The paradox of thrift

Or, how come you used to say that if consumers don’t save more, it will wreck the economy, and now you say, if consumers do save more, it will wreck the economy?

For the record, I am certainly among those who had been suggesting that America’s low saving rate was a significant problem. Let me begin by reviewing why I said that. Recall that we can separate the various components of GDP (Y) in terms of goods and services purchased by consumers (C), government purchases (G), investment spending (I), and net exports (X):

Y = C + I + G + X

Subtracting C and G from both sides of the equation,

Y – C – G = I + X

The two terms on the right-hand side are the critical determinants of what kind of economic future we’ll have. Investment in plant and equipment is the single most important variable that will determine our future productivity and standard of living. And negative net exports, such as the U.S. has increasingly opted for over my lifetime, necessarily involves selling off our national assets and going further into debt to foreigners. The size of our current account deficit is large enough relative to GDP that, if this were any country other than the United States, I would worry that a currency crisis (a sudden flight from dollars) is a very real possibility. And even for the United States, it is something I for one do worry about.



U.S. net exports as a percentage of GDP. Data source: BEA Table 1.1.5.
nx_gdp_feb_09.gif



From the equation above, if we want I + X to be bigger, we must want Y – C – G to be bigger as well. We can define private sector saving to be gross domestic income less consumption spending and net taxes paid:

private saving = Y – C – T.

Notice I’m using the same symbol Y for both GDP and GDI, since the two are conceptually the same– every dollar of production necessarily generates a dollar of income. There is a statistical discrepancy between the actual measures available for GDP and GDI, though these are not relevant for the longer run issues I’m discussing here. We likewise can define “public saving” to be the excess of the government’s receipts over its expenditures,

public saving = T – G,

and national saving to be the sum of private and public saving:

national saving = Y – C – T + T – G = Y – C – G.

In other words,

national saving = I + X

This equation is an accounting identity, as well as a condition that has to characterize equilibrium in any coherent macroeconomic model. Hence my longstanding advocacy of measures to raise the private saving rate or lower the federal deficit.

So then, aren’t I delighted that consumers are now, finally, saving more?



Personal saving as a percentage of disposable personal income. Data source: BEA Table 2.1.
saving_feb_09.gif



Well, no. It is one thing to identify a higher national saving rate as the long-term goal, and quite another thing to try to get there overnight in the form of a sudden drop in consumption spending. Here I am very much taking the side of Brad DeLong ([1],[2]) and Arnold Kling and against Eugene Fama ([1], [2]) and John Cochrane. The relevant question is whether, in response to an abrupt decrease in consumption spending such as we’re now experiencing, some of the other variables (most importantly, Y) might adjust in response as well. It is certainly true that in a very simple economic setting– for example, an economy that consists of a single farm producing only one good– the decision to save more of your income (leave some of your wheat unconsumed) is necessarily identical to the decision to invest more (save the wheat for later). And one can write down more complicated models in which economic actors and markets adjust in a way to see through the veil of production and exchange and make sure it is I + X that adjusts in response to a higher saving rate, and not Y.

But it’s also possible to write down models in which there are significant frictions that cause the adjusting to come in the form of lower Y in response to lower demand. The traditional such friction is the textbook Keynesian notion that wages and prices fail to adjust. In such models, responding to the lower C by increasing G may succeed in mitigating the loss in Y. Though here I must agree with Cochrane that those same models imply that if monetary policy could stimulate aggregate demand, that would achieve the same objective. I am definitely of the view that it is within the current power of the Federal Reserve to stimulate demand, and have urged the Fed to try to aim for a 3% inflation rate over the next several years.

But where I may disagree with some of my colleagues is in their presumption that wage or price rigidities are the core frictions that are responsible for producing the present situation. I have in my research instead stressed technological frictions. For example, when spending on cars abruptly falls, there is a physical, technological challenge with getting the specialized labor and capital formerly employed in manufacturing cars into some alternative activity. In my mind, it is a mistake to pretend that any federal program is capable of immediately re-employing those resources into an alternative, equally productive enterprise. More fundamentally, I have suggested that our present situation is as if someone had quite successfully sabotaged the basic functionality of our financial system. Until we once again have a financial sector that can successfully allocate credit to worthy projects, we’re not possibly going to be able to produce as much in the way or real goods and services, no matter what the level of aggregate demand or stimulus package might be. In terms of the textbook Keynesian models that people play with, I’m suggesting that “potential” GDP growth for 2009:Q1– that growth rate which, if we try to exceed it by stimulating aggregate demand, we primarily just get more inflation– is in fact a negative number. I do not accept the proposition that there is a level of government spending– however large a number you choose to suggest– that will prevent the unemployment rate from rising above 8%. But I do believe that if the government borrows a sufficiently large amount, we will have to worry in a very concrete way about what will sustain the foreign demand for U.S. assets.

What, then, do I propose? The first principle that’s quite clear to me is that drops in state and local government spending, or increases in state and local taxes, are a likely response to the current situation and are clearly counterproductive. Hence I’ve advocated ([1],
[2]) additional federal borrowing in order to provide unrestricted block grants to states. That’s a simple, effective plan that could and should be immediately implemented, while still preserving complete flexibility in responding to our serious longer run challenges.

I also am very comfortable endorsing additional government investment in infrastructure for which the argument can be made that the facilities could make a significant contribution to future productivity. At the top of my personal list would be investments in the electricity transmission grid, mass transit, and basic scientific research.

And unquestionably the number 1 priority for the federal government should be to restore a functioning financial sector. That in my mind should be done in a way that maximizes the return on any taxpayer funds invested.

But rushing through new government spending plans, just for the sake of spending? Count me off of that bandwagon.



