The following isn’t Brad DeLong’s entire summary of Greenwald-Stiglitz, but it gets at the central assumption:

However, even though I do not fully buy it I do think I understand the argument. And I do not think it is incoherent.

As I understand the Greenwald-Stiglitz hypothesis–about the Great Depression as applied to agriculture and about today as applied to manufacturing–it goes like this:

1. Rapid technological progress in a very large economic sector (agriculture then, manufacturing now) leads to oversupply and steep declines in the sector’s prices. Poorer producers have less income. They come under pressure to cut back their spending. Others–consumers–are now richer because they are paying less for their food (or their manufactures), but their propensity to spend is lower than that of the stressed farmers or ex-manufacturing workers.
2. Moreover, the oversupply of agricultural commodities (or manufactured goods) means that only an idiot would invest at their normal pace in those sectors. To the shortfall in consumption spending is added a shortfall in investment spending as well.
3. Thus we have systematic pressures pushing spending down below economy-wide income. These aren’t going to go away until the declining sector (agriculture then, manufacturing now) is no longer large enough to be macroeconomically significant.
4. Macroeconomic balance requires that the economy generate offsetting pressures pushing spending up. What might they be?

First let’s translate this into a monetarist framework, and then we can examine what’s wrong.

Even the Keynesian model requires a big drop in NGDP (below trend) to get a demand-side recession.  So how does the G-S hypothesis do that?  The Keynesians would argue that if the central bank held the money supply fixed, these shocks would cause a fall in velocity.  That’s not an unreasonable assumption, as DeLong is talking about a situation where desire to save rises relative to desire to invest.  That does reduce interest rates.  Lower interest rates mean a lower opportunity cost of holding base money, and thus lower velocity.  So far so good.

My complaints lie elsewhere.  On empirical grounds almost every single step in this argument is wildly implausible.  And that’s not hyperbole; I don’t mean one step, I mean every single step:

1.  I see no evidence that technological change in the farm sector that pushed farmers toward the city would boost aggregate saving rates or reduce the propensity to invest.  This process was going on continually from the late 1800s, until it began slowing in recent decades because there were so few farmer left.  Market economies are really good at adapting to these slow and predictable types of creative destruction.  Perhaps there was less investment in the farm sector, but there was more investment in the urban sector.  And was there really less investment in the farm sector?  Farmers were moving to the cities in the 1920s precisely because farming was becoming more mechanized, as machines were replacing workers.  So I’m not sure the 100 year trend of farmers moving to the cities depressed real interest rates at all.

2.  But let’s suppose I’m wrong.  Business cycles aren’t caused by 100 year trends, they are caused by “shocks.”  Where is the shock?  If each year 2% of farmers move to the city, how does that cause a sudden demand shock?  The economy was booming in the 1920s despite the gradual decline in farming.  Now you could argue that something else was propping up the economy, like a thriving manufacturing sector, and when the bottom fell out of manufacturing then the economy slumped.  But in that case why not blame the collapse of manufacturing?

3.  Stiglitz claims things got much worse in farming in the early 1930s, citing evidence that incomes fell between 1/3 and 2/3 (which doesn’t seem very precise data to build a theory around.)  But total national income fell by roughly 1/2, right smack dab in the middle of the Stiglitz estimates.  So what’s so special about farming?

4.  Let’s say everything I said was wrong.  Let’s say DeLong is right that the decline in farming during the 1920 gradually led to a saving/investment imbalance, which eventually got so bad it triggered the Great Depression.  How would this show up in the data?  We would see falling real interest rates.  When they got close to zero the real demand for base money would soar, triggering a sharp fall in NGDP (unless offset by lots of money printing.)  And something like that did happen in the early 1930s.  But the problem is that it didn’t happen in the 1920s.  After the 1920-21 deflation, prices were pretty stable for the rest of the 1920s.  So nominal rates should give us a rough estimate for real rates.  (I’d add that expected inflation rates were usually near zero when the dollar was pegged to gold.)  During the 1920s short term nominal interest rates fluctuated in the 3.5% to 6.0% range.  Those are strikingly high risk free real rates by modern standards.  Even worse for Stiglitz, they were trending upward in the latter part of the 1920s.  Thus there’s not a shred of evidence that the migration away from farms during the 1920s had the sort of macro implications that are necessary for the Stiglitz model to be plausible.

