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.
“All these people have a sort of parlay mentality, and they need to get on the playing field before they can start running it up. I’m a trader. It all happens for me in the transition. The moment of liquidation is the essence of capitalism.”
“What about the man in Rigby?”
“He’s an end user. He wants to keep it.”
I reflected on the pathos of ownership, and the ways it could bog you down.
– from Tom McGuane, “Gallatin Canyon”.
The guy may just be selling a car dealership, but he gets it: You’re not a capitalist until you get to M’. Getting attached to C-C’ for its own sake will just bog you down. But of course, organizing life around the moment of liquidation has its drawbacks as well.
UPDATE: Variation on a theme. From today’s fascinating post by Felix Salmon on a lawsuit over some disputed Jackson Pollock paintings:
In this lawsuit, Mirvish has taken the idea of art-as-an-investment to a particularly bonkers extreme. In Mirvish’s world, it seems, artworks have no inherent value, just by dint of being beautiful or genuine or unique. Instead, an artwork is only an investment if it’s being shopped around — if someone’s trying to make a profit on it, by selling it.
Similarly, in Mirvish’s world, if a gallery has a claim to 50% of the value of a painting, but again isn’t actively shopping that painting around, then the gallery’s claim is worthless.
Value doesn’t inhere in a thing, only in the process by which that thing is eventually converted to money. Bonkers, sure, yes, but also the organizing principle of the world we live in.
From today’s New York Times story about the new crop of billion-dollar internet startups:
Most of these chief executives are also veterans of the Internet bubble of the late ’90s, and confess to worries that maybe things are not so different this time. Mr. Tinker… said, “The reality is, I’ve taken $94 million in investors’ money, and we haven’t gone public yet. I feel that responsibility every day.” …
The nagging fear is that valuations, which are turned into profits only if the company goes public successfully or is bought for a high price, could still plunge.
The cheap pleasure here is gawking at the next stupid Pets.com. (The NYC subway right now is plastered with ads for some company that, wait for it, lets you order pet food online.) But maybe all of this lot will thrive, I have no idea. What I’m interested in is that bolded phrase.
You might naively think that whether a business makes profits is independent of who happens to own it. Profits appear as soon as a commodity is sold for more than the cost of its inputs. So the bolded sentence really only makes sense with the implied addition, profits for venture capitalists or for finance. But in the disgorge-the-cash era, that’s taken as read.
Capitalism is still about M-C-C’-M’, same as it ever as. But C-C’ now includes not just the immediate process of production, but everything related to the firm as a distinct entity. Profits aren’t really profits, under the current regime, as long as the claim on them is tied to a specific business or industry. And the only real capitalists are owners of financial assets.
(Of course what is interesting about the internet economy is the extent to which this logic has not held there. Functionally, profitability for internet companies has meant a relationship of sales to costs that allows them to grow, regardless of the level of payouts to financial claimants. Whether articles like this are a sign of a convergence of Silicon Valley to the dominant culture, or just an example of the bondholder’s-eye view reflexively adopted by the Times, I don’t know.)
EDIT: From the Grundrisse:
It is important to note that wealth as such, i.e. bourgeois wealth, is always expressed to the highest power as exchange value, where it is posited as mediator, as the mediation of the extremes of exchange value and use value themselves. … Within capital itself, one form of it in turn takes up the position of use value against the other as exchange value…: the wholesaler as mediator between manufacturer and retailer, or between manufacturer and agriculturalist, or between different manufacturers; he is the same mediator at a higher level. And in turn, in the same way, the commodity brokers as against the wholesalers. Then the banker as against the industrialists and merchants; the joint-stock company as against simple production; the financier as mediator between the state and bourgeois society, on the highest level. Wealth as such presents itself more distinctly and broadly the further it is removed from direct production and is itself mediated between poles, each of which, considered for itself, is already posited as economic form. Money becomes an end rather than a means; and the higher form of mediation, as capital, everywhere posits the lower as … labour, as merely a source of surplus value. For example, the bill-broker, banker etc. as against the manufacturers and farmers, which are posited in relation to him in the role of labour (of use value); while he posits himself toward them as capital, extraction of surplus value; the wildest form of this, the financier.
Finance stands with respect to productive enterprises as capitalists in general stand with respect to labor (and raw material). So it makes sense that, from finance’s point of view, profit is not realized with the sale of the commodity, but only with the sale of the enterprise itself.
