Raghu Rajan’s intuition about aggregate demand

Consider the following from Raghu Rajan:

As the United States comes to see the political limits of continuing fiscal expansion, with even some Democratic senators taking fright at the barrels of red ink leaking out into the distant future, monetary policy seems to be the primary method through which stimulus will be delivered to the U.S. economy.  Indeed, a paper from a respected macroeconomist at the San Francisco Federal Reserve suggests that if  the Fed desired to deliver “ future monetary stimulus consistent with the past — and ignoring the zero lower bound — the funds rate would be negative until late 2012.”  He continues that “this suggests little need to raise the funds rate target above its zero lower bound anytime soon.”

Of course, some who are convinced that the Fed contributed to the recent crisis by keeping real interest rates negative too long in the period 2002 to 2004 would wonder if stimulus “consistent with the past” is appropriate. Has the Fed, like the Bourbons, learnt nothing and forgotten nothing? 

Perhaps more worrisome is the view that the main problem is aggregate demand is too low. In response to ultra-low interest rates, the thinking goes, households will cut back on savings while firms will invest more, demand will revive, and the workers who have been laid off will be rehired.  

But this recession is not a “usual” recession. It followed a period of ultra-low interest rates when interest sensitive segments of the economy got a tremendous boost. The United States had far too much productive capacity devoted to durable goods and houses, because consumers could obtain financing for them easily. With households recovering slowly from the overhang of debt resulting from the binge, and with lenders extremely risk averse, it is unrealistic to expect households to spend beyond their means again, and unwise to try to tempt them to do so.

 If households are going to want fewer houses, industries such as construction will have to shrink (as should the financial sector that channeled the easy credit). A significant number of jobs will disappear permanently, and workers who know how to build houses or to sell them will have to learn new skills if they can.

I can’t tell you how maddening it is to read this sort of thing.  Let’s start with the San Francisco Fed.  As Milton Friedman pointed out back in 1998, persistently low interest rates are evidence of tight money, not an indication of monetary ease.  The reason is simple; monetary policy cannot be defined solely by a path of interest rates.  Any given interest rate path will leave the price level indeterminate.  This isn’t just my theory, or Friedman’s theory, but a generally accepted part of modern monetary economics.  Now of course the SF Fed knows all this, and they would presumably argue that they are using some sort of Taylor Rule to tie down the price level, and then forecasting future instrument settings based on forecasts of the likely path of prices and RGDP over the next few years.  But here is what drives me crazy.  They are forecasting monetary policy failure, and then describing the interest rate path that would be appropriate if monetary policy indeed fails, just as people expect it to do.  And then they are saying that that is the appropriate monetary policy.  How does that make any sense?

Rajan responds to the SF Fed by arguing that Fed policy during 2002 to 2004 blew up the housing bubble.  But how?  He doesn’t say, but I can’t make any sense out of his assertion unless I assume that he believes low interest rates imply easy money.  But if low interest rates mean easy money, then why would housing prices in Japan have fallen for about 20 years in a row, whereas housing prices in America soared in the 1960s and 1970s?

Let’s say Milton Friedman and I are wrong, and low interest rates really are easy money.  I still don’t get why easy money would cause banks to make all sorts of loans that would never be repaid, and then buy lots of MBSs which were about to implode in value.  Why would it be rational for banks to do that?  Is there some sort of model taught at the Chicago business school that explains the connection?  I do know that Rajan was one of the very few people in the world who warned of trouble ahead for the financial system during the housing bubble.  So he deserves lots of credit for that prediction.   But I honestly don’t see how easy money could cause the American banking system to collapse, even if money was easy (which of course it wasn’t in 2002.)

Suppose I am wrong and money was easy.  And suppose I am wrong that easy money did blow up the housing bubble.  I still have no idea why he doesn’t think we need more aggregate demand right now.  The job losses in construction that he mentions have little to do with the severe recession that hit the US in August 2008.  Most of the housing construction jobs were lost long before that, and had little effect on the US unemployment rate.  Our current high unemployment has little or nothing to do with labor being allocated to the wrong industry.  Labor was reallocating nicely out of construction from mid-2006 to mid-2008, with only a trivial impact on the unemployment rate.  What happened then?

