Sunday, March 18, 2012

How can debt affect GDP?


Via Tyler Cowen, I just saw this from Felix Salmon:

 
There’s a whole narrative in this chart. From 1970 through the beginning of the crisis in 2008, GDP grew at a pretty steady pace. But the amount of debt required to generate that output just got bigger and bigger — the rate of growth of the credit market was much faster than the rate of growth of GDP...
In other words, in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt... 
It makes sense that if we needed ever-increasing amounts of debt to keep up that long-term GDP growth rate, then when the growth of the debt market stops, our potential growth rate might fall significantly... 
[W]e might indeed have to resign ourselves to lower potential growth going fowards. If only because we’re taking ourselves off the artificial stimulant of ever-accelerating credit.
I have one problem with this, and one question.

The problem is this: The way Salmon talks about debt, and debt's effect on GDP, seems to reinforce a common quasi-fallacy in pop economics - the idea that debt can create temporary but "fake" or "artificial" growth.

As Paul Krugman is fond of pointing out, the economy is not like a household. A household can temporarily increase its consumption by borrowing money. But how can a nation artificially increase its maximum possible production by borrowing money? A nation's total productive capacity is determined by things like how many workers it has, how good their skills are, how much physical capital it has, what kind of production technologies it has, etc. How can borrowing money increase any of these things?

Now, as it turns out, there are ways this could happen to a small degree. People can work overtime. Machines can be operated for more hours, at the cost of wear and tear. These things will temporarily increase total production. And maybe debt could give people an incentive to work overtime and to wear out their machines (especially if people repeatedly make mistakes about how likely the debt is to be paid back). But these things aren't very sustainable. Capital will wear itself out. People will probably burn out. Even if you believe that exponentially increasing debt could force us to overwork ourselves and our capital for 40 years, you'd be right to doubt whether we could keep it up for that long. And even if we could, the effect would only be marginal.

So, to reiterate: Production is not consumption, and a nation is not a household. The idea of debt as an "artificial stimulant" that allows us to juice GDP has big problems, since potential GDP is determined by real factors of production. I'm not sure if Felix Salmon is buying into the quasi-fallacy, or just using unfortunate language that brings it to mind (I suspect the latter).

Now on to my question: How can debt affect potential GDP in the long run? Salmon's thesis is, basically, that the collapse of credit markets will permanently lower our potential (i.e. maximum possible) level of GDP. How can this be true?

It's clearly possible for dysfunctional credit markets to lower potential GDP in the short run. Financial intermediation (matching of borrowers and lenders) is a kind of technology, and if this technology is malfunctioning, that means our economy isn't capable of producing as much as it could if credit markets were functioning well. No surprises there.

But do we expect a credit crisis to destroy financial intermediation forever? It seems unlikely. And if financial intermediation recovers, how will the impact of the credit collapse be permanent? After all, long-term output is just determined by technology, right?

Now, you could invoke an endogenous growth model, and say: "During the time we spent recovering from the credit crisis, we were unable to invest in researching new technologies, so our technology level stayed on a permanently lower path." Fine. But in that case, we'd expect a small open economy to recover from a credit crisis, since most technology would come to that country from outside. Yet Greg Ip finds that slow recoveries from credit collapses are common in countries like Sweden, even when the rest of the world is doing fine. So endogenous growth does not seem to be the story here.

An alternative story is this: "Technology," defined as long-term productivity levels, is a complex phenomenon, driven as much by the arrangement of economic institutions and relationships as by the stock of human knowledge. This is an "Austrian" or "PSST" story, and one that requires multiple long-run equilibria. But if something like this is going on, it means that a credit collapse might be able to permanently bend the shape of our economic network into a less efficient pattern.

I'm willing to entertain this notion in principle. File this with the rest of complex-systems theory, under "needs a lot more research". (And, just for fun, note that Tyler Cowen might think twice about accepting this kind of explanation, since it directly challenges his "Great Stagnation" hypothesis...if productivity is a function of economic relationship networks instead of just knowledge, then our stagnation could just be due to dysfunctional institutions and arrangements, rather than a slowing of technological progress.)