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52 thoughts on “The paradox of thrift

  1. lilnev

    “I am definitely of the view that it is within the current power of the Federal Reserve to stimulate demand, and have urged the Fed to try to aim for a 3% inflation rate over the next several years.”
    I agree that the Fed can create inflation by printing money to buy treasuries (or whatever). I’m not convinced that this would stimulate demand. People with cash will be able to buy less “stuff” with it. Likewise lenders will see decreased purchasing power in their future income stream, and may cut back. Debtors traditionally benefit, but that’s only true if wages rise with prices. In this employment environment, workers have no bargaining power to demand wage increases.
    Am I missing something? How can the Fed “stimulate demand”?

  2. 2slugbaits

    JDH,
    If it turns out that sustaining demand for US assets isn’t much of a problem, then why not rush through new government spending programs just for the sake of spending? As long as interest rates are low (which suggests there’s still plenty of demand for US assets), doesn’t this tell us that almost any government spending passes a benefit/cost analsis? Satiation of demand for US assets is the kind of problem we should welcome, right? Finally, instead of looking at GDP we should be looking at Net GDP (GDP less depreciation). Looking at Net GDP (which determines the future flow of benefits) also puts more emphasis on things like national park maintenance, sodding the grass on the Mall, upgrading sewer and water systems, etc. In other words, the very things that the GOP wants gutted from the stimulus bill. And it clearly argues against things that stimulate private consumption spending…again, things promoted by the GOP.

  3. 2slugbaits

    lilnev,
    Inflationary expectations (as opposed to actual inflation) increase the opportunity cost of holding cash. Inflationary expectations send a signal that it is better to buy now, which increases demand. Deflationary expectations encourage people to hold off on buying that new car because (1) the price might be lower tomorrow, and (2) the debt burden increases with deflation. The Fed would rather deal with inflation than deflation. We know how to fix the inflation problem. We’re totally clueless how to fix deflation.

  4. donna

    We didn’t save because there was no point. Why do you think money was chasing higher and higher returns? Because you couldn’t get decent interest on any savings account to keep up with inflation.
    Our period of greatest prosperity had passport savings accounts with about 5% interest when real inflation, not government-fudged inflation with stupid messed-up numbers that under calculate real inflation, was about 2-3%. That’s how you get people to save money, by paying decent returns so money doesn’t go off creating ridiculous ponzi and kiting schemes just to stay ahead. If you put money in the hands of real people and pay them a decent amount to save it, instead of piling it up in the accounts of overpaid executives who want 20% returns on their investments, we’ll have a real economy again. Until SOMEBODY in the fancy world of economics starts saying that, repeatedly, we are well and truly screwed.

  5. Dick Fox

    The question that is never answered is where will the funding come from?
    Richard Ebling has pointed out in a recent article (http://www.aier.org/research/commentaries/1105-will-foreigners-bailout-obamas-stimulus-spending) that in the past the government has:
    1. Raided the Social Security trust fund (does anyone actually believe there is such a thing?)
    2. Sold treasury debt to foreign investors primarily China and Japan. But in 2008 foreign holdings increased around 30% but it is important to note that Japan actually reduced its holdings 4%. China, with exports crashing, is already complaining about US paper so could it be far behind Japan in reducing its purchases? Also European countries are also entering the paper market for around $350 trillion so rather than helping the US they will compete for investment.
    3. Wall Street. It should be obvious that since these firms are to receive the bailout money it makes no sense that they could support their own bailout.
    4. The Federal Reserve has expanded its balance sheet by a fantastic amount. How long can this continue.
    5. So that brings us to our last option, the printing presses. I am reminded of so many inflations of the past where the printing presses were operating day and night and could still not keep up with the demand for the hyper-inflating currencies.
    Professor, would you address the question of funding, or is it already implied that you favor the printing press by your embrace of inflation?

  6. 2slugbaits

    Dick Fox,
    A shortage of buyers for US Treasuries is a potential problem. And to a large extent it is the kind of problem that we might like to have because it would likely signal an uptick in worldwide economic activity. But instead of worrying about a potential problem, why not focus on what we know is an actual and immediate problem? We know there’s a significant shortfall to potential GDP, even if (as JDH suggests) potential GDP growth is negative. There’s an aggregate demand problem. We have two policy tools. The first is monetary policy. Conventional monetary policy is exhausted and interest rates are at zero. Unconventional monetary policies are still options, but we don’t entirely understand how they will work or even if they will work. So I think there’s some risk there. The second policy tool is fiscal. We know (or at least we knew at one time) how that worked and we know the risks. As long as people are willing to buy US assets at very low interest rates the fiscal policy option looks relatively attractive.

  7. DickF

    JDH wrote:
    Until we once again have a financial sector that can successfully allocate credit to worthy projects, we’re not possibly going to be able to produce as much in the way or real goods and services, no matter what the level of aggregate demand or stimulus package might be.
    Professor,
    This is a very important concept but it must not be limited to the financial sector. Throughout out economy capital has been misallocated. It can be seen clearly in real estate as homes sit empty in foreclosure and construction sits idle, or in auto manufacturing as inventories continue to build in the fact of layoffs, or in a myriad of other businesses that have gone under destroying more capital.
    But the question is how do we return to the proper allocation of capital? It should be obvious that stimulating the same kind of demand that got us into this mess is not the answer. And certainly the way government has mismanaged resources in Fannie and Freddie and so many other sectors should not give us much confidence in their decisions.
    Once we realize that misallocation of capital has been due to huge mistakes in central planning by government agencies, we will begin to see the light at the end of the tunnel. To properly reallocate resources, financial or otherwise, we must return to producing what the consumer wants not stimulating distorted demand. Only by getting the government out of the business of picking winners and losers and returning to allowing the consumer to choose for himself will we escape this downward spiral. Once we recognize that this is not a typical business cycle, but the consequences of intentional and misguided decisions by government will be discover the way out.
    I have used the example before but a man who has one half of his body in a freezer and the other half in an oven can have an aggregate temperature that should allow him to thrive. Knowing the results of such a condition why should we be surprised when our aggregate numbers keep giving us messages of hope when all around us is crumbling? Aggregates hide solution even though they make economists feel very secure.
    Sadly, I am not hopeful that our decision makers will discover this solution until we have faced even more horrible destruction in our economy.

