Sunday, August 30, 2015

Must-Re-Think: Yes, you do need to rethink this.

... a strongly negative natural real safe rate of interest (there’s at mouthful!) will cause sigificant problems ...

Brad DeLong seems to be a first-draft blogger: as if he has no need, ever, to go back and check his work... to fix a spelling mistake... to get rid of the extra words that muddy his meaning... to use a goddamn comma once in a while. None of that.

I don't often read the guy, because I have to fight with his sentences to figure them out. Even his titles are too long. I'm looking at Must-Re-Read: Paul Krugman: Secular Stagnation, Coalmines, Bubbles, and Larry Summers.

DeLong's post is about "a division in the ranks" among economists who agree with him on what the problem is. The division arises when it comes to a solution:
Some of us–Rogoff, Krugman, Blanchard, me–think our deep macro economic problems could be largely solved by the adoption and successful maintenance of a 4%/year inflation target in the North Atlantic. Others–Summers, Bernanke–do not.

If these guys are offering solutions, and their solutions don't agree, then maybe they ought to check their work: Re-Analyze the problem to see what the problem really is. And then come up with a solution.

Anyway, the solution offered by "some" of them -- Rogoff, Krugman, Blanchard, and DeLong -- is to double the target rate of inflation, and hit that target.

I don't like it. The problem is not that prices are too low.

Oh, hey. "Inflation" -- defined as an increase in the general level of prices (where "the general level of prices" by definition includes the price of labor, or wages, so that inflation lifts all boats) -- inflation erodes debt. Inflation encourages spending. Inflation is associated with growth. All of that.

No shit. But the problem is not that prices are too low.

"When economists write textbooks or teach introductory students or lecture to laymen, they happily extol the virtues of two lovely handmaidens of aggregate economic stabilization -- fiscal policy and monetary policy." - Arthur Okun

When I went back to school for a course in Macro in the '70s, I learned we had two goals and two policies. The policies were monetary and fiscal. The goals were price stability and economic growth.

I am embarrassed for economists. They once knew our goal to be price stability. Now they know it as inflation stability and argue about where to stabilize it. Oh my god. Milton Friedman must be turning in his grave. Maynard Keynes must be turning in his.

DeLong opens his post with a conflict: Some economists agree [with him] that higher inflation will solve the problem. Some don't.

Delong presents his view: "our deep macro economic problems could be largely solved" by higher inflation. But he does not describe the opposing view, except to say that those who hold it reject his view.

According to DeLong, the opposing view is that there will still be "sigificant [sic] problems even if 4%/year inflation allows a demand-stabilizing central to successfully do its job". Did you notice? DeLong does not attempt to understand (or even to state) the opposing view. He only restates his own view -- and adds negativity.

He could still try to understand the other side's position, of course. But instead, he tries to explain why his inability to understand their view bothers him so:

I would have said that my mental model of Bernanke thought is very good. And I would have said that the sub-Turing evocation of Summers that I am currently running on my wetware is world-class

I did say tries to explain.

That is all that there is of DeLong's contribution to the post. (It's just as well, really.) The rest of the post is made up of excerpts from those who share his view. You know: Rogoff, Krugman, Blanchard, DeLong. Oddly, the excerpts come from Paul Krugman, Gavyn Davies, Paul Krugman, and Jared Bernstein.

Well, DeLong is right about one thing: I did have to re-read his post. Here's why: In his introductory paragraphs, DeLong admits to being disturbed by disagreement between two groups. The DeLong group holds that higher inflation will solve the problem. The other group holds it will not.

"My failure to comprehend why they think this disturbs me," he says.

Maybe he means he is coming around to their point of view. Wow! It's pretty well hidden, if that's what he means. But let me tell you why I think that might be the case.

In the first excerpt, Paul Krugman says "I very much fear that [Larry Summers] may be right."