But even if I am wrong about all of those things, I still don’t see his argument.  He is essentially making a sort of Hayekian or Austrian argument about the recession.  But Hayek favored NGDP targeting.   Hayek pointed out (correctly in my view) that any reallocation would occur much more smoothly if NGDP was stable.  Instead, NGDP fell much more sharply than inflation, almost 8% relative to trend between mid-2008 and mid-2009.  So even if you buy Rajan’s entire argument, we still need more AD.

And here is the oddest thing of all.  Right after he argued that monetary stimulus is a bad idea because we don’t want any more AD, he says we need some fiscal stimulus because we need more AD:

Even while I think monetary policy is too a blunt tool, there may well be some role for fiscal policy. There is a humanitarian need to extend benefits to the unemployed. These are often the same people who have not benefited from the growth over the last few decades (the unemployment rate for the highly educated or skilled is much lower than for the poorly educated or unskilled), who have bought houses they cannot afford, and who are drowning in debt. Moreover, while I do think we have to reorient the nature of goods produced in the economy, we also do have weak aggregate demand. Unemployment benefits are likely to be spent and contribute to demand.

I’ve recently been obsessing over everyone talking about fiscal stimulus and ignoring monetary stimulus.  But this is even more perplexing.  Rajan thinks we need more stimulus, but he is opposed to using the most efficient tool possible–the one that doesn’t increase the budget deficit.

Here is the basic problem.  Rajan’s analysis is discretion at its worst.  Rajan is looking out the window and noticing that there are unemployed construction workers, and then assuming that demand stimulus would not help them get jobs in other industries.  How can he know that?  Introspection?  Without some sort of nominal rule, some aggregate that we can use as a guide to policy, we are completely flying blind.  We are back to the interwar Federal Reserve.  And Rajan gives no hint as to how we could know when the economy has too much AD.  None.  Just his intuition.  Well my intuition says we need more AD, and so does every single policy rule I have ever seen (inflation targets, Taylor rules, price level targets, NGDP targets, etc.)

HT:  Tyler Cowen


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24 Responses to “Raghu Rajan’s intuition about aggregate demand”

  1. Gravatar of MMJ MMJ
    6. July 2010 at 05:49

    Hayekian, not “Hayakian”.

  2. Gravatar of scott sumner scott sumner
    6. July 2010 at 05:55

    MMJ, Thanks, it’s fixed.

  3. Gravatar of Indy Indy
    6. July 2010 at 07:18

    I think I can guess where Rajan’s coming from. Whenever I read about AD, I think about the consumer consumption component, and I visualize this chart:

    http://calculatedriskimages.blogspot.com/2010/06/mortgage-equity-withdrawal-q1-2010.html

    Mortgage Equity Withdrawal collapsed from +9% to (so far) nearly -5% of Disposable Personal Income – a net 14% drag on cash flow left for expenditures in the last 4 years. But look at the severe 6% seasonal drop in just a few months in 2006 which only recovered to about 4% below the previous peak trend.

    And remember – this only counts home equity loans. It doesn’t count the windfall payouts to people, perhaps some early baby boomer retirees in bubble states, who sold their homes and downsized and used their new nest-eggs (and optimism as to the performance of their investments) to do some additional consumption too.

    It’s not just the decline in “house prices”, and related construction and ripple effects – it’s also partially the significant amount of total consumption growth (in every sector) that was being financed through this mechanism – a mechanism that took a major blow three years ago and which is now a drag on AD instead of a push.

    The personal savings rate the entire time was very low and continues to be quite low. So Bubble-related MEW seemed to behave like a positive AD shock.

    So, my guess is that Rajan basically believes in a kind of instinctive or intuitive model that says “AD was goosed much higher than it “ought” to have been, and now that the goose is cooked, it’s simply not coming back anytime soon no matter what we do.”

  4. Gravatar of Joe Joe
    6. July 2010 at 07:36

    Professor Sumner,

    What if one argues that loose money was the result of the “savings glut” and that the Fed’s low interest rates exacerbated the problem when the Fed should have been trying to counteract the problem.

    I haven’t seen you speak much about the savings glut, whether it really existed, its origin (ie. whether it was just people naturally saving more or if the Bank of China caused it by loading up on reserves in response to the Asian crises), and how NGDP targeting would deal with such issues. Would NGDP targeting have naturally counterbalanced the savings glut?

