, especially, teach in a language that is basically alien to that vision. They’re not reproducing the capacity for their own thought. They’re running a kind of intellectual extractive industry, mining older traditions for insights but doing nothing to maintain them.

I had this conversation with a friend at a top department the other day:

me: http://noahpinionblog.blogspot.com/2013/03/the-swamp-of-dsge-despair.html

what do you think? is this kind of critique valid/useful?

11:17 AM him: its totally true

11:18 AM and you wouldn’t know what was getting baked into the cake unless you were trained in the literature

I only started understanding the New Keynsian models a little while ago

and just had the lazy “they are too complicated” criticism

11:19 AM now I understand that they are stupidly too complicated (as Noah’s post points out)

11:20 AM me: so what is one supposed to do?

if this is the state of macro

him: i dunno. I think participating in this literature is a fucking horror show

me: but you don’t like heterodox people either, so….?

11:21 AM him: maybe become a historian

or figure out some simple variant of the DSGEmodels that you can make your point and publish empirical stuff

This is where so many smart people I know end up. You have to use mainstream models — you can’t move the profession or help shape policy (or get a good job) otherwise. But on many questions, using those models means, at best, contorting your argument into a forced and unnatural framework, with arbitrary-seeming assumptions doing a lot of the work; at worst it means wading head-deep into an intellectual swamp. So you do some mix of what my friend suggests here: find a version of the modern framework that is loose enough to cram your ideas into without too much buckling; or give up on telling a coherent story about the world and become a pure empiricist. (Or give up on economics.) But either way, your insights about the world have to come from somewhere else. And that’s the problem, because insight isn’t cheap. The line I hear so often — let’s master mainstream methods so we can better promote our ideas — assumes you’ve already got all your ideas, so the only work left is publicity.

If we want to take questions of aggregate demand and everything that goes with it — booms, crises, slumps — seriously, then we need a theoretical framework in which those questions arise naturally.

[*] Keynes’ original term was “effective demand.” The two are interchangeable today. But it’s interesting to read the original passages in the GT. While they are confusingly written, there’s no question that Keynes’ meant “effective” in the sense of “being in effect.” That is, of many possible levels of demand possible in an economy, which do we actually see? This is different from the way the term is usually understood, as “having effect,” that is, backed with money. Demand backed with money is, of course, simply demand.

UPDATE: The Cochrane post linked above is really good, very worth reading. It gives more of the specific flavor of these models than I do. He writes: In Old Keynesian models,

consumption depends on today’s income through the “marginal propensity to consume” mpc.

Modern new-Keynesian models are utterly different from this traditional view. Lots of people, especially in policy, commentary, and blogging circles, like to wave their hands over the equations of new Keynesian models and claim they provide formal cover for traditional old-Keynesian intuition, with all the optimization, budget constraints, and market clearing conditions that the old-Keynesian analysis never really got right taken care of. A quick look at our equations and the underlying logic shows that this is absolutely not the case.

Consider how lowering interest rates is supposed to help. In the old Keynesian model, investment I = I(r) responds to lower interest rates, output and income Y = C + I + G, so rising investment raises income, which raises consumption in (4), which raises income some more, and so on. By contrast, the simple new-Keynesian model needs no investment, and interest rates simply rearrange consumption demand over time.

Similarly, consider how raising government spending is supposed to help. In the old Keynesian model, raising G in Y = C + I + G raises Y, which raises consumption C by (4), which raises Y some more, and so on. In the new-Keynesian model, the big multiplier comes because raising government spending raises inflation, which lowers interest rates, and once again brings consumption forward in time.

Note, for example, that in a standard New Keynesian model, expected future interest rates enter into current consumption exactly as the present interest rate does. This will obviously shape people’s intuitions about things like the effectiveness of forward guidance by the Fed.