Anyway, to sum up this post: It seems clear to the average layperson (and it once seemed clear to me) that debt just feeds directly into GDP. But actually, this is not true. We need to think carefully about how debt could boost actual GDP during a boom, and how it could boost potential GDP in the long run. Neither effect is simple or obvious.


Update: Tim Duy says some similar things. Greg Ip, echoing JW Mason and other commenters on this post, suggests hysteresis as the explanation for the interaction between debt-fueled demand and long-run supply.

51 comments:

  1. Anonymous1:09 PM

    If we brrow $1 from another country in period t and spend 51 cents on domestically-produced goods/services, will not debt have fueled an increase in period t GDP?

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  2. Anonymous1:11 PM

    Actually, after re-reading thenpost carefully, i see im off point here.

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  3. Anonymous1:15 PM

    So a thing to think about is inequality (this is an argument I've seen somewhere). We know that high income save more than low --- so if some moderately slow-moving structural change (say routinization) is shifting income to high earners and away from middle income earners (polarization), consumption would be falling but for an increase in debt (say facilitated by an asset bubble). Long run -- not sure what that is, but we get a big capital misallocation (and artificial prop) now. --Jeff

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  4. Excellent Question, but your explanation strikes me as too narrow.

    First, as to the expansion of debt, I assume you agree that an increase in “debt,” arising from the creation of new “money” by fractional reserve banking is necessary for the economy to grow. However, we have far more borrowing (what I would call Minsky/Keen speculation) than was needed to finance growth. So I assume you are not saying that all debt is bad but are instead saying a lot, a whole lot of the recent debt was bad.

    You offer the hypothesis that things are not working because “productivity is a function of economic relationship networks instead of just knowledge.” Isn’t this is a minimal condition?

    Productivity also includes the vision of the people: their morale, confidence, or (pick your word). Outcomes are different if people see the glass half full or half empty. If you look at the United States, since 1970 we have:
    Nixon Vietnam---most stupid war in history fought and lost. Vietnam, today, is a site location for Nike factories, which it would have been had we won

    Carter---? and ? failure on energy price control---DOE over 35 years old and we are no closer to energy dependence or stable prices than when we started

    Reagan---tax cuts and record spending assure deficits (and hence disinvestment by business)

    Bush I---thousands of lenders closed by gov’t, rationing credit

    Clinton---brief period of sanity, domestically, but insanity with NAFTA

    Bush II---Reagan tax cuts and deficits on steroids plus three wars lost (the war of 9/11, the Iraq War, and now Afghanistan). 5 millions mfg. jobs lost amid closure of 50,000 mfg. plants.

    Obama---Republicans set out to destroy any effective institution in society, including forcing default on national debt

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  5. I don´t know what idea of debt you manage, but I´d say that debt is always an asset for other (yhe important thing is the productivity of net debt), and that the tendency for financial growth stronger than GDP could be quite natural in the long term. I suppose that if you include some century ago, you get no financing wheight in production.

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  6. Scott Bremner2:51 PM

    The divergence started at the time of Reagan's presidency. This suggests the necessity of borrowing over income. The acceleration of borrowing occurs as the incomes stagnate while prices continue to rise.

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  7. I take these propositions to be true:
    1) modern society is marked by the accumulation and deployment of capital (we should expect a rising capital to gdp ratio)
    2) someone "owns" the debt and it represents their capital
    3) broad economic forces have resulted in capital being increasingly channeled through public markets
    4) modern financial products result in multiple layers of inter-mediation resulting in double counting of debt (There was a time when A would lend money to B, now A lends to B who lends to C who lends to D etc resulting in much more apparent debt)
    5) the tax system encourages debt rather than equity financing

    Debt vs. equity is a choice about how we channel capital from investors to investments. The problem with debt over equity is that it can result in unstable financial systems.

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  8. Anonymous3:46 PM

    The flaw is in your thinking that using a production function to calculate potential gdp makes any sense in a world saturated with productive capacity and billions of slave-wage laborers. Who's gonna purchase all that potential output ?