I suppose some would try to resurrect the model by pointing to all sorts of “ripple effects.”  How problems in agriculture spilled over into other sectors.  The problem with this approach is that it proves too much.  There has only been one Great Depression in US history.  (In real terms the 1870s and 1890s weren’t even close.)  If capitalism is so unstable that a problem in one area causes ripples which eventually culminate in a Great Depression, then one might as well argue the Depression was caused by my grandfather sneezing.   His sneeze passed a cold to several other people, and voila, via the “butterfly effect” we eventually get the collapse of the world economy and the rise of the Nazis.  I happen to believe that any useful model has to be more than “coherent” in a logical sense, it also has to be empirically plausible.

Suppose someone walked up to you in mid-1929 and said a depression was on the way for reasons outlined by Stiglitz.  What would you think?  What data would support that conclusion?  Did the economy seem to be having trouble accommodating farmers gradually moving to the city?  No.  Was there a savings glut?  No.  Was the real interest rate trending downward?  No.  Were there a host if exciting new technological developments that would lead one to be very excited about the future of American manufacturing?  Yes.  You’d ask Stiglitz why we should believe his model.  What pre-1929 facts was it able to explain?  As of 1929 I don’t see it explaining anything.  Of course we did have a Depression, which is exactly what you’d expect if:

1.  The Fed, BOE, and BOF all tightened in late 1929, sharply raising the world gold reserve ratio over the next 12 months.

2.  Then falling interest rates and bank failures increased the demand for base money after October 1930.

3.  Then international monetary collapse and more bank failures led to more demand for both cash and gold after mid-1931.

4.  Then FDR raised nominal wages by 20% overnight in July 1933, aborting a promising recovery in industrial production.

5.  Then in 1937 the Fed doubled reserve requirements and sterilized gold, slowing the economy.

6.  Then when the economy slowed a dollar panic (fear of devaluation) led to lots of gold hoarding, sharply depressing commodity prices world-wide in late 1937.

That would be a theory with explanatory power.  Something Stiglitz’s theory lacks.

Of course I haven’t even discussed the much deeper problems with the Stiglitz worldview.  Because he insists on a “real” theory of AD, he has no explanation for movements in NGDP.  I’d guess this is where DeLong would part company with Stiglitz.  In Delong’s worldview there is a trend rate of inflation high enough to prevent liquidity traps, and hence (unless the Fed crashes the monetary base) high enough to prevent collapses of NGDP.  Not in Stiglitz’s world.  Although he often uses the language of Keynesianism (aggregate demand, etc) his model is in some ways even more primitive, like the early progressive models that Keynes pushed aside during the 1930s.  Recall that Keynes saw the problem as the failure of our monetary system.  As Nick Rowe likes to say, the problem isn’t saving, it’s money hoarding.

PS.  It seems to me that DeLong mildly scolds Nick Rowe for roughly the same reason that Nick Rowe scolds Bryan Caplan.  I agree with Caplan and Nick Rowe.  That is Nick Rowe the victim, not Nick Rowe the villain.

🙂

The commenter Jason sent me a great Wittgenstein quotation, and I immediately knew I had to use it somewhere.  It took me 10 seconds to decide where:

“Tell me,” the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, “why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?” His friend replied, “Well, obviously because it just looks as though the Sun is going around the Earth.” Wittgenstein responded, “Well, what would it have looked like if it had looked as though the Earth was rotating?”

It’s quotations like this that make life worth living.  So I wondered what Wittgenstein would have thought of the current crisis:

Wittgenstein:  Tell me, why do people always say it’s natural to assume the Great Recession was caused by the financial crisis of 2008?

Friend:  Well, obviously because it looks as though the Great Recession was caused by the financial crisis of 2008.

Wittgenstein:  Well, what would it have looked like if it had been caused by Fed policy errors, which allowed nominal GDP to fall at the sharpest rate since 1938, especially during a time when banks were already stressed by the subprime fiasco, and when the resources for repaying nominal debts come from nominal income?

