It's an interesting paper (pdf). It's a very standard New Keynesian macro model with one twist. It's a twist worth doing. There are two types of people: the impatient, who borrow from; the patient. And there's an exogenous limit to the debt the impatient are allowed to accumulate.
It's a math model, of course. I'm not going to stick literally to the assumptions of the model, because many of those assumptions were made to make the math simple, and aren't really central. Here's my reading.
1. For a given level of current and expected future income, the equilibrium real rate of interest will drop. That's because some people and firms who want to borrow won't be able to, or won't be able to borrow as much. The demand for loanable funds from qualified borrowers falls, and so does the equilibrium rate of interest. Equivalently, for a given level of expected future income and real interest rate, there is a fall in the level of current income at which desired savings equals desired investment (ignoring the desires of those who want to borrow and spend but can't). Whichever way you think about the IS curve, it shifts down, or it shifts left. Same thing.
2. The marginal propensity to spend out of current income increases. A change in current income that leaves future income unchanged has little effect on permanent income, and so will normally have little effect on the demand for goods. But borrowing-constrained people and firms will have a marginal propensity to spend out of current income of one. So anything that causes current income to change will have a bigger multiplier effect.
3. A change in the real rate of interest will have a smaller direct effect on the demand for goods. That's because the borrowing-constrained people and firms want to borrow and spend more if the rate of interest falls, but are unable to.
4. The IS curve may become either flatter or steeper, depending on whether 2 or 3 above dominates. A less interest-elastic demand for goods means a steeper IS curve. But a bigger multiplier means a flatter IS curve. With an exogenous borrowing constraint, a given fall in the rate of interest will have a smaller direct effect on increasing demand, but that direct effect will have a bigger multiplier effect. So the total effect of a fall in the rate of interest on demand for goods could be either bigger or smaller.
Now suppose an exogenous shock causes the borrowing constraint to bind more tightly. This causes the IS curve to shift left, and makes the natural rate of interest strongly negative. Since the nominal rate of interest cannot fall below zero, and since the expected rate of inflation isn't high enough, the economy goes into a recession. Any fall in the current price level increases the real value of existing nominal debt, and makes the borrowing constraint bind more tightly still. (That's the Fisher debt-deflation effect).
Monetary policy can only work if it can increase the expected future price level, and thereby increase expected inflation and lower the real rate of interest. Fiscal policy can work because a cut in current taxes will raise the current disposable income of borrowing-constrained people and firms, causing them to increase their demand for goods, even if they know that future taxes will be increased. In effect, the government is acting as lender to the borrowing-constrained, and relaxing that constraint.
One main problem with the model is the exogeneity of the level of real debt at which the borrowing constraint bites. I can think of three main channels in which making the borrowing constraint endogenous might change the results of the model:
B1. The amount that people and firms are allowed to borrow depends on their income. If a recession causes a decline in current and expected future income, this could tighten the borrowing constraints still further, deepening the recession. In effect, we get a borrowing-constraint multiplier.
B2. The amount that people and firms are allowed to borrow depends on the rate of interest. A fall in the rate of interest will lower the interest payments on a given debt, and would loosen borrowing constraints and help the economy escape the recession.
B3. A cut in current taxes implies an increase in expected future taxes, which reduces expected future disposable income, and reduces the ability of debtors to service debt in future, which may tighten the borrowing constraint. So fiscal policy may still fail, because the increased government lending may be fully offset by an equivalent tightening of the borrowing constraint. Ricardian Equivalence may still hold.
Let me add a quasi-monetarist gloss to the model: The recession is not caused by an excess of desired savings over investment. Instead, when lenders are unable to find borrowers they think are safe, they choose to save in the form of money instead. It is the excess demand for the medium of exchange that causes the recession. In a barter economy, those who desired to lend but who were unable to find borrowers they think are safe would be forced to consume or invest their income themselves.
Let me add a more monetarist objection (I'm trying to guess what Scott Sumner would say): It was the Fed, by having too tight a monetary policy, so that expected future nominal income fell, that caused the borrowing constraint to tighten. It wasn't exogenous at all.
And I would add that monetary policy might actually be more powerful in this sort of model than it would be in a similar New Keynesian model with a liquidity trap but without a borrowing constraint. The higher marginal propensity to spend out of current income is higher, so the multiplier effect of anything that gets spending started will be higher. Plus, more importantly, the borrowing constraint creates its own multiplier, because any increase in current or expected future income relaxes the borrowing constraint which creates additional demand and income.
One thing that I might want to pick out is that out of the points 1-4, the only one we can observe an analogue to in the data is 2, and here the statics point in the wrong direction - the savings rate spiked.
Posted by: Hrmmm... | November 19, 2010 at 06:09 PM
Professor Steve Keen has an interesting model that simulates the "Great Moderation" of the 20 years before the 2008 crisis and then the crisis.
He has a long video presentation here: http://www.debtdeflation.com/blogs/ You can also download his model and the software to run it.
