Debt, sticky prices, and bubbles

I’m still morose about Arnold Kling’s retirement from blogging, but the entry of Garett Jones into the blogosphere is a nice silver lining.  I plan on welcoming him the only way I know how—attack, attack, attack.

Garett argues that the sticky wage/price mechanism is not strong enough to create major business cycles, and that debt is the key sticky price:

Any force strong enough to fight against the power of prices should be a strong force indeed, strong enough for all to see.  But when economists talk about the “frictions” that keep gluts alive, we usually talk about “sticky prices” and “sticky wages” and cultural norms and public sector unions and a few other forces.  Strong forces, yes, and forces I believe in, but stronger than creative destruction and supply and demand?  For years on end?

Here’s my favorite friction, one that exists by force of contract, not because of worker sociology: Debt.  Debt in the household, debt in the firm, and–for state and local governments at least–government debt.

I have several objections to this.  Debt prices are not sticky at all (check out the bond market.)  I believe Garett is referring to debt payments, which are sticky.  That’s true, but they aren’t prices.  Debt coupon payments are sunk costs and benefits that have almost no effect on the incentive to produce output at the margin.  Even worse, any impact they do have goes the wrong way.  A debt crisis often makes people poorer.  But we have a lot of evidence that leisure is a normal good, and hence people work harder when they are poorer.  Americans used to work six day workweeks.  If I became bankrupt, I’d work much harder, I wouldn’t take a vacation.

There is a long literature on how very small amounts of wage and price stickiness can have surprisingly large macro effects.  (I’ve forgotten the authors; maybe commenters can help me out.)  I’ve already discussed the basic idea—wage stickiness in sectors like health care and education often results in job losses in other areas, such as manufacturing and construction.  In other words, there are very large negative externalities.  By analogy, it would make no sense to argue that US Steel has no incentive to pollute just because the managers of US Steel also breathe the polluted air.

In another post Garett addresses the issue of bubbles:

Did we see liquidity pushed into the housing market?  Of course we did.  Not just the Federal Reserve’s low rates in the mid-2000s (lower than the Taylor Rule recommended); we also saw the massive entry by Fannie and Freddie into the fringes of subprime, the most dangerous portion of the market.

You probably already know what I’m going to say here.  I always dredge up the Friedman quote that low rates usually mean money has been tight.  Garett may have anticipated that objection, as he referred to the Taylor Rule benchmark when arguing money was easy.  But even that won’t work, as the Taylor Rule is highly unreliable.  For instance, John Taylor has a recent post showing that (according to the Taylor Rule) money was too easy during 2008.  That’s right, even though 2008-09 saw the biggest drop in NGDP since the Great Depression, the Taylor Rule says money should have been even tighter!  And the rule also implies money is too tight easy right now!!  I wonder how the stock market, and the global economy, would react to a tightening by the Fed at this afternoon’s meeting.  (Hint:  Check out 1937.)

I’m with Ben Bernanke, the only reliable indicators of easy and tight money are NGDP growth and inflation.  (Preferably NGDP growth, but I’ll take the TIPS market if that’s all we have.)  Using those criteria, money during the 2000s was either about right, or a bit too easy. But even if you agree with David Beckworth, who argues that it was a bit too easy, it remains true that NGDP growth during the 2001-07 expansion was (I’m pretty sure) the lowest of any business cycle expansion of my lifetime.  So even if money was a bit too easy, it can’t possibly explain the huge housing bubble.

Garett is right about Fannie and Freddie, they did contribute to the problem.

Don’t get the wrong idea from this post—I’m a big fan of Garett Jones, and look forward to reading his future posts.  Indeed so far he seems to be filling in admirably for Arnold Kling.  Recall that I also thought Kling was a wonderful blogger, even while disagreeing with his views on money/macro.


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49 Responses to “Debt, sticky prices, and bubbles”

  1. Gravatar of Ritwik Ritwik
    12. September 2012 at 05:43

    Negotiated wage and employment contracts are also sunk costs, then?

  2. Gravatar of Alex Godofsky Alex Godofsky
    12. September 2012 at 05:51

    To the degree that they specify the amount to be paid for a specific amount of work, sure.

    To the degree that they specify the price of a flexible amount of work, no.

  3. Gravatar of david david
    12. September 2012 at 06:31

    The small stickiness -> large changes effect dates to the 1990s, and is due to some papers by Yellen and Akerlof on one, and Mankiw on the other. Strictly speaking Yellen and Akerlof came to the notion from bounded rationality, whereas Mankiw deduced welfare effects under rationality subject to stickiness directly. But Yellen/Akerlof probed more of the math.

    Trivia: Yellen is one of the two appointees to the Fed.