In comments, Woj asks,
have you done any research on the decline in bank lending for tangible capital/investment?
As a matter of fact, I have. Check this out:
 |
| Simple correlation between borrowing and fixed investment |
What this shows is the correlation between new borrowing and fixed investment across firms, by year (Borrowing and investmnet are both expressed as a fraction of the firm’s total assets; the data is from Compustat.) So what we see is that in the 1960s and 70s, a firm that was borrowing heavily also tended to be investing a lot, and vice versa; but after 1985, that was much less true. The same shift is visible if we look at the relationship between investment and borrowing for a given firm, across years: There is a strong correlation before 1980, but a much weaker one afterward. This table shows the average correlation of fixed investment for a given firm across quarters, with borrowing and cashflow.
 |
| Average correlation of fixed investment for a given firm. |
So again, pre-1980 a given firm tended to borrow heavily and invest heavily in the same periods; after 1980 not so much.
I think it’s natural to see this change in the relation between borrowing and investment as a sign of the breakdown of the old hierarchy of finance. In the era of the Chandler-Galbraith corporation, payouts to shareholders were a quasi-fixed cost, not so different from bond payments. The effective residual claimants of corporate earnings were managers who, sociologically, were identified with the firm and pursued survival and growth objectives rather than profit maximization. Under these conditions, internal funds were lower cost than external funds, as Minsky, writing in this epoch, emphasized. So firms only turned to external finance once lower-cost internal funds were exhausted, meaning that in general, only those firms with exceptionally high investment demand borrowed heavily; this explains the strong correlation between borrowing and investment.
But since the shareholder revolution of the 1980s, this no longer really holds; shareholders have been much more effective in making their status as residual claimants effective, meaning that the opportunity cost of investing out of internal funds is no longer much lower than investing out of external funds. It’s no longer much easier for managers to convince shareholders to let the firm keep more of its earnings, than to convince bankers to let it have a loan. So the question of how much a firm borrows is now largely independent of how much it invests. (Modigliani-Miller comes closer to being true in a neoliberal world.)
Fun fact: Regressing nonfinancial corporate borrowing on stock buybacks for the period 2005-2010 yields a coefficient not significantly different from 1.0, with an r-squared of 0.98. In other words, it seems that the marginal dollar borrowed by a nonfinancial business in this period was simply handed on to shareholders, without funding any productive expenditure at all. This close fit between corporate borrowing and share buybacks raises doubts about the contribution of the financial crisis to the downturn in the real economy.
The larger implication is that, with the loss of the low-cost pool of internal funds, the hurdle rate for investment by nonfinancial firms is higher than it was during the postwar decades. In my mind this — more than inequality, tho it is of course important in its own right — is the structural condition for the Great Recession and the previous jobless recoveries. The downward shift in investment demand means that aggregate demand falls short of full employment except when boosted by asset bubbles.
The end of the cost advantage of internal funds (and the corresponding erosion of the correlation between borrowing and investment) is related to the end of the collapse of the larger post-New Deal structure of financial repression that preferentially channeled savings to productive investment.
UPDATE: I should clarify that while share buybacks are very large quantitatively — equal to total new borrowing by nonfinancial corporations in recent years — they are undertaken by only a relatively small group of firms. For smaller businesses, businesses without access to the bond market and especially privately held businesses, there probably still is a substantial wedge between the perceived cost of internal and external funds. It is quite possible that for small businesses, disruptions in credit supply did have significant effects. But given the comparatively small fraction of the economy accounted for by these firms, it seems unlikely that this could be a major cause of the recession.
I only just realized that this exists.
In comments to the previous post on fiscal policy, Steve Roth points to a couple posts from his own (excellent) blog pointing to a similar argument by Randy Wray, that falling federal debt-GDP ratios nominal volumes of government debt have consistently preceded financial crises historically.
Also in comments,
Chris Mealy asks,
Isn’t the idea that sufficient government debts will prevent phony safe assets and the financial crises they lead to?
Right, exactly!
A couple years ago, VoxEU ran several good pieces making exactly this argument — that it was the lack of sufficient government debt that spurred the growth of mortgage securitization.
