The Slack Wire

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:

  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.

Deleveraging by Default

The new Household Credit and Debt Report came out last week from the New York Fed. Fun!

The stuff about student debt got the scary headlines, and with reason — especially once you notice that the 17 percent delinquency rate on student debt, bad enough, understates the problem, since that figure includes debt on which no payment is due:

when we remove the estimated 44 percent of all borrowers for whom no payment is due or the payment is too small to offset the accrued interest, the delinquency rate rises to over 30 percent.

Student debt is not really my beat, though, so I want to call attention to something which has gotten less attention: how much household “deleveraging” is really about defaults, rather than reduced borrowing.

The Credit and Debt Report is based on the New York Fed’s Consumer Credit Panel, with the underlying data from the credit bureau Equifax. It’s unique, as far as I know, in its comprehensive coverage of the various flows that make up changes in household liabilities. The Flow of Funds, by contrast, sees household debt only from the creditors’ side, and doesn’t directly observe flows, only changes in stocks of debt. So with this data we can see much more clearly what’s actually driving the fall in household debt-to-income ratios. [1] And here’s what we find:

The heavy lines are the year-end ratios of mortgage and total household debt, respectively, to disposable personal income. The dotted lines are the path these ratios would have followed if defaults were held fixed at their pre 2007 levels. So we see that total household debt peaked at 119 percent of income at the end of 2007, and has since fallen to 100 percent, a substantial decline. But when we break out the various factors accounting for changes in debt — new borrowing, repayment, and default — we find that the fall is entirely the result of higher defaults. If households had continued defaulting on debt at the same rate after 2007 as before, household debt would not have fallen at all. (It is true that since 2009, there has been some deleveraging even net of defaults, but even over those two years two-thirds of the fall in debt-income ratios is due to elevated default rates.) Mortgage debt follows the same pattern: If default rates had continued at their 2003-2006 level, mortgage debt would have been greater, relative to income, at the end of 2011 than at the end of 2007.

It’s interesting to compare the debt writeoffs reported by households with the writeoffs reported by commercial banks. The biggest difference between the two series is that banks report their net losses, i.e. after recoveries. But both show the same dramatic rise in the Great Recession.

As we can see, the two series move more or less together. It’s noteworthy, though, that before the crisis the amount of debt discharged by default was consistently about five times greater than banks’ default losses; after 2007, this ratio dropped to more like like two to one. This represents some mix of lower recovery rates — underwater homes are worth less than their mortgages — and a worse default performance among mortgages owned by entities other than commercial banks.

So why does all this matter? Well, the obvious reason is that we want to get the story of the recent past right. The usual debate about falling debt is how much it’s due to banks’ unwillingness to lend, and how much to households’ unwillingness to borrow. If it’s really due largely to higher default rates, our stories of the financial crisis and its aftermath should reflect that. But they seldom do. Richard Koo, just to pick one example at random, treats changes in household liabilities as simply a measure of household borrowing.

A couple other reasons to care. For one, the role of defaults is further evidence against the idea that demand is being constrained by a lack of access to credit. 

More broadly, it’s evident that the relationship between defaults and changes in income is nonlinear. Over a normal business cycle, household defaults are stable and fairly low. (This is not true of business and especially commercial real-estate defaults.) It takes an exceptionally deep fall in income to produce a noticeable rise in household defaults. The macroeconomic significance of this is that defaults, like Koo-style deleveraging, weaken the link between current income and current expenditure; in both cases, a higher share of changes in income show up as changes in the flow of payments to creditors, rather than changes in spending on currently produced goods and services. This dampening of the income-expenditure link helps put a floor under demand fluctuations, as discussed in the previous post (provided that defaults don’t limit other units’ access to credit — this is an important difference  between the recent crisis and 1929-1933.) But by the same token it also weakens demand dynamics in the recovery; if a major margin on which households adjust to changes in incomes is changes in payments to creditors, rising incomes will do less to raise demand for current output.

The central importance of defaults in the deleveraging process to date also is a reminder of the importance of the terms on which debt can be discharged. Laws and norms that make default relatively easy can evidently serve as an escape valve that helps prevent the debt deflation process from taking hold.

Looking forward, this is further evidence of how difficult it is to reduce leverage just through lower expenditure. It’s noteworthy here that since 2007, the household sector has had large primary surpluses (i.e. new borrowing is less than interest payments), but in the current environment of slow growth, relatively high real interest rates, and low inflation, this has not been sufficient on its own to produce any fall in leverage. So if lower debt-income ratios are a precondition for sustained growth, more systematic debt writedowns may be necessary. From the conclusion of Arjun’s and my paper:

A recent IMF staff report (Gottschalk et al., 2010) notes that for public sector debt, defaults are most likely to lead a long-term improvement in the fiscal position (and have generally occurred historically) in countries with small primary deficits, or primary surpluses. In such cases unsustainable debt growth is driven by the interaction of high effective interest rates with a large existing debt stock; a one-time reduction in the debt stock can change an unsustainable path to a sustainable one, even if the interest rates on new borrowing rise as a result. A similar logic might apply to private sector debt. If so, some form of systematic debt forgiveness may be the logical, and eventually unavoidable, solution to the problem of excessive household leverage.

Finally, the importance of defaults over the past five years is a reminder that a crisis is precisely a situation when inconsistent expectations cannot be ignored. By definition, in a crisis not all contractual commitments can be fulfilled, and it’s always ultimately a political question which are honored and which are not.

[1] The published report doesn’t include writeoffs, only the fraction of debt that is currently delinquent. To get annual household debt writeoffs, we have to combine the report with the numbers reported by the New York Fed in its Liberty Street blog.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

So: why do I like this paper so much?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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