Friday, December 12, 2008

Deflation, Recession, and Aggregate Supply

There has been a lot of talk (some of it from me) about the possibility of deflation in the US. Deflation would be a problem for a couple of reasons: first, deflation would make it more difficult to engineer an economic recovery; second, deflation could result in a “death spiral” like what happened (according to one interpretation) during the early 1930’s. The latter problem is a lot scarier, if you think it’s a serious possibility. There is, in my opinion, a good chance of some deflation, but, as I will argue, I don’t think the death spiral scenario is something we need to worry about today.

The death spiral would occur because of a positive feedback loop (vicious circle) between deflation and economic weakness. Even mild deflation deters long-term capital expenditures by making them less profitable. (Why build a factory, for example, if you expect product prices to go down year after year?) Moderate deflation deters even short-term capital expenditures. (Why buy a computer if declining revenues will barely allow you to recoup the cost?) When deflation becomes severe, even expenditures for consumer durables are significantly reduced. (Why replace your refrigerator this year, when it’s going to be cheaper next year?) Because of these effects, deflation reduces aggregate demand, and does so more rapidly as the deflation rate increases. Weaker demand, as everyone knows, tends to lead to lower prices. Thus it’s possible to imagine an economic implosion where deflation and economic depression feed on each other and become ever more severe.

As I said, that is, according to one interpretation, what happened (or began to happen) during the early 1930s. President Roosevelt managed to put an end (at least temporarily) to the deflation, in part by devaluing the dollar. It’s not clear whether devaluing the dollar would be an option today, because other countries might counter with intervention designed to nullify any US attempt to intervene against the dollar. Fortunately, however, there are many other tools we can use to avoid the kind of severe deflation that faced Roosevelt when he took office. Working against the positive feedback loop of deflation and depression, there is a negative feedback process: the worse the deflation becomes (or is expected to become), the more authorities will be willing to use unconventional policies to stop it.

Stopping deflation should not be very hard at all, if you’re willing to accept the side effects of your deflation cure. Most discussions of this topic have focused on the demand side: the Fed could get people to start buying things by dropping money from a helicopter; or it could buy stock and increase demand by corporations and stockholders; etc. But when it comes to stopping deflation, demand policies are the hard way. To continue my side effects metaphor: if you insist on using the less powerful drug that has fewer side effects, you may have to give ridiculously high doses before the patient responds. The easy way to stop deflation – the drug to try once hair loss and vomiting become less of an issue than the disease itself – is to reduce supply rather than increase demand.

During normal times, economists and policymakers spend a lot of time trying to figure out ways to increase supply. It’s not an easy task. Cut taxes, to improve incentives for private investment? Raise taxes, to stop consumer spending from crowding out private investment? Invest more in public infrastructure to make the economy more efficient? Invest less in public infrastructure, to make the resources available to the private sector? It’s a tough game.

The game gets a lot easier when your objective is to let the other guy win. One obvious way to reduce supply, for example, is to encourage the formation of cartels. That’s something that Roosevelt tried, though some of his programs were struck down by the Supreme Court. Scholars can debate what the overall effect was on economic growth, or whether, after already devaluing the dollar, such additional measures against deflation did more harm than good, but it’s hardly open to question that encouraging cartels will tend to raise – and in the context of a deflation, stabilize – prices.

One particular form of cartel encouragement, which would certainly go over well with some of the current government’s constituents, would be to strengthen labor unions (one thing that Roosevelt did). Under normal conditions, some economists might argue that labor unions, despite their cartel aspect, often increase supply by such means as improving morale and decreasing unnecessary turnover. But it’s certainly true that unions are particularly loath to accept cuts in wages. In the context of a deflation, the stabilization of wages would tend to stabilize prices, since it would make it unprofitable for firms to cut prices. (Paul Krugman touches on this issue in some recent blog entries. He mentions a recent academic paper, but I like to give credit to Brad DeLong and Larry Summers – in a paper that I read nearly 20 years ago before it was published – for making intellectually respectable the idea that labor unions can help the economy by helping protect against deflation. I should also acknowledge James Tobin, who worked out the theory underlying the “death spiral” concept as discussed above.)

Another way to reduce aggregate supply is by inducing inflationary expectations to replace deflationary ones, so that producers are less willing to sell at low prices. This is largely a psychological issue, but if the Fed shows a willingness to take demand-side policies to extremes, even if the extremes are still not enough to solve the demand problem, they may affect supply. For example, when James Hamilton suggests (somewhat whimsically and just for the sake of argument) that the Fed could buy up the entire national debt, one might think of it as a demand-side policy, but I would suggest that its supply-side impact would be more important. With Treasury interest rates, even for long-term bonds, already quite low, it’s not clear that reducing them to zero would have much effect on demand. But when people observe the Fed buying up the entire national debt, the perception that “Helicopter Ben has gone wild” can’t help but make an impact.