I'd be curious to know what you think of it.
Posted by: Alex Plante | November 19, 2010 at 07:22 PM
So he's trying to add Bohm-Bawerk/Mises to macro:
"There are two types of people: the impatient, who borrow from; the patient"
Good. Great to see Paul Krugman trying to catch up to the economics of 100 years ago.
Now lets see Krugman try to add the grown up stuff to his baby Bohm-Bawerk -- the fact that entrepreneurs with heterogeneous production goods who will not choose longer production processes unless those processes promise greater output.
That would move Paul Krugman all the way up to the economics of 80 years ago ...
Posted by: Greg Ransom | November 19, 2010 at 10:24 PM
Let me say this so even Paul Krugman can understand it.
If you have people who are differentially impatient, if you have production processes which are differentially productive depending on production time, and if people will not choose longer production processes unless those processes promise greater output, then the changing price of credit and the changing quantity / flow structure of money, and the changing structure of leveraged liabilities can produce systematic malinvestment and disequilibrium in the whole of the economy, across the time structure of production, and involving an incompatibility of production and consumption plans across time.
In other words, if you have an economy like the real world -- and completely UNLIKE the fake "economy" which is "modeled" by mathematical macro -- then you have all the conditions you need for an unsustainable boom and an unavoidable bust.
Posted by: Greg Ransom | November 19, 2010 at 10:45 PM
The other source of the debt constraint is asset values, of course. Declining or rising asset values must have a similar impact to income if you incorporate them into the model - if asset values fall, the debt limit tightens and the impatient find themselves more constrained in their spending, potentially further reducing asset values.
I'm not sure if the division into patient and impatient is quite right either - most people have a mixture of debt and investments with different levels of liquidity. Maybe this doesn't change anything, but since the choices are partly motivated by taxes (eg, the reason I have a 401(k) and just pay off my mortgage is partly taxes) it might be relevent
Posted by: Simon K | November 20, 2010 at 02:13 AM
what are alternative ways of getting debt into a macro model, other than supposing impatient and patient types? I'd guess different generations or heterogeneity in that some households have income but no investment projects and others have investment projects but no income, so to speak. I haven't done more than scan paper yet, but would be interested to know how the way in which you introduce debt to the model changes the predictions. Also how well a model of household and firm debt fits a crisis where the 'problem debt' was located in the bankign system.
Posted by: Luis Enrique | November 20, 2010 at 06:57 AM
"I'm not sure if the division into patient and impatient is quite right either - most people have a mixture of debt and investments with different levels of liquidity. Maybe this doesn't change anything, but since the choices are partly motivated by taxes (eg, the reason I have a 401(k) and just pay off my mortgage is partly taxes) it might be relevent."
Is this true? And even if it is, what are the proportions?
And what about the paper's observation about spending multipliers being dependant on the share of income held by debt constrained borrowers? What does this mean?
Anyway. Mr. Ransom. Clean up your attitude.
Posted by: beezer | November 20, 2010 at 07:00 AM
The key is having two types of people instead of one as in Efficient Markets.
In our current economy, the flow of money is blocked to large segments of the economy.
This model is important because it allows transaction dynamics to be explored.
Posted by: jonny bakho | November 20, 2010 at 09:29 AM
Three observations:
-During the housing and tech bubble, actors believed high current returns were indicative of high future returns. This expectation of high future income, in turn, supported higher current spending and less "money demand". Is it the Fed's fault that those income expectations declined, or was it just a consequence of the inevitable fall in bubble returns?
-While a lower rate of interest reduces the borrowing constraint of the impatient actor, it also marginally increases the amount that patient actors have to save in riskless assets in order to generate the same future income.
-What happens if the lower rate of interest results in higher bank spreads -- given imperfect competition -- rather than lower borrowing costs? The borrowing constraint would not loosen. We see this phenomenon in small business lending and consumer credit. (The higher bank spreads are used to absorb the deadweight loss of loan write-downs.)
Posted by: David Pearson | November 20, 2010 at 10:07 AM
Hrmmmm. But 2 says that the *marginal* propensity to spend increases. While 1 says that the *average* propensity to spend decreases. It's perfectly consistent with an increase in desired savings.
Alex: I may take a look at that. But after reading Steve Keen's previous, post, where he clearly misunderstands something as basic as expected utility maximisation, I am not optimistic.
Greg: It's one thing to say these things, it's another thing to model them, so we can see that the explanation is internally consistent.
Simon: good point on asset values. I missed it. My guess is that it would operate through very similar mechanisms to the interest rate and income channels though, since asset prices depend on interest rates and income.
Yes, taxes and compulsory savings plans can mean that the same individual is both a borrower and a lender at the same time. (Example: holding your own mortgage in your RSP, where you really are lending to yourself.)
Luis enrique: I think you have covered the main ways: overlapping generations, different investment opportunities, different preferences, time-varying income (same as OLG in a way).