OK, not nearly as elegant as Wittgenstein’s example.  But you get the point.

Jason also wonders what future generations will think of the Keynesian/monetarist split.  Which model will seem like the Ptolemaic system?  I won’t answer that, but will take a stab at a related question.  The Great Depression was originally thought to be due to the inherent instability of capitalism.  Later Friedman and Schwartz blamed it on a big drop in M2.  Their view is now more popular, because it has more appealing policy implications.  It’s a lot easier to prevent M2 from falling, than to repair the inherent instability of capitalism.  Where there are simple policy implications, a failure to do those policies eventually becomes seen as the “cause” of the problem, even if at a deeper philosophical level “cause” is one of those slippery terms that can never be pinned down.

In 50 years (when we are targeting NGDP futures contracts) the Great Recession will be seen as being caused by the Fed’s failure to prevent NGDP from falling.  Not through futures contracts (which didn’t exist then) but through a failure to engage in the sort of “level targeting” that Bernanke recommended the Japanese try during their similar travails.

PS.  W. Peden thinks the quotation is apocryphal, and notes that it’s used in Tom Stoppard’s play “Jumper.”  For some reason I prefer it be Wittgenstein.

When inflation rates in most countries soared during the 1970s, economists reacted by developing ad hoc theories about why this was inevitable with discretionary monetary regimes and governments that had a short term focus.  The ink was hardly dry on all these acclaimed “time-inconsistency” theories when they were decisively refuted by events.  Inflation fell sharply all over the world, in good countries and also in countries lacking “discipline.”

But economists hold on to clever theories even after they’ve been refuted; after all, the world should work that way.  Thus the theories are still taught in textbooks.

And I believe this way of thinking may have helped to create the current euromess.  Consider the following two systems:

1.  The current eurosystem.

2.  A fixed exchange rate regime where all countries have their own national euros, which trade at exchange rates of one.  For instance, imagine the US, Canada, and Australia all fixed their dollars to each other at an exchange rate of 1.0.  (We’re actually pretty close right now.)

If I’m not mistaken, the Europeans do have something similar in the coinage area, where each country has its own distinctive coins.  Why not do that for bills as well?  In that case the adoption of the euro would have still involved the same sort of “currency reform” (say 1500 lira for one Italian euro) but Italy would have preserved its own national currency.

Now lets think about the advantages and disadvantages of my alternative.

1.  Advantage:  Italy could devalue in a crisis.  It could avoid a macroeconomic disaster.

2.  Disadvantage:  Italy could devalue in a crisis, delaying needed fiscal reforms.

I don’t see the disadvantage as being all that important.  Even with your own currency, markets will still impose “discipline” in the form of higher interest rates.  There is no free lunch for deficit countries in a world of rational expectations.  Thinking you can continually fool markets with inflationary policies is not a strategy, it’s a delusion.  In addition, the peripheral countries were arguably better behaved in the pre-1999 EMS (when they’d better behave or they’d face higher rates) then in the post-1999 eurozone, when they could borrow at German interest rates and throw a wild party.  Indeed the system I am proposing (similar to the old EMS) was one where the peripheral countries were behaving in an increasingly responsible fashion, sharply reducing their inflation rates.  And before anyone jumps in and says “they were only doing that because they needed to in order to join the eurozone,” consider that the vast majority of non-European countries were also reducing their inflation rates during the 1990s.  Even countries with much worse fiscal traditions than Italy and Greece.

So why wasn’t my proposal adopted, if it was as clearly superior as I claim?  If you are a non-economist you are going to find the following hard to comprehend, but trust me, it’s true.  Even though the time-inconsistency theory was totally discredited by events, it still holds a powerful sway over the minds of the world’s macroeconomists.  Discipline is the key.  If you allow just a bit of inflation, it’s like giving a drunk a sip of whiskey.  All hell will break lose.