    Unfortunately research since has suggested that the magnitude of the large changes is still insufficient to account for the magnitude of recessions. The only way to make it work is to combine it with some real rigidity – a small amount of real and nominal rigidity works.

  4. Gravatar of Major_Freedom Major_Freedom
    12. September 2012 at 06:43

    I always dredge up the Friedman quote that low rates usually mean money has been tight.

    Why do you keep using this term that contains “usually” as if it said “always”?

    If I always mentioned a “usually” argument, then it becomes an always argument.

    If it is “usually” the case, then why can’t the recent low rates be a result of easy money? If you mean always, then say it. Otherwise, accept the possibility that low rates can mean money is loose.

  5. Gravatar of david david
    12. September 2012 at 07:46

    *where “dates to the 1990s” refers to the literature about the effect, not the effect itself.

  6. Gravatar of J.V. Dubois J.V. Dubois
    12. September 2012 at 07:48

    I think you wanted to say “And the rule also implies money is too EASY right now!!” instead of “And the rule also implies money is too tight right now!!”

  7. Gravatar of Andy Harless Andy Harless
    12. September 2012 at 07:52

    And the rule also implies money is too tight right now!!

    I’m guessing that’s a typo. The rule implies money is too loose, which it’s obviously not, hence the exclamation points.

  8. Gravatar of BL BL
    12. September 2012 at 08:10

    WSJ op-ed by P Gramm and Taylor. Any thoughts, Scott?

    http://online.wsj.com/article/SB10000872396390443686004577639590237612020.html

  9. Gravatar of RebelEconomist RebelEconomist
    12. September 2012 at 08:20

    “Debt prices are not sticky at all (check out the bond market.)”

    On the contrary, many “troubled assets” and other investments made during the bubble, are being allowed to be carried either at historic cost or mark-to-model: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=agfrKseJ94jc

    This is widely understood, but the location and extent of the problem is uncertain, and you know what Akerlof taught us about lemons. Trade does not occur, such as businesses with cash holding back from investment (or, to quote a UK example, housebuilders holding land with planning permission hold back from building: http://www.ft.com/cms/s/0/97eb8a64-f90b-11e1-8d92-00144feabdc0.html#axzz26Ex8YKBG ). My comment on Scott’s previous post about the need for reckoning apply.

    Scott wants to bail out these chancers by washing away their mistakes with a flood of money. I say let’s have a reckoning, sink the costs, and get back to an economy where people build real wealth instead of speculating and lobbying about monetary policy.

  10. Gravatar of Saturos Saturos
    12. September 2012 at 08:21

    I’m surprised Bryan hasn’t replied to Garett yet, with his usual point about a glut in the labor market only being explicable by above equilibrium wages. Of course a glut of service flows cannot be explained by a fixed drain of sunk costs. As I’ve long said, the bizarrest fact in economics is that money illusion can bring down an economy. But I sympathize with Garett’s incredulity.

    The Taylor rule is never going to be reliable, as it incorporates a term for the equilbrium real rate, which is not exogenous.

  11. Gravatar of Major_Freedom Major_Freedom
    12. September 2012 at 09:54

    RebelEconomist:

    Scott wants to bail out these chancers by washing away their mistakes with a flood of money. I say let’s have a reckoning, sink the costs, and get back to an economy where people build real wealth instead of speculating and lobbying about monetary policy.

    Finally, someone makes a good recommendation.

    You know what the financial markets larely consist of now? Computer algorithms that trade based on word clouds from Fed speeches and policy change releases.

  12. Gravatar of RebelEconomist RebelEconomist
    12. September 2012 at 09:59

    @MF, and I like your less frequent, more concise, comment style!

  13. Gravatar of Major_Freedom Major_Freedom
    12. September 2012 at 10:06

    Preferably NGDP growth, but I’ll take the TIPS market if that’s all we have.

    Too bad one cannot infer necessarily higher future inflation from higher current TIPS yields. There is an embedded option whose price may lead to rising TIPS prices (and thus lower yields) when future inflation expectations rise.

    Using those criteria, money during the 2000s was either about right, or a bit too easy. But even if you agree with David Beckworth, who argues that it was a bit too easy, it remains true that NGDP growth during the 2001-07 expansion was (I’m pretty sure) the lowest of any business cycle expansion of my lifetime. So even if money was a bit too easy, it can’t possibly explain the huge housing bubble.

    Sure it can. In order for the housing bubble to be a housing bubble, it doesn’t require that NGDP grow at abnormally high rates. Housing bubbles are based on low interest rates, credit expansion, and increased money supplies. Interest rates can fall, credit expansion can rise, the money supply can rise, and this can blow up a housing bubble despite NGDP growing at a “normal” or close to “normal” rate.

