Friday, October 25, 2013

On Depressions, the Structure of Production & Fiscal Policy

I came into economics and finance blogging in 2011 a very different economic thinker than I am today. I was convinced (and remain convinced) that we were going through a once-in a generation economic transformation, or more accurately an industrial revolution the shape of which remained uncertain. These ongoing industrial revolutions, of course, cause great upheavals. As Joseph Stiglitz has noted, the Great Depression of the 1930s can be seen as a great displacement of labour in agriculture thanks to technological improvement. Stiglitz, like myself, sees a parallel between today’s slump and that of the 1930s; in the 1930s we were transitioning out of agriculture. We are also in a transitional period today. Since the advent of globalisation, and the growth in automation in the 1970s and 1980s society had begun suffering from falling real wages, and had had to lever up on debt in order to sustain lifestyles and spending habits. The financial sector had taken advantage of this, offering cheapish debt and — morally hazardously — securitising these debts and selling it a greater fool. This was a bomb waiting to explode — because lenders did not have to take responsibility for the fruits of their lending, they could lend to any NINJA, pay the credit rating agencies to grade highly speculative debt as AAA-grade, and sell it to another bank, or a pension fund, or a hedge fund. When the financial crisis blew up, I desired very, very strongly to see the entire corrupt market liquidated. This was an entirely Darwinian wish; financial firms had acted irresponsibly, creating a monstrous system that nobody really understood and they should pay the consequences for their irresponsibility. In liquidation, people would learn a harsh lesson and the economy would be forced to adapt to the new reality. In Hayekian terms, I thought that the structure of production ought to be left alone to adjust.
So I was furious to see the financial sector bailed out and rescued, and I strongly suspected that such medicine would have very harsh negative side effects as the speculators had been rescued instead of learning their lesson the hard way. Maybe the bankers and financiers who got bailed out — and the regulators who were found to be asleep at the wheel — have not learned a lesson. We shall see. Yet, when push came to shove, governments and central banks chose to save the system instead of watching it burn to the ground and given the complexity of the system, and the danger of good businesses being destroyed alongside the speculators and shysters, that is an entirely understandable decision. Certainly, it was also a morally questionable decision — after all, while bankers and financiers get bailed out in an emergency, help for the much poorer fringes of society is much less forthcoming. Yet this is the world in which we live in.
Of course, the world goes on. Banks may not have been disciplined, but the structure of production still must adjust to the new world, albeit in a less brutal and immediate fashion. This has been far from simple. Even though the financial system was saved, economies around the world remained in a depression. In fact, I would define an economic depression in these terms — a depression as opposed to a transitory recession, which relatively quickly self-corrects is a situation in which the structure of production cannot adjust itself back into a pattern of growth, and economic activity becomes permanently lowered. In Britain and the Eurozone we are so far behind our pre-crisis trend that we still as of October 2013 have not grown our way out of the trough yet, let alone caught up with the long term trend line:
BVwGkl1CcAAkOiu
The causes of this are multiple and complex. We are in an the midst of an ongoing industrial revolution, a great whirling flourish of creative destruction in which both foreign labour and automation are displacing both manufacturing and increasingly service industries. This creates real ongoing instability. Furthermore there remains the fallout from the crisis — confidence in new job-creating and growth-creating business ventures may have become inherently depressed, as economic expectations drift lower and lower in the context of low growth. Then there is the ongoing trend of government austerity, taking money and jobs out of the economy. Energy prices remain relatively high by historical standards, as we rely on old and increasingly expensive oil-based infrastructure (although I expect energy costs to begin to fall as we transition to newer energy architectures). The private sectors in most Western countries remain in deleveraging mode from a very large private debt overhang from before the crisis, limiting their consumption and investment and paying down debt. These are just some of the possible causes of depressed growth and elevated unemployment that we see.
Governments particularly in Britain and the Eurozone have attempted to fight depressed growth using austerity policies (in the context of expansionary monetary policy). The proponents of austerity theorise that by promising to bring down taxes and spending, they will unleash private sector spending by reducing future expectations of taxes. To me, this has always seemed like a boneheaded and Rube Goldberg-style approach. Simply, the issue of depressed private economic activity is far more complex than future taxation expectations. And aggressive monetary policy has not succeeded in reversing the depression(even if it has probably made the depression less severe). So it has been entirely unsurprising to me to see this approach largely failing. I approach the problem in a far more direct manner. The solution to lowered growth and elevated (and involuntary) unemployment is relatively simple.Eventually someone will start using up the idle resources. This will either be the private sector once it independently gets over its slump in animal spirits, or it will be the government. With such huge volumes of idle capital, interest rates will remain very low until stronger appetite for credit re-emerges. In equilibrium theory, the low cost of credit will by itself start to re-energise borrowing appetite by making more projects potentially profitable. Of course, interest rates are far from the only factor that borrowers take into account when seeking credit, and so it is perfectly plausible that the economy — as it has done — can remain depressed even with very low rates due to deleveraging pressures, low expectations and low confidence, etc. So if the market is ill-suited to taking up the idle resources any time soon — lying as it is in a depressive, irrational strop — the only agent that can do so is the state. The fact of low interest rates allows this to kill two birds with one stone — the state can borrow money (utilising idle capital) to create jobs (utilising idle labour), raising interest rates and bringing down the unemployment rate. And this approach does not require anyone to make accurate predictions about the future. It simply requires a market economy, and a state willing to employ idle resources when they are idle, and to ease off using idle resources when unemployment becomes low and interest rates start to rise.
Many — including probably Hayek himself — would argue that using up idle resources in such a manner will not allow the structure of production to adjust to the new economic reality. The state, Hayek would argue is a poor allocator of capital because it lacks the informational efficiency of the market. I would mostly agree with Hayek’s objection, and note that I favour a predominantly market-based economy. Government interventions should be kept to a necessary minimum. Yet, in a depressionary environment, the structure of production deteriorates as resources lie idle. Unemployed workers lose skills, lose competitive edge and spend and invest less, further depressing the economy. Capital — factories, buildings, amenities, ideas, etc — deteriorates. Young workers may enter the labour force but never find a job. Crime rises, and shady fringe businesses like loan sharks thrive as the unemployed struggle to pay the bills. The social costs of mass unemployment are exceedingly high. The adjustment occurring in a depression is more like a rot. And it is absurd to rot your way to growth. Instead, by lowering unemployment and using up idle capital (preferably in a mix of state-run infrastructure and technology projects, and lending to new businesses) more businesses can be born into existence. Potentially successful new ideas can be tried out, and may find success in the marketplace. The formerly unemployed get to develop skills, habits and ideas, instead of sitting at home all day doing nothing, or hunting for jobs in a scarce and depressed marketplace. And money will go into people’s pockets, spurring investment and consumption, fomenting more new business growth. This, in my view, is the best shot at getting a depressed and rotten structure of production out of the doldrums and back toward strong organic growth. Sooner or later, of course, the private sector will come back and begin to use up resources. But that could be a very, very, very long way away. If we want the structure of production to adjust to the new world and to continue adjusting as the world continues to change, letting huge quantities of resources sitting idle seems like a bad way to do it. Targeted fiscal policy can change that.

