A Missing Macroeconomic Playbook? - Grasping Reality with Both Hands
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Grasping Reality with Both Hands The Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-Handed Department of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.
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A Missing Macroeconomic Playbook? I am reminded of the extraordinary gulf between economics as I see it and economics as at least some others see it when I read things like Narayana Kocherlakota's opening paragrapb: Modern Macroeconomic Models as Tools for Economic Policy: I believe that during the last financial crisis, macroeconomists (and I include myself among them) failed the country, and indeed the world. In September 2008, central bankers were in desperate need of a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances. Macroeconomics should have been able to provide that playbook. It could not. Of course, from a longer view, macroeconomists let policymakers down much earlier, because they did not provide policymakers with rules to avoid the circumstances that led to the global financial meltdown... My reaction to this is the old one: "Huh?!" For "macroeconomics" did and does have a playbook that offered a systematic plan of attack to deal with fast-evolving circumstances. The playbook was first drafted back in 1825, during the bursting of Britain's canal bubble. Let me briefly set out what the macro playbook is, and how it has been developed by economists and policymakers over the past 185 years. Start with Say's or Walras's Law: the circular flow principle that everybody's expenditure is someone else's income-ands everyone's income is somebody else's expenditure. It has to be that way: for every buyer there is a seller: and for every seller who is disappointed because they sell for less than their cost plus normal profit because of excess supply there must be another who is exuberant from selling at more than cost plus normal profit. How, then, can you have a depression--a "general glut," a situation in which there is excess supply of not one or a few but all commodity goods and services? How can you have a situation in which workers laid off from shrinking industries where demand is less than was expected and thus less than supply are not rapidly hired into industries where demand is more than was expected and hence more than supply? Moral philosopher, libertarian, colonial bureaucrat, feminist, public intellectual, and economist John Stuart Mill put his finger on the answer in a piece he published in 1844: [T]hose who have... affirmed that there was an excess of all commodities, never pretended that money was one of these commodities.... [P]ersons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute. In extreme cases, money is collected in masses, and hoarded; in the milder cases, people merely defer parting with their money, or coming under any new engagements to part with it. But the result is, that all commodities fall in price, or become unsaleable... Mill was thus explicitly refuting the older French economist Jean-Baptiste Say. Say had been well-embarked on a career in politics and government in the new French Republic of the early 1790s 1990s: special assistant to Gironde Party Secretary of the Treasury Clavier. But then Clavier fell: purged, arrested, imprisoned, and executed by Robespierre's "Mountain" faction. Somehow Say escaped the wreck with not just his life but his liberty and some property as well, and set out to pursue happiness by withdrawing from politics to write treatises on economic theory. In 1821 Say published his Letters to Mr. Malthus, in which he argued that the very idea of a "general glut" was self-contradictory, for the very fact that commodities had been produced meant that there was sufficient demand in aggregate to buy them: [W]e do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own.... it is impossible... to buy any articles whatever to a greater amount than that which they have produced.... Thence follows... that if certain goods remain unsold, it is because other goods are not produced; and that it is production alone which opens markets.... [W]henever there is a glut, a superabundance, of several sorts of merchandize, it is because other articles are not produced in sufficient quantities http://delong.typepad.com/sdj/2010/05/a-missing-macroeconomic-playbook.html
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glut, a superabundance, of several sorts of merchandize, it is because other articles are not produced in sufficient quantities to be exchanged for the former... the superabundance of goods of one description arises from the deficiency of goods of another description. Say was thus the first of a long line of economists to argue that the fact that something that appeared to exist in reality could not really be there because it was inconsistent with his theory. In a normal microeconomic case of market adjustment--excess supply of one good and excess demand for another--it is clear how adjustment proceeds. Those entrepreneurs making the good in excess supply find themselves selling for less than their costs and so losing money. They