    Inflation does not affect all goods and prices equally. A major problem with “market” monetarism is that because it focused unduly on aggregates, it cannot help but sloppily presume that inflation affects all prices by more or less 2-3% per year or whatever rate happens to be the tracked CPI or PCEPI rate.

    Inflation affects relative demands and relative prices. It is quite capable of blowing up a housing bubble despite the aggregate money supply or aggregate spending statistics decreasing. This is because inflation affects interest rates, and interest rate changes lead to changes in relative demands.

    For example, if interest rates fall by 300 bps, and this leads to a housing boom, then along with the credit expansion going to housing, there is also a concomitant relative increase/decrease change in nominal demand between housing vis a vis everything else. So we might see a slight fall in demand for other goods as the demand for housing increases at the expense of those goods, especially as the housing bubble is in its mature stages and there are many house flippers and speculators who reduce their investments in other things to go make some money in the housing market.

    So in the aggregate, while the housing bubble is unsustainably expanding, we may very well see moderate increases in NGDP alongside this.

    Macro-economic “market” monetarism is so darn crude that it almost always ignores relative demand and price changes. It’s like we’re supposed to believe that if there is a housing bubble, then NGDP must have been very high, as if NGDP is the source for everything. It’s just a mathematical summation of all individual demands.

    Who ever said that printing money had to affect each individual demand to the same extent? Where in the world is this assumption coming from? It’s not even close to being accurate.

  14. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    12. September 2012 at 10:50

    Off topic here, but it came up in an earlier thread;

    http://www.nd.edu/~jsulliv4/BPEA1.6.pdf

    ‘Official poverty statistics suggest that poverty has
    increased over the past forty years. This claim is inconsistent with our results which show substantial improvements in income based poverty over the past forty years and even larger improvements in consumption based poverty, especially in the last decade. These poverty results are corroborated by other indicators of well-being for those with low income such as increases in car ownership and evidence of improved living conditions including larger living units that are more likely to have air conditioning and other features. While the deficiencies in the official poverty measure have been the subject of much previous research, most poverty scholars still rely on the official measure as the definitive measure of trends in poverty and draw important conclusions based upon it.’

  15. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    12. September 2012 at 10:55

    ‘Garett is right about Fannie and Freddie, they did contribute to the problem.’

    More than ‘contribute’, they were essential, as former Labour politician Oonagh McDonald said;

    http://www.huffingtonpost.co.uk/oonagh-mcdonald/

    ———–quote———-
    Politicians supported Fannie and Freddie as they thought this was the best way of making sure that the banks had the funds to lend and reducing the costs of mortgages for poor families. They refused to see the dangers of low deposits, low or non-existent credit scores and no or low documentation of incomes or incomes consisting of welfare payments. Fannie and Freddie were grossly mismanaged, weakly regulated, whilst senior executives made millions.

    The subprime loans had been packaged by Fannie and Freddie into mortgage-backed securities, which were then repackaged in to collateral debt obligations, and sold throughout the world. The very complex instruments, seeming such an innovative way of distributing risk, now stood in the way of price discovery, freezing the market. The sheer size of the US market and its central role as an investment destination contributed to the rapid spread of the crisis.

    Fannie and Freddie were taken into conservatorship by the Government in September 2008. That has not saved them, for the problem has been hidden Fannie Mae currently guarantees mortgages totalling $3.5 trillion and Freddie $2.00 trillion, but these are excluded from the budget calculations in a ruse that does not work in the end. They continue to receive bailouts from the tax payer now totalling $183bn. The risks are still there, as they are for many banks, and therefore governments, throughout the world.
    ————-endquote———–

  16. Gravatar of “All in one” « Historinhas “All in one” « Historinhas
    12. September 2012 at 11:17

    […] a recent post Scott Sumner critiques Garret Jones, in particular Garret´s view, widely held, that interest rates […]

  17. Gravatar of Saturos Saturos
    12. September 2012 at 12:42

    John Cochrane on money: http://johnhcochrane.blogspot.com.au/2012/09/unraveling-mysteries-of-money.html

  18. Gravatar of Kevin Johnson Kevin Johnson
    12. September 2012 at 13:00

    Off topic here, sorry:

    Earlier I wrote:
    > How about an attempt to get a question about NGDPLT asked at (Thursday’s) Bernanke press conference?…

    I did get an acknowledgement from one reporter. I tried several times to post a follow-up here over the weekend but apparently my attempts fell into moderator limbo. Are there posting guidelines that I may have violated?

  19. Gravatar of Rajat Rajat
    12. September 2012 at 13:04

    Is this also a typo?

    “Using those criteria, money during the 2000s was either about right, or a bit too easy. But even if you agree with David Beckworth, who argues that it was a bit too easy, it remains true that NGDP growth during the 2001-07 expansion was (I’m pretty sure) the lowest of any business cycle expansion of my lifetime.”

