AD shocks aren’t so mysterious
Marcus Nunes pointed me to a Stephen Williamson post.
On the other hand, suppose I am an empirical macroeconomist, and I’m trying to understand the Great Recession. I have coffee with Paul Krugman, and he tells me not to worry. This looks pretty much like other recessions – just an insufficiency of demand. As an empirical macroeconomist, I may not know what Paul is talking about, as there now exist practicing macroeconomists who have never seen AD/AS, IS/LM. But, for example, Christiano, Eichenbaum, and Trabandt know AD/AS, IS/LM (at least I’m pretty sure the first two do). They’re well-known empirical macroeconomists, and they’re not coming out and saying the Great Recession is about aggregate demand deficiency. They have a model, and the model has stochastic shocks which they give names to, and none of those shocks appear to have the name “aggregate demand.” They have taken the time to write a whole paper in which they try to figure out how the shocks account for the Great Recession, and what the propagation mechanism is. Conclusion:
We argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were due to financial frictions interacting with the zero lower bound.
Sorry, but that’s not in AD/AS, IS/LM.
So I took a look at the abstract to their paper:
We argue that the vast bulk of movements in aggregate real economic activity during the Great Recession were due to financial frictions interacting with the zero lower bound. We reach this conclusion looking through the lens of a New Keynesian model in which firms face moderate degrees of price rigidities and no nominal rigidities in the wage setting process. Our model does a good job of accounting for the joint behavior of labor and goods markets, as well as inflation, during the Great Recession. According to the model the observed fall in total factor productivity and the rise in the cost of working capital played critical roles in accounting for the small size of the drop in inflation that occurred during the Great Recession.
That sounds an awful lot like an AD paper to me. But I’ve only read the abstract. Perhaps someone else can read the paper, and tell me why they used a NK model with liquidity traps and sticky prices, if it’s not an AD-oriented model.
Returning to the Williamson post:
Now, consider another person. This one is older than the average undergraduate – old enough to actually care about the Great Recession, and not think of this as ancient history. This person is, say, 30, and worked on Wall Street during the financial crisis. She saw a lot of stuff. Volatile financial market activity, unemployed people, large financial institutions in trouble, etc. Now she’s motivated to go back to school and take some economics so she can understand all that stuff. She takes an intro-to-macro course, learns AS/AD, and is told that the Great Recession is just like all the other recessions – AD shifts left. Given her experience in the world does this get her excited? Does this information somehow put all her practical experience into perspective? I don’t think so.
I can’t speak for her, but it would sure get me excited. If I’d run up huge debts and then found myself unable to pay them off, I’d double down and work harder. The fact that Americans, on average, decided to take lots of vacations in late 2008 is a big puzzle. Especially in industries that had nothing to do with subprime mortgage debt, like autos and services. Why did so many autoworkers stop working when the mortgage crisis occurred in 2008? Why didn’t creative destruction work, with labor moving from overbuilt housing to other areas? Why did output fall in almost all industries? I’d want to take a course in macro to find out.
And suppose I was told that there are competing theories:
1. Technological regress in autos, people forgot how to make them.
2. An earthquake destroyed most of America’s auto-making facilities.
3. Autoworkers were tired of working, and decided it was time for a long vacation.
4. The government raised the minimum wage to $30/hour, making the industry uncompetitive
5. AD fell, and Americans cut back on spending on cars.
Which of those theories, or any other you’d like to mention, might that hypothetical stock trader find plausible? If she was really smart she might ask why a decline in spending would reduce real output. And you’d answer that prices are sticky. And then she’d ask why AD fell, and you’d mention the financial crisis. And then she’d ask why the Fed didn’t offset the effect of the financial crisis on AD by easing monetary policy. And you’d mention the zero bound, and their reluctance to pursue unconventional techniques to the max.
Hmmm, sticky prices, financial crisis, the zero bound problem, isn’t that the abstract to the paper Williamson said was not AS/AD?
