When Aggregate Demand Policy Isn't Enough

Charlie’s motor scooter wouldn’t start. He checked the spark plug and it was okay. He checked the fuel line and it was in place. He even checked tire pressure. Exasperated he went inside to watch Baywatch reruns and drink a PBR. Peter asked him if there was any gas in the tank and sure enough there wasn’t. Problem solved. They filled the tank and rode off into the sunset. 

That’s a nice happy ending. It illustrates that sometimes the solution is right there in front of your face. Many of the usual suspects are not always culpable. So stop badgering them and move on. While this advice pertains to many things, it seems very obvious right now with respect to economic growth. Our predilection is to focus on aggregate demand (AD). Keeping the budget deficit and/or monetary expansion hot is a macro tool for stimulating AD.

This idea goes at least back to J.M. Keynes who thought that a modern economy, like your teenage child, has a natural tendency to stay below its potential. He concluded and became famous for his idea to prime the pump. Taken from an agricultural application, Keynes said that all the engine needs is a wee bit of fuel and it will start running. Once the engine starts running the gas will more easily flow from the tank through the carburetor. Problem fixed.

I am not sure how we got from a wee bit of temporary stimulus to massive and perpetual government deficits but let’s say that Keynesians expanded the master’s ideas. If a little stimulus is not enough then it seems logical to try more of it. But like Charlie’s dilemma above, when a lot of stimulus does not appear to work it does not mean we should move to a “whole lot more AD stimulus.”

There are two parts to this issue of what to do when stimulus seems to not be working. First, are you sure it isn’t working? Second, what else can you do to fix the problem?

Many of the articles I am reading are starting to concede that you can have too much of a good thing. I can show you too many graphs of monetary indicators – reserves, excess reserves, narrow money – that all pretty much show the same thing. There is a s-load of money out there. Doubling excess reserves won’t do a thing to solve the problems of today’s economy.  And measures of government fiscal deficits and debts are no different. As economists project the course of future debt it shows no signs of reversal despite being at least double what me might call normal. All that stimulus and virtually no one proudly boasts that it has or will cause the economy to return to stronger growth.

Worse yet from the AD side is that since money is so abundant, interest rates so low, the government debt so high – we have collectively backed ourselves into an AD corner. If AD does worsen, we have very little room to use AD policy to counter such possible downturns. Do we take national debt from 80% of GDP to 150%? Can you speak Greek?

Okay I have beaten up enough on AD. If AD is not going to save the day, then what will? The answer is in the economist’s usual toolbox. Economists explain everything from sex to sympathy with demand and supply. We think this is a balanced approach to many issues – so why not macro too?

AS completes a market analysis. While AD represents the buyers in a market, AS is identified with the suppliers. In a market system, what motivates and allows the suppliers to bring more or less to market for sale? To begin with suppliers need inputs. Depending on what is being produced they may need a building, energy, workers, police protection, raw materials, parts, equipment, trucks, and so on. That and their own labor costs money. A business usually has to assemble all this stuff before it brings the first item to market for sale. So businesses always take risk. They have to lay out money and then they have to hope that someone will want to buy the fruits of their labor.

How much should they produce? While many new businesses do not earn any profits for years the main idea is that the owner or owners get a return for taking this risk as well as for the time they put into this business. If demand and market price turn out to be very low for their product or service, then the return is not going to be very high. If the market price is low enough it might not cover costs and would warrant no production and a shutdown. But as market price rises, this satisfies the owner and makes him or her more willing to supply more output.

This shows that demand is critical to output and this idea works at the national level – more AD and a higher national price level tend to stimulate higher national output. But there is much, more to story. What matters too is the productivity and the costs associated with the productive inputs. Imagine that your workers went to a Prince/Michael Memorial Show last night and came to work today full of vim and vigor. Working at the same compensation package they manage to Moon Walk their way to much higher output per person. The consequence is that each unit of output costs less for you to produce. It makes your company more competitive. You can offer a better price to buyers. And thus your profits and your incentives to produce increase.

The upshot is that anything that increases productivity stimulates more output. The opposite is true of increased costs. Whether it is an increase in wages, compensation, energy, taxes, or the price of any productive input, it tends to raise your costs per unit and reduces your competitiveness. Thus a firm tends to reduce output when costs rise relative to productivity.