The Aussies showed that 6% to 7% trend NGDP growth keeps nominal interest rates above zero, allowing them to avoid liquidity traps.  Also allowing Australia to avoid recessions, and without inflation shooting up to double digits.   Yet the theory says this policy can’t work.  So we’ll just close our eyes to reality and pretend Australia doesn’t exist.  We’ll set up a regime that you can check into, but you can’t check out of.  Because we don’t trust democracy.  People might at some future date come to the realization that the system is not optimal, indeed it is a disaster.  And we can’t allow them to change their minds in that case.  It’s all about the time inconsistency problem.  Discipline and more discipline.

By the way, bondage disasters know no cultural boundaries.  In the early 1930s the discipline imposed by the gold standard destroyed the German economy–ushering the Nazis into power.  During 1998-2001 discipline wrecked the Argentine economy.  Now it’s damaging other economies.  There’s no telling where it will hit next.

Countries really do need self-control.  All the success stories exhibit that cultural trait.  But you don’t get there by putting your monetary system into a straight-jacket and throwing away the key.  Only by changing your culture.

PS.  I still have lots of grading to do.  I’ll get to old comments this weekend.

PPS.  What if bloggers ran the world?  These two posts suggests that not much would change:

Here’s Tyler Cowen:

At this point you have to be asking whether it is better to simply end the eurozone now, no matter how painful that may be.  Unless of course you are an optimist about Italy reaching two percent growth, or Germany becoming fully cosmopolitan.  As a politician I probably could not bring myself to pull the plug, but as a blogger I wonder if that might not, at this point, be the wiser thing to do.

And here’s Matt Yglesias:

If I were an elected official, I’d be extremely reluctant to pull the plug on this endeavor even though it was misguided from the start and isn’t functioning in practice. But I’d be leaping at the opportunity to be the second prime minister to bail on the whole thing if someone else went first.

Well!  If I was a politician . . . I’d . . . I’d . . . yeah, I’d probably wimp out too.

It’s possible that I’m the one that’s confused.  But since it’s my blog, I’ll write the post as if others are confused.

Picture the AS/AD diagram.  Now shift AS to the right, due to population growth, capital accumulation, resource discovery, or technological developments.  What happens to AD?  I guess it depends what you mean by “AD.”  I’d say nothing happens, although the quantity demanded rises at a lower price level.  When I read others I often get the impression they have in mind some sort of “real AD” concept, which would drain AD of all meaning.  After all, if it’s quantity demanded, then any and all changes in output are changes in aggregate demand.   This would allow no debate as to whether recessions were caused by AD shocks, as a recession is defined as a significant fall in output.  It becomes a tautology!   Yet I get the feeling reading people like Stiglitz that he views AD is a real concept, not a nominal concept.

Or consider an increase in AD when the economy is at capacity.  The textbooks say you just get inflation in that case.  But if you used a “real AD” concept, then there would have been no increase in AD in the first place.  That’s right, even in Zimbabwe AD did not rise, because output didn’t rise.

Why does this confusion exist?  Perhaps because we have two radically different ways of thinking about AD; the monetary approach (M*V) which is obviously a nominal concept, and the Keynesian approach (C+I+G+NX) , which could be visualized in either nominal or real terms.  Most people are Keynesians, and think in terms of actual purchases of goods and services.  To take a micro analogy, most people views the terms ‘consumer purchases’ and the term ‘demand’ as being synonymous.   Even though purchases are also sales, and could just as well be termed “quantity supplied.”    (Remember those graphs of “oil demand” over the next 50 years?)  When I read popular writers on macroeconomics I see them break the economy down into sectors, and talk about things like “December demand for US made cars,” what they really mean is “quantity demanded.”

The deeper problem is that the Keynesian and monetarist worldviews are nearly incommensurable.  It’s very hard to mentally toggle back and forth between the two approaches, because they are so radically different.

When I read the following quotation from Tyler Cowen, I initially wondered whether he was confusing AD with real quantity demanded:

Weak job creation remains at the heart of America’s unemployment problem.  Accepting this hypothesis does not require the rejection of Keynesian economics; for instance you can think of weak job and start-up creation as one reason why AD is not recovering so well on its own, with causation running both ways of course.

(BTW, commenters should not complain that his first sentence is tautological, he’s talking about gross job creation, not net job creation.)