    The way this reads, it seems like you meant to say “…money during the 2000s was either about right, or a bit too tight…”

  20. Gravatar of StatsGuy StatsGuy
    12. September 2012 at 13:09

    Scott, at some point, consider doing a post along the lines of what Saturos links to from cochrane – meaning of money. I’m getting tired of hearing hard-money advocates bluster that the Fed has de-anchored money from anything meaningful.

    Can I suggest you make an argument that an NGDP target is the MOST meaningful concept of money (in a very high level sense), because it’s a claim on a share of future production.

    Consider:

    Gold – I have no idea what it means, other than supply and demand for gold

    Inflation target – this is a claim on future production based on share of past production. Imagine, for example, that the economic productivity suddenly was cut in HALF. (supply is half). For money to remain equally “valuable”, yesterday’s dollar would need to become twice as valuable in future share terms. It is, in essence, privileging debt owners by giving them a share of future production that is indexed to past production, and crippling to debtors.

    What is an NGDP target?

    Consider this question:

    What is the split of future production between debtors and creditors (money owners) that optimized future production?

    I think you’ll get an NGDP rule. Why? because it’s incentive aligned.

    An NGDP rule makes money owners shareholders in future production, instead of a guarantee of future consumption based on past production.

    It is an equity concept of money, rather than a debt concept of money.

    the markets agree with my interpretation –

    When the NGDP rule looks probably, equity markets go up, debt markets go down, and vice versa.

    There’s a moral argument here: the NGDP concept of money is more ethical and “real” than any other concept of money.

  21. Gravatar of Tom Tom
    12. September 2012 at 13:47

    You claim:
    the only reliable indicators of easy and tight money are NGDP growth and inflation.

    But when a bubble pops, with no change in monetary policy, growth also drops.

    I claim that tight money means too many requests for loans by private wannabee borrowers are being refused.

    And during the housing bubble, too many requests for loans were being accepted — too loose.

  22. Gravatar of Doug M Doug M
    12. September 2012 at 13:51

    Debt is the sticky price.

    From the AD point of veiw…Debt service is a fixed cost as you stated. A small fluctation in personal income could wipe out all of my disposible income radically shifting my demand prefferences.

    From an AS point of view… Corporations need capital to expand. Even if they have a project that is likely proffitable, they will not be able to exploit that idea and hire workers in so doing if they can’t get the capital. If they have too much debt, they are stuck.

    From the housing point of veiw… if a mortgagor owns a house that is underwater, he will be unable to move to a location with better employment possibilities. Nor will said mortgagor have access to the capital to improve his property.

  23. Gravatar of Gene Callahan Gene Callahan
    12. September 2012 at 14:56

    “So in the aggregate, while the housing bubble is unsustainably expanding, we may very well see moderate increases in NGDP alongside this.”

    And when the bubble pops, we should see very moderate drops in NGDP, if this is the full cycle explanation.

  24. Gravatar of Michael Michael
    12. September 2012 at 15:29

    “Can I suggest you make an argument that an NGDP target is the MOST meaningful concept of money (in a very high level sense), because it’s a claim on a share of future production.”

    Scott already made this argument.

    https://www.themoneyillusion.com/?p=15308

    “This is similar to the regular model of money supply and demand in Mankiw’s textbook, except that the value of money is defined as 1/NGDP, not 1/P. I.e., the value of money is defined as the share of NGDP that can be bought with a single dollar.”

  25. Gravatar of ssumner ssumner
    12. September 2012 at 16:13

    Thanks David.

    JV, Yes, a typo.

    BL, They ignore the fact that the Treasury gains more from inflation that the Fed loses, it’s a consolidated government balance sheet. In the end all Fed profits go to the Treasury. So they are wrong.

    Rebeleconomist, Actually I’m the one who wants to get back to normality, it’s the hawks who want the misery to drag on for decades, a la Japan.

    Rajat, No, I meant too easy–there were a couple years where NGDP growth exceeded 6%.

    Statsguy, George Selgin’s made that argument quite effectively. I’ve also touched on it at times.

  26. Gravatar of Bob Murphy Bob Murphy
    12. September 2012 at 19:02

    Scott, I really think one of us (perhaps both!) is insane. I swear that back when you were trying to explain to me why NGDP growth was so important, that one of the main things you said is that workers did things like buy houses with fixed mortgage payments, assuming that their nominal paychecks would grow. For sure, I filed away the “fact” that Scott Sumner thinks debt obligations are a major reason that NGDP growth is crucial.

    Did I mishear you, or are you now just hazing the new guy at EconLog?