cut back on the wages they pay and dismiss workers. But this is not a tragedy, because the profits they have lost have gone into the pockets of entrepreneurs in expanding industries, who are eager to expand production, raise wages, and hire more workers. After a short time the structure of production is better-suited to make what people want, and wages and profits in total are higher than if the structure of production had remained frozen in its old pattern. But what if there is a general glut of commodities? What if the excess supply is for pretty much all goods and services, and the excess demand is for liquid cash or for safe investments that will not lose their value no matter what? How do you expand labor employed in the liquid cash-creating or in the AAA asset-creating businesses to make more of such assets? One possibility is to rely on the private sector, saying: risky assets are at a discount and safe assets a premium? Good! Make the profits from creating safe assets large enough, and Goldman Sachs and company will find a way. They will raise some capital willing to run large risks for large returns. They will hire people to shuffle the papers. They will finance enterprises, and then slice and dice the cash flows from those enterprises in order to create lots of AAA-rated securities. And when they do, the excess demand for safe assets will be satisfied, and that will by Walras's Law erase the excess supply of goods and services, and unemployment will return to normal. Oh. You say nobody trusts Goldman Sachs or Standard and Poor's when they say: "we know we lied last time when we warranted that the assets we were selling were AAA, but this time for sure!!"? Well, how about investing abroad? There are still lots of AAA assets out there in the wider world. Suppose everybody devalues, puts people to work in newly-competitive export industries, and thus runs an export surplus and, in exchange, imports AAA assets from abroad for our savers and investors to hold. Oh. I see. Everybody can't devalue at once. Greece can run an export surplus only if Germany is willing to run an import surplus. The United States can boost its net exports only if China shrinks its own. Maybe we could ship millions of our citizens to South Africa equipped with picks and shovels and put them to work as gastarbeiteren mining the gold of the Witwatersrand? I know! Let's cut the price of every good and service by 25%! then our same stock of nominal AAA assets will meet a 33% larger demand for real AAA assets, and there will be no excess demand for safe assets, and thus no excess supply of goods and services! The problem with this "solution" is that "money" is not just a medium of exchange and a store of value, it is also a unit of account. Suppose that a 33% increase in the real supply of genuine AAA assets would fix the problem, and suppose we do succeed in cutting all goods and services prices and wages by 25%. Have we then fixed the problem? No. A lot of people have debts denominated in money and were counting on selling their goods and their labor at something like their previous prices to pay off their mortgages, their loans, and their bonds. A whole bunch of assets that were AAA before the decline in the price level are no longer AAA. You haven't fixed the imbalance. Each nominal AAA asset does indeed satisfy a larger slice of demand for real AAA assets as a result of the price-level decline. But the price level decline has shrunk the (nominal) supply of AAA assets just as it has shrunk the (nominal) demand for them. And how have you managed to reduce nominal wages and prices? By years if not decades of idle capacity and high unemployment. Oh. So now--drumroll--it is time to pull the rabbit out of the hat. The solution is... the government! The government has the power to tax! And so the government can make AAA assets when nobody else can! Or the government can until and unless the assets that it has created for others to hold--which are its debts--rise to the point where people begin to get nervous about whether the government's taxing power will actually be deployed in the end to repay those debts--and we in the United States are still very far from that point (although we in Greece are not). The first and easiest way for the government to create more safe assets is for the central bank to create them by buying up risky assets for safe ones via open-market operations or lending cash and taking other, riskier assets as its sole security. As Walter Bagehot wrote about the Panic of 1825: The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. 'We lent it,' said Mr. Harman... [one of the Directors] of the Bank of England: by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power... Since the fall of 2007 the central banks and the Treasuries of the world have been following this playbook. They have expanded the supply of safe assets via open-market operations, pumping out cash for the private sector to hold and in return accepting duration and interest-rate risk. They have topped up bank capital. They have guaranteed private-sector loans. They have http://delong.typepad.com/sdj/2010/05/a-missing-macroeconomic-playbook.html