  8. DickF

    2slugbaits,
    I agree that the solution is fiscal but the proof is in the details. I would have to know what you are proposing to sign up.

  9. Joseph

    It’s interesting that the very things that JDH deems most effective for a stimulus bill are the things that the so-called “moderate Republicans” eliminated.
    $40 billion cut from state government grants
    $20 billion cut from school construction
    $200 million cut from the National Science Foundation
    $100 million cut from the Energy Department’s Office of Science
    In its place was added a enormous tax credit to encourage people to trade their current house for another house.
    90% of Republican senators and 95% of Republican congressmen voted for an alternate plan that consisted of only tax cuts, no spending. It is obvious that the Republicans have become a rump party of the south consisting of two classes — ignorant evangelicals and wealthy people whose only concern is lower taxes.

  10. Robert Bell

    JDH: great post, as always. Minor questions:
    “Investment in plant and equipment is the single most important variable that will determine our future productivity and standard of living.”
    My understanding of the basic Solow model is that in fact technological progress is going to determine that standard (not investment in K), but that there is controversy in more realistic models over the role of capital accumulation contra the basic Solow model. How do you think about this?
    “Until we once again have a financial sector that can successfully allocate credit to worthy projects, we’re not possibly going to be able to produce as much in the way or real goods and services, no matter what the level of aggregate demand or stimulus package might be.”
    Maybe it’s an arbitrary distinction, but I distinguish between credit as means of facilitating exchange and smoothing consumption versus equity investment in projects. (I just read a long guest post by Steve Keen at Naked Capitalism – that may have something to do with my view – and awhile back Steve Randy Waldmann at Interfluidity posed the question “what if we had a real financial system).
    For example, if I get a monthly paycheck on the 30th, but I wish to consume food during the month, a credit card would allow me to do that. That transaction probably does nothing to build up productive capacity (unless you think of learning by doing in the production process), whereas a loan or an equity investment in a new factory does. I think both mechanisms are in trouble now, but they may require very different interventions.
    I think for the first capability, once toxic assets are off the balance sheets of banks, then the credit economy can resume working somewhat normally (the trust in banks as counterparties who honor checks is probably necessary and sufficient)
    For the second capability, the idea that technological frictions matter seems extremely pertinent. We have an economy that oversupplied real estate and certain financial instruments and technology. Resources have to be redeployed out of those industries and into things that consumers will want to pay for in a new equilibrium.
    What I find a little challenging is to identify how to spend without knowing what that new equilibrium will be. Even astute entrepreneurs have a hard time predicting where demand will emerge.

  11. Anonymous

    Halleluiah! It’s great to see an expert address something that I have pondered and written numerous letters to the editor regarding this extraordinary paradox – How can it be that we all need to save more (encouraged, no doubt, by the bloated financial industry) but we must also shop more (egged on by the bloated retail industry – and most economists) Then there is the unnerving fact that our economy is 70% driven by consumerism yet most of the things we buy are no longer made here which is so accurately noted in JDH’s contention that “And negative net exports, such as the U.S. has increasingly opted for over my lifetime, necessarily involves selling off our national assets and going further into debt to foreigners.” Sadly, it seems to me that this has been a conscious decision by this country with the encouragement of an inept government as Dick F notes. I also think, however, that our government and other policies makers (and corporate heads?) have not been well served by economic thought coming from our nation’s economists of all stripes. It is my opinion that many of their theories haven’t held up all that well in the real world, just one example being the contention that our vaunted service economy is really practical in a globalized world. This is how we got to this point of selling off the country to get doo dads from other countries that still make stuff. It’s not that hard a concept.
    Finally, I’m with Donna – we have become terribly confused in this country about the difference between saving and investing. Saving, which our parents did, has been consciously discouraged with devastatingly low interest rates. At the same time the risks of “investing” have been downplayed by a financial industry (that clearly didn’t really know what it was doing), all the while egged on by the “experts” including the Fed and others. I’m no economist but it seems to me that if the problem was too much credit, badly allocated then the solution cannot be more credit badly allocated. But that’s just me.
    Now here we are. I for one (aged 60), am saving like crazy even at 2% interest because I just don’t have time to wait for the great experiments that are going on with our economy to work out. It seems to me that there are a lot paradoxes (paradoxi?) going on but the fact that people are saving shouldn’t be considered one Keynes be damned!

  12. me

    > It is one thing to identify a higher national
    > saving rate as the long-term goal, and quite
    > another thing to try to get there overnight in
    > the form of a sudden drop in consumption
    > spending.
    But we weren’t getting there! Actual income has been falling a long while for most people except the rich. No effort at all was being made to encourage people to save their growing paychecks — which weren’t growing. All the excess money was being siphoned off. Bank fees for example. The more money the richest people have, the easier it is for prices to keep going up beyond the reach of the average person, and people kept trying to have what they saw others have.

  13. RebelEconomist

    JDH is to commended for taking on this controversial subject, but while one has to accept the empirical evidence (as mentioned by Menzie) that fiscal stimulus seems to work, I still think that the questions posed by Fama and Cochrane have not been properly answered. What is missing is a rigorous, common sense explanation of how government expenditure can lead to the generation of more output than it uses. Presumably, there must be some inefficiency (coordination failure, unproductive capital?) that the stimulus overcomes. But what is it, and how does government spending help?

