...against fictions and other tall tales

Sunday 10 May 2020

Robert Solow on 'Why Economies Grow'

As a follow-up and companion piece to my previous post, I decided to publish a transcription of a lecture on economic growth by Robert Solow that I transcribed originally as an aid for friends and colleagues who were studying economics. Although the lecture was given by Prof. Solow a few years ago during the height of the financial crisis, it contains loads of timeless insights, some of which is useful to be reminded of in the current situation, as discussions about the output gap resume in the next few years (see chart).

However, it's extremely important to keep in mind that in our current predicament as a result of covid potential GDP will also likely take a huge hit, as businesses and employees require some catching up in terms of business practices (misaligned with changing consumer preferences) and job training (due to skills entropy from employees being on furlough), to name only a few aspects that are likely to be impacted. In many ways, the post-covid period will bring us back to the type of economic analysis that used to occur a long time ago when natural catastrophes had significant and frequent impacts on economies' productive capacities.

The video of the lecture is included down below, though the sound quality is very bad, which is why I recommend reading the transcription instead (and you'll get through the transcript much faster by reading it).

Key insights are highlighted in bold font. Enjoy!
The business of this course is the long run. What are the sources of economic growth in the national economy or in the larger economy? Where does growth come from? And the policy implication – well, not implication, but policy question – is ‘How do you get an economy to grow rapidly and to have that growth widely shared in the nation?’
But there is a problem – it is a problem that appeared in the slides that Prof Newstone showed. It is a problem about getting there from here. So I’m going to start by talking a little bit about right now – this is not going to be the usual stuff about the financial crisis and all that – I have something else in mind.

There is something very odd about our economic situation in the US today. I read just recently an estimate from the Federal Reserve that about $7 trillion worth of wealth has been destroyed in the last year or year in a half (in 2008-2009). The country, so to speak, is $7 trillion poorer than it was.

When I wasn’t having a conversation with Cathy in the car, I was trying to divide 7 trillion by 300 million--the population of the US--in my head. It comes to about $23,000 for every man, woman and child in the country. Some, of course, have lost more, some have lost less.

What I want to point out is how strange that is: $7 trillion of wealth has gone down the drain but the productive capacity of the US economy – the capacity of our system to produce goods and service for its people – hasn’t diminished at all. In fact, it is undoubtedly higher than it was a year ago or 18 months ago: the labour force is a couple percent larger, the skills and education and training of the population is certainly not deteriorating and have probably gained. The net investment in capital has been positive – it’s been declining – but has been positive.

So we have a bigger stock of productive capital in the economy now than we did a year ago or 18 months ago. So the productive capacity of this economy is bigger than it was, despite of this $7 trillion of disappearance of wealth. If you are thinking of buying the US economy as a gift for your boyfriend or girlfriend, it would be worth just as much as it was worth – you know, like a used car – it would be worth just about as much as it was worth a year ago.

So in that sense we haven’t lost anything at all. But, of course, the point is we are in a recession. It is one year old according to pundits. And according to other pundits, or the same pundits, it’ll continue for at least until the second half of this year and maybe beyond. And the point is we are not using the productive capacity that we have.

You saw the unemployment numbers that Professor Newstone showed you. It is a lot harder to measure excess capacity in industry than it is to measure unemployment, but there are such figures, and they show an increase in unused capacity. So we have this machine for producing the goods and services for the population and we are not making full use of it. And that under-use of economic capacity, of productive capacity will go on for a long time. Even if the economy turns up in the second half of this year we will undoubtedly finish 2010 still with some slack in the economy because the slack disappears only gradually. 
So if you are interested – now, this is the point, this is why I started this way – if we are thinking about the long run growth of the economy (which means the long run growth of its capacity to produce), it’s not a separate but it’s an analytically slightly different problem to make sure that that capacity is used.

As long as we are not using all of the capacity that we have, the economy and the decision-makers in the economy are not likely to be motivated to do the things that increase potential output, that increase the productive capacity very rapidly.

So the short-run order of business – policy business – for us and every other rich country in Europe or Asia right now is to close that gap or narrow that gap between productive capacity and actual output, which means fundamentally trying to increase the demand for goods and services. And to do that in a way that at least doesn’t create obstacles to the long-run growth of the economy once the gap is closed, and maybe does some things that will help it.

So, imagine it is now January 2011 and the American economy and the economies of the other rich countries – developed countries of the world – are prospering reasonably well, are using their capacity, have closed that gap. Then the question is: What makes them grow? What economic activities that take place have the effect of increasing the capacity of the economy to produce useful goods and services? 
Now, you won’t be surprised – in fact, I’m staring at this monitor here and it says: so what determines the rate of economic growth in the economy? And that’s the question that I want to come to now, and it becomes relevant after we have done the short run task of closing that gap. There isn’t any one word or two word answer to that question. 
And I should make it explicit that I am thinking now about what determines the rate of economic growth in a rich economy, in an advanced industrial economy. I am not thinking about developing economies where the answers are related but the answers are somewhat different.

And the truth is that for an advanced economy the answers to that question – what are the sources of growth of national output, of productive capacity – are really the usual suspects. They are things we have known about now for quite a long time. And basically, what matters is what you might describe as investment in a very broad sense. I have to emphasize “in a very broad sense”.

What increases the productive of an economy like ours is investment in physical capital, in machinery, in computers and all the rest of that, investment in what economists call human capital, meaning skills and capacities of workers and people who work in the economy, and investment in new technology.

And here there is a slight difference between the US and even most of the countries in Europe. Not quite across the board but in most branches of industry the US is the technological leader. The gap was very big at the end of the Second World War and has closed considerably. But still, if you look at sector by sector, with some exceptions, the US is the technological leader.

Other countries of the world, that were even fairly rich countries have the luxury of being able to acquire technology by innovation, essentially by adopting, using what is already known. This country (i.e., the US) is in the position of having – so to speak – to invent its own future.

