Chain of Causality

Roger Farmer:

I do not know why growth is low. There are a number of promising candidate theories. My own favorite explanation is that the Fed has lost control of inflation and that firms are not creating new technologies, at a pace that is fast enough to generate high growth, because uncertainty has increased. But I do not have a good economic model that links that idea in a coherent way with economic data. When it comes to economic growth; I have very little to say about why growth is currently slow. I am not unusual in that regard...

If secular stagnation means that unemployment can be permanently high if we don’t do something about it: I see secular stagnation. If secular stagnation means that we will be in trouble when the next recession hits because the Fed will not be able to lower interest rates further: I see secular stagnation. But if secular stagnation means that a massive bout of government investment in roads and infrastructure will cause firms to start producing better blueprints, I say; show me the theory and the evidence that leads you to believe that that is so.

Well, before you start gathering theory and evidence for Roger Farmer, I want to talk about analyzing problems. I want to say that we don't need "a massive bout of government investment in roads and infrastructure". Or, we probably do need it, but not because it will give us "better blueprints". We need it because we need it; this, however, is terribly far from the point.

If you say a massive bout of government investment will solve the problem of slow growth, then you are saying that government underinvestment is what caused the slow growth. And I don't think that's right.

We don't need a massive bout of government investment to solve the problem. That's because slow growth is not the problem. Slow growth is a consequence of the problem. The thing that's causing slow growth is the problem.

The first task is to understand what the problem is. Most people see a consequence and identify the consequence as the problem: slow growth, inequality, trade imbalance among others. These are consequences of the problem.

Or, maybe not. But this is always the first question that must be answered. The first task is to understand what the problem is. The second task is to understand the problem. The third task is to elevate the cause of that problem, and follow the chain of causality to its root.

Don't be surprised if you end up at policy.

How do you know money is tight?

Some people say money is tight, and you ask How do you know? and they say Money must be tight because the economy isn't growing.

That's not a theory. That's just the mistaken idea that there is no such thing as an economic crisis.

How do you know if money is tight? You have to compare it to something. To what? I compare money to total accumulated debt. Compare the money we have, the money we use for spending, the money that is the only money we can use to pay down debt -- compare that money to the size of debt. That's how I know if money is tight.

Graph #1

Tight money caused the Great Depression. FDR loosened things up, and then we had a golden age. Tight money caused sluggish growth in the 1970s and '80s. An accident of policy loosened things up a little in the early 1990s, and then we had good years in the latter 1990s. And tight money caused our late crisis, but things have loosened a bit since then.

Sometimes I need an example

In a comment on his recent Occult Mysteries of the Heterodox, Noah Smith linked to JW Mason's couple year old crit of something in Steve Keen's work.

One of Mason's complaints is that Keen mis-applies the concept of aggregate demand. I thought I knew what aggregate demand was, so this brought my mental process to a sudden halt.

Mason considers a detail from Keen's view, compliments its clarity, and says "With all this, I am in perfect agreement." After that comes the problem. "But then he tries to formalize these ideas," Mason says:

Keen repeatedly says that “aggregate demand is income plus change in debt.” There are many variations on this through his writing, he evidently regards it as a central contribution. But what does it mean? To a non-economist, it appears to be a challenge to another, presumably orthodox, view that aggregate demand is equal to income. But if you are an economist you know that there is no such view, whether neoclassical, Keynesian or radical.

There is no such view, Mason says. That's what stopped me.

Mason:

The term “aggregate demand” is shorthand for the argument that causality runs from aggregate expenditure to aggregate income, whereas pre-Keynesian orthodoxy held that causality ran strictly from income to expenditure. (It’s worth noting that in this debate Krugman is solidly with Keen — and me — on the Keynesian side.) But there isn’t any separate variable called “aggregate demand”; AD is just another name for aggregate expenditure insofar as it determines output.

So that sums up Mason's view of that detail, and I think I understand what he said.

//

Now I've got Lars P. Syll, who says:

The basic explanation for unemployment is insufficient aggregate demand

and there it is. There is causality in Syll's statement: Insufficient aggregate demand causes unemployment.

That's what Mason was talking about. Sometimes I just need to see these things.

//

Now I can go back to Mason's old post and wonder whether including "change in debt" in aggregate demand somehow throws a monkey wrench into the "insufficient aggregate demand" argument. I can't see it from here.

Volunteers

 
Scott Sumner in Keynes stole my musical chairs model:

But what is so obvious about involuntary unemployment, as defined by Keynes? We all agree that there were lots of people without jobs. We all agree that lots of them wanted to be working. We all agree that lots of them were miserable. I call that “involuntary unemployment.”

By way of contrast, here is one of Syll's Two reasons DSGE models are such spectacular failures:

In the basic DSGE models the labour market is always cleared – responding to a changing interest rate, expected life time incomes, or real wages, the representative agent maximizes the utility function by varying her labour supply, money holding and consumption over time. Most importantly – if the real wage somehow deviates from its ‘equilibrium value,’ the representative agent adjust her labour supply, so that when the real wage is higher than its ‘equilibrium value,’ labour supply is increased, and when the real wage is below its ‘equilibrium value,’ labour supply is decreased.

In this model world, unemployment is always an optimal choice to changes in the labour market conditions. Hence, unemployment is totally voluntary.

Syll is perfect. Sumner can't even keep straight which is his own definition and which is by Keynes. Sumner's story is embarrassingly bad. That's why I keep pointing it out.

Total Debt back to 1834 ...

Found it by accident:

Source: BAWERK.NET

I don't have numbers for debt before 1916. But I have a graph now, and the idea to look for "banks' balance sheets" in the Historical Statistics. Maybe I can put some numbers together. That's all for now.

The Exquisite Tragedies of Hinterland

I know you don't come here for my good taste in television shows. But I have no economics today, so I thought I might put the space to use a different way.

Hinterland. Cop show on Netflix. They have season one -- four episodes, each about an hour and a half long. And they're getting season two on 1 April. I can't wait.