UPDATE 2: As usual, this blog is just an updated, but otherwise much inferior, version of What Leijonhufvud Said. From his 2006 essay The Uses of the Past:

We should expect to find an ahistorical attitude among a group of scientists busily soling puzzles within an agreed-upon paradigm… Preoccupation with the past is then a diversion or a luxury. When things are going well it is full steam ahead! …. As long as “normal” progress continues to be made in the established directions, there is no need to reexamine the past…

Things begin to look different if and when the workable vein runs out or, to change the metaphor, when the road that took you to the “frontier of the field” ends in a swamp or in a blind alley. A lot of them do. Our fads run out and we get stuck. Reactions to finding yourself in a cul-de-sac differ. Tenured professors might be content to accommodate themselves to it, spend their time tidying up the place, putting in modern conveniences… Braver souls will want out and see a tremendous leap of the creative imagination as the only way out — a prescription, however, that will leave ordinary mortals just climbing the walls. Another way to go is to backtrack. Back there, in the past, there were forks in the road and it is possible, even probable, that some roads were more promising than the one that looked most promising at the time…

This is exactly the spirit in which I’m trying to rehabilitate postwar income-expenditure Keynesianism. The whole essay is very worth reading, if you’re interest at all in the history of economic thought.

Borrowing ≠ Debt

There’s a common shorthand that makes “debt” and “borrowing” interchangeable. The question of why an economic unit had rising debt over some period, is treated as equivalent to the question of why it was borrowing more over that period, or why its expenditure was higher relative to its income. This is a natural way of talking, but it isn’t really correct.

The point of Arjun’s and my paper on debt dynamics was to show that for household debt, borrowing and changes in debt don’t line up well at all. While some periods of rising household leverage — like the housing bubble of the 2000s — were also periods of high household borrowing, only a small part of longer-term changes in household debt can be explained this way. This is because interest, income growth and inflation rates also affect debt-income ratios, and movements in these other variables often swamp any change in household borrowing.

As far as I know, we were the first people to make this argument in a systematic way for household debt. For government debt, it’s a bit better known — but only a bit. People like Willem Buiter or Jamie Galbraith do point out that the fall in US debt after World War II had much more to do with growth and inflation than with large primary surpluses. You can find the argument more fully developed for the US in papers by Hall and Sargent or Aizenman and Marion, and for a large sample of countries by Abbas et al., which I’ve discussed here before. But while many of the people making it are hardly marginal, the point that government borrowing and government debt are not equivalent, or even always closely linked, hasn’t really made it into the larger conversation. It’s still common to find even very smart people saying things like this:

We didn’t have anything you could call a deficit problem until 1980. We then saw rising debt under Reagan-Bush; falling debt under Clinton; rising under Bush II; and a sharp rise in the aftermath of the financial crisis. This is not a bipartisan problem of runaway deficits!

Note how the terms “deficits” and “rising debt” are used interchangeably; and though the text mostly says deficits, the chart next to this passage shows the ratio of debt to GDP.

What we have here is a kind of morality tale where responsible policy — keeping government spending in line with revenues — is rewarded with falling debt; while irresponsible policy — deficits! — gets its just desserts in the form of rising debt ratios. It’s a seductive story, in part because it does have an element of truth. But it’s mostly false, and misleading. More precisely, it’s about one quarter true and three quarters false.

Here’s the same graph of federal debt since World War II, showing the annual change in debt ratio (red bars) and the primary deficit (black bars), both measured as a fraction of GDP. (The primary deficit is the difference between spending other than interest payments and revenue; it’s the standard measure of the difference between current expenditure and current revenue.) So what do we see?

It is true that the federal government mostly ran primary surpluses from the end of the war until 1980, and more generally, that periods of surpluses were mostly periods of rising debt, and conversely. So it might seem that using “deficits” and “rising debt” interchangeably, while not strictly correct, doesn’t distort the picture in any major way. But it does! Look more carefully at the 1970s and 1980s — the black bars look very similar, don’t they? In fact, deficits under Reagan were hardy larger than under Ford and Carter — a cumulative 6.2 percent of GDP over 1982-1986, compared with 5.6 percent of GDP over 1975-1978. Yet the debt-GDP ratio rose by just a single point (from 24 to 25) in the first episode, but by 8 points (from 32 to 40) in the second. Why did debt increase in the 1980s but not in the 1970s? Because in the 1980s the interest rate on federal debt was well above the economy’s growth rate, while in the 1970s, it was well below it. In that precise sense, if debt is a problem it very much is a bipartisan one; Volcker was the appointee of both Carter and Reagan.