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duration and interest-rate risk. They have topped up bank capital. They have guaranteed private-sector loans. They have swapped in risky private-sector debt in exchange for government bonds. They have--via expansionary fiscal policy--printed up huge honking additional tranches of government bonds and used the money raised to pull forward government spending and push back taxes. Now it may be that we are creeping up on the point at which government debts are rising to the limits of politically-limited debt capacity. But that does not mean that the playbook comes to an end. Indeed, Ricardo Caballero is writing a new chapter about how even now governments can go on: expanding the real supply of AAA assets.... [So far] governments in safe-asset-producing countries [have] produce[d] a lot more of them.... [We could also] let the private sector create the AAA assets... [with] governments... absorb[ing]... risk the private sector cannot handle... extreme systemic events... compounded by panic. Currently the focus (implicitly) is [still] on the former strategy. Indeed, funding fiscal deficits is very inexpensive these days‌ as long as one remains within the safeasset-producer category. However... at some point it will make sense to decouple fiscal deficits from asset production.... The US Treasury... [could] start buying riskier private assets rather than running fiscal deficits as the counterpart for its supply of Treasuries to the market.... [A] sounder medium-term strategy than the purely public approach... [is to use] the securitisation industry..... The private sector is much more efficient than the government in producing micro-AAA assets, but the opposite is true for macro-AAA asset production.... [I]f the government only provides an explicit insurance against systemic events to the micro-AAA assets produced by the private sector, we could have a significant expansion in the supply of safe assets without the corresponding expansion of public debt... by formalizing and making explicit what Charles Kindleberger always called their commitment to act as lender of last resort when systemic risk came calling. The playbook is old and well-established, and has been put to effective use. That Narayana Kocherlakota and company did not know it existed--that he and his circle had never studied Kindleberger and Minsky, let alone Fisher and agehot and Mill, and knew Keynes and Hicks only as straw men to be ritually denounced as sources of error rather than smart people to be listened to--will doubtless appear to future generations as an interesting episode in the history of political economy. But nobody should confuse the failure of Kocherlakota's branch of macroeconomics with the failure of macroeconomics in general. Brad DeLong on May 29, 2010 at 10:18 AM in Economics, Economics: Economists, Economics: Federal Reserve, Economics: Finance, Economics: Fiscal Policy, Economics: History, Economics: Macro | Permalink Favorite
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Comments Nick Rowe said... Wouldn't it be simpler to spread the rumour that holding government bonds and money would give you cooties? Or, in other words, won't the problem that fiscal policy is designed to solve itself disappear when the government hits the limits of its noninflationary fiscal capacity? (My previous comment, posted on the Group of 30 thread, would apply equally here.) Reply May 29, 2010 at 11:28 AM Luis Enrique said... Prof De Long Can you point to the theoretical model that you think best encapsulates this story, or is it still yet to be written? Reply May 29, 2010 at 11:29 AM Luis Enrique said... Sorry, I should add, I don't mean a model in which "fiscal stimulus works" I mean a model that has demand for safe assets etc. ... all the elements needed to fill out the playbook. (and, further to Nick above, besides "won't the the problem ... disappear when the government hits the limits of its noninflationary fiscal capacity", doesn't keep-printing-and-handing-out-money until we get inflation amount to the same thing?) Reply May 29, 2010 at 11:35 AM Robert Waldmann said... There is one to many that in that which you say about Say "Say was thus the first of a long line of economists to argue that the fact that something that appeared to exist in reality could not really be there because it was inconsistent with his theory." should be "Say was thus the first of a long line of economists to http://delong.typepad.com/sdj/2010/05/a-missing-macroeconomic-playbook.html