    Concerning the rationality of the bankers, how about this: Low interest rates and lax lending standards are also closely related. They are just two symptoms of loose money. Lax lending standards were the response to healthy banks being awash with cash and most creditworthy borrowers already fat with debt.

    Because they are in such a competitive market it makes no sense to refuse funds while other businesses are using the new funds to compete. Each individual investor and institution cannot act as rationally as they would in normal times because there is enormous pressure from all of their competitors. If they don’t catch the wave of easy money and worse lending standards, they fear someone else will beat them. All it takes is one financial institution to lower its lending practices, and it thereafter immediately becomes in everyone else’s rational interest to follow suit even if an outsider clearly sees its insane.

    In other words, from an objective rational cost benefit analysis, you are correct that they are acting irrationally. But from their perspective at the time in that situation, what they were doing seemed rational.

    Also, many argue that Fannie & Freddie drastically made this worse. Krugman totally denies this, though I think that you believe F&F greatly contributed, though I still dont understand what the differences are between the Krugmans and his opponents on F&F. Also, there’s the moral hazard argument, that they don’t fear making mistakes as much.

    Best,

    Joe

  5. Gravatar of Doc Merlin Doc Merlin
    6. July 2010 at 08:01

    @Scott:
    “Rajan responds to the SF Fed by arguing that Fed policy during 2002 to 2004 blew up the housing bubble. But how? He doesn’t say, but I can’t make any sense out of his assertion unless I assume that he believes low interest rates imply easy money. But if low interest rates mean easy money, then why would housing prices in Japan have fallen for about 20 years in a row, whereas housing prices in America soared in the 1960s and 1970s?”

    You don’t need the assertion that low interest rates mean easy money. You can do it by saying that lowering interest rates below expected price inflation rate of durable assets causes “easy money.” This is precisely what happened in the “housing bubble.” Again, we cannot argue looseness or tightness from absolute prices (this includes interest rates), but only can from relative prices between asset classes.

  6. Gravatar of Doc Merlin Doc Merlin
    6. July 2010 at 08:40

    @Indy
    ‘So, my guess is that Rajan basically believes in a kind of instinctive or intuitive model that says “AD was goosed much higher than it “ought” to have been, and now that the goose is cooked, it’s simply not coming back anytime soon no matter what we do.”’

    A good argument for this sort of model, is that without it, monetary stimulus wouldn’t just be short term gain, we could just infinitely stimulate AD as high as we wanted to. In order for monetary stimulus to be finite, there has to be some sort of adverse rebound effect in some cases.

  7. Gravatar of Benjamin Cole Benjamin Cole
    6. July 2010 at 08:57

    Another excellent post.
    I think there is an idea, deeply entrenched, that there is a virtue in calling for tight money, no matter the current circumstances.
    But inflation is dead. We may see a third straight month of falling CPI, something that has not happened since the Great depression. Unit labor costs are falling–in a economy as competive as the USA, with gluts of labor and retail space, how can we have inflation when unit labor costs are falling? All commercial rents-retail, infustrial, office–are as soft as fresh poop.

    And so what do monetarists call for? This should be their hour, their day in the sun. They should call for monetary activism. Instead, they say they want to stay indoors, they can’t help. I guess they prefer nominal declines in wages and asset values
    The problem is, when property values decline, you set up huge problems for the lending industries. I agree we nee to wean ourselves off of over-allocation of resources to real estate. But to do that now, through deflation, is going to be very injurious to the economy.
    I’ll say it again. I would rather live through an inflationary boom than a long deflationary recession. I get the impression, many prefer the latter. Why? So their posturing can be vindicated?

  8. Gravatar of Doc Merlin Doc Merlin
    6. July 2010 at 09:17

    @Cole:

    “And so what do monetarists call for”

    Generally monetarists call for some sort of nondiscretionary method for money supply creation or interest rate setting. They don’t want discretionary money expansion, because it is dangerous.

  9. Gravatar of Gregor Bush Gregor Bush
    6. July 2010 at 09:29

    If growth over the next six quarters is close to the consensus expectation(3%)it would likely result in the unemployment rate staying above 8% until late 2012 (even with 4.5% growth in 2012) and inflation staying below 1% for a similar period.