Here’s the same data by decades, and for the pre- and post-1980 periods and some politically salient subperiods. The third column shows the part of debt changes not explained by the primary balance. This corresponds to what Arjun and I call “Fisher dynamics” — the contribution of growth, inflation and interest rates to changes in leverage. [*] The units are percent of GDP.

Totals by Decade
	Primary Deficit	Change in Debt	Residual Debt Change
1950s	-8.6	-29.6	-20.9
1960s	-7.3	-17.7	-10.4
1970s	2.8	-1.7	-4.6
1980s	3.3	16.0	12.7
1990s	-15.9	-7.3	8.6
2000s	23.7	27.9	4.2

Annual averages
	Primary Deficit	Change in Debt	Residual Debt Change
1947-1980	-0.7	-2.0	-1.2
1981-2011	0.1	1.3	1.2
1981-1992	0.3	1.8	1.5
1993-2000	-2.7	-1.6	1.1
2001-2008	-0.1	0.8	0.9
2009-2011	7.3	8.9	1.6

Here again, we see that while the growth of debt looks very different between the 1970s and 1980s, the behavior of deficits does not. Despite Reagan’s tax cuts and military buildup, the overall relationship between government revenues and expenditures was essentially the same in the two decades. Practically all of the acceleration in debt growth in the 1980s compared with the 1970s is due to higher interest rates and lower inflation.

Over the longer run, it is true that there is a shift from primary surpluses before 1980 to primary deficits afterward. (This is different from our finding for households, where borrowing actually fell after 1980.) But the change in fiscal balances is less than 25 percent the change in debt growth. In other words, the shift toward deficit spending, while real, only accounts for a quarter of the change in the trajectory of the federal debt. This is why I said above that the morality-tale version of the rising debt story is a quarter right and three quarters wrong.

By the way, this is strikingly consistent with the results of the big IMF study on the evolution of government debt ratios around the world. Looking at 60 episodes of large increases in debt-GDP ratios over the 20th century, they find that only about a third of the average increase is accounted for by primary deficits. [2] For episodes of falling debt, the role of primary surpluses is somewhat larger, especially in Europe, but if we focus on the postwar decades specifically then, again, primary surpluses accounted for only a about a third of the average fall. So while the link between government debt and deficits has been a bit weaker in the US than elsewhere, it’s quite weak in general.

So. Why should we care?

Most obviously, you should care if you’re worried about government debt. Now maybe you shouldn’t worry. But if you do think debt is a problem, then you are looking in the wrong place if you think holding down government borrowing is the solution. What matters is holding down i – (g + π) — that is, keeping interest rates low relative to growth and inflation. And while higher growth may not be within reach of policy, higher inflation and lower interest rates certainly are.

Even if you insist on worrying not just about government debt but about government borrowing, it’s important to note that the cumulative deficits of 2009-2011, at 22 percent of GDP, were exactly equal to the cumulative surpluses over the Clinton years, and only slightly smaller than the cumulative primary surpluses over the whole period 1947-1979. So if for whatever reason you want to keep borrowing down, policies to avoid deep recessions are more important than policies to control spending and raise revenue.

More broadly, I keep harping on this because I think the assumption that the path of government debt is the result of government borrowing choices, is symptomatic of a larger failure to think clearly about this stuff. Most practically, the idea that the long-run “sustainability” of the debt requires efforts to control government borrowing — an idea which goes unquestioned even at the far liberal-Keynesian end of the policy spectrum — is a serious fetter on proposals for more stimulus in the short run, and is a convenient justification for all sorts of appalling ideas. And in general, I just reject the whole idea of responsibility. It’s ideology in the strict sense — treating the conditions of existence of the dominant class as if they were natural law. Keynes was right to see this tendency to view of all of life through a financial lens — to see saving and accumulating as the highest goals in life, to think we should forego real goods to improve our financial position — as “one of those semicriminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease.”

