Austerity Is Good for the Soul

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

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

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

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

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

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

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

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

Where Do the Rich Get Their Money, Again?

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

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

Sorry, that is not a rich person.

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

From the IRS Statistics of Income for 2010:

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

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

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

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

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

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

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

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

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

"Recession Is a Time of Harvest"

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

Deleveraging by Default

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

So: why do I like this paper so much?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Capitalist Wants an Exit, Short Fiction Edition

    "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.

When Do Profits Count?

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.

What Is Business Borrowing For?

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.

from Hubbard, Fazzari and Petersen (1988)

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.

Arjun Presents Our Work in Berlin

I only just realized that this exists.

Did We Have a Crisis Because Deficits Were Too Small?

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...

And here is another, from an impeccably mainstream author:

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.