  14. Anonymous

    I see Y more as an index, determined by or proxying for a match between technologies and preferences over many sectors. So I find it obvious that if C goes down (because of growing uncertainty about future consumption, income, lower wealth, et.c) Y must too. How could it not? The thing is that in contrast to the past, capital increasingly takes the form of human capital, i.e. the physical constraints of relocating to other uses are less important than before. Concrete example: http://www.nytimes.com/2008/12/28/jobs/28bankers.html (only half my tongue in cheek ; ) Also, from talking to some people in “real” industry, the machines that could be turned off so quickly can also be turned on relatively quickly. Everything and everybody is so much more flexible now. So, I think people may be surprised by the speed of recovery although I totally agree with your point that “potential” output (whatever the meaning should be) is already lower than a quarter ago and will become lower still in the near future precisely because it’s not “output” but _match_ that counts. THe problem is human cost, i.e. if a country does not have some form of safety net to buy enough time for reallocation, you might get discrete change in political areas. That has started to worry me much more than the economy, actually. Great post prof, thanks.

  15. Lord

    “I do not accept the proposition that there is a level of government spending– however large a number you choose to suggest– that will prevent the unemployment rate from rising above 8%.”
    Not even if government simply gave everyone that was unemployed salaries and counted them as employed? That could be among the most effective of any though there would be no public return to it other than taxes paid on it. I agree with your priorities though. I just wish the Republicans shared them.

  16. M

    “Not even if government simply gave everyone that was unemployed salaries and counted them as employed?”
    No, actually. These people would have some paper, but the economy would be demonetized from greenbacks and re-monetized by something else.
    Did you know, for example, that among the city college kids around here that pot, yes the herb, is often used instead of greenbacks for exchange.

  17. Rajesh Raut

    The low savings rate in the U.S. was a symptom of the low real interest rates caused by what Ben Bernanke calls “the global savings glut.” When loans are mis-priced too low, consumers will naturally borrow as much as they can. Now that loans are no longer available, consumers have become involuntary savers, a condition that is not changed by lowering the Fed Funds rate.
    Until bank rebuild their capital base, the availability of credit will be limited. In addition, consumers are compensating for the change in credit conditions by rebuilding the savings. The Federal government can not and should not compensate for the drop in consumer demand but it should try to slow the rate that production drops to ease the transition to the new demand pattern.
    I am not hopeful that the Federal government can repair the financial system quickly. Congress is unlikely to authorize the multi-trillion dollar level of spending to re-capitalize the banking system for current and expected bad assets.

  18. Anarchus

    I’ve always thought there was a logical flaw in overemphasizing national income accounting while treating the national stock of wealth almost as an afterthought.
    The methodology used makes it very clear that the low and falling savings rate (high level of consumption relative to incomes and overuse of debt) and large merchandise trade debt has gradually put us in an unsustainable, crisis-oriented situation.
    If economists focused more on net wealth and indebtedness relative to wealth, would that have helped call attention to the problems as they built up but before they reached crisis proportions?

  19. Anonymous

    @Andrew: Roughly, rents are C and new construction or significant alterations of existing stock are I. Owners “pay” rents in an accounting sense.

  20. n999

    Amusing… I get the formulas for GDP.
    It seems that academics or Keynes’ns have a solution to fix the problem. Encourage spending and if the people can’t, the government should. Even though for ever Government dollar spend it yields less that 1 buck in the economy? Gee wonder why and imagine that. Government can’t spend our way to prosperity, if it could look at the USSR or better yet, do you believe Japan who has a free market is striving in this situation? They went from depression right back into another one after 4 years of getting out of one.
    What the ivory tower economist seem to not realize is Social mood and social behavior. This coupled with the fact that Personal balance sheets are severely max’d and strained. They can’t borrower anymore, couple that with tighter lending standards, No one wants get or wants to issue promissory notes. That is what drives our economy kids, people who take risk, taking risk is finding capital, loans are a common form of getting capital. Never-mind that IPOs have fell off of a cliff too. So has consumer credit, cliff jumping.
    Real wage growth for the mean has trailed inflation over the past 20 plus years. People felt wealthy by moving out of homes every 5 years or refinancing their home loan every three years. This allowed them to monetize their credit card debts into the system. There is not more room for monetization of debt, consumers already been doing it for decades. MEW (mortgage equity withdrawals) which fueled our economy for the past 5-6 years is gone. We created nothing just borrowed more because credit creation was easy.
    It amuses me to see the debate amongst academics on how a math formula will fix the problem. If math was done right to begin with we wouldn’t be in this situation, those smart formulas wont’ allowed those who have pulses and heartbeats to get loans, now formulas won’t save us.
    In order to save us, we need to save for a decade or so, that way we can spend our savings down again.
    Better yet, pull life support from all the financial institutions (tough love if your invested in them, YOUR ENABLED THEIR MADNESS NOW pay the price). Once the fail, sell the toxic assets for 25 cents on the dollar, keep the institutions going while the auctions proceed. Sideline money of 5-6 trillion will happily buy the crap at rock bottom levels.
    New owners now can mark up assets when they wipe out 50% of all outstanding mortgages on their books, so consumers have affordable payments.
    That easy, it would cost the “G” part of your formula, what a few paychecks to seized institutions employees for a few months….
    all other solutions will almost guarantee another LOST decade or quarter century or worst, an actual depression.
    Gosh forbid we hit reset and let capitalism work.
    Imagine the “Transparency and confidence” if those assets were written down.
    Forget the shareholders and bond holders of the institutions that are insolvent or hold toxic crap. They enabled the madness time for them to pay the price!

  21. Andrew

    So does the loss of investor confidence that Keynesians describe as the cause of recessions include those investors who’ve speculated on house prices, or is it only a reference to industrial investment?
    More generally, what about D for Debt, where does it fit into the equations?

