Tuesday, January 20, 2009

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Yes, I'm back with yet another post about the Fama/Stimulus issue. I promise this will be the last one...unless there are more.

In general, for an argument like Professor Fama's to work, there has to be some finite resource that is being fully utilized, so as to impose a binding constraint on the economy. That is, when the government borrows, it must be using up something – some actual, definite thing, not just a vague "funds" (which could mean any number of things depending on how we interpret it). The government must be using up some limited resource that is no longer available to businesses seeking to invest. What is that resource?

As I understand Greg Mankiw's interpretation, the limited resource is labor. In the classical model to which Greg refers, the availability of labor is what usually constrains an economy, the reason you cannot do more of one thing without doing less of something else. Now Professor Fama says explicitly that his argument applies "even when there are lots of idle workers." On the face of it, that would seem to contradict Greg's interpretation.

But perhaps Professor Fama is referring to frictional unemployment, and perhaps he believes in a theory in which recessions are associated with increased frictional unemployment. For example, today's unemployment could just reflect the difficulty in reassigning all the people that have been laid off in construction, finance, and other industries related to the mortgage boom. I can think of a number of empirical arguments as to why that's not the case, but the position is logically sound and does not rely on any assumptions that are inherently unreasonable. If that's what Professor Fama has in mind, I wish he would be clearer about it.

Nick Rowe has a different interpretation. He thinks the finite resource is money. If that's the intended interpretation, then there is an overwhelming empirical case against Professor Fama, as he will perhaps realize if he clarifies what he is trying to say. Money is not a finite resource today: there is nothing to stop the Fed from printing more money to finance any additional federal deficit, thus leaving plenty of money for those who want to use it for investment. (The argument goes beyond this, and I'm going to retell, in different words, the story I take Nick to be telling. Our argument shall be all things to all men, that we might by all means save some.)

Even if the Fed refuses to finance the deficit, and the money supply is fixed, the empirical case is still overwhelming, once you appreciate the nature of money and the relevance of a zero interest rate. The critical point is that money, even if it is limited in quantity, is a reusable resource. Money isn't like paper towels, where you use them once and then have to throw them away, and if my wife uses up all the paper towels and I can't get to the store then the dishes will have to sit in the drainboard. Money is more like cloth towels. If my wife uses up all the cloth towels, I can just put them in the washing machine and the dryer and use them again. Similarly, my wife can use money to buy a hamburger, and to the burger cook, it is as if the money had already been cleaned and dried. (Ah, yes, laundered money!) Even though my wife has already used the money, the cook can immediately go and use it again to buy something else.

Arguments that the quantity of money matters rely on some mechanism that limits the number of times money can be reused in a given year. The usual assumption (a controversial one, to say the least, but one we can accept for the sake of argument) is that people will hold money in proportion their incomes, regardless of the interest rate. In that case, if you try to raise aggregate income (for example, by a stimulus program), there won’t be enough money to go around. The excess demand for money will cause interest rates to rise until someone reduces their demand. The classic example is a business that is contemplating building a factory. When the interest rate rises, the factory becomes more expensive to finance, building it is no longer profitable, and the business decides not to build it. As that sort of thing happens across the economy, the demand for construction is less than it would have been, construction workers are laid off, and aggregate income goes back down to where it was before the stimulus program. Since we have assumed that the supply of money is fixed, and the demand for money is proportional to income, aggregate income has to go down to exactly where it was before the stimulus program in order to equate supply with demand.

But the critical point now is that the process also works in reverse, but it runs up against a brick wall when the interest rate gets to zero. Suppose incomes drop for some exogenous reason (like, for example, that housing prices collapse and throw the banking system into disarray). When incomes drop, the demand for money goes down. Therefore interest rates go down, and a bunch of businesses suddenly want to build factories.

So far, so good, but suppose that demand for commercial construction (and all the other demand that results from lower interest rates) doesn't create enough income to replace that which was lost. In theory, interest rates should go down even further, but suppose the interest rate goes all the way down to zero, and there still isn't enough aggregate income. There could be a very large excess supply of money, but interest rates can't go down any further, and thus incomes won't go up any further, and there is nothing to increase money demand and relieve that excess supply. (And please note that the interest rate on 3-month T-bills today is approximately zero.)

Now suppose the government institutes a stimulus program to raise incomes. As incomes rise, the demand for money increases. And then what happens? Well, nothing. There is an excess supply of money, and part of that excess supply gets used up by the new demand, but some of it remains – provided the stimulus program is not too large – and the interest rate remains at zero, and there is no reason for anyone to reduce investment, and there is no offsetting decline in income: aggregate income has risen; the stimulus has worked.