And so on. Figuring out ways to produce less, rather than more, shouldn’t be very difficult. Naturally, reducing aggregate supply – trying to make the economy produce less at any given price – is not going to be directly conducive to economic recovery. But by reversing deflation and thereby making traditional demand-side tools more effective, it could be indirectly beneficial.

The death spiral should be pretty easy to avoid. The problem is that, once you get to the point where you have to make avoiding the death spiral a priority, you end up with this conflict between policies that reverse deflation and policies that increase production. It’s not the 1930’s, but it’s an experience I would hope to avoid.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Wednesday, December 10, 2008


Just some notes about this blog:
  1. Thanks to Greg Mankiw for linking to me.

  2. Against my better aesthetic judgment, I have bowed to presbyopic pressure and inverted the text and background colors from white-on-black to black-on-(almost)-white. As a note of protest, I am retaining an ever-so-slight bluish tint in the background color and changing the navigation bar from blue to black. Personally, despite having outlived the days when I could read a menu in a dimly lit restaurant while wearing unifocal contact lenses, I don’t find black-on-white or black-on-almost-white-with-a-very-slight-bluish-tint any easier to read than white-on-black, but OK: as the new kid on the block, I’m not in a position to resist the prevailing social ethos.

  3. I do hope to respond to at least some of the comments on this blog, but there may be institutional delays involved, so if you’re interested in my possible responses, you might want to check back a few days afterward.

  4. I have now signed an agreement with Seeking Alpha, whereby they will be copying some of my blog entries to publish on their site. You can view my profile there if you wish, but if you’re already reading this blog, there’s probably not much point.

  5. At the suggestion of some commenters on my first post, I have registered a new domain, which will hopefully point to this blog once the DNS records propagate. (Yeah, I don’t know why I didn’t think of “” in the first place.) Links to the original blog URL should still work.

Monday, December 8, 2008

Will Monetizing the Federal Deficit Cause Inflation?

Only if we’re lucky.

I sometimes joke that the old dispute between the Monetarists and the Keynesians was resolved when the Keynesians conceded all the substantive points and the Monetarists agreed to be called Keynesians. Like most jokes, it’s not quite true. The one thing the Keynesians never conceded was the raison d’etre of the Monetarists, the Quantity Theory of Money – the idea that nominal national incomes, and ultimately prices, are determined (in some reasonably simple and predictable way) by the quantity of money. By the mid-1980’s, financial innovation had made the quantity of money in the US very hard to measure, and so the theory – whether right or wrong – became largely irrelevant. And in August 2008, it still seemed largely irrelevant.

But that has all changed in the past three months. While it is still quite difficult to measure the “true” quantity of money, it is easy to measure the quantity of base money –the money created directly by the Fed. When the quantity of base money shoots up in a way that dwarfs all prior experience, it’s fair to say that the “true” quantity of money – whatever that may mean empirically – is also rising more quickly than usual. And some monetarists, clinging to empirical relevance over the period since the 1980s, would argue that the quantity of base money is the true quantity of money.

If this latter group is right – both about the validity of the Quantity Theory and about using base money as the true measure – then we are in for one hell of an inflation. Fortunately (or, alas, perhaps unfortunately) they’re wrong. At least I’m convinced they’re wrong. But let’s examine what has happened. On September 1, the monetary base was $846 billion. On December 1, it was $1.483 trillion. As an annualized rate of increase, that would come to more than 800%. It’s an increase of $637 billion, enough to finance the whole federal deficit for fiscal year 2008, cut every household in America a $1000 check, and have plenty left over for everyone in Washington to spend on whores and liquor – and I’m talking Glenfiddich and Ashley Dupré here.

OK, I apologize to Miss Dupré (who I imagine doesn’t even like being called a “former sex worker,” let alone a “whore”), and for that matter, to everyone in Washington (many of whom are scrupulously monogamous teetotalers, and many of whom, indeed, are in categories to which the escort business doesn’t even market itself). I was using a conventional figure of speech to make a point: the Fed has created a huge, huge, huge amount of money in the past few months. And with T-bill rates already at zero and no danger of their going lower, it’s easy to imagine that the Fed will be able to finance the entire 2009 federal deficit, gargantuan though it is projected to be, and perhaps 2010 as well, without having much immediate effect on anything.

But in the long run, will it cause inflation? This is where I declare (in case you had any doubt) with the Keynesians. I’m not even sure that two years of fully monetized deficits would be enough to stop deflation, if it should happen, let alone cause inflation. In the textbook Keynesian model – the one in today’s textbooks, not the one Keynes would have put in if he had written a textbook – the case is pretty clear: there is a non-accelerating inflation rate of unemployment (NAIRU) – an idea, by the way, derived from the Natural Rate Theory associated with Milton Friedman, the leader of the Monetarist school. When the unemployment rate goes below the NAIRU, the inflation rate rises, and it keeps rising until unemployment goes back up. When the unemployment rate goes above the NAIRU, the inflation rate falls, and it keeps falling until unemployment comes back down.