  22. Anonymous

    @n999: You said “It amuses me to see the debate amongst academics on how a math formula will fix the problem. If math was done right to begin with we wouldn’t be in this situation, those smart formulas wont’ allowed those who have pulses and heartbeats to get loans, now formulas won’t save us.”

    It’s getting tiresome to hear this over and over, people blaming “math” for economic problems. It’s like Chinese characters: You can write the Tao Te Ching in it, and you can write complete junk in it. Looks the same to those who can’t read them, and makes a world of difference to those who can. If you signed a contract written in Chinese characters without being able to read them, and later it turns out differently from what you thought, blame yourself and not the characters. Either you do your homework or you don’t take that risk. It was not math and not even bankers who “created” your problems. (Yes, I’m also getting tired of banker bashing by people who don’t seem to have a clue about basic institutions and functions.)

  23. Spry

    Professor,
    Good post. I agree that just considering wage and price frictions is too simplistic a view. And that investing wisely (to fix the financial system and in infrastructure… etc) are ideal.
    But I thought all economists (regardless of their beliefs on the impact of stimulus spending) agreed that quicker spending was more beneficial ceteris paribus. The longer we wait to deploy the stimulus the closer we will be to full employment and more “crowding out” will occur.
    So I guess the question is, would a hastily passed less than perfect stimulus plan enacted immediately be more useful than something that is more efficient in its allocation but takes longer to deploy?

  24. Anonymous

    @n999: You said “It amuses me to see the debate amongst academics on how a math formula will fix the problem. If math was done right to begin with we wouldn’t be in this situation, those smart formulas wont’ allowed those who have pulses and heartbeats to get loans, now formulas won’t save us.”

    It’s getting tiresome to hear this over and over, people blaming “math” for economic problems. It’s like Chinese characters: You can write the Tao Te Ching in it, and you can write complete junk in it. Looks the same to those who can’t read them, and makes a world of difference to those who can. If you signed a contract written in Chinese characters without being able to read them, and later it turns out differently from what you thought, blame yourself and not the characters. Either you do your homework or you don’t take that risk. It was not math and not even bankers who “created” your problems. (Yes, I’m also getting tired of banker bashing by “ordinary” people who don’t seem to have a clue about basic institutions and functions and make everybody but themselves responsible for their debt and their politicians. I mean, you guys actually re-elected Bush, remember? And even after, 40 plus percent of you still voted for Palin VP and the party of Gramm. When I’m angry, I think you actually deserve that mess. When I’m more reasonable, I think you are paying the price for serious undereducation for 90 percent of your people relative to what is possible as evidenced by countries like Finland, Switzerland, or even Germany.)

  25. Steven Kopits, Princeton, New Jersey

    “And unquestionably the number 1 priority for the federal government should be to restore a functioning financial sector. That in my mind should be done in a way that maximizes the return on any taxpayer funds invested.”
    Government is not a profit-maximizer; ROI is not an consideration at the political level. Rather, government (or more precisely, the politician who direct government) maximizes political acceptability subject to a budget constraint. I defy you to go to any government agency and utter the words ‘cost-benefit analysis’ without being made to feel like an idiot. Government action is not predicated on cost-benefit analysis. If there were, the Connecticut Turnpike would have been widened years ago; there would be two additional tunnels from NJ into NY; and the streets of downtown New York would be better than those in a war zone.
    As for investment in mass transit, consider: It costs twice as much to travel per mile on Amtrak as it does on Southwest Airlines. (Calculate it yourself.)
    The cost of mass transit (per The Economist) has risen by something like 40% over the last 25 (?) years, the cost of owing a car has decreased by 20%. Mass transit is not improving at nearly the rate of private motorization. Why? It would be hardly surprising considering there is virtually no competition in public transport.
    Consider: a NY-Baltimore round-trip on Amtrak is something like $200. To drive is something like $70, or which half is tolls. Even if I allow another $30 for vehicle wear-and-tear, public transport is still astoundingly expensive–twice that of taking a private car! How would increasing public transport with such poor economics increase social welfare?

  26. MattYoung

    “A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time.
    This is the Keynesian view as presented by Krugman and paraphrased on one of the blogs.
    The “large” part of the economy that saves is an aggregate of labor allocated for a specific purpose under the equilibrium system in place. This is not Keynes, actually, it is Hayek and his requirement for a minimum of transactions.
    That aggregate of labor acts like an individual agent within the outlines of a Jensen aggregation, which one of the researchers at Berkeley looked at (Will Smith?) Within the Jensen inequality, which measures how well a group can be represented by a common agent function, the aggregate will act as a single agent in the classical sense. Keynes missed this.
    The Keynesian (whoops, I mean Hayek) minimization of transactions tells us how the aggregates form a hierarchical computing machine, specific to the particular technologies of the economy. (Look at Krugman’s trade theory).
    Now, what happens when the aggregate relationships change and why do they change. They change all the time, forming different aggregate relationships, but absent technological shocks these changes appear smooth.
    Now, imagine that a technology creates a new more efficient set of aggregate relationships, much different than the old. This is Jim’s friction problem. What happens to the economy is the same thing happens when Jim runs one of his vector autoregressive tests on economic data, but decides in mid stream to change the regressive parameters, he suddenly and unexpectedly changes the model on which he is testing data. His VAR test gets into a whole lot of mess, measured variables show unreasonable volatility; until it stabilizes by running more data through it.
    What is going on is that the VAR model has built up expectations (literally!) on the current data, but suddenly its expectations are no longer met as the regressive parameters change.
    This is the Keynesian moment, and it rightfully belongs to Hayek who first recognized it. During the transition we are no longer obeying Hayek’s minimum of transactions, we are way off efficiency.
    As far as the velocity of money and the Treasury view, I think DeLong is mistaken. Velocity, measured in complex variable quantities should be moderately constant for a given equilibrium structure. We get our Hayekan (whoops Keynesian) moment during a major transition between equilibrium structures.
    We are, right now, operating under both the old and new equilibrium structures. We recognize the old, but barely see the new. Hence the confusion, and hence we do a deflationary spiral until we spend most of the money on the old way of doing business, and it becomes apparent to us that the new way of business is better. But we need the deflationary spiral (I call it going to auction) because demonetizion cleans up the observed variables and we can then recognize the new system, and partially discard the old.