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not really be there because it was inconsistent with his theory." should be "Say was thus the first of a long line of economists to argue that ... something that appeared to exist in reality could not really be there because it was inconsistent with his theory." without the .... I'd mention Bernanke. He was an academic economist who could have given excellent advice to the chairman of the Fed, except for the fact that he was the chairman of the Fed. Notably he showed no sign of hesitation or confusion totally dwarfing the efforts of his cross the pond predicessor in 1825. Also notably we are not in Great Depression II. It is very impressive that Kocherlakota is so sure that you (and Krugman and Summers and his superior Bernanke) don't exist, that he says that macroeconics was clueless. I am not convince by Caballero's last proposal. I don't know what "micro-AAA" could possibly mean. AAA has a clear meaning and that junk was not AAA. Insuring against macro events is a guarantee that they will occur again. The key feature of the FDIC (and the resolution authority to be) that prevents gross moral hazard is the requirement that shareholders get zero. The Treasury writing CDSs on junk is not a good idea. On the other hand, I think that it would be an excellent idea for the Treasury to buy risky assets. Given the Treasury rate, it would make a killing in expected value at no cost to anyone (I mean buying not requisitioning). What ?!? Am I say the Treasury should act as if it is risk neutral ? That's not the half of it (OK it's about the half of it). The Treasury should seek to bear macro risk. That's what we call a new automatic stabilizer and they work. The result of the risk loving Treasury would be automatic deficits in recessions. Do you have a problem with that ? This is a multi trillion better than sure thing (better as the Treasury should love to bear macro risk). Reply May 29, 2010 at 01:09 PM kid bitzer said... "Say had been well-embarked on a career in politics and government in the new French Republic of the early 1990s:" i'm thinking that should by 1790s, except in alt-history sci-fi novels. Reply May 29, 2010 at 02:08 PM Richard H. Serlin said... "But what if there is a general glut of commodities? What if the excess supply is for pretty much all goods and services, and the excess demand is for liquid cash or for safe investments that will not lose their value no matter what?" Ok, I'd like to make this more clear and concrete: – There's an excess supply of services. So, for example, AT THE CURRENT WAGE, some workers are willing to supply more labor than the market will purchase AT THAT WAGE. Thus, we have excess supply of labor. The labor market is not clearing at that wage (that price of labor). – At the same time (or conversely), there's an excess demand for money. Using the same example, at the current price of money per labor hour, workers are demanding to purchase more money with their labor than the market will supply. Thus, we have excess demand for money. The money market is not clearing at that price (that price of money in hours of labor). Why don't prices just adjust to clear both markets? One reason is that prices are sticky. Wages tend to be fixed for periods of a year or more and workers really resist nominal wage cuts (but far less real ones). Another is that the supply of money being offered in the market is not fixed. As wages drop, so does the amount of money being offered in the market (workers who are unemployed spend less). There is the real balances argument, but that would take a massive drop in the price level, which might take decades of misery. If prices changed at light speed, like in a model, with disruption effects assumed away, then you might almost instantly see prices adjust so low that people with even what was a tiny amount of savings are now super rich, and so they start buying like crazy which stimulates the economy (people who had debt would now be hopelessly in debt, but they could end this debt with what would now be the only realistic option, bankruptcy). Ok, I will now continue reading the post. I'd like to say, though, that Brad DeLong often is an outstanding teacher. He's a rare source of certain intuitions. I also really liked his recent post on naked CDS's, and hope to comment on it. Reply May 29, 2010 at 02:32 PM Richard H. Serlin said... Oh, actually I thought I was putting that comment in Economist's Veiw, thus the third person reference. Anyway hope you like it. Reply May 29, 2010 at 02:35 PM Jeffrey Deutsch said... Hello, I'm just a little bit confused here. I'm trying to figure out how increasing the amount of nominal and real AAA assets will help the economy, including in the face of a general glut such as Professor DeLong describes. People are offering things for whatever price they can get, in the face of markets full of people increasingly reluctant to buy. That's supposedly because people have greater and greater demands for money and similarly safe stores of value. If I understand the situation correctly, AAA assets, like government bonds, are simply one more thing to spend money on. So if the government puts out that many more bonds, people will be no more interested in buying actual goods and service sthen before, because instead of stuffing the cash in the (metaphorical) mattress they'll buy Treasury bills with it. Same need to sell at all costs, same reluctance to buy. Now, I do understand that if people have a high demand for AAA assets, they'll snap up Treasury bills and thus interest rates will stay low. That will help stimulate investment (unless we're in a liquidity trap because producers are too afraid to invest in http://delong.typepad.com/sdj/2010/05/a-missing-macroeconomic-playbook.html