21 comments:

  1. The problem with Hayek's objection: there are no price signals available to react to for, for instance, high-speed rail. If there were, the market would arguably use those signals better than the government.

    Private choice is wonderful stuff that way. But individual people and businesses generally have no control over the choice set. (That's the whole point of lobbyists, of course -- to control the choice set.)

    So there are always structures of production that are outside the available choice set, hence completely inaccessible to the optimizing forces of the market, hence impossible to achieve via that vehicle.

    Only by collectively agreeing to expand the choice set -- almost inevitably via government/political action -- can we move to a possibly far superior structure of production.

    ReplyDelete
    Replies
    1. "So there are always structures of production that are outside the available choice set, hence completely inaccessible to the optimizing forces of the market, hence impossible to achieve via that vehicle."
      That is plainly wrong, Steve: private actors create new products (that were formerly "outside the choice set") all the time.

      Delete
  2. "With such huge volumes of idle capital, interest rates will remain very low until stronger appetite for credit re-emerges. In equilibrium theory, the low cost of credit will by itself start to re-energise borrowing appetite by making more projects potentially profitable."

    We might need to reconsider this assumption of "huge volumes of idle capital". You offer a link to the graph of bank SAVINGS, as confirmation.

    Now remember that we often see the slogan that "loans create deposits". A loan, we claim, creates a deposit that does not disappear until the loan is paid off. An accounting of bank deposits should therefore show that bank deposits should about equal bank loans.

    Now consider a comparison of SAVINGS and bank loans found at http://research.stlouisfed.org/fred2/graph/?g=nLc.