  27. Anarchus

    I liked the article that Niall Ferguson wrote in the LA Times, (http://www.latimes.com/news/opinion/commentary/la-oe-ferg6-2009feb06,0,6972232.column).
    Money quote:
    “There is something desperate about the way economists are clinging to their dogeared copies of Keynes’ “General Theory.” Uneasily aware that their discipline almost entirely failed to anticipate the current crisis, they seem to be regressing to macroeconomic childhood, clutching the Keynesian “multiplier effect” — which holds that a dollar spent by the government begets more than a dollar’s worth of additional economic output — like an old teddy bear.
    They need to grow up and face the harsh reality: The Western world is suffering a crisis of excessive indebtedness. Governments, corporations and households are groaning under unprecedented debt burdens. Average household debt has reached 141% of disposable income in the United States and 177% in Britain. Worst of all are the banks. Some of the best-known names in American and European finance have liabilities 40, 60 or even 100 times the amount of their capital.
    The delusion that a crisis of excess debt can be solved by creating more debt is at the heart of the Great Repression. Yet that is precisely what most governments propose to do.”
    I do think it’s interesting that the CBO’s conclusion about the impact of the expensive stimulus package is not encouraging:
    “In contrast to its positive near-term macroeconomic effects, the Senate legislation
    would reduce output slightly in the long run, CBO estimates, as would other similar proposals.”
    http://www.cbo.gov/ftpdocs/96xx/doc9619/Gregg.pdf
    So the government proposes to spend a fortune of taxpayer money to moderate the near-term decline in GDP (due in part to overleverage and an unsustainable consumption boom) and in return we get slightly lower GDP in the long-run. I need a teddy bear, now . . . .

  28. JDH

    lilnev: There may be a model that implies that a monetary stimulus would cause inflation but have no effect on real output, while a fiscal stimulus in the same circumstances would cause an increase in real output but no inflation, but it is certainly not a standard sort of prediction. I think if you are agreeing with me that, even if the Fed were to create some inflation, we would still be facing a situation of falling output, then I think in a standard textbook Keynesian model, you would have to be agreeing with my premise that potential GDP is in fact falling, and that a fiscal stimulus would also produce inflation without preventing that same decline in real GDP.

    2slugbaits:Whatever would persuade you that continually rolling over a level of federal debt of this size is never going to be a problem? I maintain that our key long-run objective should be to facilitate a transition to a path on which C and G are smaller shares of GDP and I and NX are bigger shares.

    Dick Fox: As I spelled out in detail here, my proposal is to fund the block grants and infrastructure spending with additional federal borrowings, with an intention of later retiring that proposed increase in debt.

    Robert Bell: Although it’s true that in the Solow growth model, the long-run growth rate is dictated by the exogenous rate of technological growth, the model also implies that, if there is an increase in the saving rate, that will cause an increase in the growth rate as you transition to a new higher steady-state ratio of capital per effective unit of labor. Mankiw, Romer and Weil (1992) argued that those effects can be quite large quantitatively. As to whether credit is part of effectively utilizing current resources for current production, see for example this discussion by Menzie.

    Hyun-U Sohn: Thanks for your helpful answers.

    Andrew: In the national income accounts, new housing construction is part of I, though in terms of the points I’m making here, I’d regard it as more of C. I do not think the construction of so much housing in the U.S. paves the way for future productivity growth in the same way that investment in plant and equipment does, nor does it give us a flow of future output with which to repay the foreign debt we accumulated in the process of building it.

    On your later question, magnitudes like Y, C, I, G, and X are all flow variables– they are so much per month, and a different number per year. Debt is a stock, so is not in the same units and should not appear in these equations. However, the flows necessarily imply changes in stocks– the low value of national saving implied increased indebtedness over time– and this is my primary point.

    Spry: My proposed block grant stimulus could and should be implemented much faster than the proposals in the House and Senate. But as for infrastructure, I think it is worth taking our time to get it right.

  29. Mousebender

    Saving doesn’t wreck the economy; it shifts consumption from the present to the future. Borrowing (negative net saving) shifts consumption from the future to the present. Today’s rush to save in effect (1) pays for the consumption we did in past years, and (2) puts away resources for consumption in the future.
    In the past few years, borrowing has increased our GDP above what it would have been without the borrowing. Now consumers are borrowing less on net, and today’s GDP is less than last year’s (borrowing-inflated) GDP.
    A lot of politicians and journalists are behaving as if the health of the economy is a binary value–1 or 0. In truth, this recession is a return to equilibrium, not a return to the stone age.

  30. Qingdao

    I wonder if you have seen the work of the Australian Steve Keen:
    “Thus causation in money creation runs in the opposite direction to that of the money multiplier model: the credit money dog wags the fiat money tail. Both the actual level of money in the system, and the component of it that is created by the government, are controlled by the commercial system itself, and not by the Federal Reserve.” The entire argument at Steve Keen’s Debtwatch blog, where he makes an interesting argument why the spike in base money will do nothing.