While it might sound wrong to some of you to support a policy centered on improving business profits, the possibilities are pretty attractive in the sense that policies designed to raise business productivity and to reduce unnecessary business burdens and costs could go a long way to returning profits to normal, to raising the optimism of managers, and to increasing output, employment and earnings. Given that the usual AD stuff is not succeeding it might not be a bad option. Or instead we could go back to shouting at each other. 

Fed Policy, Red Bull, and Buddha

Will the Fed raise interest rates? Will I gain one pound after eating the giant pork chop at Le Petit Cochon? Answer: Who cares? Apparently the market seems to care more about interest rates than my waistline. So let’s work on that question today.

Thanks to my friends at the St Louis Fed I was able to download a chart from their lovely FRED service. This graph charts an interest rate – the 10 Year Treasury Constant Maturity Rate (or let’s call it Ted). Ted tells you what you could earn on a riskless asset with a 10 year maturity. It also seems to be at the heart of something called the interest rate yield curve. I see some of you are dosing. So let’s try one more time – this graph of Ted shows you an interest rate that represents interest rates on all sorts of assets. Ted is like the popular guy you know. If Ted goes to the Player’s Pub then everyone goes there. If Ted goes to the IU Opera, then the crowd goes to see the Flying Dutchman (highly recommended for people suffering sleep deprivation).

The Fed does not directly control Ted. But smart people watch Ted to gauge how the Fed’s actions will affect all sorts of interest rates. I love the below graph of Ted. I could write about it until the cows come in even though I don’t even have one cow.

The graph shows Ted from well before 1970 to now. It shows how Ted behaved over a long period of time and over lots of short periods of time. It shows Ted before, during, and after recessions.

Ted got really heavy as a youngster and peaked out at around 15% in 1982. Then he went on a diet and has been losing ever since. Sure he falls off the Dick’s Burgers wagon now and then but he keeps getting svelter and svelter.

As a result of looking at this graph of Ted for at least 100 hours you can come away wondering if there is something called a normal interest rate for our times. Despite what the Fed might do or not do in the coming weeks, one story is the long-term trend since 1982 towards lower rates. Perhaps rates will go even lower for yet another phase of this trend?

Or you might say that the downward trend has to end sometime. Negative interest rates are possible but it seems strange to think of negative interest rates as the new normal. It would be like going into a Whole Foods and being told that they will pay you $10 to take home a dozen natural cage free no hormone no antibiotics Omega-3 Nest laid, vegetarian diet certified human raised and handled extra-large eggs.

So let’s ignore the trend. The other thing you might note is that Ted generally rises before recessions. These recession-inducing interest rate increases might have been a natural result of a rapidly growing economy or the direct result of an intended (or not intended) Fed policy. If you have on your reading glasses you can see the shaded vertical bars representing recessions and look at how many of those bars were preceded by a rising Ted. Aha – the culprit has been found and so the recession cure is right before our very eyes. Do not let the Fed push Ted up and we won’t get another recession!

Not so fast Nathan. If you squint and look even harder you can find a number of time periods in which Ted rose but did not lead to a recession. So now we have it – rising Ted causes recessions at times and does not cause recessions at other times.

This brings us back to our current dilemma. We are all waiting for the Fed’s decision as to whether they will raise interest rates another smidge in June or July or whenever. The second Rufus gets a whiff of a rumor of such an interest rate increase, Rufus calls in the dogs and the markets go crazy. But seriously, what is wrong with these markets? 

Looking at the chart, have you noticed how low interest rates are? Are we really serious that another 15-25 basis point increase is going to throw us into a tizzy? Whatever that policy might do to Fred in coming months its value will still remain on such a low portion of the graph that you can hardly see the increase.  Imagine how people felt when the Fed engineered the 15% rate in the early 1980s? Now that increase was noticeable!

Graphs and data do not prove anything. But they sure have a way of putting things into perspective. Janet Yellen, her colleagues, and a lot of financial people need to put down their Red Bulls, take a deep breath, and say Om next to a babbling brook. Get on with normalizing monetary policy and try a little quiet meditation. 