On a methodological level, I see reframing the question of the evolution of debt in terms of the independent contributions of primary deficits, growth, inflation and interest rates as part of a larger effort to think about the economy in historical, dynamic terms, rather than in terms of equilibrium. But we’ll save that thought for another time.

The important point is that, historically, changes in government borrowing have not been the main factor in the evolution of debt-GDP ratios. Acknowledging that fact should be the price of admission to any serious discussion of fiscal policy.

[1] Strictly speaking, debt ratios can change for reasons other than either the primary balance or Fisher dynamics, such as defaults or the effects of exchange rate movements on foreign-currency-denominated debt. But none of these apply to the postwar US.

[2] The picture is a bit different from the US, since adverse exchange-rate movements are quite important in many of these episodes. But it remains true that high deficits are the main factor in only a minority of large increases in debt-GDP ratios.

Austerity Is Good for the Soul

A. C. Grayling, proprietor of the New College for the Humanities, may be a bit of a charlatan. But I suspect that in this piece for the FT, he’s a good guide to the next turn of the zeitgeist.

Is austerity a bad thing? Not always. The austerity years of the second world war and its aftermath were surprisingly good for people; calorie restriction meant flat tummies and robust health, at least for those not smoking the lethal cigarettes of the day. That was a physical benefit; the psychological benefit was perhaps greater. Being in the same boat promoted a sense of common purpose and comradeship. …

Lent, the 40 days before Easter, is supposed to involve an elective form of austerity; we are to give something up, engage in self-denial as a discipline. Different stories are told about the reason for it… But the real reason for Lent is that the late winter and early spring was always a time of dearth. … The experience of Lent, when it really was a time of belt-tightening and hard work to get the next tranche of resources on its way, was doubtless salutary in keeping people (as we now say) real. Keeping real means being mindful of how tenuously we own our comforts.

… the realities of austerity in hard economic times mean giving up the car, going out less often, cutting not just amenities but necessities, or what we think are necessities. The people who take the hardest hit are the poor and vulnerable, who already do without what others regard as necessary.

But there is the glimmer of opportunity that austerity offers. Most of the things that are intrinsically most valuable in human life do not cost money, though by the application of money to them we think we embellish them. … Epictetus, the Stoic philosopher of antiquity, said that the truly rich person is he who is satisfied with what he has. Think that saying through. How rich one is, if content with a sufficiency; how poor, with millions in the bank, if dissatisfied and still lusting for more. Enforced austerity, as in a major economic downturn, might teach what is sufficient, and how one might be grateful not to be burdened with more than is sufficient. …

So long as people measure their worth by how much they earn or own, they will think that having less is austerity, that living more simply is austerity, that getting to know their own locale rather than rushing to distant beaches is austerity. Yet perhaps “austerity” actually means “the opportunity to live more richly”. Then, of course, it would be austerity no more.

It’s insidious because it contains an element of truth. Still:

Among the highly placed,
It is considered low to talk about food.
The fact is: they have
Already eaten.

Where Do the Rich Get Their Money, Again?

This was an early topic at the Slack Wire, but worth revisiting.

There’s this widespread idea that the rich today are no different from us. We no longer have the pseudo-aristocratic rentiers of Fitzgerald or Henry James, but hard-working (if perhaps overcompensated) superstars of the labor market. When a highbrow webzine does an “interview with a rich person,” it turns out to be a successful graphic designer earning $140,000 a year.

Sorry, that is not a rich person.

The 1 percent cutoff for household income is around $350,000. The 0.1 percent, around $2 million. The 0.01 percent, around $10 million. Those are rich people, and they’re not graphic designers, or even lawyers or bankers. They’re owners.