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will stay low. That will help stimulate investment (unless we're in a liquidity trap because producers are too afraid to invest in anything but T-bills and the like) and also help the government finance expansionary fiscal policy (eg, stimulus packages). If that comes to pass, great. However, I fail to see the value to the economy from extra AAA assets *per se*. Also, I see a good case here for expansionary monetary policy itself - including the government *buying*, not selling, bonds, since if people's increased demands for money can be exogenously satisfied that may translate into higher aggregate demands for goods and services - that is, higher output and employment. But that means supplying more money, not more AAA assets that absorb money. The closest thing I can see to extra AAA assets' in themselves adding value is if the government thereby bolstered firms' and individuals' balance sheets (by swapping good assets for toxic ones). The wealth effects can enable more spending and less net paying off debt, which means more money in the real sectors and less in the financial sectors, and thus more aggregate demand and more output and employment. Even if that's the case, beyond that I'm having trouble grasping the value of enhancing people's AAA assets. Could you help me out here, please? Thank you! Cheers, Jeff Deutsch Reply May 29, 2010 at 02:40 PM christofay said... "The playbook is old and well-established, and has been put to effective use." Put to good use rescuing the oligopoly. The benefits of which are supposed to trickle down to the general populance. It's just taking its time. At present the bulk of the nation says it's still recession. What's all this triple AAA asset stuff? At present we should know that not all triple AAA assets are triple AAA assets. Reply May 29, 2010 at 05:41 PM CMike said... Brad DeLong writes, ********************************* Since the fall of 2007 the central banks and the Treasuries of the world have been following this playbook. They have expanded the supply of safe assets via open-market operations, pumping out cash for the private sector to hold and in return accepting duration and interest-rate risk. They have topped up bank capital. They have guaranteed private-sector loans. They have swapped in risky private-sector debt in exchange for government bonds. They have--via expansionary fiscal policy--printed up huge honking additional tranches of government bonds and used the money raised to pull forward government spending and push back taxes. Now it may be that we are creeping up on the point at which government debts are rising to the limits of politically-limited debt capacity. But that does not mean that the playbook comes to an end. Indeed, Ricardo Caballero is writing a new chapter about how even now governments can go on. ********************************** Caballero writes: ********************************** However... at some point it will make sense to decouple fiscal deficits from asset production.... The US Treasury... [could] start buying riskier private assets rather than running fiscal deficits as the counterpart for its supply of Treasuries to the market.... [A] sounder medium-term strategy than the purely public approach... [is to use] the securitisation industry..... The private sector is much more efficient than the government in producing micro-AAA assets, but the opposite is true for macro-AAA asset production.... [I]f the government only provides an explicit insurance against systemic events to the micro-AAA assets produced by the private sector, we could have a significant expansion in the supply of safe assets without the corresponding expansion of public debt... ********************************** Instead of expanding and propping up the public and private bond [and equity] markets, the U.S.'s central bank should be propping up the labor and other Main Street markets directly by gifting the U. S. Treasury dollar credits which Treasury can then use for stimulative spending without increasing the national debt. The Federal Reserve should provide the Treasury with these free money credits until there is evidence the resultant Treasury spending is creating an unacceptable inflation rate. The Fed can balance these new liabilities from the give away by marking the asset side of its ledger with entries for "good will," "improved economic outlook," and "doing the right thing" totaling an equal valuation. Now, of course, the spokespeople for the bond market and those of the other finance markets would squeal about such Fed action but on what grounds? Until there are signs of an inflation rate greater than whatever was Alan Greenspan's target rate arising from the granting of such credits, on what basis would the bond holders gripe? Now gripe they would, but their argument would boil down to their having the heartfelt conviction that they're entitled to a windfall from high unemployment rates every now and again. Reply May 29, 2010 at 07:31 PM Jeff V said... "Say was thus the first of a long line of economists to argue that the fact that something that appeared to exist in reality could not really be there because it was inconsistent with his theory." This pretty much covers PhD economics* as I experienced it.