So basically, if we are looking now at the US, the things we have to look after in order to have a successful fairly high rate of growth (we can talk about the equity issues later) are a high rate of savings and investment in plant and equipment. I’d rather have the saving done here than abroad so that, in effect, the capital equipment that is built by investment in this country is owned in this country, and the returns to it stay in this country. It’s not necessary but it’s probably desirable. 
We need an extraordinary amount of emphasis – and we’ll talk more about this later – on investment in human capital, on producing the labour force that has the skills that are necessary to successfully operate that plant and equipment. And that is especially important because a country like this also has to invest in new technology. There is no place it can copy from – it has to in most cases create it itself.

Now, when I say new technology, the phrase tends to have a “high tech” air about it. But I don’t mean it that way.  New technology needn’t be high tech. It turns out that – in many ways – the most important contributors to productivity in the US over the last decade or two have been the application of information technology to wholesale trade, retail trade and financial services.

In fact, there are studies trying to understand why the major, big European economies, Germany, France, UK and Italy have lagged behind the US in productivity terms, general productivity terms. And the common answer seems to be that they have been slow to adapt the information technology to the service sectors. In manufacturing, there is very little gap, if any. But the gap is in the service sectors. 
So, this is extremely important. And I want to emphasize it, even at the risk of some repetition. One of the standard, valid, almost universal generalizations about the way people behave economically is that technically the income elasticity of the demand for services is high. All over the world, as incomes rise, personal incomes rise, people want to spend, [and] choose to spend a larger fraction of that income on services rather than goods. And you can understand why that should be so.

So this means that most of the rapidly growing advanced economies grow more rapidly in the service-producing sectors than in the goods-producing sector. There are exceptions to that. A country like Germany – to a lesser extent Japan, or formally Japan, not so much anymore – has a strong bias toward trying to make its living from simply exporting high quality manufactured goods. You notice I said exporting because the population of Germany, like the population of anywhere else, wants to consume services as it gets rich, not goods.

So those are the things, the essentially important things that a country like the US needs to do to generate long-run growth of productive capacity. 
I should say, in terms of policy, that you should beware of any universal advice like “well, the market will take care of that”. You know, if the alternative to the free-market economy is some kind of central planning, there is no question to where the advantage lies. But there is absolutely no evidence in the historical record of the advanced economies that zero regulation or weak regulation of industry is somehow conducive to rapid growth, or that minimal involvement of the government in the economy is conducive to rapid growth.

The functions of the government in terms of long run growth are just what you would deduce from what I have already said: promoting research and development, providing incentives for investment when they are lacking, taking care of education, and looking after mobility. By the way, it is probably also true that a country – there is less evidence for this generalization, but it’s probably also true – that business cycle instability is bad for economic growth.

For countries that are given to wide fluctuations like the ones we were looking at a few minutes ago, that’s not helpful for long-run growth because it adds to uncertainty. The likelihood of broad fluctuations adds to uncertainty is bad for all forward looking activities, like investment, like mobility, like education.

I wanted to say one more thing about the issue of mobility. When I say mobility, I mean industrial mobility and occupational mobility. In a rapidly growing, technologically-based economy, people have to change the nature of their jobs frequently and capital has to flow freely from obsolescent industries to new industries.

It is very important when you come in this course to talk about issues of equity. I think it is very important to find ways so that the burdens that are associated with necessary mobility don’t fall on workers and other people who are ill-equipped to prepare them [for that eventuality].

Dislocation and sometimes dislocation is probably an inevitable part of fast, mainly technologically-based growth. But it is the task of economic policy to find ways of combining that with income security, up to now, where it’s mostly below the median for incomes.

Monday 4 May 2020

The macroeconomics of Robert Solow: A partial view

During a hearing before a Congressional Committee on Science and Technology, Robert Solow (MIT) described himself as a "generally quite traditional, mainstream economist".

In my view, either Prof. Solow is unaware of who qualifies as a "traditional, mainstream economist" these days or the definitions of the words "traditional" and "mainstream" need to be completely changed!

Consider, for instance, his views on the notion of "expansionary fiscal consolidation":

[H]ow does a human race with limited intelligence...deal with situations in which the short run need for policy are quite different from the long run need for policy? The feeble-minded, it seems to me, attempt to solve this problem [by asserting] that fiscal consolidation is really expansionary in the short run. I have never been able to understand the mental processes that underlie that statement. But I will take it seriously only -- only -- when its protagonists faced with a situation of clear excess demand propose fiscal expansion. Because if fiscal consolidation is expansionary then fiscal expansion must be contractionary. I don't believe that would happen. So I don't take that argument seriously at all. I think it's cooked up to make a real difficulty go away. (The Feasibility of European Monetary and Fiscal Policies: Rethinking Policy from a Transatlantic Perspective)

...on the supposed lack of microfoundations in Keynesian economics:

You know, there is something a little ludicrous in the belief that microfoundations for macroeconomics were invented some time in the 1970s. If you read Keynes's General Theory or Pigou's Employment and Equilibrium (or many lesser works) you will see that they are full of informal microfoundations. Every author tries to make his behavioral assumptions plausible by talking about the way that groups or ordinary economic agents might be expected to act...But you can recall Keynes's argument that the marginal propensity to consume should be between zero and one, or his discussion about whether the marginal efficiency of investment should be sensitive to current output or should depend primarily on "the state of long-term expectations". Those are microfoundations. (2004, p. 659)

...on the claim there is a connection between the money supply and price level:

[T]he financial press sometimes writes as though there is some special direct connection between the money supply and price level. So far as fundamentals are concerned, monetary policy works through its effects on aggregate nominal demand, just like fiscal policy, in the long run, too. The only direct connection I can think of is itself the creation of pop economics. If business people and others become convinced that there is some causal immaculate connection from the money supply to the price level, completely bypassing the real economy, then the news of a monetary-policy action will generate inflationary or disinflationary expectations and induce the sorts of actions that will tend to bring about the expected outcome and thus confirm the expectations and strengthen the underlying beliefs. (1998:4)

...on the problem with Milton Friedman's reliance on correlations between and M and other variables to infer policy conclusions and the assumption of an exogenous money supply (with John Kareken):

The unreliability of this line of argument is suggested by the following reducto ad absurdum. Imagine an economy buffeted by all kinds of cyclical forces, endogenous and exogenous. Suppose that by heroic, and perhaps even cyclical variation in the money stock and its rate of change, the Federal Reserve manages deftly to counter all disturbing impulses and to stabilize the level of economic activity absolutely. Then an observer following the Friedman method would see peaks and troughs in monetary changes accompanied by a steady level of economic activity. He would presumably conclude that monetary policy has no effects at all, which would be precisely the opposite of the truth. (Karaken and Solow, 1963, p. 16)