Here is one:
The increased demand for US government debt by emerging economy central banks led to lower yields, thus forcing those savers in the OECD countries who would normally have held government assets to frantically “search for returns”. … The AAA tranches on securitised US mortgages … seemed to provide the safety plus a “yield pick up” without any risk…
The key technology that permitted the transformation of US mortgages into safe liquid assets was securitisation. … The massive buying of US government paper by emerging market central banks had displaced other investors whose preference previously had been for safe, short-term, liquid assets. … The excess demand for short-term, safe, liquid assets created by emerging economies’ accumulation of reserves could not have been satisfied by the securitisation of US mortgages (and consumer credit) without massive credit and liquidity “enhancements” by the banking system. …
Looking forward, this analysis implies that the current (smaller but still sizeable) US current account deficit should not lead to similar asset supply and demand mismatches since US households are now starting to save and it is the US government which is running the deficit, thus supplying exactly the kind of assets needed…
The entire world had an insatiable demand for safe debt instruments – including foreign central banks and investors, but also many US financial institutions. This put enormous pressure on the US financial system… The financial sector was able to create micro-AAA assets from the securitisation of lower quality ones, but at the cost of exposing the system to a panic… In this view, the surge of safe-asset demand was a key factor behind the rise in leverage and macroeconomic risk concentration in financial institutions… These institutions sought the profits generated from bridging the gap between this rise in demand and the expansion of its natural supply. …
[Once the crisis began], the underlying structural deficit of safe assets worsened as the … triple-A assets from the securitisation industry dried up and the spike in perceived uncertainty further increased demand for these assets. Safe interest rates plummeted to record low levels. … Global imbalances and their feared sudden reversal never played a significant role for the US during this deep crisis. In fact, the worse things became, the more domestic and foreign investors ran to US Treasuries for cover and treasury rates plummeted (and the dollar appreciated). …
One approach to addressing these issues prospectively would be for governments to explicitly bear a greater share of the systemic risk. … If the governments in asset-producing countries were to do it directly, then they would have to issue bonds beyond their fiscal needs.
The logic is very clear and, to me at least, compelling: For a variety of reasons (including but not limited to reserve accumulation by developing-country central banks) there was an increase in demand for safe, liquid assets, the private supply of which is generally inelastic. The excess demand pushed up the price of the existing stock of safe assets (especially Treasuries), and increased pressure to develop substitutes. (This went beyond the usual pressure to develop new methods of producing any good with a rising price, since a number of financial actors have some minimum yield — i.e. maximum price — of safe assets as a condition of their continued existence.) Mortgage-backed securities were thought to be such substitutes. Once the technology of securitization was developed, you also had a rise in mortgage lending and the supply of MBSs continued growing under its own momentum; but in this story, the original impetus came unequivocally from the demand for substitutes for scarce government debt. It’s very hard to avoid the conclusion that if the US government had only issued more debt in the decade before the crisis, the housing bubble and subsequent crash would have been much milder.
*
While we’re at it, I can resist reposting
the old post where I first mentioned this stuff:
A focus on cyclical stabilization assumes that there is no systematic long-term divergence between aggregate supply and aggregate demand. But Keynes believed that there was a secular tendency toward stagnation in advanced capitalist economies, so that maintaining full employment meant not just using public expenditure to stabilize private investment demand, but to incrementally replace it.
Another way of looking at this is that the steady shift from small-scale to industrial production implies a growing weight of illiquid assets in the form of fixed capital. There is not, however, any corresponding long-term increase in the demand for illiquid liabilities. If anything, the sociological patterns of capitalism point the other way, as industrial dynasties whose social existence was linked to particular enterprises have been steadily replaced by rentiers. The whole line of financial innovations from the first joint-stock companies to the recent securitization boom have been attempts to bridge this gap. But this requires ever-deepening financialization, with all the social waste and instability that implies.
It’s the government’s ability to issue liabilities backed by the whole economic output that makes it uniquely able to satisfy the demands of wealth-holders for liquid assets. In the functional finance tradition going back to Lerner, modern states do not possess a budget constraint in the same way households or firms do. Public borrowing has nothing to do with “funding” spending, it’s all about how much government debt the authorities want the banking system to hold. If the demand for safe, liquid assets rises secularly over time, so should government borrowing.
From this point of view, one important source of the recent financial crisis was the surpluses of the 1990s, and insufficient borrowing by the US government in general. By restricting the supply of Treasuries, this excessive fiscal restraint spurred the creation of private sector substitutes purporting to offer similar liquidity properties, in the form of various asset-backed securities. But these new financial assets remained at bottom claims on specific illiquid real assets and their liquidity remained vulnerable to shifts in (expectations of) the value of those assets.