http://delong.typepad.com/sdj/2010/05/a-missing-macroeconomic-playbook.html
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"that he and his circle had never studied Kindleberger and Minsky, let alone Fisher and agehot and Mill, and knew Keynes and Hicks only as straw men to be ritually denounced as sources of error rather than smart people to be listened to" I spent a year in a PhD program, and never heard any of these names.... I only knew them from my reading BEFORE I entered the program at Wisconsin. I expected the PhD to broaden my knowledge; instead, if I had taken it to heart, it would have made me dumber. - Jeff V * I just say "economics", since I fail to see the big difference between micro and macro. Reply May 29, 2010 at 07:57 PM RSJ said... How to explain Japan? Hasn't the government created "enough" AAA assets? Do they still need to create more? I think there is an automatic identification of a financial panic with a debt-deflationary episode. The two are different beasts, although financial panics typically mark "peak debt" -- the point at which the business sector is no longer able to count on ever-increasing infusions of non-wage income. Citing examples of financial panics easily solved by the "heavy artillery" of government portfolio shifts obscures the real challenge before us -- challenges to do with purchasing power and growing household indebtedness. Just once, I would love to hear Brad discuss why 1907 was so brief but 1929 was not, or why Japan has been unable to improve NGDP for 20 years, whereas Korea sailed right out of the East Asian FInancial Crisis. Perhaps the difference has something to do with this chart: http://2.bp.blogspot.com/_fevQMK7kLEI/S6V8x6a38MI/AAAAAAAAAK0/QJAcMjeCFO8/s1600-h/earnings_evolution.png Reply May 29, 2010 at 08:15 PM RSJ said... And I don't mean to be a party-pooper, but the Federal Reserve is not authorized to buy any debt not guaranteed by the USG. It would take an act of congress to have the Fed start purchasing risky assets. In "emergency situations", the Fed is authorized to act as a lender of last resort, and it has done that, accepting risky assets as collateral, but that is different from purchasing the risky assets outright. Of course, buying a risky asset in the secondary market is not the same as "lending" to the issuer of the debt. And yes, this does mean that the agency purchase program is illegal, and would most likely not survive a court challenge, but no one cares. In any case, Congress could officially guarantee the Agency debt if it came to that. Reply May 29, 2010 at 08:29 PM George J. Georganas said... Japan is truly an one-word refutation of the argument of Professor Delong. Plus, the fact that the signal for the government to start buying excess assets is rarely clear. When exactly should the government have started buying distressed real estate ? What if the prices were truly excessive? Who would judge the right level etc ? Plus, open world capital markets would, also, defeat the programme of government purchases of assets by allowing private parties to load assets held abroad on the government's balance sheet. So the argument leads to capital controls, with the all the attendant abuses. If anything, the article of Professor Delong reinforces the view that macroeconomics needs a new fundamental story to tell. Professor Delong sounds much like those deniers of Keynes of old who argued that it was enough to read Marshall properly. From the point of view of logical validity, why should one postulate the decreased willingness of investors to hold non-liquid assets (saltwater macroeconomics), while denying a shift in worker preferences in favour of more leisure (freshwater macroeconomics) ? They are both equally unconvincing. Reply May 29, 2010 at 09:57 PM RSJ said... Exactly. The continuous false diagnosis of what has happened to the U.S. as just a financial panic is depressing. As a student of history, Brad should be able to distinguish between a financial panic a la 1907 and debt deflation a la Minsky. They are different phenomena. One can be solve with some monetary fiddling while the other requires structural changes. This is the lesson that Japan has failed to learn, and which has flown right over Brad's head. To him, everything is just an irrational panic, and the concept that declining wage shares and unsustainable household borrowing may cause deflationary forces outside of any financial market irrationality flies right over his head. For one, I am tired of hearing financial panics of the 19th century cited as antidotes, while the depressions of the same era are completely ignored -- and not even understood. Reply May 30, 2010 at 01:36 AM pireader said... Professor DeLong -In support of your post ... For the past 20 years, I've nurtured an ongoing perplexity at the intellectual obstinacy of the freshwater macro guys [and, of course, the Austrians].