But suppose the stimulus program is too large. In that case you can think of the stimulus as being in two parts. The first part is just enough to use up the excess supply of money, and that part will raise incomes by some amount. The second part will create an excess demand for money, and ultimately it won't raise incomes any further. Overall, therefore, incomes will rise to a certain level and no further. But that certain level is still higher than where they were before the stimulus program. Thus the stimulus program has again been successful in raising incomes.

QED, if Professor Fama is using the word "funds" to mean "money" in the literal sense. I wonder if he will explain what he does mean.

I'll conclude with another point concerning the savings-investment equation that Professor Fama uses. In the National Income and Product Accounts, that equation holds more or less by definition. To the extent that there is causation involved, that causation seems to go from investment to savings rather than the other way around. In other words, any increase in investment immediately and automatically creates the increase in savings to finance it. In the national accounts, savings is a residual calculated by subtracting consumption from income. Consumption comes from the product side of the accounts; income comes from the income side. When an increase in investment takes place, it is entered as an increase in income on the income side, and it is entered as an increase in investment on the product side. In other words, income increases, but consumption does not. By definition, therefore, savings increases. So whenever a business chooses to invest, savings must necessarily increase as a result.

I'll leave you to ponder that argument. To be honest, I don't really buy it. I think there is an inherent flaw in national income accounting that allows a bit of Keynesian sophistry, and perhaps I'll write about that in the future. I'd rather fall back on my earlier argument about how the people in the chain from those who receive the government stimulus end up saving the total amount of the stimulus. I don't see how that argument can be refuted – again, unless Professor Fama means something different from what he says. And if he means money, I think Nick and I have pretty much buried his argument.

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.


Nick Rowe said...

Andy: thank God! Finally someone's understood what I was saying!

And don't apologise for having a third go at this question. It's important. It's important both for policy reasons, and for understanding some very basic issues in macroeconomics. Take a fourth go if you feel like it!

Nobody else addressed Eugene Fama's central question: where will the extra loanable funds come from? Will they be taken away from other investments? (If so there is no increase in aggregate demand, just a switch from private investment to government spending). Will they come from increased savings? (If so, why will savings increase, and even if they did increase, that would just mean a decrease in consumption, so there's no increase in aggregate demand, just a switch from private consumption to government spending.)

And it's no answer to say that the extra savings comes from the increased income (even if it's true, in the new equilibrium). Eugene Fama would legitimately complain that that's just begging the question: assuming what we seek to prove, that income does in fact increase.

Too many people have been critical of Eugene Fama for getting it wrong. I would be equally critical of those who failed properly to explain to him why he was getting it wrong. (And Fama's at least got the excuse that he's not a macroeconomist). Hey, we all get stuff wrong, anyway. It's not enough to just point to another model which shows different conclusions to Fama's. You have to be a teacher, and get inside his head, figure out why the approach/model he is using is wrong, figure out his implicit assumptions, and then explain to him why it's wrong. He needed to be reminded that we are talking about a monetary exchange economy, where an excess demand for goods is a result of an excess supply of money, then explained, via interest rates and money supply and demand, where that excess supply of money comes from. (After many years teaching ECON 1000, I've developed practice at this!)

This is a sorry episode, for all of us. We so often don't understand intuitively the basic models we teach.

Andy Harless said...

"And it's no answer to say that the extra savings comes from the increased income (even if it's true, in the new equilibrium). Eugene Fama would legitimately complain that that's just begging the question: assuming what we seek to prove, that income does in fact increase"

I disagree. I think, provided one is careful about how one wants to define “income,” that one can show in an example that income initially increases, and the question will be whether some other income will subsequently have to decline. And I define income as when somebody pays you some money that you don’t have to pay back.

So here’s the scenario: the government issues a T-bill. Jane Saver, who has $1,000,000 of savings in the bank, buys the T-bill. So far, no effect on private savings (Jane just changed the form of her savings), and no effect on income. Now, the government sends a $1,000,000 tax rebate check to Joe Billionaire, which he deposits in the bank. Effect on private income: +$1,000,000. Effect on private savings: +$1,000,000. Now Joe hires Betty Builder, previously unemployed, to build a house for him for $500,000, which (just for simplicity) he pays in advance and she deposits in the bank. Effect on private income +$500,000. Effect on private savings: nothing. (Joe’s savings is reduced by $500,000; Betty’s is increased by the same amount.) Then Betty, being an honest craftsperson, builds the house instead of absconding with the money. Voila: you have productive activity that would not otherwise have occurred. And total private savings has risen by exactly enough to offset government dissaving. The money that was in the bank when the process started is still in the bank, and any firm that wanted to borrow it to make a capital expenditure can still borrow it. And the whole process involved no changes in the total quantity of money: $1,000,000 worth of bank deposits were simply passed around from one entity to another. Where is the flaw in that argument?