...on choosing the right model in macroeconomics:

[I] believe rather strongly that the "right" model for an occasion depends on the context --  the institutional context, of course -- but also on the current mix of beliefs, attitudes, norms, and "theories" that inhabits the minds of businessmen, bankers, consumers, and savers. (2004, p.xi)

...on the problems with the DSGE model:

I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way. I do not think that this picture passes the smell test. The protagonists of this idea make a claim to respectability by asserting that it is founded on what we know about microeconomic behavior, but I think that this claim is generally phony. The advocates no doubt believe what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether. (For more, see here and here)

...on the difference between budgetary and real resources costs:

The trouble is that the great world -- including a large part of the intellectual world -- has lost sight of the fundamental difference between budgetary costs and real resource costs. An unemployed worker and an underutilized or idle plant is not something we're saving up for the future. Today's labor can't be used next year or the year after. And the machine time in a plant that's down can't be redone two years from now or three years from now. Three years from now we hope that the plant will be running for current uses. So there's that important sense in which idle resources are almost - and maybe literally - free to the economy. The problem is to get them used in a reasonable way. (see 22:00 here):

...on the importance of fiscal policy for stabilization purposes:

I start from the belief that non-trivial imbalances of aggregate supply and demand do occur in modern industrial capitalist economies, and last long enough that public policy should not ignore them...When such imbalances occur, fiscal policy is a useful tool. The single instrument of monetary policy can not do justice to the multiplicity of policy objectives; and the Ricardian equivalence claim is in practice not nearly enough to convince a realist of the ineffectiveness of fiscal policy. The real obstacles to the rational conduct of fiscal policy are the uncertainties about the proper target for real output and employment, and the tendency for stabilization goals to become inextricably tangled in and distracted by distributional and allocational controversy. (Is fiscal policy possible? Is it desirable?, p. 23)

...on the long run potency of deficit spending financed by bonds vs. deficits financed by money creation, and on the contractionary nature of open market purchases of government bonds (with Alan Blinder):

[N]ot only is deficit spending financed by bonds expansionary in the long run, it is even more expansionary than the same spending financed by the creation of money. [Foonote: An interesting corollary of this is that an open-market purchase, i.e. a swap of B for M by the government with G unchanged, will be contractionary!] (Blinder and Solow: Does Fiscal Policy Matter? 1973)

...on how statements by a central bank can influence how the public translates relative price changes into expectations about the consumer price index:

There are various interest groups in the economy: bankers, investors, savers, lenders, borrowers, buyers and sellers and what not. There is no reason for them to react in the same way. How does one aggregate expectations?

...on the use of "expectations" to explain macro policy outcomes:

[T]o rest the whole argument on expectations -- that all-purpose unobservable -- just stops rational discussion in its tracks. I agree that the expectations, beliefs, theories, and prejudices of market participants are all important determinants of what happens. The trouble is that there is no outcome or behavior pattern that cannot be explained by one or another drama starring expectations. Since none of us can measure expectations (whose?) we have a lot of freedom to write the scenario we happen to like today. Should I respond...by writing a different play, starring somewhat different expectations? No thanks, I'd rather look at data. (1998:93)

...on the claim of self-correcting markets and the role of aggregate demand in causing output fluctuations:

Capitalist economies do not behave like well-oiled equilibrium machines. For all sorts of reasons they can stray above or below potential output for meaningful periods of time, though apparently they are sightly more likely to stray below than above. Even apart from considerations of growth, macro policy should lean in the general direction that will nudge aggregate demand toward potential, whenever a noticeable gap occurs. The relevant point is that this strategy is also growth-promoting. Whatever the level of real interest rates, excessively weak aggregate demand -- and the prospect of weak and fluctuating aggregate demand -- works against investment. Few things are as bad for expected return on investment as weak and uncertain future sales...Successful stabilization contributes to growth too. (Role of macroeconomic policy, p. 301)

...on the need for public policy to address the unemployment of unskilled labor:

It needs to be insisted that the root of the problem lies in the enormous range of earning capacities generated by the interaction of modern technology (and other influences on the demand for unskilled labor) with the demographic and educational outcomes on the supply side of the labor market. There is no really good way for a market economy to deal humanely with that spread. (Too Optimistic)

...on the fallacy of self-correcting markets and the limits of monetary policy during deep recessions:

One important lesson that I hope we have learned from the crisis and the deep recession still going on is that economies like ours can experience uncomfortably long intervals of general excess supply or excess demand. Of course, we -- economists and interested civilians -- used to know that. But it was widely forgotten during the Great Moderation and the accompanying optimism among economists and civilians about smoothly self-correcting markets. The general belief than was that monetary policy was an adequate tool for taking care of any minor blip. During long and deep recessions, however, it has become evident that monetary policy may reach its limits without being able to generate enough aggregate demand to close the excess supply gap. (IMF Talk: Macro and Growth Policies)

...on the problems with Ricardian equivalence:

What might interfere with [the claim that it is optimal for households to save a tax reduction]? Any number of things: if households had been unable to consume as much as their optimal plan required because they lacked liquid assets and could not borrow freely, then the added liquidity provided by the tax reduction would enable them to consumer more now. If the Treasury were a more efficient, less risky, borrower than many households, then the appearance of some new public debt would also affect real behavior. And, of course, if consumers do not look ahead very far or very carefully, if they give little weight to the interests of descendants, or if they tend to ignore or underestimate the future implications of current budgetary actions, then Ricardian equivalence will fail, and tax reduction financed by borrowing will indeed be expansionary. All those "if" clauses strike me as very likely to be real and quantitatively important, and that suggests that Ricardian equivalence is not a practically significant limitation on fiscal policy. (Is fiscal policy possible? Is it desirable?, p. 12)

...on the problem with the natural rate of unemployment hypothesis:

Let me try to explain what nags at me in all this...We are left here with a theory whose two central concepts, the natural rate of unemployment or output and the expected rate of inflation have three suspicious characteristics in common. They are not directly observable. They are not very well defined. And, so far as we can tell, they move around too much for comfort -- they are not stable. I suspect this is an intrinsic difficulty. I have no wish to minimize the importance of, say, inflationary expectations. But we are faced with a real problem: here is a concept that seems in our minds to play an important role in macro behavior, and yet it's very difficult to deal with because it escapes observation and it even escapes clear definition. 