  27. Gravatar of StatsGuy StatsGuy
    12. September 2012 at 19:06

    Selgin? Like this?

    http://www.freebanking.org/2012/07/08/a-question-for-the-market-monetarists/

    I’m not sure I find him a convincing proponent of the ethical basis for NGDP targeting.

  28. Gravatar of Peter N Peter N
    12. September 2012 at 20:09

    I found this summary of GSEs and sub-prime in Wikipedia. It agrees quite closely with what I know about the sub-prime mortgage market.

    “As mortgage originators began to distribute more and more of their loans through private label MBS’s, GSE’s lost the ability to monitor and control mortgage originators. Competition between the GSEs and private securitizers for loans further undermined GSEs power and strengthened mortgage originators. This contributed to a decline in underwriting standards and was a major cause of the financial crisis.[34]
    Investment bank securitizers were more willing to securitize risky loans because they generally retained minimal risk. Whereas the GSE’s guaranteed the performance of their MBS’s, private securitizers generally did not, and might only retain a thin slice of risk.[34] Often, banks would offload this risk to insurance companies or other counterparties through credit default swaps, making their actual risk exposures extremely difficult for investors and creditors to discern.[35]
    The shift toward riskier mortgages and private label MBS distribution occurred as financial institutions sought to maintain earnings levels that had been elevated during 2001-2003 by an unprecedented refinancing boom due to historically low interest rates. Earnings depended on volume, so maintaining elevated earnings levels necessitated expanding the borrower pool using lower underwriting standards and new products that the GSE’s would not (initially) securitize. Thus, the shift away from GSE securitization to private-label securitization (PLS) also corresponded with a shift in mortgage product type, from traditional, amortizing, fixed-rate mortgages (FRM’s) to nontraditional, structurally riskier, nonamortizing, adjustable-rate mortgages (ARM’s), and in the start of a sharp deterioration in mortgage underwriting standards.[33] The growth of PLS, however, forced the GSEs to lower their underwriting standards in an attempt to reclaim lost market share to please their private shareholders. Shareholder pressure pushed the GSEs into competition with PLS for market share, and the GSEs loosened their guarantee business underwriting standards in order to compete. In contrast, the wholly public FHA/Ginnie Mae maintained their underwriting standards and instead ceded market share.[33]
    The growth of private-label securitization and lack of regulation in this part of the market resulted in the oversupply of underpriced housing finance[33] that led, in 2006, to an increasing number of borrowers, often with poor credit, who were unable to pay their mortgages – particularly with adjustable rate mortgages (ARM), caused a precipitous increase in home foreclosures. As a result, home prices declined as increasing foreclosures added to the already large inventory of homes and stricter lending standards made it more and more difficult for borrowers to get mortgages. This depreciation in home prices led to growing losses for the GSEs, which back the majority of US mortgages.”

    The key here was Fannie management wanting to keep up earnings by not losing market share. You had an entity implicitly guaranteed by the government taking risks to avoid disappointing its stockholders (which would, of course, threaten managements’ jobs). A conflict of interest. It had to happen sooner or later.

    That being said, Fannie and Freddie had language in their mortgage purchases that said that the mortgages had to meet certain standards, and allowed the GSEs to force the seller to repurchase them at cost.

    A huge number of mortgages didn’t meet the standards, but the GSEs hadn’t the auditing capability to determine this.

    Now they do, and they’re examining all the bad loans for compliance. They’ve already requested billions of dollars in take backs, and its still early in the process. Considering how sloppy the banks’ paperwork has been found to be and how they’ve committed wholesale fraud on individuals and even courts, the takeback total could be huge. I believe it will exceed $50 billion with a possibility of even more.

    So, if your method of placing blame is to ask who lost the most money in sub-prime securitization, the final figures are not in. The big losers could end up being the banks, an outcome they richly deserve.

    Meanwhile Fannie is clearly guilty bad judgment in entering the sub-prime market at exactly the wrong time and lack of compliance controls on the mortgages it accepted (for cost competition reasons? The private securitizers were selling the loans, so they didn’t care about compliance beyond what little it took to convince the rating companies.).

    It was not, however the lead villain of the piece – more like his dumb sidekick.

  29. Gravatar of Saturos Saturos
    12. September 2012 at 20:36

    Bob, I think Scott agrees that sticky debts imply that falls in NGDP hurt households and cause debt crises which reduce wealth. But he doesn’t agree that this implies recession and unemployment, or explains the business cycle.

    I think I’ve got it right this time 😉

  30. Gravatar of Saturos Saturos
    12. September 2012 at 20:38

    “Rajat, No, I meant too easy-there were a couple years where NGDP growth exceeded 6%.”