I actually enjoyed reading Williamson’s post. Lots of good observations about Krugman and Meltzer. A nice critique of Phillips curve thinking. But I’m far less impressed by modern modeling techniques than he is. For me the proof is in the pudding. If modern macro really is making progress, then we ought to hear its practitioners make useful observations during a major crisis. Or at least make observations as astute as someone like Milton Friedman would have made in 1997:
Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.
. . .
After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.
Instead we’ve regressed, and most of what I’ve read since 2008 has been utter nonsense, starting with claims that the Fed has been conducting an “easy money” policy. In fairness to Williamson, he and David Andolfatto are among the extremely tiny number of macroeconomists who don’t equate low interest rates with easy money.
PS. I have a new post on Iceland over at Econlog.
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10. June 2015 at 17:15
Do you think central bank asset purchases and rate targeting exacerbate monetary shocks more than other tools? Asset purchases/rate targeting generate portfolio flows, increased credit and financialization because the finsector underpins these activities.
10. June 2015 at 17:29
Strawmen set up by Sumner and demolished. But Sumner conveniently forgets the one theory that Tyler Cowen and others have been espousing: AD did indeed fall initially in the Great Recession due to a failing in the financial sector, but subsequently, after a short duration, structural factors are to blame, not a mere shortage of AD, but a shortage in AS. Employers took the fall in AD to fire zero marginal productivity workers and such workers decided to retire early. (And printing more money won’t solve these structural factors).
10. June 2015 at 18:01
“If I’d run up huge debts and then found myself unable to pay them off, I’d double down and work harder.”
The Austrian theory of the business cycle is that debt in the form of credit expansion, among other implications and effects of the Fed pumping reserves out of thin air into the banking system, is that it covers up free market relative prices and interest rates, and thus makes it impossible for investors to know where capital can be allocated in a coordinated manner.
Coordination requires free market forces, period.
As a result, laborers and capital are allocated to projects that are not coordinated with each other in real terms.
It is that real discoordination which builds up and builds up and later on is the proximate case for these inexplicable “demand shocks” that MM does not bother to explain, indeed cannot explain.
No, “the Fed did not print enough” is no more an explanation for the cause of the effects of a rise in cash preference, than “the guy did not keep drinking” is an explanation for the cause of the hangover.
The reason why AD fell for so very many different companies is that so many companies were not in real coordination, and given the complexity of the whole economy, it takes time for both investors to learn of the discoordination and for physical reality constraints to manifest in a need for extremely high accelerating inflation just to keep bad investments solvent.
“Which of those theories, or any other you’d like to mention, might that hypothetical stock trader find plausible? If she was really smart she might ask why a decline in spending would reduce real output.”
You do realize that when you ask that question in that way, you are actually making a claim that it was the decline in spending that caused the real output drop. It is a rhetorical question.
If your hypothetical stock trader were even smarter than your definition of very smart, then she might ask why did both spending and real output decline, even though the Fed did not destroy other people’s money.
And you’d answer that cash preference suddenly increased. And then she’d ask why cash preference suddenly increased, and you’d mention real economic discoordination. And then she’d ask what caused the real discoordination. And then you’d answer it is because investors are forced to make choices in a socialist monetary order. Then you might refer her to Mises’ work on the economic calculation problem of socialism.
What a smarter than very smart person would NOT say is “Not enough socialist interference to fix the problems caused by past socialist interference.”
What a smarter than very smart person would NOT say is “Given a communist economy where the state monopolizes the production of almost all capital goods, that the relatively lower extent of productivity is caused by not enough state interference.”
Deliberate stabilizing of ANYTHING in a socialist monetary order, be it price stabilization, or interest rate stabilization, or AD stabilization, it does not matter what variable is stabilized. Economic coordination cannot be made sustainable in an absence of free market pricing, interest rates, and yes, AD!
Deliberate stabilization of AD invariably brings about changes to relative pricing, relative (and absolute) interest rates, and since nominal variables affect real variables (and vice versa), stabilizing AD therefore has effects on relative real variables. These effects are SIGNIFICANT. So significant, that it can lead to bouts of massive and widespread cash hoarding across multiples of millions of separate profit seeking individuals in a division of labor!