On the natural rate of unemployment, I think the behavior of the profession exhibits problems. In order to make sensible use of this kind of theory, you want the natural rate of unemployment to be a fairly stable quantity. It won't do its job if it jumps around violently from one year to the next. But that's what seems to happen. We, the profession, are driven to explaining events by inventing movements of the natural rate, which we have not observed and have not very well defined. The issue came up first in the passage of the big European economies from 2 percent unemployment, on average, to 8 or 9 percent unemployment, on average, within a few years. The only way to explain that within the standard model is to say that the natural rate of unemployment must have increased from something like 2 percent to something like 8 or 9 percent. The actual facts that could account for any such dynamics never seemed to me or to any critical person to be capable of explaining so big a change. So we are left with inventing changes in the natural rate of unemployment to explain the facts, and it is all done in our heads, not in any tested model. I regret to say that you often find this kind of reasoning: the inflation rate is increasing because the unemployment rate is below the natural rate. How do you know that the unemployment rate is below the natural rate? Because the inflation rate is increasing. I think we are all good enough logicians to realize that this is exactly equivalent to saying that the rate of inflation is increasing, and nothing more. 

It seems to me that we ought to be thinking much more about the determinants of whatever you choose to call it. I hate to use the phrase "natural rate" but of course I do. It was a masterpiece of persuasive definition by Milton. Who could ever want an unnatural rate of unemployment? (Fifty years of the Phillips Curve: A Dialogue on what we have learned, p.84)

...and more on the natural rate of unemployment:

There is nothing like an adjustable, unobservable parameter to keep a theory afloat in rough seas...I think the doctrine [of the natural rate of unemployment] to be theoretically and empirically as soft as a grape. To say that in the long run the unemployment rate tends to return to the natural rate of unemployment is to say almost nothing. In the long run the unemployment rate goes where it goes. You can call where it goes the natural rate; but unless you have a more convincing story than I have seen about the length of the long run and the location of the natural rate, you are only giving a tendentious name to a vague concept (1998, pp. 9, 91)

Thursday 30 April 2020

The Keynesian-Monetarist debates and reverse causation (or how Keynesians destroyed monetarism using only logic)

Traditional monetarist theory held that changes in the money stock are the best indicator of monetary influence on the economy, and that these influences have a significant impact on the course of economic activity over the business cycle.

The idea that "money matters" in this sense is not new. In many ways, monetarism's basic premise dates back to the beginning of political economy as a discipline. However, in the 1950s, the idea gained prominence when a number of "money supply theorists", as they were called back then, began producing studies and charts that appeared to lend support to the view that changes in the money supply had a predominant role in causing fluctuations in (nominal) income and output.

Initially, (neo-)Keynesian economists -- who as a result of their reading of events of both the onset of and recovery from the Great Depression viewed income (output) as determined largely by aggregate demand or the spending of firms, government and household spending -- were not phased. At first, Keynesians responded by saying that their preferred theoretical approach, the Hicks-Hansen IS-LM model, already recognized the role of money in affecting economic activity via the LM curve.* However, these Keynesians also argued that, while money does have a role in driving economic activity, it was of secondary importance, behind consumer and investment spending.**

Also, while Keynesians admitted that fluctuations in the money supply can affect economic activity, they also argued that the seemingly causal relationship between money and output portrayed in monetarist studies could partly be explained by changes in the public's demand for money, the propensity to hold financial assets in the form of money.

The debate intensified when Milton Friedman and other monetarists produced studies (seemingly) showing the empirical importance of money over spending and investment in explaining output fluctuations. In order to show that fluctuations in the money supply cause fluctuations in output, monetarists had to demonstrate that the demand for money was stable (to support their view regarding the predominant role of the money supply in affecting economic activity), and that fluctuations in aggregate demand were a weak source of fluctuations in income.

With respect to the stability of the demand for money, Keynesians argued that the demand for money was not stable (i.e., as a stable function of interest rates, expected inflation, wealth and other variables), nor predictable (thus countering the monetarist view that the predictability in the demand for money would enable the monetary authority to expand or contract the money supply to offset any predicted changes in money demand). The neo-Keynesian view was later proven right when the stability in money demand collapsed in the 1970s and 1980s in the US.

As for the monetarist claim that money supply fluctuations outperformed the traditional Keynesian drivers such as investment and other forms of spending in explaining output fluctuations, which figured most prominently in Friedman's "A Monetary History of the United States", neo-Keynesians responded in several ways.

First, Keynesian critics proposed that the apparent causal relationship stemming from money to income (and economic activity overall) might be a fallacious case of post hoc ergo propter hoc (i.e., what comes before must therefore be the cause), or at the very least, a statistical illusion caused by the fact that investment is recorded in national income accounts in periods subsequent to monetary aggregates, which capture the same transaction but at an earlier stage when investors first come to the money market.

Also, Keynesians challenged the methodological approach used by Friedman and other monetarists to support their claim that the money supply is the key variable explaining fluctuations in output. Most importantly, Keynesian critics suggested that Friedman's approach in the "Monetary History" of assuming an exogenous money supply under the full control of the monetary authority and completely independent from the influence of other economic variables, was unrealistic and overstated the influence of money on economic activity.