    This chart would suggest that deposits are presently not adequate to support the loans already made! There would be, therefore, no money to lend. This lack would be the justification for the present QE policy by the Federal Reserve.

    The low interest rates are not caused by an excess of money to lend. The low interest rates are caused by the Federal Reserve stepping in to lend money not available from the public.

    Perhaps many years of ever-increasing debt have brought the economy to a point of concentrated ownership (ownership would include job capture), leaving only a few in control of the productive resources. When citizens have no ownership of resources, they become dependent upon those who do have ownership and control. This is the curse of excessive debt.

    ReplyDelete
  3. But the "informational efficiency of markets" is obviously related to information itself, which is not independent of government action. Thus, the immense and crucial markets in real estate and home construction decades after the interstate highway program made suburbia a reality. Thus the booming market in software and software engineers decades after DARPA funded the original network of networks. Even Google's first search algorithm is said to have come from NSF. For government to sit on its fiscal hands is criminally insane.

    ReplyDelete
  4. "Governments particularly in Britain and the Eurozone have attempted to fight depressed growth using austerity policies (in the context of expansionary monetary policy). The proponents of austerity theorise that by promising to bring down taxes and spending, they will unleash private sector spending by reducing future expectations of taxes. To me, this has always seemed like a boneheaded and Rube Goldberg-style approach. Simply, the issue of depressed private economic activity is far more complex than future taxation expectations. And aggressive monetary policy has not succeeded in reversing the depression(even if it has probably made the depression less severe). So it has been entirely unsurprising to me to see this approach largely failing."

    The big four advanced currency areas that are currently at or near the zero lower bound in policy interest rates are the U.S., the eurozone, Japan and the U.K.

    One proxy for the amount of QE done is monetary base expansion. This isn’t perfect of course since it also measures other policy responses such as “credit easing”. The ECB has done credit easing but no QE for example. But let’s not make things too complicated for the moment.

    As of May the BOE’s monetary base was up by 348% since August 2008, the Federal Reserve’s up by 260%, the BOJ’s up by 75% and the ECB’s up by 48%:

    http://thefaintofheart.files.wordpress.com/2013/06/sadowski3_1.png

    Since aggregate demand (AD) is the appropriate measure of the effectiveness of macroeconomic policies whose ultimate purpose is in fact to stimulate AD, perhaps we should look at the relative AD performance of the four large advanced currency areas since the Great Recession. But before we do that, we should take a look at the other main policy tool for stimulating AD, namely fiscal policy.

    In my opinion the most objective way of measuring fiscal policy stance is the change in the general government cyclically adjusted balance, particularly the cyclically adjusted primary balance (CAPB). The cyclically adjusted balance takes into account any changes in the general government budget balance due to the business cycle. Thus changes in the cyclically adjusted balance are mostly due to discretionary fiscal policy, and consequently may be taken as a proxy for the degree of fiscal stimulus. The CAPB goes a step further, factoring out changes in net interest on government debt and thus ensuring that practically all of the changes in fiscal balance are discretionary in nature. The following is a graph of the changes in CAPB by currency area over the calendar years 2009-13. All data comes from the April 2013 IMF Fiscal Monitor.

    http://thefaintofheart.files.wordpress.com/2013/06/sadowski3_10.png

    (continued)

    ReplyDelete
    Replies
    1. (continued)

      The first thing you should note is that Japan has had the most expansionary fiscal policy every year without exception. And although all of the currency zones adopted a much less expansionary fiscal policy stance in 2010, it was the U.K. that took the lead in fiscal consolidation, having the most contractionary fiscal policy in both 2010 and 2011. The U.S. has had the most contractionary fiscal policy starting with calendar year 2012.

      Now, let’s take a look at relative AD performance. To be technical, AD is nominal GDP (NGDP) when inventory levels are static (i.e. nominal Final Sales of Domestic Product). Thus for all intents and purposes AD is virtually identical to NGDP. The following is a graph of the NGDP of the four big advanced currency areas with NGDP indexed to 100 in 2008Q2, that is, before large scale monetary base expansion started in September 2008.

      https://research.stlouisfed.org/fred2/graph/?graph_id=125131&category_id=0

      Note that the U.K. led in relative NGDP growth from 2010Q1 through 2011Q3 with the exception of 2010Q4 and 2011Q2. The U.K. also led in relative monetary base growth from June 2009 through January 2011. And as previously noted the U.K. had the most contractionary fiscal policy in 2010 and 2011.

