One worrying aspect of GDP growth prior to 2007 was that it came even as real household incomes stagnated. Assuming that boom-era growth rates were sustainable, and not fueled by a surge in house prices and a credit boom that simply pulled forward demand from the future, is a huge leap in logic.
I think there is some confusion on both sides regarding this point, and to clear it up we need to make a distinction between the demand side and the supply side. Usually when economists talk about “sustainable” growth, they’re referring to the supply side: some growth rates are not sustainable because they deplete the supply of resources too quickly. (In particular, an output growth rate is not sustainable if it exceeds the sum of population growth and labor productivity growth, because we would eventually run out of willing and qualified workers and end up in a wage-price spiral.) But here Kelly Evans seems to be referring to demand sustainability rather than supply sustainability.
Is demand sustainability, in this aggregate sense, a meaningful concept? Many economists would say no, because aggregate demand – demand for everything except money itself – is really just the inverse of the demand for money (or for financial assets in general), and there is no limit on the sustainability of the supply of money: we can always print more. And indeed we can always print more money, but the problem is, will we? Aggregate demand sustainability isn’t meaningful in an absolute sense, but it is meaningful if we condition on the growth of some nominal quantity such as the money supply, the price level, or nominal GDP. A certain level of aggregate demand may not be sustainable at a given rate of inflation, or at a given rate of NGDP growth, and thus there is no guarantee that the trajectory of nominal aggregate demand prior to 2007 was sustainable.
When Kelly Evans refers to a “boom that simply pulled forward demand from the future,” Karl Smith interprets this to mean that people were living above their means. But this is a supply-side interpretation: their means (supply) were not sufficient to sustain the pattern of consumption. I believe that the relevant interpretation is a demand-side one: people were choosing (demanding) a certain pattern of consumption based on false information. To say that their demand was “pulled forward from the future” is to say that they would, had they known the truth, have preferred to consume in the future rather than in the present (or in some cases, that their lenders, had they known the truth, would have preferred that the borrowers consume in the future instead of borrowing from them and consuming in the present)
The underlying problem over the past decade is excessive patience: everyone (by which I mean, mostly, the Chinese) wants to defer their expenditures into the future at the same time. But everyone can’t do that at the same time. In a perfect world, we would solve this problem by allowing prices to drop temporarily, far enough to convince enough people to take advantage of the low prices by spending today instead of in the future. But in the real world, price adjustment doesn’t happen quickly, and it often causes more problems than it solves.
So how do you get people to shift their expenditures into the present? One way is by fooling them. Make them think they’re richer than they really are. Make them think there are ultra-safe assets available to safeguard their future spending capacity. Find the people who want to spend today but don’t have any money, and make someone else think it’s safe to lend them money. But this solution is…unsustainable.
The sustainable solution, in theory at least, is to generate an expected inflation rate high enough that – at some positive interest rate – enough people will choose to spend money today instead of in the future. But that solution may not be on the table. Inflation rates much higher than 2% are heavily frowned upon by…just about everyone, it seems, except a few economists. Is 2% high enough? Who knows?
NGDP targeting is another solution, but is it sustainable? As I discussed at the end of my last blog post, and as Nick Rowe expands upon, NGDP (level) targeting would eventually succeed in raising demand, because every time it failed, it would then promise a yet more aggressive (and therefore more inflationary) policy. But what happens after it succeeds? Unless people have become less patient, we’re back where we started: everyone tries to shift expenditures into the future at the same time. The economy gets depressed again, and the cycle repeats.
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. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
40 comments:
Andy, as usual very clearly written. But I don't think it covers the whole story, because I think distribution matters. I think this is the end game of the transfer up of income and wealth, as people have made false assumptions about their future income. The structure of the economy is build for a middle class economy, but the distribution of income wants us to have a more feudal economy.
Is demand sustainability, in this aggregate sense, a meaningful concept? Many economists would say no, because aggregate demand – demand for everything except money itself – is really just the inverse of the demand for money (or for financial assets in general), and there is no limit on the sustainability of the supply of money: we can always print more.
Sure we can always print more money. But that doesn't mean we can indefinitely expand purchasing power or effective purchasing desire, especially within our current institutional and social arrangements. Without changes in the way real goods and services are produced and distributed, increases in the supply of units of the medium of exchange will only cause a change in the number of units of that medium that are required to make purchases.
In our system, people don't just come into the possession of money by government fiat. They receive money in exchange for for something else - usually some labor drawn from their capacity for labor, but also for other things of value they already possess. In the end, exchange via money only lubricates a system of exchange of some goods and services for other goods and services.
If the distribution of real goods and capacities becomes grossly unequal, then the distribution of effective purchasing desire will also become very unequal. And if too much of income is flowing toward people whose purchasing desires are mostly sated, a rising portion of that income will be saved as stores rather than spent. The private economy is capable of evolving over time into a distributional system that, in aggregate, generates a level of effective demand that is inadequate to purchase the total output of the economy. The only long-run solutions are to repair the distributional system, or to readjust output downward. However readjusting downward might simply prompt a vicious cycle if the distributional system isn't fixed.