Over 50 years ago, neo-Keynesian economists John Kareken and Robert Solow, using simple logic, pointed out the fatal flaw in the monetarist assumption of the exogeneity of the money supply:
The unrealiability of this line of argument is suggested by the following reducio ad absurdum. Imagine an economy buffeted by all kinds of cyclical forces, endogenous and exogenous. Suppose that by heroic, and perhaps even cyclical variation in the money stock and its rate of change, the Federal Reserve manages deftly to counter all disturbing impulses and to stabilize the level of economic activity absolutely. Then an observer following the Friedman method would see peaks and troughs in monetary changes accompanied by a steady level of economic activity. He would presumably conclude that monetary policy has no effects at all, which would be precisely the opposite of the truth.
Karaken and Solow in this example were not suggesting that the money stock was endogenous in the sense that the money supply was negatively correlated with aggregate spending shocks. Rather, they were suggesting that abstracting from the actual behavior of the central bank as Friedman did could result in flawed conclusions about the magnitude of monetary policy's impact on the economy.***

Also, this line of reasoning suggested that the statistically significant relationship (correlation) between money and output highlighted by the monetarists should not be understood as implying that changes in the supply of money cause changes in income. Instead, this objection suggested the possibility that the observed relationship could just as well be the consequence of reverse causality, that is, that spending shocks, by affecting money demand and generating pressure on the interest rate, led to accommodating changes in the supply of reserves provided by the Fed during that period, and ultimately resulted in changes in the money supply.

Having then demolished the Friedman assumption of an exogenous money supply, neo-Keynesians in the 1960s thus allowed for the possibility that the relationship between money and economic activity could be the result of actions from the public, as they respond to current economic conditions, and that these actions from the public could have such a significant influence on observed movements in the money stock that one could not tell the direction of causality between money and economic activity simply by looking at measurements of monetary aggregates and income.

For a few years later, a lively debate on reverse causation followed between monetarists and the economic staff of the St. Louis Federal Reserve Bank on one side and neo-Keynesians and staff economists of the Federal Reserve Board on the other. Empirically, a breakthrough in favor of the reverse causation argument occurred in 1973 when two staff economists of the Federal Reserve Board, Raymond Lombra and Raymond Torto, demonstrated in a paper entitled "Federal Reserve Defensive Behavior and the Reverse Causation Argument" that during the 1953-1968 period the supply and demand for money was interdependent and that this interdependence provided an avenue for the reverse influence of the business cycle on money.

In doing so, Lombra and Torto confirmed the endogeneity of the monetary base and money supply resulting from the Fed's offsetting and accommodating actions whenever it sought to stabilize conditions in the money market by pegging the level of short-term interest rates over the short-run:
If the demand for money is, in part, a function of the level of economic activity and the supply of money has been at least partially demand determined, then the money stock is endogenous whether or not the Fed has the power to control it
However, the conclusions by Lombra and Torto were eclipsed by the conclusions of a paper published one year earlier by Christopher Sims utilizing newly developed statistical techniques which contended that the hypothesis of unidirectional causality running from money to income could not be rejected. Of course, monetarists, in their attempt to support their case, cited this work with approval since it appeared to support the monetarist assumption of an exogenous money supply.

In 1982, Sims published another paper recognizing that his earlier work and work based on it was open to serious question. This paper along with Lombra and Torto's paper should have demolished the monetarist case from the start. Unfortunately, such an attack was not enough to stop the monetarist ascendancy that was gathering support within and outside the economics profession (such as the St.Louis Federal Reserve Bank) in the 1970 and 80s.

Today, we know that this monetarist view influenced later New Keynesians (not older New Keynesians like Stiglitz, Akerlof and Blinder). Some Post Keynesians adhere to reverse causation in their monetary economics.

* The LM curve had been relegated to the background (as a supporting role) during the war years and early post-war years when interest rates were pegged as a result of the Treasury-Fed accord

** The main changes through which the real money supply affects the economy are: the real balance effect, the portfolio effect, and money as a medium of exchange effect.

*** More specifically, by assigning total control over the money supply to the central bank in their model, Friedman and other monetarists were effectively dismissing the potential influence of both the banking system and the real economy in influencing the money supply.

Sunday 17 January 2016

Stiglitz on credit creation by banks

For those who think that Joseph Stiglitz doesn't know that banks actually create credit:

"We are not in a corn economy where banks serve as an intermediary between farmers who have excess seed and farmers who want more seed. We are in an economy where banks actually create credit. And that makes a very big difference."

h/t: wonkmonk

Saturday 19 December 2015

Loanable Funds Theories: Classical vs Keynesian

It's been an embarrassingly long time since my last post. It's not due to a shortage of good topics to write about. Rather, I've been caught up in a number of projects at work and been busy on the home front. Hopefully, this post, which was inspired by ongoing conversations I've been having offline with friends and colleagues will partly make up for the radio silence.

One of the biggest fallacies in macroeconomics and macro policy is the idea that the interest rate is determined by the intersection of the upward sloping supply curve of (desired) savings and downward sloping curve of (desired) investment.

According to this traditional, credit-based approach to interest rate determination (as opposed to a "money-based" one à la Keynes's Liquidity Preference Theory in which the interest rate is determined by the supply of and demand for money), savings consist of the supply of loanable funds (i.e., funds that are not spent on consumption), assumed to be positively related to the interest rate, while investment is the demand for loanable funds and assumed to be negatively related to the interest rate.

As far as simple theories go, the old (classical) loanable funds theory is of very little or no use for making sense of the real world and in terms of providing prescriptive insight to policymakers. For one, there's very little evidence that the real rate of interest has significant impact on business investment.

But more importantly, the problem with the traditional loanable funds theory is its public policy implications: it assigns no role to government as a stabilizing feature of the economy during a recession, which is a ludicrous proposition given what we know now about the Great Depression, the Japanese Lost Decade(s) and the Great Recession (the lesson being that government has a role to support recovery, as market mechanisms won't be sufficient, or at the very least, will take too long).

Consistent with the classical origins of this approach, the traditional loanable funds model holds that government intervention to stabilize the economy is not needed because, as the economy falls into recession, there is an automatic stabilizing force clearing the loans market, enabling the supply of and demand for funds to adjust, shifting to the left, reaching a new equilibrium, as in the diagram below.

The self-adjusting mechanism works as follows: first, as the shift in demand for funds is assumed to be greater than the shift in the supply of loans during a downturn, the result is a decrease in the (real) rate of interest, which subsequently causes investment to recover, thus helping to restore economic activity and growth.