      The U.S. has led in relative NGDP growth since 2011Q4. The U.S. also led in relative monetary base growth from February 2011 through January 2012. And as previously noted the U.S. has had the most contractionary fiscal policy starting with calendar year 2012.

      Japan has ranked last in relative NGDP growth throughout. Japan has also ranked last in relative monetary base growth with the exception of March through August 2011 and since April 2013. And as previously noted Japan has had the most expansionary fiscal policy throughout.

      Delete
    2. Mark,

      "Now, let’s take a look at relative AD performance. To be technical, AD is nominal GDP (NGDP) when inventory levels are static"

      Just want to confirm my understanding here -

      If inventory increases (decreases) through successive time periods, then NGDP will differ from the goods/services demanded by end consumers. Such that over the period T0 to T1:

      --> If inventories grow, AD is less than NGDP
      --> If inventories shrink, AD is greater than NGDP

      As a follow-on thought, it is clear the inventory levels cannot continue on a particular course indefinitely. However, should inventory levels shrink for any duration, I would expect this to be a supply-side problem and price levels to increase.

      Delete
    3. Dustin,
      I agree with your characterization of the difference between NGDP and AD.(And let me stress once again, in practical terms the difference is trivial.)

      However, with respect to your follow up thought, just because inventory levels shrink that does not automatically imply there is a supply-side problem. In the case of manufactured goods this often happens simply because producers underestimate demand during a given period.

      Delete
    4. I understand. In fact, my statement “should inventory levels shrink for any duration“ meant to suggest an inventory reduction that occurs for many successive periods; it seems this would suggest producers’ inability or unwillingness to meet demand (ie, supply-side problem).

      And as to AD in a broader sense – is this term used to describe inherent demand? Or strictly the, well, ‘actualized’ or ‘acted upon’ demand that ignores potential supply constraints? The latter would certainly be the parallel of NGDP. However, my reading of this is that AD = NGDP only if there are no supply-side issues, and supply-side constraints can be difficult to measure reliably.

      Disclaimer: I am new to these terms, if that helps explain my meandering questioning.

      Delete
    5. "And as to AD in a broader sense – is this term used to describe inherent demand? Or strictly the, well, ‘actualized’ or ‘acted upon’ demand that ignores potential supply constraints? The latter would certainly be the parallel of NGDP. However, my reading of this is that AD = NGDP only if there are no supply-side issues, and supply-side constraints can be difficult to measure reliably."

      The term used to describe ‘actualized’ or ‘acted upon’ demand. But this is not at all as much of a problem as you believe. Final sales of domestic product is commonly reported and is highly correlated with NGDP. I'm also less skeptical than you are of our ability to detect negative aggregate supply shocks. In fact I am confident that the UK has suffered such a shock.

      Delete
    6. Anonymous2:15 PM

      "In my opinion the most objective way of measuring fiscal policy stance"

      Right, in your opinion, meaning that statements such as "The U.S. has had the most contractionary fiscal policy starting with calendar year 2012" are also just an expression of your opinion, and should not be confused with statements of fact.

      You always cherry pick whatever information suits your argument, and carefully exclude everything else. This is obvious to most people.

      Delete
    7. Anonymous:
      "Right, in your opinion, meaning that statements such as "The U.S. has had the most contractionary fiscal policy starting with calendar year 2012" are also just an expression of your opinion, and should not be confused with statements of fact."

      That's why I added the qualifier. But in defense of that particular opinion it is widely shared. Page 3:

      http://www.imf.org/external/pubs/ft/tnm/2011/tnm1102.pdf

      "Measuring the fiscal policy stance.

      Changes in structural balances can also indicate the impact of discretionary fiscal policy on the economy (Muller and Price, 1984). For example, a widening in the structural deficit points to an expansionary fiscal policy stance, or in other words, to an intended positive contribution of discretionary fiscal policy to aggregate demand (the actual impact depends on other factors and could result in different effects from those originally planned)..."

      Anonymous:
      "You always cherry pick whatever information suits your argument, and carefully exclude everything else. This is obvious to most people."

      This too is an opinion. But almost all of the people holding that opinion go by the name of "Anonymous".