The response to the crisis in 2008 then consists of the Fed retroactively correcting the undersupply of government liabilities by engaging in a wholesale swap of public for private liabilities, leaving banks (and liquidity-demanding wealth owners) holding government liabilities instead of private financial assets. The increase in public debt wasn’t an unfortunate side-effect of the solution to the financial crisis, it was the solution.
Along the same lines, I sometimes wonder how much the huge proportion of government debt on bank balance sheets — 75 percent of assets in 1945 vs. 1.5 percent in 2005 — contributed to the financial stability of the immediate postwar era. With that many safe assets sloshing around, it didn’t take financial engineering or speculative bubbles to convince banks to hold claims on fixed capital and housing. But as the supply of government debt has dwindled the inducements to hold other assets have had to grow increasingly garish.
From which I conclude that ever-increasing government deficits may in fact be better Keynesianism – theoretically, historically and pragmatically – than countercyclical demand management.
(What’s striking to me, rereading this now, is that when I wrote it I had not read any Leijonhufvud. Yet the argument that capitalism suffers from a chronic oversupply of long, illiquid assets is one of the central messages of
Keynesian Economics and the Economics of Keynes — “no mortal being can hold land to maturity,” etc. I got the idea from Minsky, I suppose, or maybe from
Michael Perelman, who are both very clear that the specific institutions of capitalism are in many ways in deep tension with the development of long-lived capital goods.)
UPDATE: Hey look, The Economist agrees. I think that means it’s time to move on.
UPDATE 2: So does Joe Weisenthal at the The Business Insider. His argument (and Stephanie Kelton’s) is different from the one here — it focuses on the fact that net savings across sectors have to sum to zero, as opposed to the government’s advantage in providing liquidity. But the fundamental point is the same, that the important thing about the government fiscal position is the implications it has for private balance sheets.
UPDATE 3: Steve R. points out that I misread his posts — Wray’s argument is about the nominal volume of federal debt outstanding, not the debt-GDP ratio. Hmm. I’m not sure I buy that relationship as evidence of anything … but it’s still good to see that Wray is asking this question. Steve also points to this paper, which looks very interesting.
Hyman Minsky famously asked, Can “it” happen again? No, he answered, it can’t: A deep depression on the scale of the 1930s is not possible in the post-World War II US. One reason why not:
There is a large outstanding government debt… This both sets a floor to liquidity and weakens the link between the money supply and business borrowing.
In other words, a large government debt is stabilizing, because it means that the supply of liquidity — assets that can serve as, and can readily be converted into, means of payment — depends less on the state of the financial system.
Let’s take a step back. Any unit in a capitalist economy incurs various money obligations, and receives various streams of money payments. [1] If a unit cannot meet its contracted payments in any period, it must default, with whatever legal consequences that entails. To avoid this, economic units, especially banks, must manage both market liquidity (the ability to convert assets in their portfolio into means of payment) and funding liquidity (the ability to issue new liabilities.) In general, when a bank expands its balance sheet, it becomes less liquid — that is, it increases the number of possible future states of the world in which it is unable to acquire the means of payment to meet its current obligations. This is why interest rates tend to rise in response to increased private borrowing.
Or rather, a bank that expands its balance sheet in order to acquire
private debt becomes less liquid, or is likely to find itself less liquid in a crisis. A bank that acquires public debt, on the other hand, becomes more liquid. This is why banks hold government liabilities as reserves, beyond any statutory requirements. Government bonds are, in Minsky’s words, “ultimate liquidity” — the only assets that can always be converted to means of payment as needed. This is why
interest rates do not rise in response to public borrowing, even when government deficits are very large. [2]
 |
| DR is the federal deficit as a percent of GDP. It’s the one that goes way up during the war. CPR and RRBR are the two main private interest rate indices for the period. They’re the ones that don’t. |
This all
respectable mainstream economic theory. But I don’t think the Minskyan implications are really acknowledged in mainstream policy discussions. Do we agree that one of the main reasons that a crisis on the scale of 1929-1933 was impossible postwar was the “floor to liquidity” provided by banks’ holdings of federal debt? Then perhaps we shouldn’t be surprised that a crisis of that scale almost did occur in 2007, when the share of federal debt in financial-system assets had fallen to less than 5 percent, compared with 15 percent when Minsky wrote those lines.