I found the show last fall, a couple months before I retired. Watched all four episodes in a couple nights. Loved it. For a while there, I would watch an episode again every weekend, while my wife was shopping.

Since retiring, I try to watch an episode every day.



Here's how the wife described the stories: "Even the criminals are victims."

The stories are tragedies -- magnificent, exquisite tragedies. Episode four, I think, rivals Romeo and Juliet. Episode one is better.



You know the British cop hierarchy? Detective Chief Inspector (DCI) on top, Detective Inspector (DI) next, then Detective Sergeant (DS) and Detective Constable (DC). At least that's what I figured out since getting Netflix.

Hinterland is set in Wales. West Wales. Watching the show, I feel like I've been let in on a well-kept secret. Oh, the camera work is good! You know those grand views in almost every scene of the Lord of the Rings movies? Well, it's something like that, only not overdone. You watch DCI Mathias driving to a crime scene, and his car is tiny on the screen. Sit back and enjoy the view.

Best part? The eyes. The eyes of DCI Mathias and the eyes of DI Mared Rhys. Mathias walks up to a crime scene, stops, and looks at everything. He's inspecting. He's detecting. He's doing his job. Then he walks into the crime scene and stops to inspect and detect some more. I don't know if it's the directing or the acting or the writing or dumb luck or what, but it's perfect.

DI Rhys has great eyes, too. They can be stone cold when she's questioning a suspect who has earned it, but at other times -- often -- Rhys will show empathy for victim and suspect alike. You never saw such empathy in a cop show.

I think there's less dialog in Hinterland than most other shows. Another reason I like it. Many things get done with the eyes or the slightest nod of the head.

My favorite scene? That's easy. In the opening moments of the first episode we see DCI Mathias out for a jog. Returning home from a jog. He approaches his "caravan" -- the little trailer he calls home. The camera changes from outside the caravan to inside. We see Mathias walk up to the front entrance, turn, and sit down hard. The whole trailer shakes.

I laugh every time.

There's more, but let me summarize: Hinterland makes me wish I was Welsh.

When would you know?

Not happy with Steve Keen's spreadsheet, as noted yesterday. He predicts recession, and shows it in a spreadsheet. But in the spreadsheet he makes recession happen by suddenly changing the growth rate of credit.

Now... that's probably practical and realistic and it sounds exactly like what happened back in '07. But it didn't happen because somebody changed a number on a spreadsheet. It happened in the economy.

You could argue that people were looking at their spreadsheets and playing with the numbers and suddenly said to themselves, Hm, this doesn't look good, I'm going to have to cut my borrowing and unload some debt.

Maybe that is what happened. Something like that. But I always separate the decision-making process from the economy. The decisions arise within us -- in response to economic circumstance, sure, but within us -- and the decisions we make emerge from us, from our nature, human nature. And I don't think it's good for economists to muck with human nature.

You can't change human nature. That's what was wrong with "From each according to his abilities, to each according to his needs". If you want to change the economy, you have to do it without trying to change human nature. You have to induce people to make the decisions you want them to make. You have to create the economic circumstance that makes people want to do the things you want them to do. That's what economic policy is all about.

If you're not good at it, you end up making a circumstance in which people are induced to do things out of fear and desperation.

The whole trick is to understand the economy.

Anyway, the sudden change in the growth of credit, the one that had an effect on the economy, it wasn't a change in a spreadsheet. It wasn't a change in plans. It was a change in actions. It was the sudden cutback in borrowing, in the economy.

But when would you know? How soon can you see it happening?

Graph #1: Private debt, quarterly data, percent change from previous quarter

There is no hint on this graph as of 2007 Q2, what would happen over the next year. How far to the right would you have to look on this graph, before you had an idea what was happening?


// edit 25 march
changed
"the economic circumstance that makes people want to do what you want them to do"
to
"the economic circumstance that makes people want to do the things you want them to do"

The Australian Recession of 2017: Disappointing

Almost came in my jeans when I saw the link to Steve Keen's Get ready for an Australian recession by 2017

Keen claims to be one of the few who says of the crisis, that he saw it coming. And now he's predicting recession next year. This has to be worth a click.

In Australia. Recession in Australia.

Keen writes:

For the last 25 years, Australian politicians of both Liberal and Labor hue have been able to brag that, under their stewardship, Australia has avoided a recession. Those bragging rights are about to come to an end. During the life of the next Parliament — and probably by 2017 — Australia will fall into a prolonged recession.

That's it, except for the graph. Oh, and down under the graph he writes

Click here to read the rest of this post, and here to download the Excel file showing the link between a slowdown in the rate of growth of debt and a recession.

He can do it in an Excel file? Oh! -- oh, excuse me while I go change my jeans.


According to Recognition Lag at Investopedia:

Followers of the market are familiar with the phenomenon of when economists signal a recession in the economy several months after it has actually begun.

Well yeah. If a recession is defined as two consecutive quarters of negative economic growth, it's gonna be six months at least, from when a recession starts to when it is "recognized". A recession doesn't exist until six months after it starts.


Couple weeks back I showed a version of my debt-per-dollar graph, where I extended the 2008-2015 trend out to 2030. I said "We are at the bottom now, ready to go up." I also said something like I don't know where the top is.

But here is Steve Keen, saying he knows where the top is. And he knows a year ahead of time, instead of six months after. Most interesting.

In "the rest of the post" Keen says

... this recession has been set up by the sidestep both parties have used to avoid downturns for the past quarter century: whenever a crisis has loomed, they’ve avoided recession by encouraging the private sector to borrow and spend.

Policy encourages private borrowing. Keen thinks like I think. He says

This credit sidestep has worked because the extra debt-financed expenditure lifted aggregate demand and income well above what it would have been in the absence of a debt binge.

Yup.

Unfortunately for Australia’s next Prime Minister, there are two catches to this trick. The obvious catch is that getting that much extra demand out of credit necessarily increases debt much faster than it increases income ...

Yes. And the bigger the existing debt, the more it costs to maintain. The more it costs, the more "extra demand out of credit" it takes to offset the cost. As I have it, the bigger the debt accumulation, the faster debt must grow in order to lift aggregate demand and income.