      Delete
  5. Anonymous12:33 PM

    We have created a tax and legal structure that encourages the run-away concentration of wealth in a few hands. The working and middle classes in the West are doomed to a downward spiral if they are not willing to force the truly wealthy to pay taxes.

    ReplyDelete
  6. Good article. We're in an era of unprecedented wealth creation & prosperity, if only for a few. People are getting richer than ever - whether it's through real estate, stocks, speculation, home building, and web 2.0. Anyone with some coding and a good idea can be a millionaire in months and a billionaire in a couple years. Twitter, facebook, instagram, snapchat, and square.com are just a handful of instant success stories in today's hyper meritocracy. Real estate still going gangbusters in the Bay Area with no signs of slowing. Stocks keep making new highs every week. Large cap tech companies like Google & Amazon keep reporting blowout earnings quarter after quarter with no end in sight. Profits & earnings, exports, consumer sending, and productivity keep going up. Treasury yields still refuse to rise, throwing cold water over the hyperinflation argument. Wealth disparity is going to keep widening. No amount of whining will change reality. Never before have the potential financial rewards for smart, ambitious people been so great. When the left says the America dream is dead due to debt, job loss, inequality etc they are using anecdotal evidence to make assumptions about a much larger system (the US economy), also known as the fallacy of composition , which results in incorrect predictions and generalizations.

    ReplyDelete
    Replies
    1. Those special few are leaving others behind.

      Delete
    2. Anonymous12:44 PM

      This can be seen as a bug rather than a feature. The system can now be gamed easily enough by those with some luck or unusual skill or lack of ethics to obtain hugely outsized rewards for their efforts. They appear to mostly hang on to their wealth and pile it up rather than deploying it. It's not a recipe for long term stability.

      Delete
    3. Anonymous2:12 PM

      Dan, the "Institute" above thinks that's a good thing. He loves kleptocratic plutocracy and handouts for the rich at the expense of everyone else. He thinks that sitting on your ass getting rich doing nothing just because the stock market goes up is "being hyper productive".

      Delete
  7. I've been thinking along similar lines. We are entering not only a new economic revolution, but also a currency revolution. The amount of work people do for free, creating entertainment, software, blogs, is astonishing. The currency is recognition, friends, followers, etc. I don't think bailing out the banks is what is preventing the necessary shift, rather it's so much rent seeking, monopolies and duopolies, and IP.

    ReplyDelete
  8. I just want to insert a pitch for Mariana Mazzucato's recent work on the entrepreneurial state. In some areas, the state is a very effective investor indeed, and is better-placed than the private sector to bear the risk of the large, strategic, mission-oriented investments that help set broad economic directions and reduce the risk for private sector investments that follow on. In other words, more picking winners please. We can't afford to gamble our future on 100,000 separate entrepreneurs wastefully fumbling around in the hustle after the satisfaction of consumer desires. We had more progress when the state played a larger role.

    The kneejerk Hayekian universal information-processing argument against planning is too clever by half, and half again. Hayekians can't even seem to understand how an ordinary corporate enterprise - which is highly organized and planned - is capable of succeeding.

    Bring back big government:

    http://ruggedegalitarianism.wordpress.com/2013/10/20/market-myths-and-the-real-drivers-of-american-progress/

    ReplyDelete
  9. "Sooner or later, of course, the private sector will come back and begin to use up resources."

    Based on the context of your post, I assume you meant to refer to idle resources. Based on what I've seen, this isn't reflective of reality. If you've ever been through the midwestern US and even some towns in our mountain west, you will have no trouble finding brown fields, abandoned mining towns, literally mounds and mounds of unused resources delapidating over the decades. The private sector will never make use of these resources.

    But we know the public sector could. Government entities could scrap and recycle old factories. Mining towns could become tourist attractions, complete with shored-up mines for visitors to tour. Put in a couple cabins and a breakfast house and you've even got a break-even, maybe even a money-making proposition.

    Private sector decision makers chase status before they chase profits. They want to stake out the new stuff, the resources nobody else has ever touched, they want to make money, and be king of the new hill while they're at it. As a result, the private sector can never make full use of idle resources. It always prefers to leave the idle ones idle.

    ReplyDelete
    Replies
    1. "The private sector will never make use of these resources."

      That is because the market does not consider them to BE resources.

      "Put in a couple cabins and a breakfast house and you've even got a break-even, maybe even a money-making proposition."

      Yes, the government is so much better than people with their own money on the line at picking profitable businesses!

      Delete