From the IRS Statistics of Income for 2010:

	Wages and Salaries	Pensions, Social Security, UI	Interests, Dividends, Inheritance	Business Income	Capital Gains	Total Capital Income
Total	64.5%	18.5%	6.1%	7.2%	3.8%	17.1%
Median Household	72.7%	21.5%	2.4%	2.4%	0.0%	4.8%
The 0.01%	14.6%	0.7%	23.1%	19.0%	40.6%	82.7%

As we can see, for households at the very top of the distribution, income overwhelmingly comes from property ownership. Total property income at the far right, the sum of preceding three columns. (The numbers don’t add to quite 100% because I’ve left out a few small, hard-to-classify categories like alimony and gambling winnings.) The top 0.01 percent’s 15 percent of labor income is not much more than the same stratum got from wages and salaries in 1929. No doubt many of these people spend time at an office of some kind, but the idea of “the working rich” is a myth.

Here’s the same breakdown across the income distribution. The X-axis is adjusted gross income.

So across a broad part of the income distribution, wages make up a stable 70-75 percent of income, with public and private social insurance providing most of the rest. Capital income catches up with labor income around $500,000, making the one percent line a good qualitative as well as quantitative cutoff. It’s interesting to see how business income peaks in the $1 to $2 million range, the signature of the old middle class or petite bourgeoisie. And at the top, again, capital income is absolutely dominant.

It’s an interesting question why this isn’t more widely recognized. Mainstream discussions of rising inequality take it for granted that “those at the top were more likely to earn than inherit their riches,” with the clear understanding that “earn” means a paycheck. Even very smart Marxists like Gerard Dumenil and Dominique Levy concede that “a large fraction of the income of the wealthiest segments of the population is made of wages,” giving a figure of 48.8 percent for the wage share of the top 0.1 percent. Yet the IRS figures show that the wage share for this stratum is not nearly half, but less than a third. What gives?

I think at least some of the confusion is the fault of Piketty and Saez. Their income distribution work is state of the art, they’ve done as much as anyone to bring the concentration of income at the top into public discussion; I’d be a fool to criticize their work on the substance. They do, however, make a somewhat peculiar choice about presentation. In the headline numbers in much of their work, they give not the top 0.01, 0.1, 1, etc. percent by income, but rather the top percentiles by income excluding capital gains. [*] This is clearly stated in their papers but it is almost never noted, as far as I can tell, by people who cite them.

There are various good reasons, in principle, for distinguishing capital gains from other income. But in an era when capital gains are the largest single source of income at the top, defining top income fractiles excluding capital gains seriously distorts your picture of the very top. For instance, you may miss people like this guy: In both 2010 and 2011, the majority of Mitt Romney’s income took the form of capital gains.

“They have taken untold millions that they never toiled to earn,” or if you prefer, “Save your money — same like yesterday.”

[*] The fractiles are defined this way even when capital gains income is reported. You have to dig around a bit in their data to find the composition of income by raw income fractiles, equivalent to my table above.

“Recession Is a Time of Harvest”

Noah and Seth say pretty much everything that needs to be said about this latest #Slatepitch provocation from Matt Yglesias. [1] So, traa dy lioaur, I am going to say something that does not need to be said, but is possibly interesting.

Yglesias claims that “the left” is wrong to focus on efforts to increase workers’ money incomes, because higher wages just mean higher prices. Real improvements in workers’ living standards — he says — come from the same source as improvements for rich people, namely technological innovation. What matters is rising productivity, and a rise in productivity necessarily means a fall in (someone’s) nominal income. So we need to forget about raising the incomes of particular people and trust the technological tide to lift all boats.

As Noah and Seth say, the logic here is broken in several places. Rising productivity in a particular sector can raise incomes in that sector as easily as reduce them. Changes in wages aren’t always passed through to prices, they can also reflect changes in the distribution between wages and other income.

I agree, it’s definitely wrong as a matter of principle to say that there’s no link, or a negative link, between changes in nominal wages and changes in the real standard of living. But what kind of link is there, actually? What did our forebears think?