    Borrowing by consumers in the advanced economies could support that Ponzi "potential" economy for a time , but that time has now past.

    What economists in 1988 or 1989 using conventional thinking about potential gdp would have predicted the post-1990 Japan gdp trajectory ? Japan's struggle to maintain growth has included fiscal and monetary pumps , and they've had the benefit of good global growth , but look what happened to their "potential gdp". The global economy is now Japan , magnified , and will suffer the same fate in the absence of major structural changes that balance consumtion capacity with productive capacity.

    Stop buying into the neoclassical Big Lie and just stand back and take a look at the world.

    How wrong must economists be , and how many times must they be wrong , before you realize that being wrong - for them - is not a bug , it's a feature.

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  9. Look a Kiyotaki-Moore (1997) Credit Cycles, for a model in which growing debt implies growing output.

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  10. If he's thinking what I'm thinking, it is a demand-side effect, but that doesn't mean the effect will just go away when the economy recovers.

    The problem with growing debt is that it is not an impediment to growth at all, until it is. Wages can stagnate for decades, and there are no demand-side problems created because the money trickles down in the form of cheaper and easier credit. But there is not a bottomless pit of potential loans that are rational to make; at some point you hit a wall where savings continue piling up at the top but lots of it isn't financed, because any loans still not being made are too risky/too low return to be worth making. And that disrupts the flow of money through the economy, creating a drop in demand.

    We have the same productive capacity we had before, but to get the demand back that we had before, we'd have to have the money continue to flow from the wealthiest back to the middle class, only now it couldn't be as credit. Whether that is politically possible or even just is beyond my pay grade.

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  11. no, no, no. its very disappointing to see so many economists baffled.

    *First, the inverse of the relationship is what is relevant (see below).

    * Second, going back to the 1950s, there is a consistent increase, (or more pertinently, drop in GDP/Debt). there is no correlation to interest rates or money velocity, its not a "credit binge" thing.

    So what could this possibly mean??

    First, lets talk about the pile of bricks, total debt. {technically, you want to remove financial debt because the assets and liabilities of a bank are both debt so you're double counting, but then the billions of dollars Apple has in cash is parked in short term "investments" which are also debt, but the difference does not matter}.

    That pile of debt really is the pile of bricks, or capital we've built up over time.

    GDP is nothing more than the flow of brick-making activity.

    so what does the ratio mean??

    Well, go back to a simple Tobin's Q type formulation. the ratio of GDP/debt really is fundamentally the GDP/capital ratio more or less.

    http://research.stlouisfed.org/fredgraph.png?g=5L1


    ... which has been going down over time.

    So all this graph really says is: 1) the marginal product of capital has been decreasing; and 2) we've built up an awful lot of capital (i dunno, maybe for all those baby boomers who are about to retire).

    Now, if you think of the "debt" as capital and suppose you need a real rate of return of, say, 4% then 4%*totaldebt/gdp is about 15% of gdp or less. yawn, not really so unsustainable is it?

    An for anyone who complains we owe "debt" to foreigners, the flip side is the productive capacity ... as long as we can basically earn a income sufficient to pay the interest on the debt as a % of GDP then the zombie apolcalyspe is not imminent.

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  12. ... incidentally, for those of you who complain i've left a bunch of stuff out of the demoninator for Tobin's Q (market cap of equities, etc) sure you are correct. There may be some tax reasons to favor debt vs equity financing of capital.

    now that would be an interesting economic debate

    ... but for a bunch of economists to be confuddled by a bunch of journalists spouting economic nonsense, really sad. truly the dark ages.

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  13. Anonymous6:10 PM

    @dcomerf,

    You said :

    "Look a Kiyotaki-Moore (1997) Credit Cycles, for a model in which growing debt implies growing output."