In his General Theory, J.M. Keynes illustrated how widespread the belief in traditional loanable funds theory was during his time:
Certainly the ordinary man — banker, civil servant or politician — brought up on the traditional theory, and the trained economist also, has carried away with him the idea that whenever an individual performs an act of saving he has done something which automatically brings down the rate of interest, that this automatically stimulates the output of capital, and that the fall in the rate of interest is just so much as is necessary to stimulate the output of capital to an extent which is equal to the increment of saving; and, further, that this is a self-regulatory process of adjustment which takes place without the necessity for any special intervention or grandmotherly care on the part of the monetary authority. Similarly — and this is an even more general belief, even today — each additional act of investment will necessarily raise the rate of interest, if it is not offset by a change in the readiness to save.  
In a recent post, Paul Krugman dismissed the relevance of the traditional loanable funds model for the real world, pointing out the basic Keynesian insight that the theory is only relevant if the level of income in the economy is fixed. In reality, as Krugman correctly argues, given that income is not fixed, all the traditional loanable funds theory does is "define a relationship between interest rates and income, the IS curve of the conventional Keynesian IS-LM model".

Also, in his post Krugman showed how misleading the model can be for explaining the determination of the rate of interest in a world where the central bank sets the short term interest rate as a way to achieve its policy objective (i.e., hit its inflation target):
The Fed sets interest rates, whether it wants to or not — even a supposed hands-off policy has to involve choosing the level of the monetary base somehow, which means that it’s a monetary policy choice.

Keynesian Credit-based Loanable Funds Theory (credit view) vs Classic Loanable Funds Theory (money view)

So it needs to be repeated: the old loanable funds theory is irrelevant for understanding how the economic activity resumes after a downturn. That said, the basic insight that "credit matters" and that credit fluctuations have significant effects on the real economy should not be rejected out of hand.

Such was the thinking in the 1970s and 1980s when a few Keynesian economists, including Andrew Weiss, Joseph Stiglitz, Bruce Greenwald, Benjamin Friedman, Alan Blinder and others (including, to some extent, Ben Bernanke) set out to devise Keynesian-inspired credit-based models as alternatives to the conventional and popular Keynesian and monetarist "money-based" models that dominated macroeconomics at the time (all of which assumed a special role for money in the determination of aggregate demand).

The result was a set of economic models highlighting the importance of credit in the economy and the critical role of commercial banks in affecting real output. Though they were labelled "new and improved" versions of loanable funds theory because they emphasized credit rather than money, these models were nothing like their classical predecessor, as the new models assigned no special role to the supply of savings and recognized the critical role of government regulation and macroeconomic stabilization to improve economic outcomes.

At the heart of these new models is the idea that, unlike the traditional loanable funds model, credit is not allocated in an auction process, with the loan going to whoever is willing to pay the highest interest rate. Rather, in these models banks understand that increasing interest rates can in some instances (especially when economic activity is weak or slowing) increase the probability of borrowers to default, as increased lending rates can lead to adverse effects on the incentives of borrowers to undertake activities that are increasingly risky.

Default and bankruptcy are therefore possible in these models -- unlike in the traditional loanable funds model -- because lenders are often unable to properly assess the risk profile of potential borrowers due to a lack of information or the high cost of adequately assessing the default risk of potential borrowers.

So, rather than being determined by the forces of supply and demand, the interest rate in these Keynesian credit-based models is determined by the maximum expected return to banks, that is, the rate with which profits are maximized and risks (e.g., probability of loans not being repaid that can lead to an increase risk of bankruptcy) to the bank are minimized.

In other words, the interest rate is a variable determined by banks themselves as a way to remain profitable. In these models, there is no presumption that increases in the interest rate will boost bank profits given that higher interest rates can increase the probability that borrowers will not pay back their loan, which could result in profit losses for the bank and, in some cases, could lead to bankruptcy.

Nor is there is any presumption in these models that the market for loans is perfect and clears. The market mechanism in these models does not lead credit supply to equal demand because, in their attempt to maximize profits and minimize risks in a context where information about borrower risk is scarce and/or costly to uncover, banks will not supply the amount of credit necessary to meet the demand at the lending rate. In other words, the result is an excess demand for funds (i.e., credit rationing).

Perhaps the simplest and most revealing of these Keynesian loanable funds models is the model by Joseph Stiglitz and Bruce Greenwald (2003)*. In this model, unlike in the traditional loanable funds model, the supply of loans (regardless of whether those loans are supplied via traditional financial intermediation or credit creation**) is not depicted as an upward sloping curve, as in traditional credit-based (loanable funds) models. Rather, banks' supply of loans is represented by a backwards bending curve (see chart below). The reason the curve bends backward in this model is because a rise in the interest rate increases average borrower risk. Also, the model assumes banks scale back the amount of loans supplied as the rate of interest increases to avoid borrower default and, by consequence, profit losses. (In a recent talk, Stiglitz referred to this model as a modern, Keynesian version of Irvin Fisher's debt-deflation theory. The similarities aren't obvious, but they are there.)

When combining the backwards sloping supply curve with a conventional demand curve for loans (where the demand for loans increases as the interest rate falls), the result is a credit market that is not perfect in the sense that the market mechanism (supply and demand for credit) does not provide a market-clearing interest rate, where the demand exceeds the supply for credit.

Ideally, in this model banks should be lending at point L* and setting the lending rate at r* where expected returns are maximized and where credit rationing (CR in the diagram) occurs. However, screening loan applications and paying interest on deposits imply costs to banks, therefore, typically the lending rate will be set a little lower, at point e. At point e, however, there is even more credit rationing because there is less lending.

From a macroeconomic perspective, credit rationing can lead to reduced economic activity by limiting aggregate demand, investment, employment and output. When credit is not available, firms involved in production cut employment and investment, thus lowering national income, output and the general level of employment. In some instances, as Alan Blinder argues, credit rationing can even lead to a Keynesian shortage of effective supply, that is, a shortage of produced goods and services to meet current demand, which in some situations could have the effect of increasing prices.

The impact of credit rationing on output will depend on whether the firms are dependent on bank loans. Firms that rely on bank financing will cut spending while businesses using bank loans for working capital will stop operating.

The table below provides a comparison between the traditional (classical) loanable funds theory and the modern Keynesian version.

Monetary Policy...