Keen:

The less obvious [catch] is that when debt is at stratospheric levels that apply in Australia today, total demand falls even if the debt ratio merely stabilises.

What?

Oh. Wait.

If nominal GDP grows this year at the 2.8 per cent rate it has averaged for the last five years, then GDP in 2016 will be roughly $1,634 billion. If private debt continues to grow at its average rate of 6.9 per cent per year, it will reach $3,414 billion — an increase of $220 billion over the year.

Okay. But then

What about 2017, if private debt grows at the same rate as GDP itself, so that the debt ratio stabilises?

What if it does?

The sum of [GDP and new private borrowing] will be ... 4.3 per cent less than the year before.

Yeah... and

This is the inevitable debt crunch coming Australia’s way, but conventional economists are oblivious to this danger because they’ve brainwashed themselves to ignore private debt as just a “pure redistribution”

Yeah, I know. But just because it is "inevitable" doesn't mean it is going to happen in 2017. I don't understand how Keen comes up with that particular date.

The day of reckoning can be delayed by encouraging yet more private borrowing ...

Yeah, I know. As Keen said up top, whenever a crisis has loomed, they’ve avoided recession by encouraging the private sector to borrow and spend.

They have delayed the day of reckoning. So why won't that trick work again in 2017?

The day of reckoning can be delayed by encouraging yet more private borrowing, which the RBA can attempt to do by cutting interest rates, and the government can reduce the crunch by running a large budget deficit. But these are likely to happen after a crisis rather than before it, because our Reserve Bank and our politicians are as oblivious to the dangers of private debt today as Bernanke was back in 2007.

Yeah no. Yeah, those solutions are likely to happen after a crisis, rather than before it. But that doesn't answer the question: How does Keen know -- or why does Keen think -- that 2017 is the year of recession? That's what I want to know.

Here's his conclusion:

The 2016 election could be a good one to lose.

Could be? That's it?

Well that's a little disappointing, Steve.


The first time I read his post, I didn't have all the questions. I heard Keen telling me what I thought he was saying, instead of what he was actually saying. Whatever. I do that a lot.

I went to his Excel file, looking for a sim that shows the cost of debt accumulating so much that the money left over to buy GDP forces us to buy a smaller GDP than the year before.

This is conceptually magnificent. If income drains out of circulation to the point that there's just not enough left to buy a GDP as big as last year's GDP, that is excruciatingly clear evidence of the cost of finance causing recession. Wow. So I worked thru Keen's Excel sheet carefully, to see what he was thinking.

Keen uses a constant rate for GDP growth and a constant rate for credit growth, and a different number for the "final credit growth rate". That "final" number is a low one, 2.8% instead of 6.9%. The same as the rate of GDP growth.

Granted, this is exactly what Keen described. I quoted him, above. And given those numbers, credit growth drops like crazy in the "final" year. The "nominal growth rate" number on the spreadsheet goes negative. And you know what that means: Recession.

You have to think like I think, or like Keen: Look at the money and look at the numbers. Don't get distracted by oil, or by things people say, or all the other realities of life. To my way of thinking, Keen's analysis is satisfying. Except he doesn't explain the sudden change in the growth of credit. He doesn't account for the one thing that I needed to know.

More than a little disappointing. But he has given me something to think about.



Here's a picture of Keen's spreadsheet:

His sheet ends in 2017. If you look at the Credit growth row (fifth from the bottom), the amounts are $180 in 2013, then $193, $206, and $220 in 2016, and then all of a sudden $96 in 2017. That's the change that gives us a recession, in Keen's spreadsheet world. That's the sudden drop that makes the numbers negative in the pink cells. But he got the sudden drop because, for the year 2017, he used the Final credit growth rate instead of the Nominal credit growth rate. (Those two are up near the top of his spreadsheet.)

I don't have trouble with the arithmetic. I understand what he's doing here. He's showing us that if the growth of credit were to suddenly drop from its usual level, down to the level of the GDP growth rate, the result would be a sudden drop in the Nominal growth rate, so severe that we end up in recession.

It's an excellent lesson. But it doesn't explain why he says

During the life of the next Parliament — and probably by 2017 — Australia will fall into a prolonged recession.

I understand that excessive debt is a problem.

I don't understand why Keen thinks we get a recession in 2017.

Recommended reading -- Ancient Rome

How Maritime Insurance Built Ancient Rome, at Priceonomics.

I thought it was a bit long, actually, but it paints a picture of the ancient world as far more financially developed than you might have thought.

Scattered Thoughts on the Private-to-Public (P2P) Debt Ratio

If I take TCMDO debt -- All Sectors; Debt Securities and Loans; Liability, Level -- and subtract out the Federal portion of that debt, I'm left with something I call the Non-Federal debt. If I take the non-Federal debt and look at it relative to the Federal, I get the red line in this graph:

Graph #1: The Private-to-Public Debt Ratio (red) and the Growth Rate of RGDP (blue)

The red is the same data I looked at twice recently -- but only the FRED part this time, so it starts after World War Two instead of during World War One. Sigh... Also, the data frequency is semiannual instead of quarterly because -- spoiler alert -- I'm going to show a scatterplot, and it turns out that "Quarterly, End of Period" is not the same as "Quarterly". Sigh...

The blue line is inflation-adjusted GDP, the so-called "real" GDP. Percent change from year ago. Semiannual. And (in case you missed it) blue.

The scatterplot caught my eye:

Graph #2: The Scatterplot Version of the Previous Graph with
the Debt Ratio on the X-Axis and the RGDP Growth Rate on the Y-Axis

What caught my eye is this: On the left, the dots fit themselves pretty well to an up-and-down pattern. On the right, the dots fit themselves mostly to a left-and-right pattern. And in the middle, there's just a jumble of dots.

That jumble is mostly between 3¼ and 5¼ on the X-Axis. But if you look, most of the activity of the red line on Graph #1 is between 3.25 and 5.25 on the vertical axis:

Graph #3: Showing the "Activity Zone" of the Red Line

In other words, there is a big cluster of dots there on the one graph because that's mostly where the red line is, on the other.