You can hide the problem in the short run by increasing the amount of credit - the number of exchanges in which currently existing real goods and services are exchanged for promises of future goods and services. But if you don't fix the underlying structural problem, those promises can't all be kept.
Increased saving reduces the natural interest rate. If the natural interest rate is more negative that the target inflation rate (or the inflation implied by the target nominal GDP and potential output,) then there is a problem.
However, part of the problem follows from imagining that there is a single interest rate. "The" natural interest rate? There are many natural interest rates. Why focus on the shortest and safest? Because that it what central banks traditionally do, and new Keynesian economics accomodates the preferences of central bankers and also focuses on short and safe interest rates.
From a monetarist perspective, it is the quantity of money that counts. From a market monetarist account, the quantity must rise to offset any decrease in velocity. If the natural interest rate on short and safe assets is too negative, then that means that open market operations will have to extend, sooner or later, to assets that are not short and not so safe.
Now, if all interest rates are more negative than the trend for inflation, then the central bank buys all of them, and you are exactly where you described before. The nominal GDP target cannot be maintained. But how realistic is that scenario?
In my opinion, if that really happened, the answer is to privatize currency and have negative nominal interest rates on deposits. But I doubt such drastic steps (which I like better than a higher trend inflation rate) would be necessary.
Following up from Bill's comment, the way I would pose the question would be: just how big would the Fed's balance sheet have to be if the (implied) inflation target were too low relative to the natural rate? If it meant the Fed would have to buy up all the short T-bills, would we be prepared to accept a Fed that big?
Printing money and creating new financial assets are two different things. The Fed can indeed print more money, but this just substitutes one financial asset for another, changing their relative prices and yields. If the Fed is determined enough, it can push the yield of the target asset close to zero by making massive purchases or maybe even directly targeting the yield (direct yield targeting may be more efficient, since in this case the size of the balance sheet may remain relatively small).
However, supply of financial assets depends not only on interest rates, but also on a lot of other factors; and this is particularly true for the two most important types of financial assets -- federal government securities and mortgages/MBS –- which between them have recently accounted for about 80% of the total net borrowing.
The supply of government debt is currently limited by politics and a relatively a small change in the debt service cost will not make much difference. This may change after the elections, but for now the US federal government is unlikely to increase its level of borrowing.
For mortgages, the main problem is obviously the level of real estate prices. So far the Fed has been reasonably successful in its efforts to stabilize the prices, but a lot of mortgages are still under water, and the question now is whether very low mortgage rates can actually push the prices up. If this happens, then monetary policy may finally get some traction and the Fed will be able to choose between different policy targets; if not, the US economy will follow in Japan’s footsteps with Ben Bernanke watching from the sidelines, omniscient and powerless.
Bill,
There is only one natural risk-free interest rate. (It's not quite risk-free but close enough.) If the central bank is buying assets other than T-bills, then it is accepting risk on behalf of the public. I don't have a problem with this from a tactical point of view. (In fact, I wish the Fed were doing a lot more of it and were authorized to do more than it is currently authorized to do.) But I'm not comfortable with it as an ongoing approach to monetary policy. I would extend Nick's point: it's not just the size of the central bank but how much of the private sector's function (in this case, accepting risk) it has to assume. Apparently, your solution is to have a more and more intrusive central bank until and unless that approach completely fails (which I agree is unlikely) and at that point to get rid of it completely. I'd prefer to have a central bank that's reliably unintrusive, and the way to do that is to keep the inflation rate (or the growth rate of the target NGDP path) high and steady.
This issue, as with so much else, can only be seen in the context of global imbalances.
The world as a whole was not pulling demand forward from the future. We only consumed what we actually produced (nothing arrived from outer space). So if some people (the US) "pulled demand forward", others must have sent the same amount in the other direction. So, did we really transfer demand across time, or just across borders?
To cut a long story short, the "sustainability" question then becomes one of the sustainability of current and capital account imbalances. In particular, is it sustainable for the US to run a current account deficit of approx 5% indefinitely?
If you speak to the MMTers, they will tell you that it is. Personally I doubt it, but it is atleast clear that it's possible to sustain long periods where a nation/region imports (consumes) more than it exports (produces) and vice versa.
It's also clear that with the appropriate fiscal transfers, this relationship CAN be sustained indefinitely. The transfers between the south and north of the UK, or Italy, demonstrate this.
So, the "sustainability" question may simply be a political choice. That is, northern Italy chooses to sustain the imbalance with the south, but Germany may choose not to sustain their imbalance with Greece.
The US/China imbalance is slightly different to the European examples. The currency is less permanently fixed, and the fiscal balances are loaned in US currency. That may create a different twist on the sustainability question.
That is, the imbalances may not be "sustainable" in the sense of carrrying on indefinitely, but they may be "sustainable" in the sense that we can live with the results of them. So, at some point the currencies will have to realign and the US will end up exporting more and importing less, but the legacy of imbalances may be perfectly sustainable at that point.