So what are the implications of this model for monetary policy? The conventional story holds that central banks reduce interest rates and investment increases as a result. In the Keynesian loanable funds models, the central bank may succeed in driving down the rate of interest on government securities (Treasury bills), however, it may not get banks to reduce their lending rate if banks perceive an increased risk of default on the part of households and firms due to a worsening economy, or if banks believe economic conditions are not likely to improve. Instead of increasing their loan portfolio, banks could simply choose to purchase safe government securities, as was done during the Great Depression, an outcome that does nothing to support recovery unless it prompts government to implement a fiscal stimulus by making public sector borrowing more attractive.

One doesn't have to think too much to see the relevance of these models to the period since the onset of the Great Recession.

As for contractionary monetary policy, the outcome is similar to the mainstream story in that investment can be curtailed as a result of the increased rate on government securities. However, as Stiglitz and Weiss, argue, "banks will often be unwilling to raise interest rates because of a fear that higher rates will have the adverse effect of chasing away credit-worthy borrowers and adverse incentive effect [of] inducing them to undertake greater risks". Instead, banks may opt to restrict the supply of loans, as in the diagram below.

So the point here is...

A basic principle in Keynesian economics is that no matter how dedicated unemployed workers are in their search for employment or how low the unemployed are willing to bid wages down, there are times when these actions are futile because jobs just are not available to meet the demand. The key insight of Keynesian credit models is similar, except that the crucial element is the insufficient supply of credit. In other words, this 'credit view' can be summarized as follows: often times the amount of loans is not sufficient to meet the demand for credit, regardless of the rate of interest.

To conclude, the main take away from this post is that the influence of interest rates (including the natural rate of interest) is often oversold, as the rate of interest may not be as important as it's often made out to be in the determination of aggregate demand.

The innovative aspect of credit-based Keynesian models was to shift the focus from money (as emphasized in monetarist models) and interest rates (as emphasized in traditional, old Keynesian models) towards elements such as the general degree of risk perceived by banks, both with regard to the default risk of potential borrowers and banks' expectations about future economic conditions. These are the key factors that influence the amount of credit supplied in the economy in credit-based Keynesian models.

* This blog post is dedicated to Joseph Stiglitz and Bruce Greenwald.

** Joseph Stiglitz & Bruce Greenwald (2003): "When a bank extends a loan, it creates a deposit account, increasing the supply of money."


Blinder, Alan. "Credit Rationing and Effective Supply Failures" in Macroecomics Under Debate, Ann Arbor, University o Michigan Press, 1992

Stiglitz, Joseph. and Bruce Greenwald, Toward a New Paradigm in Monetary Economics, 2003.

Monday 30 March 2015

Ben Bernanke and the natural rate of interest

From Professor Bernanke to Governor Bernanke to Chairman Bernanke to Ben Bernanke, Blogger. Quite the progression!

I enjoyed reading Ben Bernanke's blog post today. But it doesn't appear everyone thinks like me. I noticed some have criticized Bernanke for using the concept of the equilibrium (or natural) rate of interest, or the real rate of interest consistent with output at its potential level and with stable prices.

Now, I realize that the equilibrium real rate is unobservable and varies through time, which means it's subject to uncertainty. However, we could say the same thing about the concept of potential output, yet few would deny it is a useful concept.

In fact, most people are aware of the concept of "output gap", the difference between potential output and actual output. The corollary concept for the real interest rate is the "interest rate gap", the deviation of the actual policy rate from the real equilibrium rate.

This is essentially what Bernanke was driving at in his post today. Simply, the interest rate gap is a measure of the stance of monetary policy: a large (small) gap means monetary policy is loose (tight).

Back in the Keynesian era, policymakers used the concept of the "full employment surplus" (FES), or the budgetary surplus consistent with full employment, as a way to illustrate how the actual budget deficit wasn't being caused by a lack of tax revenue or out of control government spending but rather was caused by the weakness of the economy and the lack of output due to unemployed and idle resources. I view the interest rate gap in a similar way. Whereas the FES provided a useful measure of the stance of fiscal policy by highlighting the difference between the actual "surplus" (or negative surplus in the case of a deficit) and the FES, the interest rate gap provides a useful measure of the stance of monetary policy.

But don't get me wrong. In no way does any of this mean that central banks should be rigid in adjusting their policy rate to track the estimated equilibrium real rate.

As far as I'm concerned, central bankers should use their judgement and consider all information, not just their estimates of the real equilibrium rate and interest rate gap. For instance, if a central bank's estimate of the real equilibrium rate shows it is rising, yet inflation isn't, it may not be the right time to increase the policy rate.

Similarly, if a central bank's estimate of the equilibrium rate shows it is remaining stable, yet unemployment is rising, it may be entirely justified for the central bank to keep its policy rate at the same level or even to reduce it. I'm of the same view when it comes to the concept of the natural rate of unemployment: using it properly requires good judgement.

A final note on Bernanke's comment about how large deficits tend to increase the equilibrium real rate given that government borrowing diverts savings away from private investment. One thing I noticed is that Bernanke carefully added that this would occur "if everything else stays equal". In other words, this means he's not denying that a different (or even, opposite) effect could occur if other forces are at work.

For instance, the opposite effect could occur if budget deficits, by sustaining business activity, reduce default risk on corporate bonds and subsequently narrow the spread between the yields on corporate and government bonds, thus helping to reduce the cost of capital to the private sector. In such a scenario, budget deficits have effectively "crowded-in" private sector spending. I doubt Bernanke would deny that budget deficits could have such an effect.

Friday 20 March 2015

The Federal Reserve Bored

Paul Krugman points out possibly the biggest challenge to sensible, rational policy making and debating these days:
The Times has an interesting headline here: Richard Fisher, Often Wrong but Seldom Boring, Leaves the Fed. Because entertainment value is what we want from central bankers, right? I mean, Janet Yellen is such a drag — she just keeps being right about the economy, and that gets old really fast, you know?
It really is too bad that it's these 'entertainers' -- they range from the likes of Rick Santelli and Larry Kudlow to the establishment types like Fisher -- get such media attention. I mean, it's not like decent analysis doesn't exist, especially since the appearance of websites like Vox and the increased popularity of economics blogs.

Anyway, in other news, I've had very little time to blog these last few months but I intend to get back into it in earnest fairly shortly so stay tuned.