Indeed, much of the Fed’s response to the crisis was various policies to raise this ratio; and one danger of deficit reduction is that the banking system still needs more government bonds. Or as Brad DeLong
says:
When the world is short of safe assets–and investors are desperate to hold them–to complain about budget deficits in rock-solid reserve-currency countries and thus about safe asset issuance is profoundly stupid.
Right on; Delong has read his Minsky.
Now, Brad, will you take the next step with me and Hyman? Can we also agree that even when there isn’t a shortage of safe assets today, it’s good to keep a stock on hand, just in case? Can we agree that if there’s a chance that in the next decade the world economy will fly apart due to a lack of safe assets, then it’s a bit foolhardy to deliberately reduce the supply of them? Can we agree that, in retrospect, those big Clinton surpluses were — well, I won’t say profoundly stupid, but maybe not the best idea?
And then we can agree that whenever anyone talks about “tackling our long-term government debt problem,” what they really mean is “making future financial crises more likely.”
EDIT: Obviously, this sounds a lot like Modern Monetary Theory. But while I agree substantively with MMT, I think it’s better to think of government liabilities being special because they increase the net liquidity of the financial system, rather than because they can be used to satisfy tax obligations.
There’s one other analytic issue, which I haven’t seen dealt with satisfactorily. Government deficits operate through two channels: They increase the flow of demand for currently-produced goods and services, and they increase the stock of government debt in private hands. Now, under certain assumptions, you might say these are just two ways of describing the same phenomenon. If you think of the economy as a market with two goods, current output and bonds, then increasing the demand for one and increasing the supply of the other are logically equivalent. But this is not the only way of thinking of the economy. (Among other things, while markets certainly exist as social phenomena, describing the economy as a whole as a market is only a metaphor — one that may be more or less illuminating depending on the questions we are interested in.) In general, the two channels are going to have two distinct effects, and it would be nice to be able to think them through separately. But almost everyone, across the whole spectrum, tends to collapse them into one.
[1] One reason
I like David Graeber is that he understands that this is a better starting point for economic analysis than the exchange of goods.
[2] Obviously this claim applies only to the United States and similar countries. I am going to leave aside for now what “similar” means.
[just a list]
Eric Foner, A Short History of Reconstruction
Alexander Cockburn, The Golden Age Is in Us
Lance Taylor, Maynard’s Revenge
Christian Parenti, Tropic of Chaos
J. P. Nettl, Rosa Luxemburg
Alain Supiot, Homo Juridicus
John Cheever, various
Gene Wolfe, various
Some books I read this year:
Mrs Dalloway, by Virginia Woolf. I didn’t strictly read this, but listened to it, while driving between New York City and western Massachusetts. What a magnificent novel! I don’t feel I have a lot to say about it: It’s brilliant, it’s beautiful, it captures the way one can be committed to one’s life and choices while recognizing that they are ultimately arbitrary and contingent. “No doubt with another throw of the dice, had the black been uppermost and not the white, she would have loved Miss Kilman. But not in this world, no.” (And then the alternative, the poor schizophrenic demobbed soldier, the destruction that awaits you if you insist everything happens for a reason.)
Prosperity Without Growth, by Tim Jackson. I used this in the macro class I taught this past spring — I needed to do a unit on the environment and my old teacher
Bob Pollin recommended using Jackson. I would use it for that again, and recommend it to anyone looking for a short, accessible overview of the intersections of macroeconomics and environmental issues. Not with great enthusiasm, though, but only because I don’t know of anything better. (On the other hand the students seemed to like it a lot, so maybe I’m being too critical.) It’s not deep, but it has good solid chapters on environmental critiques of national income accounting; climate change and the question of discount rates; decarbonization and limits to growth; and the importance of thinking of wellbeing in terms of capabilities (there’s a lot of Sen) rather than just income. I particularly like that last bit; though he doesn’t use the term, it’s nice to see a strong argument for the progressive decommodification of social life from such a respectable source.