    See Cecchetti et al (2011) , for real-world data that shows that at high levels , debt is damaging to growth :

    http://www.bis.org/publ/othp16.pdf

    "At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. When does debt go from good to bad? We address this question using a new
    dataset that includes the level of government, non-financial corporate and household debt in
    18 OECD countries from 1980 to 2010. Our results support the view that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP.
    The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the
    estimated thresholds. Our examination of other types of debt yields similar conclusions.
    When corporate debt goes beyond 90% of GDP, it becomes a drag on growth. And for household debt, we report a threshold around 85% of GDP, although the impact is very
    imprecisely estimated."

    Now consider that some of the countries that have major shares of global gdp have sectoral debt/gdp levels that are either near or exceed those growth-damaging thresholds , some with more than one sector at the same time , and you'll see what's going to bend those potential gdp curves downward , in spite of the protestations of all the PhD eCons.

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  14. Noah: "A household can temporarily increase its consumption by borrowing money. "

    Or permanently; it depends on what the borrowed money is used for, and under what terms it is obtained.

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  15. When the government borrows where does the money come from?

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  16. For another take on the effect of debt, see Steve Keen. He's a bit outside the mainstream but 95% of what he says makes a lot of sense to me and his Youtube lectures are pretty good.

    According to him, high debt/GDP causes a few problems, one being instability and increasing danger of a debt/deflation spiral, that debt can fuel asset price bubbles, and that when debt starts decreasing the money supply can contract.

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  17. "Financial intermediation (matching of borrowers and lenders) is a kind of technology, and if this technology is malfunctioning, that means our economy isn't capable of producing as much as it could if credit markets were functioning well. No surprises there.

    But do we expect a credit crisis to destroy financial intermediation forever? It seems unlikely. And if financial intermediation recovers, how will the impact of the credit collapse be permanent? After all, long-term output is just determined by technology, right?"

    I haven't thought this through completely, but if the malfunctioning of financial intermediation was the cause crisis, and not a result, then wouldn't that make it possible for the economic activity resulting from that malfunctioning market to be permanently lost?

    Shouldn't the result of Dodd-Frank and Basel III be a reduction in the potential output of the financial industry, and a permanently reduce potential GDP arising from those activities?

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  18. DWB:

    "An for anyone who complains we owe "debt" to foreigners, the flip side is the productive capacity ... as long as we can basically earn a income sufficient to pay the interest on the debt as a % of GDP then the zombie apolcalyspe is not imminent"

    I for one would never complain about that. This is really noting to be concerneed about at all to the contrarry right now foreigners are willing to pay us to lend us money.

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  19. Anonymous1:25 AM

    For anyone who questions whether the U.S. , U.K. , and EU have "turned Japanese" , see the charts at the end of this presentation of the Governor of the BOJ this past Jan :

    http://www2.lse.ac.uk/assets/richmedia/channels/publicLecturesAndEvents/transcripts/20120110_1830_deleveragingAndGrowth_tr.pdf

    We're following right in their footsteps , lagged by about 15 years.

    For evidence that the smashdown of global potential output curves has already begun , look at the changes in 2012 growth forecasts made by the IMF in the summer of 2011 versus new estimates made only seven months later (pages 21 and 22 ) :

    http://www2.lse.ac.uk/assets/richmedia/channels/publicLecturesAndEvents/slides/20120123_1830_theStateOfTheWorldEconomyIn2012_MWolf_sl.pdf

    World growth has been downgraded from ~3.5% to ~2.5% , while Japan and the US have been moved to ~2% from ~3% , with worse still for the UK and EU.

    Of course , by summertime they'll look at their fancy potential GDP curves and realize they're not working too well, so it'll be time for another smashdown.

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  20. "See Cecchetti et al (2011) , for real-world data that shows that at high levels , debt is damaging to growth"

    Perfectly consistent with KM's Credit Cycles model: there is a steady state debt level; being below this level implies debt growth and output growth; being above this level implies debt contraction and output contraction.

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  21. You title the article with "GDP", then switch to the question "But how can a nation artificially increase its maximum possible production by borrowing money?"

    GDP & 'maximum possible production' aren't the same thing.