http://delong.typepad.com/sdj/2010/05/a-missing-macroeconomic-playbook.html
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They hold such strong intuitions about how the world works that they simply cannot accept everyday realities that cut against those intuitions. In particular, they cannot accept the reality of involuntary unemployment. It's sad really. They genuinely are some of our smartest people. Reply May 30, 2010 at 04:33 AM Neal said... The idea that there are no limits to an activity (creating AAA securities) is absurd. Moody;s clearly state recently that when the interest payment on the debt reaches 20% of fdera; revenue the debt would be downgrades. A real, practical limit. Two scenarios: * a continuing low interest rate environment--in other words, the economy sucks. Trillions more in new debt can be issued over many years due to the almost zero interest costs in borrowing that money. But is that limit truly way out there in time, or is there a possibility that the absurd charade of handing money to the US Treasury for no return other than a return of the original sum will lose it's attraction due to the asking of the simple question, "But why??". Second, in a prolonged period of bad economy with presumably most of the major purchasers facing the same economic hardships as the US, will there be the same pool of money or will governments be less willing to roll over vast sums, let alone purchase new securities with money they will presumably be pushed to expend in other directions? * a rising interest rate environment. The economy is improving in the rest of the world or in the US. Normal borrowing patterns arise and more normal interest rates return. The limit to creating AAA securities comes very fast with a few percentage points increase in interest (20% of income spent on interest). Because the US has tried to maximize borrowing at minimum cost, the borrowing has moved to shorter and shorter duration--the shortest in the OECD countries at 4.4 years. Improvements over a couple of years impinge rapidly on the limits of AAA securities and provide a significant headwind just when the economy needs additional nurturing. What kind of extraordinary recovery would be required for the economy, in a couple years, to go from massive borrowing to elimination of an almost 10% structural deficit and maintain that recovery? The limit then is to allow enough room for borrowing in a future higher interest rate environment so that an immaculate, sharp V_shaped recovery is not the only scenario under which a durable recovery is possible. There are limits--how much paint do we want to lay down now and still leave viable options to exit this recovery. Reply May 30, 2010 at 06:15 AM Peter T said... I think the governing assumption here is that money is a store of value in a direct relationship to actual goods and services. If this were so, increasing the supply of money would increase the supply of goods and services - or, if that did not happen, lead to inflation (devaluation of money relative to goods). The empirical evidence for both propositions is weak. In fact, money is a promise, and the key issue when - as now - there is a very large overhang of unrealisable "promises" is who does not get paid (hence the flight to quality). In this case, the promises seem to have been promises about promises (and promises about promises about promises...) financial engineering. Which raises the issue of what goods and services actually relate to the promises in circulation. The experience of 1825 is useful, but may not apply as a general model. The 1930s depression only ended when governments bought very large amounts of real goods and services and trained very large numbers of people in new trades and skills - in fact re-made the economy. Which suggests the underlying problem was a mismatch between what and how things were made and who wanted them/could afford them. Would the US really benefit from more financial engineering of the sort that produced 40% of profits in the years before the crash? If it (and the UK) are to shrink the financial sector, what is to replace it? Reply May 30, 2010 at 07:04 AM stunney said... I remember discussing Say's Law 20 years ago in, funnily enough, Berkeley with a Spanish friend. We were both pursuing graduate studies at the time, though neither of us in economics. We both agreed and took it for granted that said Law was obviously wrong and had long since been refuted and shown to rest on an obvious fallacy. Maybe this was only true in Berkeley, however---hence Professor deLong's evident bemusement upon learning that there are tenured economics professors elsewhere who remain in thrall to the fallacious Frenchman. Reply May 30, 2010 at 09:47 PM Jon said... Thanks for this post. Speaking as someone whose economic intuitions were formed in a very freshwater institution, I've had a lot of trouble "grokking" arguments made by more saltwater economists. Your description here really clarified the concept of an aggregate demand shortfall, which I've always found very confusing. One question though -- if the problem is a shortage of bonds, why aren't private companies jumping at the opportunity to issue bonds and other instruments at very low interest rates? Are the economies of scale in bond issuance so great that only the government is able to issue bonds at near-zero rates? Is there just too little demand for new investment to make it worthwhile for firms to borrow at any rate? Or is it something else? Reply May 31, 2010 at 09:17 AM Comment below or sign in with
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