Granted, that argument is only about what could happen and not about what will happen, once we start thinking about how our characters are likely to behave. The monetarists will say, “Why ever would they hold so much of their savings in the form of money, when it could be in interest-bearing instruments? Surely they will only hold enough money to facilitate their day-to-day transactions, and that amount will be proportional to their incomes.” And then it proceeds into our argument about money demand. But Prof. Fama’s claim, if you take him at his word, has nothing to do with behavioral assumptions. He says that the national income identity, in and of itself, implies that the stimulus cannot be successful. I think my last paragraph is sufficient to disprove that contention. If he is actually sneaking in behavioral assumptions without telling us what they are, then the onus is on him to defend his argument by making those assumptions explicit.

Also, if he is using the classical model, as Greg Mankiw suggests, then he needs to be more careful about using the national income identity as the basis of his argument. The national income identity is inherently in nominal terms, because there are no implicit deflators for the income side. If he wants to say that it must hold in real terms, there is no empirical substance to his argument unless he specifies how incomes should be deflated.

Anonymous said...

Andy..."In general, for an argument like Professor Fama's to work, there has to be some finite resource that is being fully utilized..."

The binding constraint is the quantity of goods/services that can be efficiently extracted from consumers via inflation. An infinite quantity of money can be created, but a finite quantity of goods/services can be extracted via this method. If more than a small quantity is extracted, a wage/price spiral stagnates the economy. If an attempt to extract even more is initiated beyond the wage/price spiral, hyper inflation makes the economy dysfunctional, and GDP spirals downward.

The goods/services extracted can potentially be used to pay unemployed workers to produce something of value, so the loss to consumers is not necessarily total. However, inflation is a very blunt and regressive extraction tool, and results in very real social costs to vulnerable citizens. The social cost to fixed income retirees et al can easily exceed the benefit to the unemployed. Fiscal policy offers far better ways to extract resources from targeted citizens for redistribution to the unemployed.

Andy Harless said...

Anonymous, it sounds like you are essentially making the classical argument, but with just enough of the Keynesian Phillips curve thrown in to allow for the existence of idle resources. ("The goods/services extracted can potentially be used to pay unemployed workers to produce something of value, so the loss to consumers is not necessarily total.")

I have a couple of objections. First of all, nowhere does Prof. Fama suggest that this Phillips curve exists at all. He seems to think that the loss to consumers is necessarily total. Second, while your argument might apply under ordinary circumstances, it doesn’t carry much weight when the country is on the verge of deflation. Under these circumstances, inflation is a good thing.

“The social cost to fixed income retirees et al can easily exceed the benefit to the unemployed.” Perhaps, but aren’t the fixed income retirees getting an unfair subsidy when the inflation rate turns out lower than expected, and especially if it turns out to be negative? And personally, I don’t have a whole lot of sympathy for retirees that are rich enough not to have to live mostly on Social Security, which is inflation-adjusted, or for retirees that were imprudent enough to put all their eggs in the fixed income basket.)

The only way your argument works is if you think either (1) that there is extreme uncertainty, so that any policy that tries to use even some of the idle resources is liable to result in serious inflation, just because any amount of stimulus might by chance turn out to be too much, or (2) that there is a knife-edge equilibrium such that, if we don't hit it precisely, we have to choose between very low inflation or very high inflation (or some combination of weaker versions of these two premises). My opinion is that, while neither of these premises is 100% wrong, they are not true enough to make an empirically relevant agument.

Anonymous said...

>any policy that tries to use even some of the idle resources is liable to result in serious inflation, just because any amount of stimulus might by chance turn out to be too much

There are certanily idle resources now, but there may not be idle resources in the future, and the market may take this into account when evaluating any stimulus, since the stimulus will not just affect the immediate future but also the mid-term future (like the next year or two). If the market judges this mid-term impact of the stimulus to be excessive, then even the short-run impact of the stimulus may be contractionary, even though there are currently idle resources in the system.

In particular, if inflation expectation jump as a result of the stimulus, then the dollar might collapse. This might have no immediate effect on export quantities, but would have an immediate effect on import costs, and thus would probably cause a reduction in aggregate demand. If the Fed responded to the dollar collapse by doing nothing, then long interest rates would skyrocket, causing a further collapse in housings, bonds, stocks and business investment, all of which will be contractionary. So the Fed would be forced to raise overnight rates, which is contractionary in itself.

Perhaps this is the underlying line of reasoning motivating Fama and the other critics of a big stimulus now. It is important to recall that the federal government is now set up for ongoing fiscal stimulus from now to eternity due to exploding Medicare costs, high payments on existing federal debt, and insufficient taxes. The only reason we haven't had serious inflation in the past few years is those 6% of GDP trade deficits we've been running.

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