  31. Andrew

    Debt is not a flow? Doesn’t debt flow from debtors to creditors? And if a debtor has a line of credit with a creditor (i.e. a bank), isn’t the circle essentially complete? Banks borrow and lend to other banks. Isn’t that a circular flow?
    This (long) blog post is pertinent.
    http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/
    Making a distinction between stock and flow units might be a useful way of looking at an economy, but the argument that “debt is a stock, so is not in the same units and should not appear in these equations” sounds somewhat arbitary. Isn’t debt financed consumption part of aggregate demand? A very big one recently i’d say.
    The real problem seems to be that credit and debt are simply not part of the fundumentals of Keynesian economics, nor can they easily be added to the basic framework. The Keynesian economist says that recessions start when investor confidence drops suddently and dramatically, but this just amounts to calling one of the symptoms of a bust the cause, and preceeding as if nothing else in particular had occured.
    I think the frustration now being shown to towards economic theory, including in the replys to this post, is indicative that the Keynesian point of view is starting to be seen as irrelevant, incomplete and even dangerous. It’s time for a new theory.
    http://business.smh.com.au/business/wanted-a-new-economic-theory-20090206-7z7h.html?page=-1

  32. DickF

    JDH wrote:
    Dick Fox: As I spelled out in detail here, my proposal is to fund the block grants and infrastructure spending with additional federal borrowings, with an intention of later retiring that proposed increase in debt.
    Professor,
    When I was younger I had the same plan to buy a really nice house. The only problem is that no one would lend me the money.
    Who do you suggest our government borrow the money from?

  33. jult52

    “It is one thing to identify a higher national saving rate as the long-term goal, and quite another thing to try to get there overnight in the form of a sudden drop in consumption spending.”
    Professor, the US rate of saving has a risen maybe 2 percentage points so far. Is that too sudden for you? I don’t regard that as a dramatic change.
    Is your statement an implicit admission that there are no good solutions to a crushing debt load?

  34. JDH

    Andrew: Debt is most assuredly a stock variable. This labeling of “stocks” or “flows” refers to the units in which something is measured. Consumption spending, for example, might be measured in dollars per month, or, if you instead measure it in dollars per year, the number would be 12 times as big. Debt is measured in dollars, at a point in time. You can’t write an equation like 10 apples + 12 bananas = 22 apples. The units have to be the same when you write down an equation. You can’t measure C in dollars per month and Y in dollars per year and say Y = C + I + G + X.

    Although the equations above describe the relations between particular flows, the implications I am discussing are indeed about stocks, namely, national wealth and the total stock of productive capital.

  35. N

    Amazing … Producers are the only legitimate consumers, and they’re the only ones who should be able to consume, having earned their right to do so. Pray tell, just who would pay the present price of government “services” if taxes were shared equally? I watch (poor) people paying 30% of their income in fees, taxes, SSI (a scam for sure), etc. and getting less and less for their expenditures.
    Then elite are panicked. There are some for sure that earned their money, but a lot didn’t. Connected insiders to the money machine don’t pay taxes because they don’t impart any value to the currency they receive: they simply return some of the funds which were given value by genuine producers. Let the whole group of “elite” go down or start producing. That’s my advice. And it’s damn good advice too. And lose the “bailout” … it isn’t for the citizenry for sure.
    Just incredible.
    – JIMB

  36. Greg Ransom

    “technological frictions”
    Isn’t this account another label (with details) for Hayek’s explanation of the unemployment of labor and capital?
    John Taylor’s recent empirical work on the Fed + “technological frictions” = Hayek’s theory of the trade cycle.
    All you need to add to Taylor is additional detail on the relation of interest rates to investment and the time structure of production and consumption.
    By all means give stuff new names and new images if that will help the economics profession come around to accepting good science over bad science rivals.

  37. Ian

    Thank you, Professor Hamilton. That was an illuminating post. But perhaps you can clarify a point for me (and perhaps for other readers as well).
    In a vain attempt to understand the current mess, I’ve been reading far more Keynesian economics than is probably healthy. I have to say, though, that at least to a layman, the Keynesian approach holds together well. So I don’t understand why it makes more sense to blame technological frictions, rather than liquidity preference and sticky prices, for causing recessions.
    It would seem to me that if technological change were the primary agent causing recessions, then periods of economic underperformance in advanced countries should be relatively short-lived. Downturns should last no longer than it would take a rational society to adapt to the new technological realities. But, in fact, the Great Depression and the recent Japanese downturn seemed to linger for years and years.
    Also, I’m not quite sure how to gibe the notion of technological frictions with history. It seems to me that you can easily point to many technology-induced booms, from the grand railroad-building era of the 19th century, to the radio and automobile heyday of the 1920s, to the dotcom bubble of the 1990s. But I can’t easily think of many busts that were (obviously) caused by a technology shift. Both the Japanese downturn of the 1990s and our current woes seem to have their roots in overvalued real estate and overleveraged banks. Heck, if technological frictions were the root cause of downturns, why didn’t we have a severe downturn at about the same time as Netscape were introduced? Or the personal computer?
    Sorry, for this long post, but as you can probably tell, I’m starting from a position of profound ignorance. Any light you can shed would be appreciated.

  38. don

    JDH “For example, when spending on cars abruptly falls, there is a physical, technological challenge with getting the specialized labor and capital formerly employed in manufacturing cars into some alternative activity. In my mind, it is a mistake to pretend that any federal program is capable of immediately re-employing those resources into an alternative, equally productive enterprise.”
    Oh, I don’t know about that. It is not hard for me to imagine a more productive activity than producing more SUV’s (the specialty of the U.S. auto industry). In fact, just about any other employment would seem to do the trick, except maybe more highway construction to reduce congestion, which would probably come on line just in time for the new technology to charge for road use, sort of like when New York finally started to meter and charge for water usage, rather than trying to expand the supply in response to ‘water shortages.’
    I think the idea of supporting State spending is a particulary good one.
    Dick Fox and 2slugbaits – You do realize that, to the extent fiscal stimulus (federal deficit) is funded with external borrowing, virtually all of the benefits from the stimulus will go to foreign exporters, not to U.S. producers. The U.S. taxpayer will still be stuck with the bill, though.