For the record, the activity zone is too high. If the red line ran mostly below the 3.25 level instead of mostly above it, our economy would be in a lot better shape. But that's neither here nor there, I guess...

You can see that the red line is mostly between the two dotted red lines (in other words, between 3.25 and 5.25 on the X-Axis of Graph #2). Below the lower dotted line are the dots that fit themselves to an up-and-down pattern on the left on Graph #2. Above the upper dotted line are the dots that fit themselves to the mostly left-and-right pattern on the right on that graph.

I want to take Graph #2, the scatterplot, and separate the dots into those three regions: left, right, and middle. Then I want to look at the dots in those three regions and look at the Y-Axis values, the RGDP Growth Rate values. I want to get the average of the RGDP Growth Rates for each of those three regions. It looks to me like the left will show a high average rate of growth, the right will show a low average rate, and the middle will show in the middle. But we don't have to guess.

//

Out with the dogs, I was thinking about the scatterplot dot behavior. On the left, when the P2P debt ratio is low, we see RGDP growth following the expected, business-cycle-like behavior: up and down, up and down, up and down, and so forth. On the right, where the P2P ratio is high, we see RGDP growth behaving unexpectedly. And large changes in the debt ratio have relatively little effect on RGDP growth. Moreover, the highs and the lows of RGDP growth are lower on the right (when P2P is high) than on the left (when P2P is low).

I'm thinking these differing behaviors of RGDP growth may show up in the Phillips curve. When P2P is low, the curve behaves as Bill Phillips described. When P2P is high, it does not. Hey -- it's just a thought. I can't prove it yet. I haven't even looked into it yet. I'm just sayin, there is more to this P2P story than anyone realizes.

//

I downloaded the data from the scatterplot graph and eliminated rows before the second half of 1951, where some values were missing. I ended up with data from 1951 H2 ("H" for half, as opposed to "Q" for quarter; that's FRED notation) to 2015 H1. I got 128 rows of data.

Of the 128 items, 30 show P2P ratios less than 3.25. These have an average growth rate of 4.06 percent.

Of the 128 items, 19 show P2P ratios above 5.25. These have an average growth rate of 2.01 percent.

The balance, the 79 items with a P2P from 3.25 to 5.25 (inclusive) have an average growth rate of 3.05 percent.

So yes, as we might have expected, a low private-to-public debt ratio is associated with a high rate of RGDP growth. And a high P2P debt ratio is associated with a low rate of RGDP growth.

What else is new.


// The Excel file.

Further thoughts on the Pictorial History of Debt

The other day I looked at a graph comparing private and public debt as a ratio. I showed the graph several times, highlighted to identify the various up- and down-trends it shows. Here again is that graph:

Graph #1: Private Debt relative to Public Debt

I'm going back to that graph now, to get the dates of turning-points. These dates are, in particular, low points and high points of the ratio, not necessarily the commonly observed dates for the start or end of named periods such as the "Roaring Twenties" or the "Great Depression".

Graph #1 shows an alternating pattern of up- and down-trends. Graph #2 considers each of those trends separately, and compares for each the growth of Federal debt (blue) to the growth of the non-Federal debt (red):

Graph #2: Comparing Public and Private Debt Growth by Period

The first thing to notice is that the vertical bars are in pairs -- one blue and one red in each pair. The blue is the government debt, and the red is non-government debt.

The second thing to notice is that the tall bar alternates -- blue in the first pair, red in the second, blue again in the third, and so forth. When the blue bar is taller than the red, the line on Graph #1 is going down. When the red bar is taller than the blue, the line on Graph #1 is going up.

The most important thing to notice is the fifth pair, for the 1974 to 1993 period. Both bars are tall. Oh, the blue is taller, definitely. But the red isn't short, as it is in the first pair and the third pair and the last pair. In those other three periods -- 1916 to 1919, and 1929 to 1945, and 2007 to 2014 -- the red bar is extremely short. And in those three periods, what we see on Graph #1 is emphatic downtrend.

For the 1974 to 1993 period, Graph #1 shows only a leisurely downtrend. 1974 to 1993 is a longer period than 1929 to 1945, three years longer. But the decrease visible on Graph #1 is far less in the 1974-1993 period than the other. The reason is that private debt growth remained quite vigorous in the 1974-1993 period.

On Graph #2 the blue bars are very similar for the 1929-1945 and the 1974-1993 periods. Both show close to an 800% increase. But the red bar in the earlier period is near zero, while the red bar in the latter period shows substantial increase.

The lesson I take from these thoughts is as follows: If our plan is to let private debt increase until economic problems abound, and then solve the problem by increasing the public debt -- a foolish plan, to be sure -- if that is our plan, then our solution will be inefficient while rapid private debt growth continues.

The 1974-1993 decline on Graph #1 occupied more years than the Great Depression and World War Two combined, and produced only about one third the decline in the private-to-public debt ratio.

During World War One, government debt growth far exceeded private debt growth. And during the Great Depression and World War Two, government debt growth far exceeded private debt growth. And during the recent post-crisis period, government debt growth far exceeded private debt growth. These were efficient and effective implementations of our miserable plan.

But during the 1974-1993 period, government debt growth only slightly exceeded private debt growth. Therefore, it was many years before uptrend and recovery could begin. And when it finally did begin, the uptrend and recovery could not last long, because the ratio (Graph #1) was already at a high level.

We need a better plan.


// The Excel file.

Designing the Future

I happened to notice the straight-line trend in household-debt-to-GDP:

Graph #1: Household Debt as a Percent of GDP. Red Highlight 1987Q1 to 1999Q4

The red line. I got wondering if that trend was sustainable. I mean, like this:

Graph #2: With the 1987-1999 Trend Extended Fore and Aft

You can see how the debt-to-GDP ratio went above the red line in the 1950s and '60s. But it peaked in 1965 and came down again, then stayed below the red line until that 1987-1999 stretch. After that it went quickly high, gave us a crisis and some problems, then came back down again. And now it's just below the red.

