Monday, February 13, 2012

++"Wealth Shock"

Krugman has an interesting take on James Bullard's "Wealth Shock" idea:

Maybe the idea is that the burst bubble reduces demand, and hence leads to lower production.

Yeah, that's how I took it, though I had to wait for Krugman to make it clear. But what else can it be, if a "wealth shock" leads to lower GDP? It's not that we're suddenly able to produce less. It's that we're suddenly buying less. That follows from the wealth effect.

I don't buy the "wealth effect" story, myself. I'm with Jazz on that:

given empirical data that closely links consumption to income, how can consumption depend "primarily on wealth rather than income?"

But falling demand due to a "wealth shock" and its wealth effects, was the only way I could make sense of Bullard's rather direct words: "The negative wealth shock lowers consumption and output."

Krugman, again:

Maybe the idea is that the burst bubble reduces demand, and hence leads to lower production. But at that point you’re into a Keynesian world of deficient demand, and you should be talking about ways to close the gap, not accepting it as a fact of life.

I thought that was clever, rubbing Bullard's nose in his own Keynesian poo. should be talking about ways to close the gap, not accepting it as a fact of life.

I'm with Krugman on that. Here's mine:

If [Andolfatto] was trying to explain why GDP was slumping and why potential GDP was slumping -- because of excessive private debt, for example -- I would have some use for his analysis. But like Bullard, he brushes aside any concern with "special factors and headwinds". David Andolfatto seems to be saying only that things are bleak and we ought not expect anything better.

We do expect better. However, Krugman tells only one side of a story. Yes, demand is inadequate. The other side of the story is that demand must be excessive. According to Bullard, remember, inflation is already above our new explicit 2% target level. He wouldn't tell us that unless he thought it time to start pushing interest rates up again, to curtail demand. So demand must be excessive in Bullard's view.

Only two percent? Yeah. And if I thought Bullard's "wealth shock" analysis was right, I'd support him at two percent. Other people think we ought to push the inflation target higher, up to four percent maybe. If I thought that would solve the problem, I would support it. But the problem is certainly not that prices are going up too slowly. That's not the problem at all.

The problem, as Krugman said, is that we're in a world of deficient demand. But it's an inflationary world of deficient demand. So, wait: Let's not talk about ways to close the gap. Let's talk about how we got into this mess. Because this world of simultaneously insufficient and excessive demand is a result of the problem that needs to be fixed.

We got into this mess when everybody started deleveraging. Paying down debt. Rather than borrowing more and spending more, we started borrowing less and paying off more. So the reduced borrowing is spending that we're not doing, and the paying off is more spending that we're not doing. A double-whammy on spending.

So, paying down debt is the problem? No. Paying down debt is our solution to the problem. The problem is that we had so much debt in the first place. Private debt.

I left Bullard hanging.

Bullard is concerned about inflation. Now I know, a lot of people just want to dismiss that concern, because we have bigger problems. But you can't just dismiss arguments you don't like. You have to deal with them and show them wrong, or accept them.

Or bide your time and don't jump to any conclusions. That's always a good rule.

So, the inflation. I don't think inflation is a crisis. But I don't like a two percent target. I like a zero target (even if I can only fail to achieve my target). And I really don't like the doublespeak that says "a constant price level" when it means "a constant inflation rate". Bill Mitchell recently pointed out an example of that:

In that Press Release, the ECB said it main role was to achieve “price stability” (that is, stable inflation)

Anyway, Bullard. He says if we overestimate potential output and set policy by it, we will encourage excessive demand and we will get inflation like we got in the 1970s. (And, he says, inflation is already above target.)

Everybody else says the economy is not growing enough, and we don't have jobs enough, and unemployment is too high, and demand is insufficient, not excessive.

How can there be such a difference in views? I think the trouble arises from the way we explain inflation. Here's Mitchell again:

Inflation is driven by nominal aggregate demand growth that exceeds the capacity of the economy to respond in real terms – that is, to increase output.

Too much money chasing too few goods. For Billy, as for Milton and Anna, inflation is caused by excessive demand -- by demand "that exceeds the capacity of the economy to respond". Demand being excessive relative to potential output is the cause of inflation, they say. Exactly what Jim Bullard says.

If you think of inflation along those lines, and you admit we're getting inflation already, then you end up thinking that "the capacity of the economy to respond" must somehow have been crippled. You end up thinking that there must have been a sudden drop in potential output. Exactly what Jim Bullard says.

But all we need -- if we wish to undermine Jim Bullard's argument -- is to realize that demand-pull isn't the only inflation story there is. There is also a cost-push inflation.

Economists seem always to pooh-pooh and ha-ha the concept of cost push inflation. But it makes perfect sense to me.

There is a nice short Wikipedia article on cost-push inflation and if I take two parts of it and put them in reverse order, I get what seems to me an excellent explanation of cost-push inflation:

Monetarist economists such as Milton Friedman argue against the concept of cost-push inflation because increases in the cost of goods and services do not lead to inflation without the government and its central bank cooperating in increasing the money supply.

Keynesians argue that in a modern industrial economy ... a supply shock would cause a recession, i.e., rising unemployment and falling gross domestic product. It is the costs of such a recession that likely causes governments and central banks to allow a supply shock to result in inflation.

I accept both sides of that disagreement. It doesn't even seem to be a disagreement, with the order reversed like that. Here's what I see:

Yeah, it is demand that affects prices. More demand pulls prices up more. Less demand pulls prices up less. And demand expresses itself as spending. And spending is done for the most part with money -- money and credit. With things that work like money.