Hateship, Friendship, Loveship, Courtship, Marriage; Open Secrets; and others, by Alice Munro. Sometime this spring I asked for fiction recommendations on Facebook; Munro was the suggestion of my friend Deidre, who’s from Alberta. Around the same time my mother, visiting Vancouver, happened to read some of the same collections after finding them in the house where she was staying. So it seems that despite all the dozens of Munro stories published in the New Yorker (she’s apparently one of a handful of writers to whom the magazine has committed to print anything she submits), Munro still functions as a Canadian export. It would be hard to overstate how much I admire these stories. They’re not flashy, there’s almost nothing that stands out at the level of the sentence, and the lives they describe are usually (though not always) overtly ordinary. They do the thing that New Yorker stories are traditionally supposed to do, but seldom really achieve — show the emotional depths and high moral stakes in the seemingly small choices of everyday life. The more recent stories I’ve been reading — I don’t know if this is also true of the earlier ones — have a distinct and consistent construction: For the most part they don’t have a narrative moving forward in time, but are static portraits of a particular situation. So you really can’t imagine her writing a novel. Anyway, what’s remarkable is how consistent the artistry is — how thoroughly she works over the same material without its ever becoming less fresh — how she manages to convey such powerful emotions with such careful restraint. When you think that she’s over 80 now and still putting out story after story without ever hitting a wrong note, it’s hard not to feel an almost religious awe.
Chaos and Night, by Henry de Montherlant. This short novel from the 1950s is best known for the line, “I accuse the Americans of being in a continuous state of crime against humanity.” Though it’s spoken by Don Celestino, the book’s central character, it’s almost always attributed to Montherlant himself, which is a little odd since the conservative author hardly shares his protagonist’s curdled leftism. Besides anti-Americanism, Montherlant is also known for — at least it’s where I first encountered him — Simone de Beauvoir’s savage attack on the misogyny of his novels. (“For Montherlant it is first of all the mother who is the great enemy; … it is clearly seen that what he detests in her, is the fact of his own birth.”) It’s true that Celestino’s daughter Pascualita, the novel’s only female character, is vain, superficial and rather stupid. But she comes off much better than the protagonist himself, a delusional, rage-filled and hypocritical Spanish ex-anarchist. Though the book is constantly echoing Don Quixote, Celestino is a rancid parody of Quixote — his fantasies are repulsive as well as unreal. It’s about the least sympathetic portrayal of an old radical I have seen, a brutal travesty of the revolutionary intellectuals of the early 20th century.
So, why read such a thing? Mainly because it’s an very nicely constructed little book, written in a perfect style and with a whole series of brilliant little set pieces. And Don Celestino, vicious and self-pitying, is one of those unignorable personalities who takes over the page, with his rage against the whole world, from America to his few friends down to the pigeons he goes out of his way to drive from their crumbs. Personally, I was hooked from the monologue that opens the book: “To the north, there’s England, an incomprehensible country, and the Scandinavian states, incomprehensible countries. To the south there’s the Vatican. The dome of St. Peter’s is the candle-snuffer of Western thought… To the west there’s the United States. The United States is the canker of the world…”
The American Political Tradition, by Richard Hofstadter. I picked this up after Seth Ackerman — a very smart guy and good comrade, even if I don’t share his political vision — mentioned it here. I can’t believe I hadn’t read it earlier, it should be required reading for any halfway educated USAnian. The central theme is the fundamental conservatism of American political thought: With the partial exception of the abolitionists (represented here by Wendell Phillips), there’s never been a popular anti-systemic politics with any real access to state power. At the highest levels it’s just been a choice of conservatisms. Hofstadter has clear preferences among these. He likes best the reluctant radicals who under the pressure of events are prepared to change everything so that everything can remain the same, like FDR and Lincoln — though as he pointedly notes in the case of Lincoln, this meant that he spent most of the Civil War seeking to restore the conditions that had produced the war in the first place. (This is always the problem for conservative reformers.) Much worse are the principled conservatives like Calhoun — or more unexpectedly Grover Cleveland, who out of pure principle favored business over labor even more than the most venally pro-business Republicans of the Gilded Age. Worst of all are the populist conservatives like Bryan and Theodore Roosevelt. TR’s is the most thoroughly repulsive of the generally unflattering portraits in the book, combining smug thoughtless aristocratic privilege with brutal petty-bourgeois resentment. He frankly said that the only good Indian is a dead Indian, and eagerly hoped that every strike would finally let him haul out the Gatling guns, or at least bring his “cowboys” around to smash some workers’ heads. After reading this, it’s hard to walk through the lobby of the Museum of Natural History without feeling a little queasy.