I was going to say I don't think there is any such trend as that red line and, if there is, I would certainly expect it not to be linear. However, my description of it turned out stronger than I expected. I'm still by no means convinced that the red line shows a trend that exists. But now it doesn't seem such a crazy thought.

Suppose that trend does exist.

I'm looking at the right end of the graph. The debt ratio is just below the red line. Just below, and going down, but going down slowly now, ready to start rising soon.

Suppose it does start rising soon.

I want to look at the future in terms of that red line. Yeah, the one that I doubt. (But what if it does exist?)


Okay. Let's imagine a future.

I re-created Graph #2 in Excel. Then I took debt-to-GDP and put a curved trendline on it, a second order polynomial to extend the blue line out to 2020 (but in black). As you can see, by 2018 debt-to-GDP goes above the red line, just as it did a few years before the crisis. In other words, if present trends continue, we are already on our way to another financial crisis:

Graph #3: Household Debt as a Percent of GDP (blue), the 1987-1999 Trend (red),
and the 2011-2015 Household-Debt-to-GDP Trend Extended to 2020 (black)

Is there an alternative? Of course there is. We must choose the red trend, not the black. Choose the one Alan Greenspan called the new economy. The one Robert J. Gordon called a macroeconomic miracle. The one Maynard Keynes called a quasi-boom. Choose policies that give us the red trend, not the black.

You remember the 1990s. The economy was pretty good. Choose the red trend, not the black.


// The Excel File with Graph #3. (Not sure if Google Drive handles the graph properly.)

A Pictorial History: Private and Public Debt

The graph shows the size of private debt, as a multiple of public debt, for the years 1917 to 2014.

This graph shows the level of private debt relative to the level of public debt.
Or you could call it Non-Federal debt relative to Federal debt.
The older (blue) data are from the Bicentennial Edition of the
Historical Statistics. The newer (red) data are from FRED.
All these images use the same graph, with different highlighting.

The Ratio of Private to Public Debt Fell During World War One

After the War, the Roaring Twenties

The Great Depression and World War Two

After World War Two, a "Golden Age"

Beginning Around 1974, Two Decades of Sluggishness Ensued

Beginning Around 1994, a "Goldilocks" Economy. Good Years.

Since 2000, Slowing Growth

Crisis and Aftermath

A New "Goldilocks" Economy?

Something interesting this way comes

Suppose we take this graph of the short-term interest rate and the calculation that makes a pretty good simulation of it for eighty years or more --

Graph #1: The Interest Rate (blue) and the Result of Calculation (red)

Suppose we take that graph and get rid of the interesting part. We're left with a picture of the quantity of base money, relative to NGDP. It reaches a low point in 1981:

Graph #2: Base Money relative to NGDP

There is an interesting increase in the recent years. I want to get rid of that.

Oh -- but you know, the line reaches a local maximum in 2003 and then goes down till 2007. That downsloping dingus may or may not have caused the crisis and led to the big increase of the recent years. That's interesting, huh? Let's get rid of the dingus, too.

That leaves us with a line that ends in 2003. That's 22 years after the 1981 low.

Now I want to go back 22 years before the low, back to 1959, and I want to cut off all the interesting stuff that happened before then. This gives me a graph of Base to NGDP for the period from 1959 to 2003, with a low point right in the middle:

Graph #3: Base Money relative to NGDP, 1959-2003

Nothing interesting here. I changed the line color to blue to liven things up.

I'm wondering what the activity was, that caused the change in the blue line, first running downhill, then up. Thought I'd take a look at the growth rates of NGDP and Base Money.

Graph #4: M/PY (blue), Base Money Growth (red), and NGDP Growth (green)

For the blue line we have the label "M/PY". That's left over from the Hussman Funds interest rate calculation I got from Oilfield Trash the other day. The "M" stands for "Money", here Base Money. The "PY" stands for "Price times Output". You can think of Price as the GDP Deflator, and Output as RGDP, and RGDP as GDP with the price changes stripped away, GDP being the same as NGDP. Or you can think about more interesting things.

On the graph, in the years before 1981, when the blue line is going down, the green line is consistently higher than the red. Before 1981, NGDP growth is consistently higher than base money growth. That's why the blue line goes down.

After 1981, the red line is generally higher than the green. Base money growth is generally higher than NGDP growth. That's why the blue line goes up.

Okay, so the blue line tells us that NGDP grew faster than Base for the period before 1981, and Base grew faster than NGDP for the period after 1981. That's a fact. Taking it as a fact, now I have a question or two.

How come we had inflation before 1981, but not so much after 1981? How come it was said they were printing too much money (and this was causing the inflation) before 1981, when base money growth was relatively slow? And, how come we didn't get inflation after 1981, when base money growth was relatively fast?

There must be something wrong with the inflation story they tell.

Now, that is interesting.

At root, it's always unintended consequences of policy, overlooked by policy makers.

At Reddit, jimrosenz links to Our Four-Decade Antitrust Experiment Has Failed by Kevin Drum.

My response:

If I set aside my sympathies for Kevin Drum's view, I am left with a problem. Drum writes:

The federal government should do its best to ensure that markets have plenty of competition, and then it can afford to get out of the way and regulate fairly lightly.

But ensuring that markets have plenty of competition is regulation. Heavy regulation. Drum wants to use a crude old rule: "ensuring that there are plenty of competitors in every market and refusing to allow any single company to become too dominant." If that's not an explicit call for heavy regulation, it could easily become one.

Drum admits that "even a crude market share rule" would have problems:

You'll have arguments over just how big a single company should be allowed to get (30 percent share or 50 percent share?).

When I read of calls for that sort of regulation, my mind goes to The Road to Serfdom. We can't solve problems that way. We mustn't solve problems that way.

Take a step back, and consider the possibility that our problems are self-created. We have too little competition? Too much dominance by single companies? Maybe such common problems are the result of existing policy -- an unintended consequence, so to speak.