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  22. "high debt is bad for growth"->

    Cecchetti et al (2011), Rogoff, etc have quite a number of problems but fundamendally get the causation backwards. Is there an anti-Nobel prize? this has seriously caused the dumbing down of the profession.

    All you are really observing in the data is that with very low nominal rates the Fed has not pushed rates low enough (inflation high enough) that it makes sense to build more capital.

    I prefer to think of what happened in the housing market as a supply shock: the cost of financing owner-occupied homes was artificially low (bad lending standards) so what you are seeing now is that a)the price level has to drop until prices reflect the proper return) and b) investment going to rentals. A re-allocation of capital from onne sector to the other. Rental rates are going up, the demand for "housing" overall including rentals has only dropped cyclically and will rebound as UE drops.

    in other words, the return on the existing capital stock is low so we are allowing it to depreciate (if you will) until the return rises to the point that it makes sense to build it again.

    If the Fed could raise inflation that would help.

    its silly by the way to say equities are assets but debt is bad... think about it.

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  23. Salmon is getting smoked. Let me poach my Salmon post (originally a comment at Thoma's blog)

    http://robertcomments.blogspot.it/2012/03/over-savings.html

    I think Salmon is not Austrian or Austerian at all. Quite the other thing. He seems to believe that demand can't grow without bound. Sure we could consume more and more without increased debt, but that doesn't mean we will.

    You identify potential with the supply side. The idea that growth will stop, because some consumers will be satiated has been out of fashion for so long that it is forgotten.

    Lots of economists used to believe this (Keynes was not one of them). They look silly now as consumption has grown and grown. But we don't have proof that average consumption of people with income in the top 1% of the US income distribution can have the normal proportion with their income. No large group has ever consumed that much.

    Maybe they won't. Maybe growth will stagnate, because those of us who aren't liquiity constrained are satiated and not foolish enough to lend any more to those who aren't satiated.

    It is easy to write down models (with exogenoush technological progress) in which this happens. Technological progress causes higher consumption of leisure and not higher output.

    The case against is that the ratio of consumption to GDP hasn't changed much as the GDP per capita has grown enormously. But the argument against Salmon is based entirely on extrapolation. It can be represented as maximizing a utility function (anything at all can) but the case for CES utility is just that it corresponds to growth which is not demand limited, that is assuming CES utility is assuming what you seek to prove.

    I personally have unbounded faith in the unbounded gluttony of US consumers. But I have no proof.

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  25. To be precise. Do a Ramsey Cass Koopmans model with u(c) = -exp(-lambda c) - h^2. (h is hours worked per worker) The rate of growth will decline and decline.

    Now how about u = max(0,(c-cstar)^2)) - h^2

    Growth will stop.

    The case for CES utility is the fact that, so far, technological progress has implied more increase in GDP than reduction in hours worked (especially in the USA which, of course, is the only country which really exists).

    This is just extrapolation.

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  26. Louis9:24 AM

    Why not look at things this way:

    Potential GDP, seen as long-run full employment AS, shouldn't change in any first-order way in response to debt levels.

    However, matching AD to AS given the liquidity constraints of many market participants necessitates the accumulation of debt by certain market participants. If on an economy-wide level these participants suddenly have no access to incremental credit, aggregate demand will fall short of AS, and can stay that way for a while until spending patterns change or debt is reduced. So it becomes a story about a persistent output gap, instead of a reduction in productive capacity.

    Over medium term you could even say that depressed economic activity lowers potential AS, further limiting recovery back to trend rates of growth.

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  27. I see a lot of confusion in the comments here between public debt and private debt.

    Why would high public debt have anything but a positive effect on GDP?

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  28. You title the article with "GDP", then switch to the question "But how can a nation artificially increase its maximum possible production by borrowing money?"

    GDP & 'maximum possible production' aren't the same thing.


    You're right. There are two discussions here: one about long-run potential output, one about short-run actual output.

    However, in a boom period, short-run actual output is thought to equal or exceed potential output, so many of the same arguments apply. I didn't mention that in the post, to save space.