One of the problems with the NAIRU is that nobody ever knows exactly what it is. But recent estimates have tended around 5 percent, and just about any economist will agree that it can’t be much higher than 6 percent. The unemployment rate for November was 6.7 percent, comfortably above anyone’s estimate of the NAIRU. A nearly universal consensus holds that it will rise from here, and some very reputable economists are talking casually about double digits. Moreover, the experience of recent business cycles suggests that, once it rises to its peak, it will come down only very slowly. So if you’re even just a little tiny bit Keynesian, you won’t be expecting much inflation for quite a while. If you take the textbook model as gospel and have confidence in recent empirical estimates of the NAIRU, you probably expect deflation, and you may be worried that the deflation could become quite severe.

I don’t take the textbook model as gospel, but I think it’s a pretty good way of looking at things, and I’m confident that the NAIRU – to the extent that the concept is valid – is not too far from 5 percent. Moreover, the 65 percent drop in the price of oil, which would have been considered wonderfully good news during most of the last 40 years, is not encouraging under today’s circumstances. Things could get quite ugly, and the ugliness will not resemble that of the 1970’s.

Now you might say, “So much for the short run, but in the long run, monetization today will cause inflation in the future.” When I start to see double-digit inflation in Japan, maybe I’ll believe you, but that long run is starting to look very, very long. Even if the US recovery comes fairly quickly (like the middle of 2009, rather than the end of 2010 or the beginning of 2015), the Fed will have plenty of opportunity to demonetize the federal debt before the unemployment rate starts to fall to a normal level.

But I’m skeptical as to whether much if any demonetization will even be necessary. Back in the old days, the four decades after World War II, we used to have sharp recessions – mostly the manufacturing sector would contract quickly, then turn around and expand quickly. That doesn’t happen any more. Today’s service economy doesn’t expand and contract quickly. Recessions begin more slowly, and recoveries are painfully slow. Even in a best-case scenario, the unemployment rate is likely to be above the NAIRU for quite some time. It strains my crystal ball to try looking ahead to the time when any demonetization at all will be necessary.

No, we won’t have to give back the $637 billion (or even the trillions that may follow). It was a Christmas present from the Weak Economy. The biggest Christmas present the US has ever gotten. Unfortunately, it’s not the one that was at the top of my wish list.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Wednesday, December 3, 2008

The Etymology of Macroeconomics

When I was setting up this blog, I had a devil of a time coming up with a URL that wasn’t already taken. Google wanted me to use “” but I just couldn’t ask people to type in that whole thing. I ultimately settled on “andytheeconomist” for the bottom level name because it was easy to remember and not too long, but my mind went to some strange places along the way. It’s just as well that I thought better of “” – not too long, but who is going to remember it?

Nonetheless, I can’t purge “makron oikon nemo” from my mind, so, since I need something for a first blog entry, that’s going to be my topic. Literally, provided I haven’t made a mistake in the morphology, “makron oikon nemo” (μακρον οικον νεμω) is Classical Greek for “I manage a large house.” That might seem to have very little to do with anything, but the words μακρον, οικον, and νεμω are also the etymological roots of the word “macroeconomics.” (By the way, I’m an economist, not a linguist, so you shouldn’t necessarily trust anything I say about etymology. But then again, I’m not sure you should trust what I say about economics either.)

“Oikon” (οικον) is an inflected form of “oikos” (οικος), which means “house.” “Nemo” (νεμω) – which by the way is usually pronounced with the “e” as in “bed,” not as in “Finding Nemo” – means “I manage.” (It is conventional to identify Greek verbs in the first person form rather than the infinitive. If we were talking about the English verb, we would probably say, “to manage” rather than “I manage.”) In Classical Greek, the two words were combined into the word “oikonomos” (οικονομος), which means “house manager.” The etymological meaning survives to some extent in English phrases like “home economics,” which they used to teach in grade school when I was young. (Do they still teach Home Economics?)

Anyhow, a house manager for a man of substance had a lot of coordination to do – a lot of arranging and buying and selling and making sure things would be in the right place at the right time – to keep the house running smoothly. A similar art could, in principle, be applied at the level of the city-state, or “polis” (πολις). And someone who practiced that art at the level of the state would be a “house manger of a state” or “state house manager” – “politikos oikonomos” (πολιτικος οικονομος). I have no idea whether the ancient Greeks actually used that phrase, but somehow it showed up in Modern English as “political economy” – the study of how to manage a state’s production and consumption, or something to that effect.

Somehow “political economy” turned into “economics.” How that happened I don’t know, but the phrase “political economy,” to the extent that it is used today (other than in the title of an academic journal), usually refers to a specific branch of economics which deals with the political context of economics (in the modern sense of the word “political”). Once upon a time, however, there was no “economics” at all, just “political economy.”

And then there is the prefix “macro,” which occurs so often in English that its meaning needs no discussion. The canonical form of the Greek adjective is “makros" (μακρος), which of course means “large.”

...and so on....I could go on about this, but I have to get back to managing a large house.