Not Entitled, by Frank Kermode. The thoroughly charming memoir of the critic and English professor. Somebody said that if we wrote about lives the way we experience them, there’d be a dozen chapters on childhood, two or three on adolescence, and a brief afterword covering the rest. Kermode more or less follows this formula, with almost half the book devoted to his childhood on the Isle of Man, and another third to life in the British navy during World War II; there’s a couple short chapters on his postwar flounderings, and he passes over his long and successful academic career in a rushed handful of pages, as if embarassed by them. Which he probably was: The title of the book refers to what sailors were told on payday when they had incurred enough fines to cancel out their whole salary, but it’s also the attitude Kermode takes toward his whole life. His successes were fortuitous and unearned; more deserving people missed their chance for no good reason. Even writing in his 70s, he describes himself as feeling always like the youngest one in the room, unprepared, the newcomer, off balance and out of place, having arrived late and trying to find his place in a conversation already under way. Traa dy lioaur, “at the heel of the hunt,” in the Manx phrase his mother used to use of him. It’s a long time since I’ve read a book in which I’ve found such a kindred spirit.
What the Best College Teachers Do, by Ken Bain. I won’t lie, I picked this up to help me talk about teaching on the academic job market. But it’s really good! It was recommended to me by Prof T., to whom it was recommended, I think, by some other teacher; it seems to be kind of a cult thing that way. Bain’s central point is that we should think of classes in terms of what students do, not what the instructor does. Teaching isn’t a matter of pouring “material” into students and hoping they “retain” it, it’s about creating an environment in which they can actively engage in the same kind of work and critical thought that professionals do. (The same spirit someone like Andrew Lawrence brings to guitar teaching.) It’s an insight I’d been stumbling toward on my own but which is much more fully developed here and backed up with research and case studies. This book goes on the short shelf with other pieces of everyday utopianism — A Pattern Language, Cziksentmihalyi’s Flow. It’s a slighter book than those but the spirit is the same — we don’t have to just carry out our daily activities the way they always have been, but we also don’t have to revolutionize them according to logic of profit. It is possible to think clearly, freely and genuinely about how to do things right on their own terms.
Man Gone Down, by Michael Thomas. A first novel by someone you’ve never heard of; he doesn’t seem to have published even a story before this. It was recommended to me by my father when it came out a couple of years ago; I resisted reading it then because I knew it had a 9/11 subplot, and I’m allergic to WTC sentimentalism. But that’s only a small part of the book, which as it turns out I like very much. It’s a bit hard to say why. After all, it’s an entry in the justly reviled struggling-writer-in-Brooklyn genre. And while I generally prefer a clean austere style, Thomas is a writer of compulsively detailed descriptions — a single golf swing takes half a page. (Think Updike on Doritos.) Now one obvious difference between Thomas and “all the sad young literary men” is that he is African-American. It’s treacherous to think that any work of art can allow you to really understand a subjective experience foreign to your own (but isn’t that always what we hope for from art?) but this feels like a convincing picture of (one kind of) life as a black man in post-civil-rights America. In tone it’s somewhere between Nathan McCall’s memoir Makes Me Wanna Holler and the lovely Medicine for Melancholy. It’s significant that, as a “type,” the unnamed (but clearly autobiographical) protagonist is arguably a black man only second, and a struggling artist first. Why can’t you have all the angst that goes with that just because you’re black?, is one of the main themes of the book. There’s a nice scene about halfway through where he plays a set at an open-mike night and, after doing various old blues songs ends with “Mr. Tambourine Man.” The white hipster running the thing is disappointed: “I thought you were going in a different direction.”
It’s also a book about being broke, about alcoholism, and most distinctly, about blue-collar work. The narrator, who needs to earn money very quickly to preserve his marriage, has set aside his novel and returned to his old work as a carpenter. Thomas’ overflowing, almost compulsive descriptions are so much more interesting when they’re not about golf swings, but about the specific tasks and relationships involved in renovating a building. (So it’s a book about gentrification too.) At one point the narrator finds himself in a nice restaurant, and all he can think about is how superb the dry-walling is. (This goes in the labor-as-man’s-highest-need file, next to the poor hatmaker in Mrs. Dalloway, whose favorite activity in her walks around London is admiring the workmanship of ladies’ hats.) That so much of the loving description is of manual labor rather than middle-class consumption rituals is one important thing that sets this book off from Updike and from the Jonathans. But setting aside all that, it’s just beautifully constructed, it achieves what fiction is there for, it engages you emotionally. When the narrator finally has some bills in his pocket and seems set to squander them, when he seems set to give up in his fight against alcohol, you want to push your head through the page and shout, No.