Or do you really believe that millions of people suddenly wanting to hoard cash has nothing to do with the real economy?
“Why did so many autoworkers stop working when the mortgage crisis occurred in 2008? Why didn’t creative destruction work, with labor moving from overbuilt housing to other areas? Why did output fall in almost all industries?”
This has been explained by many people many, many times. Why don’t you read them!? Maybe you don’t like reading anything that crushes your worldview?
The answer to your question is most easily answered with an example.
Suppose there is a team of 150,000,000 workers, managers, and owners. This group is special. They are producing and selling something, but they don’t know what it is. Why is that? This group is set up in a massive, complex assembly line. Each individual worker is responsible for one task in the overall production scheme.
Now the only way any given individual knows what component to produce, where to produce it, and using what means, and very importantly how long of a period of time each task must be completed, is by way of the relative profits they earn by “selling” their components to other individuals. Also importantly is that there are individuals in this company whose task is to produce money.
Suppose this group goes along their merry way, and each day many mistakes are made, bottlenecks appear every now and then, but because they are free to correct any errors, there are no errors that are permanent.
Now suppose Baron Von Socialisumnerstein, who currently produces money, has the dasterdly plan to hire an army of goons to threaten violence against the other individuals of the company so as to monopolize all money production, in such a way it shields itself from the market forces of the other individuals in the company, which is to say all the other individuals cannot bankrupt Von Socialisumnerstein. If Von Socialisumnerstein overproduces or underproduces, he himself won’t face any losses.
Now any reasonable person who studies the rudimentaries of coordination would point out that due to all individuals utilizing the money monopolized by Von Socialisumnerstein, it is not the case that Von Socialisumnerstein, nor the 149,999,999 other individuals, somehow developed the ability to know that there should be X collectivist conceptual amount of other than money goods, and 1-X collectivist conceptual amount of the money good, given that money is now monopolized.
Monopolization does not and cannot bring about a superhuman ability for anyone in the company to know that there should be 1-X money issued.
Coordination does not require, and is in fact destroyed by, any one individual to know what 1-X should be in order for Von Socialisumnerstein to remain a permanent monopolist and prevent discoordination between everybody. It is a pipedream. A fatalistic, cynical retreat.
10. June 2015 at 18:15
“no nominal rigidities in the wage setting process”
-Whaaa….?!
10. June 2015 at 18:22
“And suppose I was told that there are competing theories:”
-0% of which explain why Russian auto manufacturing has collapsed in the past ten months.
10. June 2015 at 18:49
It may well be a theory which could explain why unit auto sales had collapsed by Q3 ’08, while nominal sales had not:
https://research.stlouisfed.org/fred2/graph/?g=1eke
Note: I don’t have this theory, at least, fleshed out in any depth. But what’s happening in Russia right now is highly reminiscent of what the U.S. experienced in 2008 before 9/15 (excepting the reversed direction of the oil prices).
10. June 2015 at 19:07
Inflation increases wealth inequality, according to THIS anti-Fed source.
10. June 2015 at 19:13
Heh.
“Related reading:
Stiglitz: Fed’s Zero-Rate Policy Boosts Inequality
Janet Yellen Decries Widening Income Inequality
Bernanke Says Central Bank No Engine of Inequality”
10. June 2015 at 19:17
@Major_Freedom
-Depression also reduces wealth inequality. So frikin’ what?
11. June 2015 at 02:59
firms face […] no nominal rigidities in the wage setting process.
Of course, if I assume that humans are frictionless perfect spheres, I can reach all sort of interesting conclusions.
Truly, the economics profession is in a very poor state if this is the sort of “cutting edge” stuff that people get excited about.
11. June 2015 at 03:24
E. Harding:
It is not for you to worry about.