    But if the Fed has a 2% target, why would they allow inflation to stay below 1% for so long? Shouldn’t the central bank be trying to bring inflation back to its target fairly quickly (1-2 years) and not gradually over a 5-6 year period? Right now the TIPS market is signaling that the Fed is off course. Maybe it’s because markets keep hearing things like this:

    In the second half of 2010, the U.S. will experience “slower economic growth than we’ve had in the first and second quarter,” Fisher told the Japanese business daily Nikkei. He estimated U.S. growth of 2%-3%, saying that the figure will likely come “closer to the low end of that range.”

    “It is very difficult to improve the labor market situation. … Employment … is going to continue to struggle,” Evans said. “It is going to be a number of years before it gets down to any type of [jobless] rate which we would almost say is acceptable,” he said.

    In a speech in Atlanta, Warsh set a high bar for his support of further asset purchases, saying he would need to be convinced the benefits of the purchases would outweigh the costs of “erosion of market functioning, perceptions of monetizing indebtedness, crowding-out of private buyers, or loss of central bank credibility.”

    So comments from Fed officials (and the Fed’s own forecast) imply that the Fed expects inflation to remain well below its own target for an extended period and that the Fed doesn’t intend to do anything about it. Markets have picked up on this and now (rationally) also expect an extended period of below target inflation (via weak demand). The Fed sees that the markets are expecting below target inflation and (implicitly) confirms these expectations. I don’t understand this. They should be saying things like “we will act as necessary to ensure that inflation returns to, and remains within, our preferred range”. Then again, I don’t understand why the BoJ constantly worried that high inflation was always just around the corner when markets were telling them they had the opposite problem.

  10. Gravatar of Ed Dolan Ed Dolan
    6. July 2010 at 10:43

    Scott writes “I can’t make any sense out of his assertion unless I assume that he believes low interest rates imply easy money. . . . He is essentially making a sort of Hayekian or Austrian argument about the recession.”

    Yes, I think Rajan is making a Hayekian argumet. And Yes, Hayek liked NGDP targeting, but in the case under discussion, NGDP targeting means less expansionary monetary policy than does inflation targeting. This is easiest to explain with a few graphs. For a simple version of the argument, see this link to an excerpt from a presentation I made a couple years ago to the Liberal Institute in Prague. http://www.archive.org/download/DolanLiberalInstitute2008/DolanLiberalInstituteCrisisPresentation2008Excerpt.ppt

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  13. Gravatar of marcus nunes marcus nunes
    6. July 2010 at 19:58

    As the french would say: Plus ça change…
    http://economistsview.typepad.com/economistsview/2010/07/gunnar-myrdal-fiscal-policy-in-the-business-cycle.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+typepad%2FKupd+%28Economist%27s+View+%28typepad%2FKupd%29%29

  14. Gravatar of scott sumner scott sumner
    7. July 2010 at 06:42

    Indy, I hope that is not his model, because it doesn’t provide any guide to monetary policy other than guesswork. Without a nominal target, it’s pure discretion.

    Joe, You said;

    “What if one argues that loose money was the result of the “savings glut” and that the Fed’s low interest rates exacerbated the problem when the Fed should have been trying to counteract the problem.”

    This confuses saving and money, which are two very different things. A higher propensity to save will tend to reduce interest rates. This increases the demand for money–which is deflationary. Unless the Fed supplies more money, you could go into a depression. If the Fed had not cut interest rates to 1% in 2002, we might have gone into a severe depression.

    Again, low interest rates don’t mean easy money, they mean a weak economy.

    I wouldn’t call the situation a “savings glut” as I don’t think there is any data to support that. Investment in the US economy was not particularly high. If there is a savings glut, you ought to see high rates of investment. Instead, I think low rates of business investment contributed to high rates of residential investment.

    I plan a post soon on the financial crash. I believe bad regulation, not easy money, was the culprit.

    Doc Merlin, You said;

    “You don’t need the assertion that low interest rates mean easy money. You can do it by saying that lowering interest rates below expected price inflation rate of durable assets causes “easy money.” This is precisely what happened in the “housing bubble.” Again, we cannot argue looseness or tightness from absolute prices (this includes interest rates), but only can from relative prices between asset classes.”

    But that is still confusing money and credit. There may have been easy credit, but the Fed’s in charge of monetary policy, not credit policy.