I see economic dynamism, creative destruction, as something that affects AS, not AD.  Yet in the very next line he shows that he’s not confused.  Like me, he views AD as a nominal concept:

Remember “” monetary velocity is endogenous to perceived gains from trade.

But I’m still not happy, because I don’t agree with his implicit assumption that velocity shocks affect AD.  They do under Friedman’s 4% money growth rule, and they do under a gold standard.  But velocity shocks have no impact on AD under the following monetary regimes:

1.  Inflation targeting.

2.  NGDP targeting.

3.  A Taylor Rule.

4.  A hybrid policy where the central bank does just enough QE to prevent inflation from falling below 1%, but no more.

I’m not quite sure what sort of regime we have today, but my hunch is that it’s closer to the 4 items on that list, then it is to either a 4% money rule or a gold standard.  If I had to guess I’d assume Tyler might have made the following error:

1.  He developed a real theory of unemployment (no problem there.)

2.  Saw market monetarists looking over his shoulder, or perhaps felt uncomfortable with empirical evidence that AD matters too, and decided that the theory was in some way compatible with AD theories of the recession.  But I don’t think you can do that.  An AD theory must be 100% nominal.  That means it must move the monetary policy process front and center into any explanation.

This doesn’t mean that real shocks can’t matter.  For instance, I speculated that in 2008 and 2011 the oil price shocks made monetary policy more contractionary, which reduced AD.  In both cases the Fed saw high headline inflation rates, and became squeamish about monetary stimulus.  In both cases they tightened enough to reduce NGDP growth, even as inflation was still above target.  The slower NGDP growth slowed the economy.  It’s possible that a similar explanation could be developed with Tyler’s job creation story.  But I don’t think it’s enough to tack on a “velocity might fall” explanation.  To me, that seems too much like someone working out a real theory of AD, and then assuming nominal AD must move in the right way to make it work.  As when Keynesians convince themselves that fiscal policy must affect AD, and then offhandedly suggest that velocity will move in the right direction to make it happen.  Maybe so, but the theory needs to be developed in terms of actual central bank practice, i.e. changes in M*V, not just a add on assumption about velocity.

PS.  A whole different issue is the question of how nominal AD shocks get translated into real changes in quantity demanded (those December car sales.)  For that you need wage/price stickiness, and Tyler Cowen has a new post that discusses fascinating evidence on wage stickiness in rural India (where you might expect wages to be flexible.)

PPS.  Here’s how I’d make the argument if a gun was pointed at my head.  A more dynamic job creation process would somehow raise the Wicksellian equilibrium real interest rate.  This would allow the Fed to do less of the “unconventional monetary stimulus” that is it squeamish about doing, and more conventional stimulus, for any given inflation rate.  Do I believe that?  I’m not sure.

Keynesian economists have never been able to accept my assertion that the fiscal multiplier is roughly zero because the Fed steers the (nominal) economy.  There’s a mental block on their part (or on my part from their perspective) that prevents us from seeing eye to eye on the issue, even if we agree on the need for monetary stimulus.

Everyone seems to agree that the fiscal multiplier is zero when we aren’t at the zero bound.  The issue being debated is whether this is also true when rates are near zero.  I say yes, most Keynesians say no.  See if you think the Fed continues to steer the nominal economy at the zero bound:

Bernanke and his colleagues may be considering more measures to aid growth and improve public understanding of Fed policy, which could be unveiled as soon as their next meeting taking place Jan. 25-26, said Julia Coronado, chief North America economist at BNP Paribas. The Fed reiterated that it expects joblessness to drop “only gradually.”

“They still see downside risks, so I still think they’re tilted toward easing,” said Coronado, a former Fed researcher who is based in New York. She said she expects a new round of asset purchases in the second quarter, or as soon as the January or March meetings should the economy deteriorate faster.

The “recent strength in data” allows Fed officials to “be a little more patient than they otherwise might be,” Coronado said.

Case closed?  Unfortunately the answer is no.  Both sides are dug in pretty deeply, so it will take more than a snippet from Bloomberg.com to change minds.

Stay tuned for snippet number 248 in the near future.

PS.  When I say “everyone seems to agree,” I of course mean everyone but Joe Stiglitz.