The business tax structure favors bigness. The more you can spend, the more you can avoid tax. That's the driving force behind merger and acquisition.

Kevin Drum brings up the returns to scale. I read a Kiplinger letter, decades back, where they wondered why agribusiness grows beyond its economies of scale. It's not only agribusiness that grows beyond economies of scale. It's business in general. And it's the business tax system, favoring bigness, that drives it.

Presidential Politics in 1932

by William E. Leuchtenburg:

At the Democratic national convention late in June, the anti-Roosevelt coalition came within an ace of success. Roosevelt took a decided lead on the first ballot with 666¼ votes to Smith's 201¾, Garner's 90¼, and scattered support for favorite sons. Yet he was still more than a hundred votes short of the needed two-thirds ... When the convention recessed after the third ballot, the Roosevelt leaders had a margin of only a few hours in which to try to save the day.

Late that afternoon, when the fourth roll call reached California, the rangy, straight-backed William McAdoo strode to the platform. California, he announced, had come to Chicago not to deadlock a convention, but to nominate a President. Quickly, the meaning of his words became clear. California had abandoned Garner and was casting its forty-four votes for Roosevelt... With the switch of California, it was all over. The other states, all save the diehard Smith forces, climbed on the band wagon, and within minutes Franklin Roosevelt had been named as the Democratic nominee.

Upsetting all precedents, Roosevelt flew to Chicago -- in a tri-motored plane that was buffeted by squalls and twice had to land to refuel -- to deliver the first acceptance speech ever made to a nominating convention ...


The Democratic convention displayed little more interest than the Republican in the crucial problems of the depression. Roosevelt's platform, drafted at the Governor's request by A. Mitchell Palmer, was a conservative document. Senator Key Pittman protested: "The platform has the merit of being short, and the demerit of being cold. There is not a word in it with regard to the 'forgotten man'" ...

At both conventions the delegates showed far more concern over prohibition than over unemployment. "Here we are," wrote John Dewey, "in the midst of the greatest crisis since the Civil War and the only thing the two national parties seem to want to debate is booze" ...

While the platform aroused little enthusiasm, the nominee kindled little more...

Roosevelt's campaign did little to reassure critics who thought him a vacillating politician. His speeches sounded painfully discordant themes...

Yet all this was as nothing compared to his oscillations on fiscal policy. He would increase aid to the unemployed, but he would slash federal spending. On this one point he was specific; he would cut government spending 25 per cent. At Sioux City, Iowa, in September, Governor Roosevelt stated: "I accuse the present Administration of being the greatest spending Administration in peace times in all our history. It is an Administration that has piled bureau on bureau, commission on commission, and has failed to anticipate the dire needs and the reduced earning power of the people." In Pittsburgh the next month, he declared: "I regard reduction in Federal spending as one of the most important issues of this campaign. In my opinion, it is the most direct and effective contribution that Government can make to business." One of his New Deal administrators reflected subsequently: "Given later developments, the campaign speeches often read like a giant misprint, in which Roosevelt and Hoover speak each other's lines."

Leuchtenburg, William E.  Franklin D. Roosevelt and the New Deal, 1932-1940. New York: Harper & Row, 1963.  From Chapter 1.


For the record, this is what Franklin Roosevelt actually did:

Total (public and private) debt, relative to the money available to pay down debt

Velocity and Interest Rates move together

Okay, I slept on it.

Oilfield Trash commented on my previous post:

the 3-month Treasury bill yield as a function of liquidity preference: I = EXP(4.27 – 45.5*M/PY) where M= Monetary Base and PY is Nominal GPD.

"You get a pretty good fit," he says. I drew it up:

Graph #1: The Interest Rate (blue) and the Result of Calculation (red)

You get a pretty good fit.

The blue line is the 3-Month Treasury Bill: Secondary Market Rate. The red line is calculated using some carefully chosen constants along with the St. Louis Adjusted Monetary Base and a measure of GDP. I used annual data from FRED.

I showed the economic data, the M/PY from the calculation, in light gray, using the right-side vertical scale. It moves in the opposite direction from the calculated (red) line. Has to do with M/PY being subtracted in the calculation. If we were adding it, I expect the red line would move in the same direction as the gray, rather than opposite.

Looking at the red and blue lines, the first thing I noticed was that on the uphill, from 1934 to 1981, the red line tends to run low on the blue. On the downhill, after 1981, the red tends to run high on the blue. At first I thought that might be a fluke result of the calculation. But I don't see how that can be, because the red line comes from base money and GDP and a couple constants, and nothing else. There are no flukes in the calculation.

Looking at the graph again now, it occurs to me that on the way up the Fed was fighting inflation all the while. On and off, but all the while. So then the red runs relatively low on the uphill because the Fed kept pushing interest rates up to fight inflation. On the downhill side, then, it looks like the Fed kept trying to boost growth by repeatedly reducing interest rates. And the red runs relatively high as a result.

Or maybe it wasn't even the Fed doing it. Maybe it was the result of the mass of economic decisions made by, you know, people participating in economic activity. Some people say the Fed follows the market.

//

The red line is a lot less wiggly than the blue. The wiggles show the pattern of business cycles, draped over the longer term path established by the M/PY ratio.

As of course you know, the M of M/PY is money, P is the price level, and Y is real output. Together, those three variables constitute three quarters of the equation of exchange: MV=PY.

What's missing is V: velocity. If you take the equation of exchange and divide both sides by M, you get V=PY/M.

Invert both sides, and you get (1/V)=M/PY.

Wait a minute now: M/PY is part of the calculation.

The calculation from Oilfield Trash says that the interest rate is equal to the exponent of one number minus another number times M/PY. But M/PY is equal to (1/V). So the calculation says that the interest rate is equal to one number minus another number divided by the velocity of money.

So there is a relation between the interest rate and the velocity of money.

Why would that be?

It's pretty easy to say things that are more common are cheaper, things that are less common are more expensive. When money is moving fast -- when velocity is high -- does money seem more common, or less common?

What does the graph say?