Keynes notoriously took the Yglesias line in the General Theory, arguing that real and nominal wages normally moved in opposite directions. He later retracted this view, the only major error he conceded in the GT (which makes it a bit unfortunate that it’s also the book’s first substantive claim.) Schumpeter made a similar argument in Business Cycles, suggesting that the most rapid “progress in the standard of life of the working classes” came in periods of deflation, like 1873-1897. Marx on the other hand generally assumed that the wage was set in real terms, so as a first approximation we should expect higher productivity in wage-good industries to lead to lower money wages, and leave workers’ real standard of living unchanged. Productivity in this framework (and in post-GT Keynes) does set a ceiling on wages, but actual wages are almost well below this, with their level set by social norms and the relative power of workers and employers.

But back to Schumpeter and the earlier Keynes. It’s worth taking a moment to think through why they thought there would be a negative relationship between nominal and real wages, to get a better understanding of when we might expect such a relationship.

For Keynes, the logic is simple. Wages are equal to marginal product. Output is produced in conditions of declining marginal returns. (Both of assumptions are wrong, as he conceded in the 1939 article.) So when employment is high, the real wage must be low. Nominal wages and prices generally move proportionately, however, rising in booms and falling in slumps. (This part is right.) So we should expect a move toward higher employment to be associated with rising nominal wages, even though real wages must fall. You still hear this exact argument from people like David Glasner.

Schumpeter’s argument is more interesting. His starting point is that new investment is not generally financed out of savings, but by purchasing power newly created by banks. Innovations are almost never carried out by incumbent producers simply adopting the new process in place of the existing one, but rather by some new entrant — the famous entrepreneur– operating with borrowed funds. This means that the entrepreneur must bid away labor and other inputs from their current uses (importantly, Schumpeter assumes full employment) pushing up costs and prices. Furthermore, there will be some extended period of demand from the new entrants for labor and intermediate goods while the incumbents have not yet reduced theirs — the initial period of investment in the new process (and various ancillary processes — Schumpeter is thinking especially of major innovations like railroads, which will increase demand in a whole range of related industries), and later periods where the new entrants are producing but don’t yet have a decisive cost advantage, and a further period where the incumbents are operating at a loss before they finally exit. So major innovations tend to involve extended periods of rising prices. It’s only once the new producers have thoroughly displaced the old ones that demand and prices fall back to their old level. But it’s also only then that the gains from the innovation are fully realized. As he puts it (page 148):

Times of innovation are times of effort and sacrifice, of work for the future, while the harvest comes after… ; and that the harvest is gathered under recessive symptoms and with more anxiety than rejoicing … does not alter the principle. Recession [is] a time of harvesting the results of preceding innovation…

I don’t think Schumpeter was wrong when he wrote. There is probably some truth to idea that falling prices and real wages went together in 19th century. (Maybe by 1939, he was wrong.)

I’m interested in Schumpeter’s story, though, as more than just intellectual history, fascinating tho that is. Todays consensus says that technology determines the long-term path of the economy, aggregate demand determines cyclical deviations from that path, and never the twain shall meet. But that’s not the only possibility. We talked the other day about demand dynamics not as — as in conventional theory — deviations from the growth path in response to exogenous shocks, but as an endogenous process that may, or may not, occasionally converge to a long-term growth trajectory, which it also affects.