    Scott, according to Marcus Nunes, that was necessary to recover the trend line: http://thefaintofheart.wordpress.com/2012/09/12/all-in-one/

  31. Gravatar of Saturos Saturos
    12. September 2012 at 20:38

    (And tell him his old theme was fine, would you, he’ll listen to you I bet.)

  32. Gravatar of RebelEconomist RebelEconomist
    13. September 2012 at 00:26

    @Statsguy, I recall the topic of the meaning of NGDP targeting for debt contracts coming up in this blog here: https://www.themoneyillusion.com/?p=13841#comment-148678

    See also the interesting discussion here: http://andolfatto.blogspot.co.uk/2012/04/ngdp-targeting-some-questions.html

    I agree that NGDP targeting would make debt contracts more like equity, but (not being Islamic!) I do not consider this an ethical issue. To me it is just a contract detail, to be agreed between the supplier and the user of funding, according to their preferences and bargaining power. But I would emphasise two key points:

    (1) Given that equity returns tend to be higher than debt returns on account of the “equity risk premium”, it seems likely that NGDP targeting would raise long term interest rates. Advocates of NGDP targeting should be open about this.

    (2) For me, the moral issue – and I fear much of the present attraction to NGDP targeting – is the transition from the present inflation targeting regime. A transition to 5% NGDP targeting starting from a level close to pre-crisis NGDP would almost certainly involve a surge of unanticipated inflation which would transfer of wealth from creditors to debtors (and, I would argue, extend a series of monetary policy bailouts going back as least as far as the LTCM crisis, and lay the ground for the next financial crisis). The more conservative the NGDP target – eg, say 4% starting from around present NGDP would – the less important this transition. In fact, I would go as far as to say that any advocate of NGDP targeting who cares about getting their proposal adopted for the right reasons rather than for the expediency of cornered rats, should recommend such a conservative target.

  33. Gravatar of Bill Bill
    13. September 2012 at 04:04

    @MajorFreedom

    It makes no sense that massive bankruptcy across the entire economy would help- Keynes pointed it out in the 30’s and its too bad it didn’t sink in until 1932 (and then was forgotten again in 1938)

    “It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924-1929] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man’s speculative spirit. It would, they feel, be a victory for the Mammon of Unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy.

    We need, they say, what they politely call a ‘prolonged liquidation’ to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.

    I do not take this view. I find the explanation of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity…”

  34. Gravatar of Bill Bill
    13. September 2012 at 04:21

    @PeterN

    bingo

    Fannie and Freddie should absolutely not be resurrected in the former image (providing insurance but not a balance sheet for holding mortgages would make sense).

    for those who think the GSEs were more significant than other parts of the mortgage industry, Google

    “Magnetar Trade” to understand the mispricing of CDSs and the ridiculousness of synthetic securities which multiplied the loss effect

    and “Gaussian copula function” which was used to estimate defaults- but it had a positive feedback loop in it which meant that if home prices went up, then it said defaults will go down

    and “Chainsaw James Gilleran” for perspective on how Countrywide and others became the primary channel for poorly underwritten mortgages

  35. Gravatar of Michael Michael
    13. September 2012 at 05:00

    “For me, the moral issue – and I fear much of the present attraction to NGDP targeting – is the transition from the present inflation targeting regime. A transition to 5% NGDP targeting starting from a level close to pre-crisis NGDP would almost certainly involve a surge of unanticipated inflation which would transfer of wealth from creditors to debtors”

    If you look at the price level trend from pre-crisis to now, inflation has been extremely low, which suggests a transfer from debtors to creditors (although the benefit to creditors is offset by higher losses due to unanticipated default). Why should transfers in one direction be acceptable – even good – while transfers in the other are immoral?

  36. Gravatar of Major_Freedom Major_Freedom
    13. September 2012 at 05:34

    Bill:

    It makes no sense that massive bankruptcy across the entire economy would help- Keynes pointed it out in the 30″²s and its too bad it didn’t sink in until 1932 (and then was forgotten again in 1938)

    It makes a lot of sense. If there are massive investment errors, in the sense of coordinated unsustainability in real physical productive terms, then massive liquidations are a part of the correction of these errors and movement towards recovery.

    If you can understand that it makes sense for an individual firm to go bankrupt if it expands too much in real terms relative to other projects that the firm depends on, such that it should change its ways, then you should understand it makes no sense to ask for an inflation deluge to prevent “spending” on this firm and other firms from falling. It makes sense that these firms go bankrupt.

    Merely adding adjectives like “massive”, and “widespread”, in front of the word “bankruptcies”, doesn’t change the principles involved here. From an individual’s perspective, he can only go unemployed or bankrupt once at a time. If one, two, or tens of millions go bankrupt, then each individual will suffer just as one person suffers from unemployment or bankruptcy in a healthy economy.