Summers Misleads with Secular Stagnation Tilt

Larry Summers recently peered into his cob-webbed trunk of worn out economic ideas and found something that was discarded with Dad’s WWII army uniform – the concept of SS. For those of you unfamiliar with Lucky Cigarettes and Bing Crosby, secular stagnation basically means that your economy has a disease that implies it will forever grow at a rate slower than your mailman on the day the Social Security checks arrive.

SS was coined after WWII. Alvin Hansen thought that the US would go back into a depression since defense spending would be greatly reduced at the end of the war. The logic was clear – Great Depression – war spending up – war spending down – Great Depression. It didn’t actually happen that way and despite three recessions in the 1950s, the US was off and running like Forest Gump.

You cannot blame Summers for wanting to dust this baby off and try it out again. We had a great recession in 2008/2009 and ever since we have had lackluster economic growth in the US. If my fingers are correct it has been about seven years since that recession technically ended. It ended and we had no real recovery stage. And the expansion stage would not put pho on the table for most of us. So Summers is right to wonder if maybe this time we have contracted SS.

Summers is as predictable as Charlie Sheen at a Margarita Bar, but he is also nuanced. He was a college President and you learn a lot of skills in that kind of job. Summers new emphasis on the long-run issue of SS appears to have distanced him from the usual mantra about short-run demand. But he is like the pickpocket who attracts your glance toward one hand while he empties your IU Credit Union Account with the other.

Summers doesn’t exactly say why it is that the government debt shifted to twice its long run average (as a percent of GDP), and increasing debt even more is perfectly fine for long-run economic growth. Recall that he wants to end SS. Hopefully he wants to end it in the next decade but you’d never know it. For example, he wants to stop SS in its tracks with more spending on the environment and education. I don’t care what political colors you wear – there is no way to connect the dots here – you can spend a lot more on both of those things and you might get your pug to leap through a gas-fired ring six feet off the ground. But how long will it really take to get the growth needle to move after more of this kind of spending?

He also wants to tax the rich and redistribute the proceeds to the poor and middle class. Again, that’s a nice thought. It might even increase spending in the short-run. But in what circus do you call that long-run economics? I remember the kid’s comic book wherein Scrooge McDuck (Donald’s Uncle) sat in his vault and played in the money. So it makes sense to give some of that money to poorer people. But please – don’t tell me this is a means to permanent raise the growth of the economy.

Finally, Summers want to increase infrastructure spending. Most of us nod and say that’s a cool thing to do. And despite its budget-busting implications it can logically be classified as long-run policy. But please do not tell me that it is going to do much for growth in my lifetime. Remember in 2008 the term “shovel-ready" projects? 

We learned what many of us knew – government spending is a long and tortuous (and corrupt?) road. Correct me if I am wrong but it took five years before a healthy portion of that money legislated in the last recession was actually spent on something. You know the deal – someone has to advertise for bids and then someone has to type them out on nice typing paper using an Underwood typewriter. Then all the stamps must be licked and pressed on envelopes. Okay I am joshing with you but you get the point. It takes a while to select the contractors and then they have to get geared up to do the work. Bribes must be paid and checks cleared. Then the checks roll and the magic happens. Hold on to your kiddies -- the Summers express is ready to take-off.

I have hit my six million word allotment for the day. While our liberal and revered soothsayers are talking long-run policy or not, the truth is that they are asking for the same policies they always ask for. These policies are not working. A real durable supply-side policy is possible that might find compromises by all the parties that address our current economic slowdown. But you are not going to get it from the usual hacks. Their faux SS argument means little. It is time to try something else. 

Macro and the Perfect Storm

I am currently teaching two macro courses at the University of Washington in Seattle. I get free purple rain wear and as much Starbucks coffee as I can drink. It’s a nice deal. I can harass MBA students and my son’s family during my stay here. What could be better than that?

Introducing macro to a new group of MBAs is always challenging. People choose to attend MBA programs to pursue careers in marketing, finance, accounting, and so on. They do not come to business schools to study macroeconomics. The wisdom at many MBA programs is that macro is a tool these students need. Alternatively it is an excellent means to punish them for past sins. Whichever is true, my 119 years of teaching macro at Kelley has left me with a lot of scars and a lot of great memories.