In the second excerpt, Gavyn Davies says if the other guys are right, inflation won't solve the problem: "... the problem of under-performance of GDP will last for a very long time, and will not solve itself through flexibility in prices"

In the third excerpt, Krugman favors higher inflation, but still has doubts:

One answer could be a higher inflation target, so that the real interest rate can go more negative. I’m for it! But you do have to wonder how effective that low real interest rate can be if we’re simultaneously limiting leverage.

In the fourth excerpt, Jared Bernstein favors higher inflation, but still has doubts:

I’m totally with the program re getting the real interest rate down… But I’m nervous that it might not be as effective as historical correlations would suggest.

In those excerpts together, there is as much doubt as support for a policy of 4% inflation. So I think DeLong is telling us he's having second thoughts. Soon, he will abandon the DeLong group.

In his first paragraph he's firmly in favor of 4% inflation as a solution to "our deep macro economic problems". In his second paragraph he is disturbed by other views. In the rest of the piece, he dwells on the fears, worries, concerns, and doubts of others. Brad DeLong is preparing to change his views on the effectiveness of higher inflation as a solution.

My respect for Brad DeLong just hit a record high.

But listen, Brad, buddy, we don't have time for this. We're six years into the sinkhole. You gotta get your act together.

I want to take bits and pieces from the excerpts DeLong provides, to see if I can come up with something he might have missed.

Krugman(2): "When the Minsky moment came, there was a rush to deleverage; this drove down overall demand for any given interest rate, and made the Wicksellian natural rate substantially negative, pushing us into a liquidity trap…"

When the Minsky moment came, there was a rush to deleverage, Krugman says. But I suspect we knew the Minsky moment had come because there was a rush to deleverage. It's not like the Minsky moment came and then we all said let's get out of debt now. The Minsky moment is just the name for that moment when there's a rush to deleverage.

Other than that, Krugman's statement is one long trail of theory. See how he takes an actual event -- the rush to deleverage -- and buries it in layer after layer of theory? It drove down demand... it made the natural rate negative... it created a liquidity trap. This is as good an example as I have ever seen of an economist who needs to go back and rethink the problem: First see what the problem really is. Spend a lot of time on that. Then consider solutions.

Krugman's thought process doesn't start with deleverage. It starts with the liquidity trap. It starts with his conclusion.

Krugman(1): "The underlying problem in all of this is simply that real interest rates are too high…. The market wants a strongly negative real interest rate, [and so] we’ll have persistent problems until we find a way to deliver such a rate."

What the market wants is to be out of debt. Remember the rush to deleverage? Stop focusing on negative real interest rates and other elegant claptrap. Focus on facts.

As of this moment, we're still not ready to rush back into leverage. That's why we still have large output gaps and no evidence of price pressures.

Bernstein: "Many years post-panic, we still have large output gaps and no evidence of price pressures. The zero-bound is constraining Fed policy..."

Fuck the zero bound. That's not the problem. It's a result. Many years post-panic, we still have large output gaps and no evidence of price pressures because we're still delevered.

From mine of 22 September 2012:
The problem is not that prices are too low. The problem is that growth is too slow. There is only one correct focus, and it is to understand the reason growth is slow.

For the record, as long as economists continue to dismiss out of hand the possibility that excessive private sector debt is the reason growth is slow, economists will continue to fail to understand slow growth.

Maybe that's confusing. I just took a lot of your time to tell you the rush to deleverage was the problem. Then I say excessive debt is the problem. Do you see how those pieces fit together?

The excessive private sector debt was the cause of the rush to deleverage. When the excessiveness of it finally hit home, deleverage was the only option left. Excessive debt was the problem that caused the deleverage problem that caused the negative real rate problem that caused the liquidity trap problem. That's how the pieces fit.

Okay. But I also said growth is slow because debt is excessive. But it's the deleveraging that slowed things down. How do those pieces fit?