In those Harrod-type models, investment is simply required for higher output — there’s no innovation or autonomous investment booms. Those are where Schumpeter comes in. What I like about his vision is it makes it clear that periods of major innovation, major shifts from one production process to another, are associated with higher demand — the major new plant and equipment they require, the reorganization of the spatial and social organization of production they entail (“new plant, new firms, new men,” as he says) make large additional claims on society’s resources. This is the opposite of the “great recalculation” claim we were hearing a couple years ago, about how high unemployment was a necessary accompaniment to major geographic or sectoral shifts in output; and also of the more sophisticated version of the recalculation argument that Joe Stiglitz has been developing. [2] Schumpeter is right, I think, when he explicitly says that if we really were dealing with “recalculation” by a socialist planner, then yes, we might see labor and resources withdrawn from the old industries first, and only then deployed to the new ones. But under capitalism things don’t work like that (page 110-111):

Since the central authority of the socialist state controls all existing means of production, all it has to do in case it decides to set up new production functions is simply to issue orders to those in charge of the productive functions to withdraw part of them from the employments in which they are engaged, and to apply the quantities so withdrawn to the new purposes envisaged. We may think of a kind of Gosplan as an illustration. In capitalist society the means of production required must also be … [redirected] but, being privately owned, they must be bought in their respective markets. The issue to the entrepreneurs of new means of payments created ad hoc [by banks] is … what corresponds in capitalist society to the order issued by the central bureau in the socialist state.

In both cases, the carrying into effect of an innovation involves, not primarily an increase in existing factors of production, but the shifting of existing factors from old to new uses. There is, however, this difference between the two methods of shifting the factors : in the case of the socialist community the new order to those in charge of the factors cancels the old one. If innovation were financed by savings, the capitalist method would be analogous… But if innovation is financed by credit creation, the shifting of the factors is effected not by the withdrawal of funds—”canceling the old order”—from the old firms, but by … newly created funds put at the disposal of entrepreneurs : the new “order to the factors” comes, as it were, on top of the old one, which is not thereby canceled.

This vision of banks as capitalist Gosplan, but with the limitation that they can only give orders for new production on top of existing production, seems right to me. It might have been written precisely as a rebuttal to the “recalculation” arguments, which explicitly imagined capitalist investment as being guided by a central planner. It’s also a corrective to the story implied in the Slate piece, where one day there are people driving taxis and the next day there’s a fleet of automated cars. [3] Before that can happen, there’s a long period of research, investment, development — engineers are getting paid, the technology is getting designed and tested and marketed, plants are being built and equipment installed — before the first taxi driver loses a dollar of income. And even once the driverless cars come on line, many of the new companies will fail, and many of the old drivers will hold on for as long as their credit lasts. Both sets of loss-making enterprises have high expenditure relative to their income, which by definition boosts aggregate demand. In short, a period of major innovations must be a period of rising nominal incomes — as we most recently saw, on a moderate scale, in the late 1990s.

Now for Schumpeter, this was symmetrical: High demand and rising prices in the boom were balanced by falling prices in the recession — the “harvest” of the fruits of innovation. And it was in the recession that real wages rose. This was related to his assumption that the excess demand from the entrepreneurs mainly bid up the price of the fixed stock of factors of production, rather than activating un- or underused factors. Today, of course, deflation is extremely rare (and catastrophic), and output and employment vary more over the cycle than wages and prices do. And there is a basic asymmetry between the boom and the bust. New capital can be added very rapidly in growing enterprises, in principle; but gross investment in the declining incumbents cannot fall below zero. So aggregate investment will always be highest when there are large shifts taking place between sectors or processes. Add to this that new industries will take time to develop the corespective market structure that protects firms in capital-intensive industries from cutthroat competition, so they are more likely to see “excess” investment. And in a Keynesian world, the incomes from innovation-driven investment will also boost consumption, and investment in other sectors. So major innovations are likely to be associated with booms, with rising prices and real wages.

So, but: Why do we care what Schumpeter thought 75 years ago, especially if we think half of it no longer holds? Well, it’s always interesting to see how much today’s debates rehash the classics. More importantly, Schumpeter is one of the few economists to have focused on the relation of innovation, finance and aggregate demand (even if, like a good Wicksellian, he thought the latter was important only for the price level); so working through his arguments is a useful exercise if we want to think more systematically about this stuff ourselves. I realize that as a response to Matt Y.’s silly piece, this post is both too much and poorly aimed. But as I say, Seth and Noah have done what’s needed there. I’m more interested in what relationship we think does hold, between innovation and growth, the price level, and wages.