The gray line M/PY is the same as (1/V). In recent years, for example, the line goes up like crazy because of all the QE. Money became more common, relative to GDP. And the interest rate went down. But that's (1/V). What about V itself?

When (1/V) goes up, like in the recent years, V goes down. V goes down, and interest rates go down. So, velocity and interest rates move together.

Velocity and interest rates move together, perhaps because things that are more common are cheaper and things that are less common are more expensive. It seems to work. But you know what? I shouldn't have asked. I shouldn't have asked "Why?"

The fact is, velocity and interest rates move together. That's the fact. It will probably help me to remember that fact, thinking things that are more common are cheaper. But I don't know if that's the reason. It's only a theory. The fact is, velocity and interest rates move together. Base velocity, anyway.


// see also
http://www.hussmanfunds.com/wmc/wmc110124.htm

Insights from an Interest Rate Simulation

Interest Rate and Simulation

George Lucas might not agree, but if you want to design economic policy you need to create a simulation of the economy in a spreadsheet. Your simulation needn't exactly duplicate each twist and turn of every real-world variable, but it has to be a decent facsimile. And the calculations that produce the numbers for your "sim" have to be based on real-world economic forces. Otherwise it's not a simulation, it's a fantasy.

Robert Lucas, I mean.

//

In that Noahpinion post I was railing about the other day, Noah links to The Leverage Cycle (PDF, 58 pages) by John Geanakoplos.

I've come across Geanakoplos before. I like his thinking. I checked out Noah's link. This detail from the PDF stuck in my head:

In standard economic theory, the equilibrium of supply and demand determines the interest rate on loans.

That makes sense. I thought it was more complicated. Now I want to look at it. Maybe I can come up with a calculation of real-world factors that give me numbers I can use to simulate an interest rate. For the simulation I've been wanting to create since Jimmy Carter was President.

No rush.

Design

I did the following graphs and worked out the calculations already once this morning, taking notes. I'll do it all again now, hopefully a little more organized and presentable.

To simulate the interest rate, I want to base my calculation on the years before inflation became a problem. So when I design the calc I won't look at data after 1965.

I wanted to start right after World War Two, but some of the data doesn't start until the end of 1951. That's okay. It's good, actually, because it gets me past the Fed-Treasury Accord.

I want to ignore the recessions and the changes in policy intended to create or to recover from recessions. I think that will give me a smoother simulated path of interest rates. I can already imagine that rates go up (due to the demand for loans) until rising rates cause recession, and then falling rates allow the decline in borrowing to bottom out and then increase again. I don't need to complicate the sim calc with all of that. Not yet, at least.

Similarly, I want to ignore inflation. Solved a lot of that problem just by stopping at 1965.

And then I want to look at consumer debt, changes in consumer debt, as a measure of the demand for new credit. (Existing debt is the measure of demand for total credit in use.) I'm thinking interest rates pretty much move in sync, for consumers and for everybody else. And I have data I can use for consumers. And this is a first effort. I can revise the thing later, if I get bigger ideas.

So I've got the price of credit (the interest rate) and I've got the demand for credit (consumer debt), and I've got nothing for the supply of credit. That's okay. I'm assuming the supply is constant (or, growing at a constant rate). That's what I get by ignoring policy responses to inflation and recession. And come to think of it, ignoring such unusual moments is probably what John Geanakoplos meant by "the equilibrium of supply and demand".

If I have success simulating the interest rate while ignoring supply, I can still try to improve it later by looking at supply.

So that's the plan.

Development

For an interest rate I figured I'd use the Federal Funds rate. But at FRED the FEDFUNDS rate only goes back to 1954. So I got the "3-Month Treasury Bill: Secondary Market Rate" instead. That goes back to 1934 and runs real close to FEDFUNDS since '54. Should be good. Here's what I'm thinking:

Graph #1: The Price of Credit  --  The Interest Rate

Something like that. The red line shows the general area I'm looking at to design my calculation, and the general shape I expect to get from my calculated numbers. It would be nice, though, when I extend the red line all the way to the end, if it follows the actual interest rate better than the red line here.

That will be my test:  I figure a "sim" interest rate based on the years 1952 to 1965. Then, using that calculation, I extend the line out all the way to 2016. If my sim line goes crazy, I wasted my time figuring and you wasted your time reading (unless you're just here for the laughs). But if my simulated interest rate seems to follow the actual interest rate, then I'll be happy with my calculation. And I'll be one step closer to actually creating a simulation of the economy on a spreadsheet.

(I know: Other people have probably done that already. No problem. I get satisfaction from trying to do it, and more satisfaction if I succeed.)

So that's the interest rate. The "price" of credit. I looked next at the "demand" component, consumer debt. (For now I'm taking "supply" as given, remember.) First, the quarterly change in consumer debt:

Graph #2: Quarterly Change in Consumer Debt

I'm showing "demand" in red in these graphs, by the way.

I rejected Graph #2 at a glance. It shows instability in the last three years of the 1960s, to my eye, but doesn't show increase until the 1970s. By contrast, the price of credit -- Graph #1 -- shows increase right from the start. From 1950. Persistent increase. Graph #2 does not show the growth of demand for credit that  would be needed to generate the increase visible on Graph #1.

I changed Graph #2 to show the quarterly change as a percent of GDP. That made it worse: higher in the mid-1950s than the mid-1960s. It should have been low early and high later. And the downslope from 1964 to 1967 was more sharply down -- down, just when inflation was picking up. It was exactly wrong.

I thought: I need to multiply it by something that shows increase. I knew immediately then what to bring in to the calculation: accumulated consumer debt, relative to GDP. I revised the calculation, and put it on the same graph with the interest rate from Graph #1:

Graph #3: The Interest Rate (blue) and my Calculation (red)

Oh. The red line shrunk down to make room for the blue line. That's always a surprise. But it's easy to fix. I just multiplied the calculation by 7 to scale the red line up, so I could compare it by eye to the blue:

Graph #4: My Calculation (red) Sized to Fit the Interest Rate

Hey, I think I got something there. Pretty good simulation, up to 1965. There are some wiggles, where the lines differ. But the red line starts out a good match to the blue. And it's a good match from 1960 to 1965, give or take. And that is what I was going for -- to design the calculation based on the years before inflation became a problem, the years before 1965. The goal was to get satisfactory results from my calculation for the period before 1965.