Teaching macro today is even more challenging. Just as capitalism and free trade are under the microscope, so is macro. Events since the popping of the housing and stock market bubbles have left many people ready for revolution. Bernie wants to replace markets with more government control. Trump  wants to replace free trade with Trumpian Trade.  Congress won’t approach anything that resembles an economic plan and the central banks around the world think low or negative interest rates are beneficial despite Keynes’ warnings about liquidity traps.

Meanwhile the average bloke thinks the economy is either broken beyond repair or run by rich, selfish people. They are ready for revolution and macro is part of the heap they want to toss out and replace with something better. I am not ready to give in to a premature burial for macro but I realize that students will not take for granted that studying a dying science is worthwhile. I can’t say “shut up and eat your macro; it is good for you.”So it is up to me to try to motivate why they should spend the time and energy on macro.

Part of understanding the strengths of macro is to admit its weaknesses.  Macro lopes along. The basics of supply and demand stay the same but when the world changes, macro must too. One kind of macro seemed to be helpful in the 60s until inflation picked up. Macro wasn’t too sure about itself in the 70s but then new theories helped to improve its explanatory power as time wore on. We invented the word stagflation around that time to name a new unsatisfactory phenomenon. Macro was not so good at explaining the impacts of energy price increases and then decreases – so we had to dress it up a little more to improve predictability when energy or for that matter when food prices went haywire. Macro clearly was not ready to deal with a dot.com bust and then years later with housing and stock price bubbles. Macro is having a struggle today to digest globalization, declining productivity, and labor market disappointments. 

Macro is evolutionary. I remember being a young graduate student (with hair and teeth) and hearing a professor proclaim that macro knew everything it had to know. We had Keynesian macroeconometric models that could forecast the economy almost perfectly. What hubris!  That bubble burst in the late 60s as inflation rose and kept rising. The world is always changing.  Macro’s charge is so broad that its models have to incorporate many variables and many phenomena. So it is easy to understand why macro models will never be perfect. But even when they are bad, they are helpful. When they are bad economists scurry around until they figure out how to make them better. As we scurry the picture is not pretty – sort of like making sausage.

Right now we find ourselves in that sausage-making stage. Watching all this most of us would prefer a nice banana. In the meantime we have to make decisions. Households have to find ways to save money for the future. Business firms must decide when to build another store or factory. Multinational corporations have to position supply-chains. Investors have to come up with a mix of stocks, bonds, and other investments. As we remake the macro sausage none of those decisions are easy and they can be very frustrating. It’s hard to know which Ark to choose when the water is rising.

In the meantime as we filter through what will someday be the next stage of the macro model, the old model helps us make at least imperfect decisions. Supply and demand are concepts that help us think through the haze. We can apply supply and demand tools to any market. For example, the world has a very pronounced tendency to favor demand-side remedies. But in 2016 it looks like traditional monetary and fiscal policy thinking are not working. That does not mean macro is a  failure. It means that policymakers can think about supply approaches. 

Some politicians are promoting revolution where revolution is just short-hand for more government control and oversight.  Maybe more of that is necessary these days but macro always warns about unintended negative consequences. What happens to international trade when we treat Mexicans (or Chinese)  as naughty step-children? What happens when we penalize companies for making global decisions? What happens when bankers feel a constant threat of legal action over everyday banking decisions? 

I don’t blame anyone for feeling seasick. The world economy today is like a small boat in a perfect storm in which the boat never stops moving up and down. A bubble bursts in 2007. A recession hits in 2008 in the US. It spreads to the rest of the world and then the economic waves of their downturns reverberate to our shores. Policymakers get active and we get cash for clunkers – another wave. In Europe they stimulate and then turn to austerity. Bam again. Earthquakes and tsunamis. Bam. Energy prices decline. Bam. Negative news about China. Bam. None of this is usual or normal or easy.

We are seasick but it is not time to desert the boat. Even a perfect storm subsides. It exits slowly and as we recover the scenery is cloudy and unclear. And yet we have to go on making decisions. I am happy to teach my courses and to write my blog and keep reminding us that while macro is not perfect, it can be helpful and is among the tools we all need to keep making decisions in a complicated and uncertain world. 