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  29. I agree with Noah that debt boosts demand, but not productive capacity, and that Salmon's post unfortunately elides this distinction.

    I disagree with Noah that the evolution of potential GDP is independent of demand conditions. it is perfectly possible to imagine a world (or write a model) in which debt-financed consumption --> higher investment --> more rapid growth in potential GDP. Similarly, it is perfectly possible to imagine a world in which debt-financed consumption --> lower unemployment --> faster growth in the laborforce (hysteresis) --> more rapid growth in potential GDP.

    Of course the conclusion then should not be Salmon's, that if further accumulation of private debt becomes infeasible we must accept lower growth. Rather, we should look for alternative sources of demand growth, for instance redistribution of income to wages, institutional changes that raise desired private investment, or higher public investment.

    So Salmon is wrong, but Noah S. is also wrong to think (as, to be fair, many economists do) that the long-term growth rate must be independent of demand-side factors.

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  30. I think Salmon is right, though he doesn't quite spell it all out. The story for me looks like this: high debt in the U.S. caused artificially high demand which in turn caused an artificially low unemployment rate which ensured that more of our workers maintained their skills - and even more crucially that more of our workers' children were less likely to under-utilize their skills (since poor kids tend to make less of their natural talents than rich ones) - which kept national productivity levels high.

    The sudden collapse of our debt reversed this trend and permanently reduced our productivity potential. It may be a demand-side explanation for a supply-side phenomenon, but it's certainly plausible and I think it's right.

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  31. Noah S. is also wrong to think (as, to be fair, many economists do) that the long-term growth rate must be independent of demand-side factors.

    JW, I do accept in principle that these sort of things could happen. I just think the model required to model these things is a lot more complex, with a lot more specific and possibly weird-seeming assumptions, than people realize.

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  32. JW and Andrew:

    Hmm, I dunno...I think that to tell the story Salmon et. al. are trying to tell using demand-side hysteresis effects, you'd need to have observed higher inflation in the 80s and 90s and 00s. The story would be that increasing debt levels kept boosting AD above potential GDP, leading to hysteresis effects on human and physical capital that then raised potential GDP. But since building up capital takes a while, there would have to be a burst of inflation. And then if this process happened continuously for 30 years, you'd need pretty persistent inflation. Which we didn't see.

    Now, I totally agree that a breakdown of financial intermediation might cause a persistent demand shock that could then lower long-term potential GDP via hysteresis effects. In fact, I kind of bet that this is what is really going on in all these examples of post-financial-crisis slowdowns. But I think that any reasonable model of hysteresis will not have permanent effects; the recovery of the financial system and the return of normal demand levels will slowly erase the effects of the hysteresis. I'm pretty skeptical of permanent hysteresis effects (though I guess they could exist in principle).

    Then again, I think the right sort of overly hawkish policy regime, if it lasted a very long time, could have negative effects on potential output that lasted as long as the regime lasted (and longer). But that is true for pretty much any sub-optimal policy regime...

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  33. Anonymous4:43 PM

    "The story would be that increasing debt levels kept boosting AD above potential GDP, leading to hysteresis effects on human and physical capital that then raised potential GDP. But since building up capital takes a while, there would have to be a burst of inflation. And then if this process happened continuously for 30 years, you'd need pretty persistent inflation. Which we didn't see."

    What if the build-up in capital showed up as asset inflation - stocks and housing , mainly - rather than as increases in CPI or PPI ?

    Those two net worth/gdp bubbles are now pretty obvious , in hindsight. If creation of a new bubble is the only way to fill the "gap" , I'd suggest it's better left unfilled.

    Of course , that's not the only way to do it. It's the only way the plutocrats would allow us to do it.

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  34. The story would be that increasing debt levels kept boosting AD above potential GDP, leading to hysteresis effects on human and physical capital that then raised potential GDP. But since building up capital takes a while, there would have to be a burst of inflation. And then if this process happened continuously for 30 years, you'd need pretty persistent inflation. Which we didn't see.