As an economist, my objection to the Yglesias column (and to stuff like the Stiglitz paper, which it’s a kind of bowdlerization of) is that the intuition that connects rising real incomes to falling nominal incomes is just wrong, for the reasons sketched out above. But shouldn’t we also say something on behalf of “the left” about the substantive issue? OK, then: It’s about distribution. You might say that the functional distribution is more or less stable in practice. But if that’s true at all, it’s only over the very long run, it certainly isn’t in the short or medium run — as Seth points out, the share of wages in the US is distinctly lower than it was 25 years ago. And even to the extent it is true, it’s only because workers (and, yes, the left) insist that nominal wages rise. Yglesias here sounds a bit like the anti-environmentalists who argue that the fact that rivers are cleaner now than when the Clean Water Act was passed, shows it was never needed. More fundamentally, as a leftist, I don’t agree with Yglesias that the only important thing about income is the basket of stuff it procures. There’s overwhelming reason — both first-principle and empirical — to believe that in advanced countries, relative income, and the power, status and security it conveys, is vastly more important than absolute income. “Don’t worry about conflicting interests or who wins or loses, just let the experts make things better for everyone”: It’s an uncharitable reading of the spirit behind this post, but is it an entirely wrong one?

UPDATE: On the other hand. In his essay on machine-breaking, Eric Hobsbawm observes that in 18th century England,

miners’ riots were still directed against high food prices, and the profiteers believed to be responsible for them.

And of course more generally, there have been plenty of working-class protests and left political programs aimed at reducing the cost of living, as well as raising wages. Food riots are a major form of popular protest historically, subsidies for food and other necessities are a staple policy of newly independent states in the third world (and, I suspect, also disapproved by the gentlemen of Slate), and food prices are a preoccupation of plenty of smart people on the left. (Not to mention people like this guy.) So Yglesias’s notion that “the left” ignores this stuff is stupid. But if we get past the polemics, there is an interesting question here, which is why mass politics based around people’s common interests as workers is so much more widespread and effective than this kind of politics around the cost of living. Or, maybe better, why one kind of conflict is salient in some times and places and the other kind of conflict in others; and of course in some, both.

[1] Seth’s piece in particular is a really masterful bit of polemic. He apologizes for responding to trollery, which, yeah, the Yglesias post arguably is. But if you must feed trolls, this is how it’s done. I’m not sure if the metaphor requires filet mignon and black caviar, or dogshit garnished with cigarette butts, or fresh human babies, but whatever it is you should ideally feed a troll, Seth serves it up.

[2] It appears that Stiglitz’s coauthor Bruce Greenwald came up with this first, and it was adopted by right-wing libertarians like Arnold Kling afterwards.

[3] I admit I’m rather skeptical about the prospects for driverless cars. Partly it’s that the point is they can operate with much smaller error tolerances than existing cars — “bumper to bumper at highway speeds” is the line you always hear — but no matter how inherently reliable the technology, these things are going to be owned maintained by millions of individual nonprofessionals. Imagine a train where the passengers in each car were responsible for making sure it was securely coupled to the next one. Yeah, no. But I think there’s an even more profound reason, connected to the kinds of risk we will and will not tolerate. I was talking to my friend E. about this a while back, and she said something interesting: “People will never accept it, because no one is responsible for an accident. Right now, if there’s a bad accident you can deal with it by figuring out who’s at fault. But if there were no one you could blame, no one you could punish, if it were just something that happened — no one would put up with that.” I think that’s right. I think that’s one reason we’re much more tolerant of car accidents than plane accidents, there’s a sense that in a car accident at least one of the people involved must be morally responsible. Totally unrelated to this post, but it’s a topic I’d like to return to at some point — that what moral agency really means, is a social convention that we treat causal chains as being broken at certain points — that in some contexts we treat people’s actions as absolutely indeterminate. That there are some kinds of in principle predictable actions by other people that we act — that we are morally obliged to act — as if we cannot predict.