From Each According to his Ability to Each according to his Needs

Though it stems from former socialist writers, the statement in today’s title has been widely attributed to another famous socialist Karl Marx. A broader statement would include these three points which I stole from Wikipedia (https://en.wikipedia.org/wiki/From_each_according_to_his_ability,_to_each_according_to_his_needs )

I. Nothing in society will belong to anyone, either as a personal possession or as capital goods, except the things for which the person has immediate use, for either his needs, his pleasures, or his daily work.
II. Every citizen will be a public man, sustained by, supported by, and occupied at the public expense.
III. Every citizen will make his particular contribution to the activities of the community according to his capacity, his talent and his age; it is on this basis that his duties will be determined, in conformity with the distributive laws.

While all of us would agree that this statement is highly utopian it does express some values that we all might share. It is nice to think of us giving what we are cable of giving and taking only what we need; sharing the rest. It is like the experience of being on a college basketball team. Clearly some guys are taller than others; some faster; some better shots. They each contribute in different ways. They each get a similar scholarship. They share in the glory when they win. Go team!

From this start you might think that this posting is about socialism. But it isn’t directly. In our seemingly reasonable request to make things more fair today we have lost sight of another dimension of society. Fairness and equity are critical as are clean air and freedom from fear. This list of social desirables is important and long. But in focusing so hard on these requirements of society we sometimes forget and perhaps do not even know about the main lessons and real constraints of economics.

Yes, economists are probably at fault for not teaching and spreading their ideas better. So let me give it a try. I am out of JD and I need to do something.

Let’s start with that college basketball team. The team and its many loud and obnoxious supporters,  followers and mascots want to win. Players do not put in all those practice hours and risk life and limb for the fun of it. They want to win. And to win they have to play like a team. And that means they should make use of the best talents of all their players. But it does not usually mean that all players get treated exactly alike. The star gets dates with the best looking cheerleaders and sometimes gets a free steak or expensive automobile from an overzealous fan. In some schools the star player forgets to attend classes and somehow all that is overlooked despite being labelled a “student”. 

The best high school players are recruited and while they love to play basketball, being on a winning team is what the best ones desire. They want to be stars and get all that goes along with that.

Glad I got that off my chest. You might be wondering how this relates to economics. Imagine that you were one of the first persons to see the world and there were no stores and no factories and no means to easily get things. Yet, you have to live. You have to survive. So you and your buddies design a system so you can eat, have shelter, warmth, protection, watch porn channels, and so on. This is the challenge that economics deals with. How do people get what they need and want? There are a bunch of resources lying around out there. Like the basketball team players you want to find the best way to achieve these goals. You want to get the most consumption with the least amount of effort and/or cost. In other words, why be wasteful? Get what we need in the best possible way.

Economists call this efficiency. And like Marx, economists concerned with efficiency want people to use their highest skills. But unlike Marx, market economists do not assume that people will employ their skills fully unless they are rewarded to do so. If society wants more bananas, then we want more pickers working on banana trees and fewer working on guava trees. If most of them are hanging around the guava fields (or Truffles Bar), an announcement that they would earn more income picking bananas reallocates pickers to bananas away from other work options. Firms can pay these workers more because they can pass along the higher labor costs to the consumer who is willing to pay a higher price to get more bananas. Workers do not usually do this and undergo all the costs of change out of the goodness of their hearts.

Let’s suppose workers hate banana trees or that they have to undergo special training to pick bananas. Inasmuch it might take large increase in wages (or benefits) to attract the resources into bananas. Accordingly prices of bananas would have to push even higher.

Later, when we decide we want to have i-phones, a similar process attracts more labor and capital into producing funny little devices that allow us to tweet inane messages as we peel bananas…at the expense of perhaps fewer hoppy beers.  

Notice that as long as workers (and other resources) are freely mobile and firms are free to switch products and keep the proceeds of their labors, this process works – and it works fluidly. It does not take any one single person to make it work. Hey dudes, Charlie’s Banana Farm is looking for workers and they are giving your kids free kindergarten if you work for Charlie. If information is free and if firms and workers are free this system is on autopilot.

This quick discussion of economic efficiency has two points related to our economy. First, efficiency does not require a central planner. Second, the process of efficiency demands unequal rewards.

There is a lot more to say but let’s stop here with one more point. No, market efficiency does not always work perfectly. Evil lurks in capitalism But whatever the negatives arising from such evil they must be compared against the mistakes made by sometimes evil and misguided central planners. Fairness sells in the political marketplace. Efficiency puts the food on the table.