The sim does appear to fall apart by 1965. I think what I'm seeing is the blue line rising with inflation, and the red line not. But remember I said that I'm "ignoring policy responses to inflation and recession." I should expect to see the red and blue lines separate while inflation is building. So I'm not disappointed.

Come to think of it, while inflation is building the "erosion" of debt is increasing. Perhaps this accounts for the apparent downtrends in the red line from 1965 to 1970 and 1973-1975 or so.

These same influences likely cause the "wiggles" of the mid- and latter-1950s, noted above. Those wiggles may not be so big a problem as I thought.

I made a copy of Graph #4 and marked it up to show where the two lines run together. I count six locations:

Graph #5: Copy of Previous Graph with the Stitching Highlighted

It is as if the red and blue lines are stitched together. Between stitches of equilibrium, inflation and what-all drag the lines in separate directions. Something draws them together. Equilibrium draws them together.

I'm pretty happy with my calculation.

Graphs #4 and #5 end in 1980. I moved the end-date to 2016 to see the whole picture. The half-dozen "stitch" points still exist in the years before 1980. In addition, you can see that the red and blue lines run together for about five years in the 1980s and for most of the 1990s:

Graph #6: Copy of Graph #4 Extended Into 2016

If it wasn't a good calculation, I would expect to see the lines diverge. But the stitching continues. That gives me confidence in the calculation.

From the start to the year 2000 -- almost 50 years -- the two lines run together, with disturbances that appear to arise largely as effects of inflation. After 2000 it's a different story. But before 2000 the result is promising.

I don't think my calculation is useful for a simulation of interest rates as it stands. I'm wondering how it will look if I include the inflation rate in the calculation.

Graph #7: Added Two-Thirds of the Inflation Rate, and Revised the Size Adjustment

I could use that. For a simulation, I could use that.

The Last Years

The years after 2000 deserve another look.

Before I added inflation into the calculation (see Graph #6) the calculated line (red) runs consistently at or below the blue line, till 2000. After 2000 the red line runs significantly higher than the blue, to the crisis.

On closer look, I see the red line starts to go high in 1998. Whatever date you pick, the change from "at or below the blue" to "above the blue" is unusual because the red line does not run above the blue until that date. There was a change, I'm saying -- a change in the economy.

The red line, my simulation of the interest rate, is based on the real-world relation of debt to GDP. The red line going high is a result of debt going high, unusually high in those years. You remember that.

If my calculation provides a good simulation, then maybe what it shows in the years after 1998 is right. If the simulation is good, maybe it shows that interest rates should have been higher in those years, higher than they actually were. In other words: interest rates were too low for too long.

Remarkable, huh?

Then, after imagining interest rates as high in the 2000s as actual rates were in 1981, the simulation shows interest rates going negative. My graph, based on debt and GDP, shows a sudden need for negative interest rates. That's something Paul Krugman was saying:

Early on in this crisis I and quite a few other economists — but not enough! — declared that we had entered a classic liquidity trap. This is a situation in which even a zero short-term interest rate isn’t low enough ...

The economy, Krugman was saying, needed negative interest rates. Like Krugman, my interest rate simulation wants negative rates.

More recently then, the simulation has rates in positive territory again.

John Taylor:

I’m saying if they had a strategy in place that would have seen interest rates moving up in 2011 or 2012, but not a lot, then I think things would be working better.

The simulation shows rates positive and increasing in 2011 and 2012.

Look: I don't think my interest-rate simulation is perfect. Adding the inflation rate to it is a fudge factor. But with or without that fudge factor, the simulation produces conclusions similar to Krugman's conclusions. And it indicates the same patterns of interest rate behavior as the Taylor Rule.

For the record, I don't claim to be a fan of the Taylor Rule. But I get similar results. Looking at consumer debt in this way

change-in-debt-as-a-percent-of-GDP * the-accumulated-debt-to-GDP-ratio

I get the same result that John Taylor gets when he looks at actual inflation and desired inflation and the equilibrium real interest rate and GDP and potential GDP and whatever else he stuffed into his rule.

The interest rate simulation presented here emerges from debt-to-GDP ratios. What the simulation shows is that you can arrive at Taylor Rule conclusions simply by looking at consumer debt and GDP.


// Update 18 March 2016: For another example of combining levels and rates in a calculation, see my Levels and Growth Rates of Debt and Income from last October.

Prevention

"The best way to stop a crash is to act long before it occurs"

- John Geanakoplos

Yes!

Repeating the key point, since I buried it yesterday

Noah identifies his biggest problem with the Folk Theory of business cycles:

The story the Folk Theory tells is that you can't have good economic times without increasing debt, and that increasing debt always causes a bust. So good times come at a price - you can't have prosperity today without disaster tomorrow.

My response:

You have to understand that the problem with debt is cost. There is a benefit from using debt, but there is also a cost. If we increase our use of debt for 75 years, and increase it enough to offset the cost of the debt we're accumulating all the while, at some point the shit is gonna hit the fan.

The shit doesn't have to hit the fan. But you have to understand that it will, unless we do something to prevent it.

It will, unless we do something to prevent it.

We have all sorts of policies that encourage people to use credit, because using credit is good for economic growth. Because of policy, our use of credit is unnaturally high.

We have all sorts of policies that encourage people to use credit. But we have no policy that encourages people to pay down debt.

Because of policy, we borrow money faster than we pay it back. This is how debt got so big. But it doesn't have to be like this.

We could set up policies to encourage people to pay off debt a little faster. We could counterbalance policy-driven borrowing with policy-driven debt repayment.

We could. It would be easy to do. But we will never create these policies until people come to believe they are necessary. And that may never happen, because people like Noah insist that debt might not be a problem.

Toynbee was right. Civilizations die by suicide.