Gavyn Davies: "The normal route through which monetary policy works, by bringing forward consumption from the future into the present, is unlikely to be successful… There will still be a shortage of demand when the future comes around".

Bringing forward consumption from the future into the present is accomplished by spending future income in the present. In other words, by the use of credit.

We have policies to encourage the use of credit. Indeed, as Gavyn Davies says, that is the normal route through which monetary policy works. (Tax policy also encourages credit use, through tax deductions.) These policies accelerate the use of credit.

We have policies to accelerate the use of credit. But we have no policy to accelerate the repayment of debt. Therefore, debt accumulates to unnatural and excessive levels. The cost of that debt hinders economic growth, fosters the growth of finance, and drives the inequality of wealth and income.

Yadda, yadda, yadda, and rather than raising interest rates to fight inflation, policy must accelerate the repayment of debt to fight inflation.


jim said...

Krugman's analysis of Minsky is a lot like the blind men of India describing an elephant. Krugman would do better if he read Minsky.

The Minsky Moment as coined by Paul McCulley refers to the point in time when asset prices switch from going up to going down.

How does that relate to debt? When you have a significant portion of debt dependent on asset price inflation as the source of income for servicing the debt there is a positive feedback loop that exists before Minsky Moment that turns into a negative feedback loop after Minsky Moment.
Minsky called debt that relies on asset price inflation to service the debt Ponzi debt.

Before Minsky Moment Ponzi borrowers can roll over debt based on their growing net worth. In other words they can service debt without actually using much in the way of the proceeds of asset sales. lenders are happy to accommodate more debt since debt itself is an asset (to the lender) and asset values going up means more is good.

After Minsky Moment Ponzi borrowers are forced to actually sell assets to fund debt payments and when lots of borrower are doing the same, that drives down asset prices which in turn lowers both the ability to service debt and the net worth of borrowers. Lenders are reluctant to lend because they don't want new assets that will lose value. This explains why Minsky Moment is the point where asset prices start to collapse.

When debt has a large Ponzi component, the Minsky Moment is the point when there is a change from lots of people chasing after assets to lots of people running away from assets. The result is not so much about deleveraging - its about defaulting .

Greg said...

Good analysis Jim

It seems to me that everyone understands the risk with borrowing money to buy stocks (as I understand that used to be illegal but now there are ways to do so and so called "margin debt" has been rising of late) but I don't think enough understand that what we did to housing in the 2000s was essentially turn them into a stock. By taking the mortgages and turning them into a financial product to be traded you essentially delinked the real use of a house ( a place to stay warm and dry and watch college football) from the price of the house. People started to get way more house than they really needed or wanted because they saw that as a way to turn it over and get richer. Once that mindset reached a certain critical mass and enough people were right to the edge of what they could afford, all it took was the usual level of income insecurity (cut in hours, downsizing at your job) to make the MBS/CDS critically unstable. They were running all those markets at way past the usual level of capital backing because they knew that housing prices never drop and the default rate historically was only x%..... Defaulting on a $75,000 loan is one thing, defaulting on a $750,000 is another. Too many big zero loans started to look shaky.

The Arthurian said...

so jim, read the post again and this time where i have 'minsky' you should read 'problem' and see if that makes a difference.

jim said...

The nature of private debt is to bring future cash flows
into the present.

What happened in 2008 was a huge drop in the price of assets.

That drop, in and of itself would not have been a problem. It became a a major catastrophe ONLY because there was a significant amount of private debt that was counting on future cash flows coming from asset price inflation.

Look at the $6 trillion worth of US mortgage that private investors financed through private lending channels during the bubble. Of that total less than $700 billion worth of those mortgages survive today. Compare that to Freddie and Fannie who continued to steadily increased the amount of mortgages that they back. There was no delevering in the part of the market that was making loans that depend on ordinary income for their cash flows. The part of the market that was counting on asset inflation was wiped out.

The Arthurian said...

Thanks Jim. I have to think about this a bit.