Andy -- I don't think your characterization of the CB in this case as intrusively taking risk on behalf of the public is the only perspective. In your scenario, the government can be first said to be intrusively *removing* risk (or appearing to remove) from the non-government market by offering the lowest risk security at an inadequate price. They really just reversing that initial intrusion by the usual method of lowering the expected return of that security toward a clearing price... or in this case by increasing its riskiness to match the stuck price.
There are strange versions of that world where (say) P&G commercial paper becomes the safest security and can trade at negative rates, because it is not dominated by a risky medium of exchange at the zlb. Some camps would seemingly call this a complete abdication what they see as the main role of central banks -- to provide intermediation services the private market cannot. But if you think the role of the central bank is instead to facilitate market clearing in the face of market frictions like sticky price and the zlb, then the government's failure to provide the safest security is not obviously intrusive or malignant. It may even be true that the market would create even safer securities if the government stopped providing the absolute safest. Of course, there may be a question whether the medium of exchange stops being the medium of exchange if it is no longer the safest asset. more likely, the safest assets would just become a little less safe given the "intrusive" price ceiling.
In any case, i think it is far preferable for the government to counteract its provision of a safe asset at a non-market price even at the cost of not providing the lowest-risk asset possible, than to maintain the availability of underpriced safety. and of course this would if credible mostly be more a feature of its reaction function than its hydraulics.
Great post. NGDP seems to be becoming a huge debate issue these days.
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I'm curious why income inequality is not mentioned -- it seems to be the elephant in the room, both in the U.S. and in China. In that situation, you are not going to get rid of excessive patience. It's almost impossible for the top 1% to consume that much -- they are more or less immune to interest rates.
But if you believe in a consumption function (a.k.a Carroll and Kimball -- 1996) that is strictly concave in wealth, then re-distribution should be the cure for excessive patience, just as (I believe) the structural shifts towards top earners was the cause of the excessive patience. And better income security would also help.
rsj,
Good point, though I'm not sure how much it applies to China. I mean, I expect that consumption is a strictly concave function of income even in China, but I believe it's also true that working class Chinese (who are much poorer on average than working class Americans) save more than even upper middle class Americans. So I think distribution is part of the explanation but not all of it. If Chinese people had the same consumption function as Americans, the problem would be solved even with no change in income distribution, and indeed we would probably have the opposite problem of underinvestment globally.
Also it's not entirely clear to me that "you are not going to get rid of excessive patience" even given the wealth distributions and consumption functions of the US and China. The other elephant in the room is risk tolerance. By the same token that rich people can't increase their consumption, they certain can increase their risk tolerance, because, in principle, if you have all this extra wealth that you can't even spend, who cares if you lose some of it? If you can increase risk tolerance, then excessive patience ceases to be a problem, because the extra savings get invested in newly produced physical assets instead of held in cash.
Now it might not be practical to expect rich people to increase their risk tolerance spontaneously (though I do still find the equity premium puzzle to be a puzzle), but the issue throws a wrench into the works, because redistributionist policies will tend to reduce rich people's risk tolerance. For example, more progressive taxation, if it's applied to capital, will reduce the after-tax return to risk and thus tend to make rich people less risk-tolerant. So it is an empirical question, I think, whether the effect of redistribution on aggregate risk tolerance would outweigh the effect on aggregate patience.
Andy,
Disclaimer: am posting while drunk
Re: China. A case can be made that Chinese *urban* households save the same as U.S. households -- 5% of their income. But China is not a private ownership economy, and only 60% of Chinese income accrues to households, the rest accruing to State Owned Enterprises. Of the remaining 60%, 40% of income goes to the top 1% of households. I think the reason why Chinese consumption is now 1/3 of GDP, with investment being 2/3, is due to government policies and is not the result of "patience".
re: risk premium. My view (correct me if I am wrong), is that
1. The risk premium is sticky
2. With low nominal rates, asset prices are more sensitive to future earnings earnings, and therefore become more volatile, meaning that even if the cost of a unit of volatilty is constant, risk premiums will go up as the nominal rate declines.
3. As nominal rates *decline*, the resulting capital gains cause total return to increase, and therefore a secular period of falling rates can cause investors to become accustomed to high total returns. When the rates hit zero, they will continue to demand high total returns. So gradually adjusting interest rates downward may have the opposite of the desired effect.
Ask pension funds what total returns they expect. My understand is that 8% is still the industry standard figure, even though FedFunds is at zero.
All of the above tells me that redistribution is more effective than cutting interest rates. And I don't believe that it is an accident that the period of secularly falling rates was accompanied by a period of increasing inequality and high total asset returns. I believe that those excessively high total returns are ingrained, but now that overnight rates are at zero, the demand for high total returns is causing a decrease in employment.
It may the be the Ardbeg talking, but I can try to come with more data at a later time. I'm curious to know what you think,
Apparently, your solution is to have a more and more intrusive central bank until and unless that approach completely fails I would extend Nick's point: it's not just the size of the central bank but how much of the private sector's function (in this case, accepting risk) it has to assume. http://www.templatesspot.com/
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