    Why exactly is it so bad that tens of millions go unemployed, but it’s OK if a few thousand go unemployed? From your perspective, sure, you SEE more unemployed people. But from THEIR perspective, they are each only unemployed in the singular sense. They don’t experience unemployment tens of millions of times greater. It’s still singular. If you don’t give a flying rat’s ass should 5% of the workforce be unemployed, then why do you care so much about 10% or 15% or 20%? They won’t be unemployed forever. If you let the price system work, and stop asking for inflation to keep people a drunken state of unsustainable dependency, then it would have been less worse than it is now. Instead of 4 years of depression, we probably would have had around a year or two of depression, but with a clean, sustainable, ready to break production records recovery on the way out. Right now however, the Fed and the state in general have kept the US economy weak, so while unemployment did not rise as much as it would have without inflation and bailouts, tens of millions of people are now in a quasi-permanent state of weakness and lower living standards.

    Your feelings regarding unemployment have absolutely no bearing on the economic science of it. They have no bearing on the science that tells us how the market process works, what hampers it, and what makes it thrive. If you feel bad about unemployment, then go out there and use your own money to help those people. Don’t presume to consider yourself master of everyone else’s property, such that you presume to know that inflation tax can do anything other than redirect wealth away from where the market process would have directed it, and as such, prolong the unsustainability of the economy in real terms, which of course is what hampers recovery.

    Liquidation makes sense. Accept it.

    “It seems an extraordinary imbecility that this wonderful outburst of productive energy [over 1924-1929] should be the prelude to impoverishment and depression. Some austere and puritanical souls regard it both as an inevitable and a desirable nemesis on so much overexpansion, as they call it; a nemesis on man’s speculative spirit. It would, they feel, be a victory for the Mammon of Unrighteousness if so much prosperity was not subsequently balanced by universal bankruptcy.”

    “We need, they say, what they politely call a ‘prolonged liquidation’ to put us right. The liquidation, they tell us, is not yet complete. But in time it will be. And when sufficient time has elapsed for the completion of the liquidation, all will be well with us again.”

    “I do not take this view. I find the explanation of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment. And I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity…””

    Keynes did not understand that a fall in wages and prices is accompanied by a rise in net investment, which, contrary to his belief, increases profitability. Keynes falsely believed that the MEC declines as more net investment is made.

    You’re quoting 1930s Keynes? OK, I have a quote from Keynes you’ll enjoy:

    “I find myself more and more relying for a solution of our problems on the invisible hand which I tried to eject from economic thinking twenty years ago.” – Keynes, J.M., April 11th 1946 (10 days before his death).

  37. Gravatar of Major_Freedom Major_Freedom
    13. September 2012 at 06:08

    Cash holding is an integral aspect of coordinating the capital structure of the economy. “Market” monetarists incorrectly infer a monastic mechanistic relationship between money and spending from cash holding. They see cash holding go up, and they think this means the central bank should inflate more. After all, the “market just wants more money, so give it to them!”, right? Wrong. Money holding affects the capital structure of the economy if it is accompanied by a relative change in demand for capital goods and demand for consumer goods. Yet inflation from the central bank cannot send the same signals to the market as this cash holding. This is because cash holding can come from many sources. From the many stages of capital goods, from consumer goods, and from various locations across the country or the rest of the world. If I reduce spending in consumer goods in my location say, but retain my nominal investment, then the central bank’s reactive inflation to counter-act my cash holding will not send the same signals to others in the price system. It introduces a new set of signals totally apart from my signal. Thus, the actions taken by myself and others will not be coordinated by the price system, as the signals as such are distorted by non-market information.

    Cash holding should be welcomed, not responded to like the plague and attempted to be reversed as soon as possible by indiscriminate and random inflation. Focusing on “aggregates” like NGDP totally glosses over the important micro-level activities that an economy actually consists of.

  38. Gravatar of StatsGuy StatsGuy
    13. September 2012 at 06:59

    @ Rebel

    In terms of the net shift, I would counter that the moral issue is that the era of 1980 to 2012 has represented the greatest shift in wealth to net creditors in 80 years. In essence, we went from 12% long term interest rates to 2.5%, and NGDP of 15% to 4% or less. Creditors are complaining about what?

    At the moment, creditors are NOW complaining that interest rates on bonds are too low and that savings is being punished. The silliness of this is that interest rates on bonds are low precisely because of what you said – failure to target NGDP has resulted in LOWER long term real rates, precisely because future productivity is expected to be low due to investment failure and poor overall economic growth.

    The solution? Savers want higher interest rates at banks, so they want the Fed to tighten to give them their higher savings rate. That way lies madness and bankruptcy, note Argentina.