    Benjamin, I am very puzzled by the silence of monetarists.

    Gregor, I completely agree.

    Ed Dolan, Yes, less expansionary during the bubble years covered in your paper, but more expansionary than inflation targeting since September 2008. And that’s what I was talking about.

    That’s because NGDP fell far more sharply relative to trend than did the price level.

  15. Gravatar of John Papola John Papola
    7. July 2010 at 11:11

    Scott,

    Through what mechanism can we assume that AD leads to full employment? That’s my question. Here’s a stylized example:

    Imagine an economy of 10 people. Each buys 1 good at $1 in the measured period. AD/NGDP = $10, then, right? Okay. Let’s say that 2 of these people become unemployed and simply stop spending. They live off of their gardens and return to autarky with zero cash balances. Is it not possible that the same level of total nominal spending could occur among the remaining 8 employed people?

    Is the supply constraint the issue? These aggregates of supply and demand always confuse me. What is being supplied and demanded seems pretty important, yet is masked by the aggregates.

    In a practical sense, I could imagine a world where aggregate demand grows despite unemployment. In fact, isn’t that what’s happening right now? Perhaps I’m making fundamental mistakes in my thinking. What am I missing?

  16. Gravatar of scott sumner scott sumner
    8. July 2010 at 06:49

    John, Your problem is that you don’t have a model of how nominal shocks have real effects. Without such a model, you can’t make any headway understanding business cycles.

  17. Gravatar of Doc Merlin Doc Merlin
    8. July 2010 at 06:54

    @Scott,John
    “John, Your problem is that you don’t have a model of how nominal shocks have real effects. Without such a model, you can’t make any headway understanding business cycles.”

    We can still get RBCs with without nominal shocks having real effects. We only need a model of the connection between nominal and real for some recessions that RBC doesn’t properly explain.

  18. Gravatar of scott sumner scott sumner
    9. July 2010 at 17:13

    Doc Merlin, You said;

    “We only need a model of the connection between nominal and real for some recessions that RBC doesn’t properly explain.”

    That would be almost all of them, in my view.

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  20. Gravatar of Henry Kaspar Henry Kaspar
    4. December 2010 at 21:16

    I don’t get what Sumner doesn’t get. More expansionary monetary policy implies more private sector debt, hence it stretches further already overstretched private sector balance sheets. This is neither desirable nor is it likely to be effective–as households won’t react to lower interest rates if they struggle with a debt overhang.

    Fiscal policy does not overstretch private sector balance sheets. It stretches the public sector’s balance sheet instead, which is further away from binding liquidity constraints, however. Hence fiscal policy is the superior alternative.

    More generally, what matters is not only the overall level of aggregate demand, it is also its composition. Pre-crisis the U.S. private sector over-absorbed and over-accumulated debt. Post-crisis, domestic private demand must ultimately be replaced with external demand to safeguard a sustainable growth pattern. But this is a protracted process. In the interim, domestic public demand can chip in.

    This is Rajan’s point (at least as I understand it). And he is correct.

  21. Gravatar of ssumner ssumner
    5. December 2010 at 06:54

    Henry, I don’t understand your point.

    Monetary stimulus improves balance sheets. It was the tight money of 2008-10 that has hurt Americans’ balance sheets. It’s not a zero sum game. Easy money leads to more real wealth creation, which impriove balance sheets.

    I’m even more mystified by your comment on the need for more exports. If you want more exports then fiscal stimulus is the last thing you’d want to do, as that strengthens the dollar. Monetary stimulus depreciates the dollar.

  22. Gravatar of Henry Kaspar Henry Kaspar
    5. December 2010 at 19:40

    Monetary stimulus “improves” balance sheets by inflating asset values. Just as the U.S. housing bubble “improved” balance sheets.

    But the counterpart is a built-up of debt and (consequently) higher leverage. When assets values deflate (and at some point they will) what is left behind are overindebted households.

    Agreed that monetary easing is beneficial if it depreciates the dollar. The trouble is that China et al. won’t let the US do this.

  23. Gravatar of ssumner ssumner
    6. December 2010 at 19:24

    Henry, The dollar has already depreciated since QE2 was adopted, even agaisnt the yuan. So you are wrong there.

    QE does not necessarily increase leverage, although it might. It does increase real wealth, which is good.

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