    No, that doesn't follow at all. Or rather, that could be true. But it would be just as logical to say:

    Increasing debt levels kept AD *at* potential GDP, preventing negative hysteresis effects that would cause a permanent reduction in human and physical capital. And if this process happened continuously over 30 years, you would not see the deflationary pressures that the economy would otherwise be subject to.

    That story is logically equivalent to yours, and it fits the facts fine.

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  35. BT (London)5:46 PM

    "Anyway, to sum up this post: It seems clear to the average layperson (and it once seemed clear to me) that debt just feeds directly into GDP. But actually, this is not true."

    Oh dear. Creating debt also creates credit. A rising stock of credit normally translates into a rising *flow* of credit.

    The flow of credit through transactions for goods and services (and hence incomes) equals nominal GDP (NGDP).

    Credit can also flow to asset markets, giving asset price rises that are not counted in NGDP (hence the rising debt:GDP ratio).

    Real GDP growth is driven by population growth (workforce growth) and technological change (which creates new goods and services).

    If you have insufficient NGDP growth, you will have a demand shortage which can stifle workforce growth (create unemployment, which can become long-term) or slow down technological changes.

    Try running an economy on zero credit growth (or zero NGDP growth) and see how much real GDP growth you can get.

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  36. I think that any reasonable model of hysteresis will not have permanent effects; the recovery of the financial system and the return of normal demand levels will slowly erase the effects of the hysteresis. I'm pretty skeptical of permanent hysteresis effects (though I guess they could exist in principle).

    Read this: http://www.nber.org/papers/w14818

    The empirical evidence for very long-lasting hysteresis is strong.

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  37. Increasing debt levels kept AD *at* potential GDP, preventing negative hysteresis effects that would cause a permanent reduction in human and physical capital. And if this process happened continuously over 30 years, you would not see the deflationary pressures that the economy would otherwise be subject to.

    So wouldn't that mean we were subject to a continuous string of negative AD shocks for over 20 years?

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  38. The empirical evidence for very long-lasting hysteresis is strong.

    OK. Like I said, I'm willing to be persuaded. I'll have to read the paper, though, because hysteresis is very difficult to demonstrate from aggregates without a natural experiment to provide a counterfactual.

    But my question then is still this: What were the negative AD shocks over the last 25 years that all this credit expansion was supposedly required to offset? Deficits were expanding. Interest rates were low. The only thing I can think of is the currency...

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  39. Anonymous11:49 PM

    "But my question then is still this: What were the negative AD shocks over the last 25 years that all this credit expansion was supposedly required to offset?"

    How about this :

    A shift , politically ( bipartisan! ) driven and nurtured along , of 10% of total income shares from the bottom 90% to the top 1% , and mostly to the top 0.1%. A shift from those with a high MPC to those with a low MPC , resulting in a more-or-less continuous shock to AD , which was alleviated by the debt ( public and private )bubble.

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  40. Anonymous12:42 AM

    Above , at 1:25 AM Mon morning , I noted that IMF global growth estimates have been ratcheting down , as they've realized our "potential" is actually rather limited , and I predicted the following :

    "Of course , by summertime they'll look at their fancy potential GDP curves and realize they're not working too well, so it'll be time for another smashdown."

    Hours later , NY Fed Prez Dudley gave a speech in which he seems to be jumping on the IMF bandwagon , specifically as regards American's lack of potential :

    http://economistsview.typepad.com/timduy/2012/03/fed-still-lowering-potential-output-growth-estimates.html

    How could someone like me , who's never taken a single econ course ( thank you , dear Tebow ! ) so clearly see this coming , while all around the brightest minds in economics dispute the intricacies of the matter whole ignoring the obvious ?

    BTW , I want to make it clear that I think we can reclaim our potential , that solutions are available , but those solutions aren't on the table just yet.

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  41. Noah -

    But my question then is still this: What were the negative AD shocks over the last 25 years that all this credit expansion was supposedly required to offset? Deficits were expanding. Interest rates were low. The only thing I can think of is the currency...

    Increasing income and wealth disparity has led to eroded purchasing power in the middle class and below.