    Bailouts since LTCM? No, bailouts are targeted money injection (TARP was a bailout). That was through Treasury. Fed monetary policy is merely the optimal monetary response, given a very poorly run regulatory apparatus, which occurred largely due to the deconstruction of Depression era separation of investment banking and retail banking. Courtesy of both parties.

    I think your arguments are reasonable, but only from a very short term perspective (starting at 1998-2001 as the starting point).

    Also, I resist the economist’s view that this is simply an efficiency issue (equity or debt financing). The other side is framing it as a moral issue – monetary policy is morally wrong, unjust, unfair, and deeply lacking in any notion of reality. Exactly the opposite is true.

  39. Gravatar of ssumner ssumner
    13. September 2012 at 07:11

    Bob, It’s crucial for avoiding debt crises, but not for avoiding recessions. Recessions are caused by disequilibrium in the labore market, not a screwed up debt market.

    Statsguy, That Selgin post was a critique of a narrow technical issue, he’s sympathetic to a rule-based NGDP target (although his productivity norm is slightly different), and has discussed the debt fairness issue extensively.

    Saturos. Marcus has a defensible argue, and I tend to agree. But David Beckworth doesn’t. It’s hard to prove who’s right, as when the Fed has not been doing NGDP targeting, any trend line will be arbitrary, more an art than a science. Yopur reply to Bob is exactly right.

  40. Gravatar of Saturos Saturos
    13. September 2012 at 08:45

    “I’m surprised Bryan hasn’t replied to Garett yet…”

    Spoke too soon:
    http://econlog.econlib.org/archives/2012/09/sumner_channels.html

  41. Gravatar of PrometheeFeu PrometheeFeu
    13. September 2012 at 11:12

    @ssumner:

    “Debt coupon payments are sunk costs and benefits that have almost no effect on the incentive to produce output at the margin.”

    If nominal income falls, a greater proportion of the firm’s revenue will have to be dedicated to debt repayment. That means the firm’s credit risk will rise, they will face higher borrowing costs which will reduce their incentive to produce.

  42. Gravatar of Bob Murphy Bob Murphy
    13. September 2012 at 12:04

    Scott wrote:

    Bob, It’s crucial for avoiding debt crises, but not for avoiding recessions.

    Scott, if you are still reading this thread, it would really help me (I’m being serious) if you could select one of the two positions:

    (A) I, Scott Sumner, believe that nominal debt contracts have nothing to do with why it’s important to keep NGDP rising.

    (B) I, Scott Sumner, believe that nominal debt contracts can sometimes be a very important factor in why it’s so important to keep NGDP rising.

  43. Gravatar of Saturos Saturos
    13. September 2012 at 12:05

    It’s B. But that’s a separate point from the question of what makes the business cycle happen.

  44. Gravatar of Saturos Saturos
    13. September 2012 at 12:07

    Prometheefeu: “greater proportion of the firm’s revenue”

    You mean nominal revenue. So you’re still assuming general stickiness there.

  45. Gravatar of RebelEconomist RebelEconomist
    13. September 2012 at 12:55

    Michael / Statsguy: “If you look at the price level trend from pre-crisis to now, inflation has been extremely low, which suggests a transfer from debtors to creditors”; “the era of 1980 to 2012 has represented the greatest shift in wealth to net creditors in 80 years”.

    If you think about it, your statements show how unquestioningly biased against savers US monetary policy has become. You characterise a period in which, for once, the monetary authorities did fulfil their promise to get inflation down as a process that transferred wealth to creditors, rather than a suspension of the usual attempts to transfer wealth away from them, and characterise on-target inflation (CPI inflation since the financial crisis has averaged very close to 2%) as “extremely low”.

  46. Gravatar of Bill Bill
    13. September 2012 at 13:03

    @MajorF

    See “Paradox of Thrift”

    Not sure where your unemployment tirade came from but here’s an analogy: If life expectancy tables say that 2% of a large population of age X should die this year, and 2% die, then we probably shouldn’t be concerned. But if 20% die, I think we have a problem.

  47. Gravatar of Mike Sax Mike Sax
    13. September 2012 at 13:28

    Bernanke’s bold new frontier

    http://diaryofarepublicanhater.blogspot.com/2012/09/ben-bernankes-bold-new-frontier.html

  48. Gravatar of Dave Thomas Dave Thomas
    13. September 2012 at 21:36

    What if the fed announced higher interest rates coinciding with a President Romney announced marginal tax rate reduction paid for by deduction reform a la Robert Mundell’s policy prescription from “The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability?”

    Sound money meets economic expansion.

  49. Gravatar of Assorted Links « azmytheconomics Assorted Links « azmytheconomics
    14. September 2012 at 05:22

    […] Garett Jones on Sticky Debt. Sumner responds. Share this:TwitterFacebookLike this:LikeBe the first to like this. from → Links ← […]

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