To follow me on Twitter, just look me up @circuit_FRB.

Sunday 23 November 2014

It's baaack: Paul's Japan paper (monetary policy and expectations in an era of low inflation) (trying not to be wonkish)

One of the ongoing debates in economic policy these days is the question of whether a central bank on its own can be effective at getting an economy out of the doldrums.

The most famous exposition of the idea that a central bank, by itself, has the ability to boost economic activity is Paul Krugman's paper entitled "It's baaack: Japan's Slump and the Return of the Liquidity Trap" (1998).

In the paper, Prof. Krugman explains that, in a (hypothetical) world of Ricardian equivalence in which fiscal policy has no effect on the real economy, the central bank can get households and firms to borrow and spend by announcing it will bring about higher inflation in the future.

Prof. Krugman knows that the assumption of Ricardian equivalence is far fetched and unrealistic; he only includes this simplifying and unrealistic assumption in his paper to make the point that the central bank can on its own stimulate the economy when fiscal policy is unavailable as a policy option (due to policymakers ideological aversion to public spending, the presence of high public debt, etc.).

Now before I go any further I want to say that I'm a huge fan of Paul Krugman. I think he's one of the most sensible economic commentators out there and I agree with almost all his views on policy. On the effectiveness of central banks alone to boost economic activity during a deep recession or depression, however, I'm quite skeptical.

The logic in Prof. Krugman's paper can be summarized as follows:
  • households and firms will borrow and spend if they expect higher inflation in the future;
  • borrowing and spending is influenced by the real interest rate (i.e., the nominal rate of interest less the expected rate of inflation); and 
  • a rise in expected inflation is for all intents and purposes equivalent to (i.e., has the same effect as) a fall in the real interest rate.
In other words, Prof. Krugman is saying that an increase in expected inflation of, say, three percent will have the same expansionary effect as a three percent cut in interest rates.

All this makes for a plausible story. However, things aren't as simple in the real world.

The problem is that Prof. Krugman's 1998 paper makes inflation a function of expected future inflation, as in the New Keynesian Philips curve (which, in passing, since it assumes no trade-off between inflation and output gap stabilization, is "neither Keynesian or a Philips curve", as Robert Solow once quipped).

In the real world -- and the evidence and the current state of economic activity seem to support this -- inflation is a function of backward-looking expectations: inflation displays significant inertia. Peoples' beliefs about expected inflation are based on past and present inflation. The notion that past inflation is irrelevant, as embodied in the New Keynesian Philips curve, seems to me implausible.

Prof. Krugman is aware of this criticism. Economists Robert Gordon, Alan Blinder and Martin Neil Baily all raised this point during the discussion that took place following the presentation of his paper. Here are the minutes that were recorded from that discussion:
Robert Gordon...criticized the assumption in Krugman's models that the monetary authorities can easily change inflationary expectations for the future -- that the announcement of a policy will change expectations despite present slack in the economy. He believed that agents' expectations depend largely on actual experience, and that they will experience increased inflation only when there is pressure in the markets for goods, services, and labor. Alan Blinder agreed. He thought that Krugman's inflationary policy would work if it could be implemented; but that would require the Bank of Japan to create expected inflation, which, in turn, would require persuading people that the future was going to be fundamentally different from the past. Japan had zero inflation in the past six years, and the average in the previous decade was 1.8 percent per year. Thus to create expected inflation of 4 percent, with actual inflation lagging behind, would be difficult.[Martin] Baily concurred, observing that it would be easy for Russia to be credible in announcing inflationary policy but hard for Japan. (Krugman, 1998:201)
True believers in the power of central banks will respond to this line of criticism by reverting to this old saw: a credible central bank would not have let inflation get too low in the first place, thus people's expectations would never had been unhinged as a consequence. To this, I say: wishful thinking!

When it comes to the role of expectations in explaining macroeconomic outcomes, Robert Solow warned that it should be used with caution (though Solow said this in a different context):
...[T]o rest the whole argument on expectations -- that all-purpose unobservable -- just stops rational discussion in its tracks. I agree that the expectations, beliefs, theories, and prejudices of market participants are all important determinants of what happens. The trouble is that there is no outcome or behavior pattern that cannot be explained by one or another drama starring expectations. Since none of us can measure expectations (whose?) we have a lot of freedom to write the scenario we happen to like today. Should I respond...by writing a different play, starring somewhat different expectations? No thanks, I'd rather look at the data. (Solow and Taylor, 1998:93)
The problem with economics and economic policymaking these days is that too much of it relies on monetary policy and the role of the central bank. There are limits to what central banks can do because people do not believe central banks are omnipotent and have the ability to control inflation expectations on demand. For this reason, Old Keynesians had it rightfiscal policy must be resorted to bring about normal economic activity.

To summarize: Inflation displays inertia and peoples' expectations about the future cannot be dictated by the central bank alone. Basically, inflation is the result of the interplay of supply of demand for goods and services. When you have more demand than supply, prices and inflation accelerate; when you have more supply than demand, prices and inflation decelerate. It's that simple. That's the secret to understanding what creates inflation, barring the effect of any bottleneck issues.

The central bank can have an impact on future inflation, but mainly as a result of its influence in affecting aggregate demand and real economic activity in the present and future, not as a result of its ability to affect expected inflation and overall expectations in general.

The ongoing low inflation affecting economies at present despite considerable monetary stimulus and the use of unconventional monetary policies such as forward guidance in countries such as the U.S., the U.K, and Japan is evidence that expected inflation relies on past and actual inflation and that central banks' ability to stimulate economies at present via the so-called expectations channel or by attempting to increase expected inflation is currently severely limited.*

To follow me on Twitter, just look me up @circuit_FRB.


Solow, Robert, and John Tayor, Inflation, Unemployment and Monetary Policy, (MIT Press: Cambridge MA), 1998

Krugman, Paul. It's Baaack: "Japan's Slump and the Return of the Liquidity Trap", Brookings Papers on Economic Activity, 2:1998

* This post is dedicated to my heroes in macroeconomics: Robert Solow, Alan Blinder, Robert Gordon, Martin Neil Baily and Paul Krugman, to whom I owe so much for their insights