11. June 2015 at 06:18
@Prof. Sumner,
It looks to me a good idea to try to undertand why AD shortfall occurs, don’t you think? I think that is what that paper does. One thing is what is the best policy response give an observed AD shortfall, the other thing is to understand why the AD shortfall occurred in the first place. Also, it is not that the paper mentioned denies wage rigidity, it just models observed labor market inertia in a different way, that does not assume wage rigidity a priori, but also does not deny it.
http://www.nber.org/papers/w19265.pdf
11. June 2015 at 06:23
Interesting blogging. Williamson has interesting views but his complicated models strike as fragile, esoteric.
Back to basics: demand was weak in 2008 and deflation was present. The central bank can print more money. What would be the result of more money in circulation in a depressed economy facing deflation?
Sure there are institutional frictions in every economy, and structural impediments. The supply side could always be improved in every modern economy. So then why do modern economies sometimes enter recessions and at other times boom? Speaking of structural impediments, why did the US economy boom boom boom boom boom in the 1960s when structural impediments were much worse?
Gee, I think it comes back to central banking and printing more money.
11. June 2015 at 08:33
“Speaking of structural impediments, why did the US economy boom boom boom boom boom in the 1960s when structural impediments were much worse?”
-They weren’t. Oil and natural gas was cheaper and there were no emissions standards or EPA.
“Gee, I think it comes back to central banking and printing more money.”
-Which explains why the U.S. economy boomed, boomed, boomed during the 1970s.
11. June 2015 at 09:40
So, scott, if fed raises rates as everyone is expecting, do you think the 10yr will be below 2% 6 months later when GDP data starts to become available?
11. June 2015 at 11:59
Roc’s in M*Vt = roc’s in AD, aggregate monetary purchasing power (not explicitly its Keynesian subset: N-gDp, which is simply used a proxy for all economic transactions in Professor Irving Fisher’s truistic “equation of exchange”).
The 2 year rate-of-change, roc, in N-gDp, or unambiguously, Professor Irving Fisher’s PRICE-LEVEL for over the last 100 years (which the FOMC can indirectly control), peaked in the 2nd qtr. of 2006 @ 12%.
N-gDp’s roc fell to 8% by the 4th qtr. of 2007 (or by -33%).
N-gDp’s roc fell to 6% in the 3rd qtr. of 2008 (another -25%).
N-gDp’s roc then collapsed to (-)2% in the 2nd qtr. of 2009 (another – 133%).
That is to say AD was already deficient before AD was argued to be subpar during the Great-Recession.
The Fed’s problem was how to expand the money stock to boost AD. But the U.S. Treasury didn’t supply the debt markets with the right volume and duration of “safe-assets” for the commercial bankers to purchase, the FDIC destroyed Vt, in part, by enacting unlimited transaction deposit insurance, and the Bank Capital Plan Rules counter-cyclically issued by the BOG, FDIC, and OCC organizations drained the money stock. Can you say teamwork?
11. June 2015 at 12:37
CMA, No.
Ray, So money is now just neutral in the long run, not the short run? I wish you’d make up your mind.
E. Harding, So why did auto sales fall in the US?
Jose, Yes, I’m not surprised they had something to say about AD.
Ben, Whatever the market forecasts, is my forecast. I will say that if policy is tightened so much that NGDP growth slows sharply, rates are likely to dip below 2%.
11. June 2015 at 17:25
The first part of it (before Q4 ’08) was due to a commodities bubble. The second part (Q4 ’08 and Q1 ’09) was due to the money shortage caused by the financial crisis and insufficient intervention by the Fed, and also by a shift in relative spending patterns caused by tightening credit and shifting RGDP, NGDP, and inflation expectations.
Note: I haven’t fleshed out the reasons behind these expectations changes.
12. June 2015 at 04:41
E. Harding, I’d say that tight money was hurting even before 2008:4, NGDP growth slowed in late 2007.
12. June 2015 at 08:33
But nominal (dollar) auto sales showed no collapse before Q4 ’08, as I pointed out.
13. June 2015 at 06:17
E. Harding, The recession got dramatically worse at that time. NGDP also rose slightly in the first half of 2008.