    I supported a family on one income. My children's families need two.

    Every penny of GDP growth, every increment of productivity increase since the at least the mid-70's has gone to the top 50%, and increasingly skewed toward the top.

    Up there, the marginal propensity to spend is small. They speculate and collect rents.

    Finance sector profits have gone from about 25% of the corporate total to about 50%.

    What we have is massive wealth disparity and asset misallocation - the direct legacy of supply side economic practices for 30+ years.

    JzB

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  42. So wouldn't that mean we were subject to a continuous string of negative AD shocks for over 20 years?

    No, it would mean that AD falls short of AS structurally. This isn't supposed to happen in mainstream macro, but the equilibrating mechanisms that prevent it are weak-to-nonexistent in practice. (Or, perhaps more precisely, the mechanisms that prevent it have take the form precisely of rising debt.)

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  43. Also, what JazzBumpa and anon said. Upward income redistribution may reduce AD.

    Alternatively, a downward shift in investment demand, as a result of the stronger financial claims on nonfinancial firm cashflow. I've written about this on my blog.

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  44. Also, what JazzBumpa and anon said. Upward income redistribution may reduce AD.

    Alternatively, a downward shift in investment demand, as a result of the stronger financial claims on nonfinancial firm cashflow. I've written about this on my blog.

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  45. Anonymous2:27 PM

    JW,

    Your post that you linked to is certainly relevant here. This graph is great :

    http://1.bp.blogspot.com/-yFRQt80dPKk/TpUFa9fZayI/AAAAAAAAAJ0/xiuJjaKFE_E/s1600/profits+and+payouts.png

    I suppose one could debate , in a chicken-and-egg manner , whether it was the reduced investment or the shift upward in income distribution that was the first-mover leading to reduced AD , but as your chart shows , the former was a contributor to the latter , given the high concentration of equity holdings at the top of the income pyramid.

    Together , the result was an economic "doom loop" of failing AD , and debt only served to postpone the collapse.

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  46. Anonymous2:33 PM

    Since GDP = private consumption + gross investment + government spending + (exports − imports)"

    When debt levels are lowered, it appears to logically follow that gross investment and private consumption are reduced. Gross investment is reduced, asuming your standard supply curve, by the lower rates resulting from diminshed effective demand, and private consumption is reduced because of diminished capactity to pay.

    Effective demand in this case is borrowers with the excess long term income necessary to repay additional loans.

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  47. o. nate2:43 PM

    People take on debt because they want to buy something, so this shows up in GDP as consumption. Those who lent the money might have spent part of it if they hadn't lent it, but they also might have just sat on the cash. So debt gooses GDP, up to a point. The problem comes when debt grows too large relative to income and debt service cuts into consumption. This reverses the flow described above and thus causes a drag on GDP.

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  48. Echoing a couple of other commenters:

    I find it amazing that this topic can be bandied without referring to Steve Keen's work showing the correlations between debt levels and house prices, unemployment, and stock prices.

    Actually, a second derivative: the rate of change in the rate of change in debt -- what he calls the credit impulse or the credit accelerator. He's demonstrated strong correlations in the U.S., the U.K, and Australia:

    http://www.nakedcapitalism.com/2011/06/steve-keen-dude-where%E2%80%99s-my-recovery.html

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  49. Laura G.6:53 AM

    Very insightful article. The connection between the debt and the GDP growth seems less important that I thought.
    I can see some similarities between what you said and between the book of John McMurtry Cancer Stage of Capitalism, because he uses the same argument that debt and generally the financial (unproductive) market can´t influence the real production.
    It also corresponds with the prof. Stiglitz claim, that US government in the last Privatizing Profits, Socializing Losses. The austerity and bailout of the financial corporations was not necessary to save the US economy. It actually had an opposite effect on the real production.

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  50. It can fall to nothing. It is a little dangerous taking the risk.

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  51. Anonymous7:46 PM

    In a debt economy should GDP growth matter? Debt is created from vacuum and it has to be paid back to the system. So in my mind all debt in the economy must be counted as negative.

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