So, the quantity of money has to have an influence on prices. The quantity of stuff that works like money. I accept that. (I accept it even though I do not accept the graphs Milton Friedman offered to convince us of the truth of it.)

But if something happens -- a "shock" call it, pathetic as that explanation is -- and it drives costs up, then the existing quantity of money has to stretch to cover the higher prices that accompany increasing costs. And if the money doesn't stretch enough, then the spending has to shrink. And if the spending shrinks enough, you get a recession.

And if the central bank has a "dual mandate" to keep prices stable and to keep the economy growing, getting a recession means it has failed to meet its mandate.

And if the central bank decides to take a safe, "middle of the road" position, it ends up compromising between recession and inflation, and getting some of each.

And the inflation we get in such circumstances arises (as monetarists argue) because the quantity of money was allowed to expand. But actually, the prices had to go up anyway, because the costs were going up; and the central bank opted to allow some of that cost-push inflation to continue rather than creating another recession.

That's what it was like in the 1970s. That's the future Jim Bullard sees. The alternative is to figure out why we have cost-push, and to fix that problem.

At the root of cost-push you will find the ever-increasing cost of accumulating debt.

[ Part 1 ] This is Part Two [ Part 3 ]


jim said...

I think Krugman et. al. are arguing against a strawman. Bullard agrees that low consumption is the problem. He just doesn't believe The Feds low interest rates are helping to solve that problem.

Bullard writes:

These low rates of return mean that some of the consumption that would otherwise be enjoyed by the older, asset-holding households has been pared back. In principle, the low real interest rates should encourage younger generations to borrow against their future income prospects and consume more today. However, this demographic group faces high unemployment rates
and tighter borrowing constraints, which may limit its ability and willingness to leverage up to finance consumption. Consequently, the consumption of the older generations may be damaged by the low real interest rates without any countervailing increase in consumption by other households in the economy. In this sense, the policy could be counterproductive.

Jazzbumpa said...

I rarely disagree with Jim, but I don not think that Krugman has fallen into a straw man trap. He's too careful and too honest.

And note that low rates of return reducing consumption is completely consistent with consumption as an income phenomenon, since the return is income to those depending on it.

Younger people cannot borrow at these rates because 1) they are still over-leveraged (h/t Art) and 2) banks aren't lending.

So I agree with Jim (I think) that raising interest rates will be, on balance, counter-productive.

Those of us 65 and up are 13% of the population. We can't carry the economic ball.

And not all of us live on interest income. I certainly don't.


Jazzbumpa said...

Because this world of simultaneously insufficient and excessive demand is a result of the problem that needs to be fixed.

What it shows is that Bullard's position is incoherent. You can't have excessive demand with U6 at 15%, regardless of interest rate.

The Fed is ignoring half of it's dual mandate and focusing exclusively on inflation.

That's because they are bankers.

BTW, cost push inflation happens when, frex, commodity price shocks affect core inflation. It happened in the 70's. It has not happened i the last decade.


Jazzbumpa said...

Besides being incoherent, Bullard's argument is also both ignorant and stupid.

Bottom Line: Bullard really went down an intellectual dead end last week. He criticized the focus on potential output, but revealed that he doesn't really understand the concept of potential output either empirically or theoretically. He then compounds that error by arguing against the current stance of monetary policy, but fails to provide an alternative policy path. And the presumed policy path, tighter policy, looks likely to only worsen the distortions he argues the Fed is creating. I just don't see where Bullard thinks he is taking us.


jim said...

To JzB

I wasn't arguing for or against Bullard's argument.

I was saying his argument is being misrepresented.

Banks are intermediaries between borrowers and lenders. The lenders are represented by the roughly $10 trillion in deposits.
Those lenders are being paid $100's of billion dollars per year less than they might if interest rates were higher.

So that is one prong of Bullard's argument is that the owners of those deposits would be consuming more if they were paid interest. That means the policy is not helping to improve aggregate demand (which is the intent). I don't know if Bullard is right or wrong, but it seems like a valid point to consider. And instead of considering it Krugman argues against something Bullard didn't say.

The second prong of his argument is easy to miss because he is very obtuse in stating it. He talks about the distorted affects this may have on markets.

That could mean several things, but one thing I can think of is that many who have deposits in the banking system may try to get them out. The problem is if you buy an asset the deposits you exchange for the asset go to someone else's bank account, but don't leave the system. That means it could get pretty ugly if a very large number decide they want to get their deposits out.

But even without carrying it to the logical extreme there are people bidding up the price of gold, stocks, bonds and even houses because they prefer not to have cash deposits. That means another ponzi collapse could be in the making.

The Arthurian said...

JzB: "And not all of us live on interest income. I certainly don't."

How to test this proposition: MOST interest income remains in the financial sector, earning interest, and only comes into circulation by lending.

I found Andolfatto's post and Bullard's paper most interesting. Something new to think about.

Jim: "one prong of Bullard's argument is that the owners of those deposits would be consuming more if they were paid interest. That means the policy is not helping to improve aggregate demand"

Interest income is non-productive income. I think we need to increase productive income, wages and profits.

Jazzbumpa said...

Jim -

I know you weren't defending Bullard. I just think you got the PK part wrong. I went back and reread the Krugman post. He is most definitely arguing against something Bullard did in fact say,and he quotes it.

That is really the whole thrust of his post. I don't see straw there at all.

Bullard said a lot of things. I can't find a way to connect the part you cite to the part Krugman criticized.

Art -

How to test this proposition: MOST interest income remains in the financial sector, earning interest, and only comes into circulation by lending.

Beats me.