  39. Lord

    Government as employer of last resort has some real value to it. Whereas the employed may save most of marginal increases to their income, the unemployed are unlikely to save at much more than the rate of the employed. Targeted, timely, and could be made temporary.
    Sadly, this is a political process. ‘Taking time to do it right’ is an oxymoron. The more time taken, the worse it will become. We are already seeing that occur.

  40. ean

    Ian: There is not one technology in the economy, there are thousands, or hundreds of thousands of little sectors and products, and each employs different technologies. Technology is not to be taken too literally here, it’s a metaphor for “all that goes into the production of X”. So even location plays a role. Some demands are correlated, and technologies take a long time to build up (education, specialization, buying the intermediate goods, setting up the machines,…). So when you start investing, you don’t know whether people will want what you will produce. If it turns out that en masse, people do not want what producers have prepared, we have a mismatch. Clearly, assets will have to be relocated/put to different uses, which usually impairs their value, particularly in a differentiated economy. What you get is a downturn in overall exchange, in other words, a recession or even depression. The mistake Keynesians and descendants tend to make is to take technology to mean, representative agent style, “one big production technology to transform economy’s resources into economy’s output”. This is not a helpful simplification, in fact, it’s misleading, which is evident from your questions. So there is my answer, let’s see what JDH has to say (if).

    don: sorry to be so rude, but this is a moronic post. DO you really think productivity has anything to do with your particular taste or distaste in SUVs and such?! Learn some abstraction, man.

  41. 2slugbaits

    JDH:
    Whatever would persuade you that continually rolling over a level of federal debt of this size is never going to be a problem? I maintain that our key long-run objective should be to facilitate a transition to a path on which C and G are smaller shares of GDP and I and NX are bigger shares.
    I probably wasn’t clear enough. I don’t think it’s a major problem as long as investors are willing to buy US Treasury bonds at very low yields. If bond prices fall because investors no longer have faith in US Treasuries, then we’ve got a problem. But right now we are nowhere near that point.
    The objective isn’t to maximize “Y”, it’s to maximize a sustainable level of “C” over some long horizon. The only reason we invest today is so that we can consume tomorrow. There are lots of different ways we can consume. Private consumption usually comes out of net private investment, but we also consume public goods and those public goods come from public (i.e., “G”) investment. I don’t see anything wrong with increasing “G” if “G” takes the form of increased public investment that yields a higher public consumption stream down the line. And when 10 year Treasuries are well under 3 percent it’s pretty easy to justify public investment.

  42. Andrew

    JDH,
    so what’s stopping us from measuring debt in dollars per month? Maybe that would be quite insightful.
    And why not call savings a stock – of deposits!
    Isn’t non-consumption debt just another way of looking at investment?
    Isn’t non-investmebt debt a part of aggregate demand, just like C and I?
    You haven’t convinced me with the apples and oranges. Everything is measured in dollars.
    Its not any measuring units that we have that allows us to call one category of dollars stock, and another flow. Its just an accountants way of looking at things that’s convenient to the accountant. But why should the real world care?

  43. Mike Laird

    Andrew: JDH’s response is correct,but incomplete. Debt is indeed a stock, an accumulation. Taking on debt or credit creation is a flow, and paying off or writing down debt is also a flow. When you are talking about the latter 2 flows, you are talking about flow of funds – not GDP. Economists seldom talk about flow of funds because of a view that it is a temporary phenomena on the way to more important topics like the elements of GDP. Normally, this is true, but when the Fed makes short term debt free like they did for 2 years in 2002 – 2003, then the credit creation flow becomes important. Eventually, economists will recognize that the debt write off flow is important, but we have not suffered enough pain for that to sink in yet.

  44. Boo-urns

    This is an incredibly asinine question, an exercise in Sophistry 101. I could similarly ask about the paradox of sleep (first you tell me I need to sleep, and then you tell me I need to wake up).
    There is a time to save (when the economy is good) and there is a time to deficit spend (when the economy is bad and needs a bump up). There. Was that so difficult?

  45. asinus

    Andrew: Stop being silly and hit the books. If even the reference by Hyun-U Sohn is too difficult for you, then why not take up an Econ 101 class at a community college or high school near you. Stock and flow variables are so basic, I don’t know what you gain from reading JDH’s posts.

    Boo-urns: Yeah, everything is very simple. A hockey mom can do it, right?!

  46. pat

    An excellent post, JDH.
    It’s the damage of the financial system that keeps me thinking about the great depression. What makes it scary is that many people and policymakers don’t fully comprehend the danger. The situation is particularly acute in the US. We had evolved into a setup that about half of our financial intermediation was conducted outside the traditional commercial bank system. In a sense, ABS is just a substitute for universal banking: it allows a small local bank to diversify. From this angle, the dryups in ABS, commercial paper, tender option, etc. markets were just classical bank runs, to markets and institutions that do not call themselves banks. So basically we are dealing with a full blown banking crisis without the tool of FDIC. And we haven’t been able to do much better than policymakers in the early 30s … so far …

  47. bellanson

    Andrew,
    The definition of debt is that it is the sum total of money you own.
    If you borrow $50 from me and $100 from JDH, then your total debt is $150, not $60 per month or some sunch thing.
    If you have a formula where you are saying things like: Total debt = sum of partial debts, then you can’t throw in things like “rate of borrowing”, because that would have to be measured in $/time rather than in planin $ (you could however say something like: debt = rate of borrowing * time)
    Bellanson

  48. Andrew

    Ok, i’ll use that $150 to buy shares, and then i’ll have an investment “stock” of $150. And if we both do that then accumulated I=$300 and accumulated D=$300. And if we each do that twice a year then our combined investment rate is $600 p.a. and our combined debting rate is $600 p.a. – though of course we’ll call the later borrowing.
    But i’m off to hit the books…

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