My guess is that the main effect of introducing banks would be that the supply of money would be linked in with debt. But even though New Keynesian models are models of monetary exchange economies, they don't have money in there explicitly (at least, the canonical ones don't).
beezer: The consumption of people who are not borrowing constrained depends on permanent income. A temporary change in income causes a very small change in permanent income and so a very small change in consumption. Their mpc is very small. But people who are borrowing constrained consume all their current income. Their mpc=1. Since the simple multiplier is 1/(1-mpc), the bigger is the average mpc for the population, the bigger is the multiplier.
jonny: efficient markets doesn't mean that all people are the same. Actually, if all people are the same, you don't (normally) get a market at all. No motive to trade.
Posted by: Nick Rowe | November 20, 2010 at 10:11 AM
David:
1. Back to the old argument on Scott's blog about whether the Fed *caused* the decline in nominal income or *failed to prevent it*.
2. A lower r has one income effect on lenders and the opposite income effect on borrowers. But the borrowing constraint eliminates the substitution effect for some debtors.
3. Dunno. In general, an increase in spreads is equivalent to a leftward shift in the IS curve.
Posted by: Nick Rowe | November 20, 2010 at 10:21 AM
Alex: I started listening to Steve Keen. I switched off after a couple of minutes. He is already confusing what happens to *levels* of unemployment and inflation with what happens to their *variances*. Sorry, but I don't have the patience.
Posted by: Nick Rowe | November 20, 2010 at 10:25 AM
How would one distinguish lenders deeming borrowers unqualified from borrowers deeming themselves unqualified, that is, no longer deeming their investment projects worthwhile? Credit constraints externally imposed to internally imposed? If the real rate could be lowered to be sufficiently negative than most anything could be seen profitable, but not while its price is still falling or expected to fall or while its supply is still in excess of non-speculative demand. One might consider agents that move between borrower and lender as expectations and rates change.
Posted by: Lord | November 20, 2010 at 10:32 AM
I wonder if folks like Andolfatto will continue to claim that PK doesn't do modern macro, and therefore his opinions on things like fiscal stimulus can be ignored.
Posted by: ISLM | November 20, 2010 at 10:41 AM
ISLM: Funny, I had the same thought. He hasn't updated his blog. There is something about Paul Krugman that makes people lose their minds - for example, someone in these comments starting with "I'll say this so that even Paul Krugman can understand it" - the man has a Nobel Prize, a John Bates Clark Medal and tenure at Princeton. I think he understands plenty.
Posted by: brendon | November 20, 2010 at 11:14 AM
Lord: good questions. It might not matter; you might get the same effects either way. Now you mention it, investment might be different from consumption, in how the borrowing constraint gets determined. The GE/PK model only has consumption loans. I talked about investment and consumption here, because I thought they might have similar effects.
ISLM and brendon: Here's Steve Williamson's thoughts: http://newmonetarism.blogspot.com/2010/11/eggertsson-and-krugman.html
Posted by: Nick Rowe | November 20, 2010 at 11:48 AM
Beezer is telling this to someone writing about PAUL KRUGMAN? The man has utter contempt for the history of economic thought -- and utter contempt for truth when it comes to writing about that economics.
Krugman openly tells the world that he doesn't read any economics published before the 1970s -- and he patently BSs in a truth be damned fashion about the economics of those who wrote prior to the 1970s, writing stuff that EVERY competent authority has identified as utterly incompetent. (See, e.g., Roger Garrison on Krugman on Hayek).
Give me a break. The one who need to clean up his act is Paul Krugman.
"beezer" wrote,
"Anyway. Mr. Ransom. Clean up your attitude."
Also, "brendon" writes,
"I think [Krugman] understands plenty."
We know Krugman does not understand much of any economics produced in the period between 1500 and 1970s -- that has been shown again and again by many competent authorities.
Competent academic authorities has testified to this fact about Krugman repeatedly. He's not to be taken seriously when he writes about such things, because it is plain that he doesn't' know the stuff and doesn't understand it.
Competent authorities has said the same even when Krugman writes about Keynes (I don't claim to be one of those authorities).
There are all sorts of Nobel Prize winning economists with Ivy League tenure who have limited competence in the vast fields of economic thought -- this is a given in today's academy.
I'd suggest folks read some David Colander on this general topic.
Posted by: Greg Ransom | November 20, 2010 at 12:00 PM
"We know Krugman does not understand much of any economics produced in the period between 1500 and 1970s"
This is a very odd claim, and I guess would preclude any knowledge of Keynes which would be news to nearly all of his critics.
Posted by: brendon | November 20, 2010 at 12:03 PM
The interesting thing about the paper are the paradoxes of toil and the paradoxes of flexibility - these are testable hypotheses, contrary to those tedious 'microfoundations' (which are no micro foundations at all, as they are not based upon individual agents) assumptions. The questions therefore are:
- do sudden debt constraints in a severely indebted economy lead to:
A. A backward bending AD curve? The USA and Ireland can serve as an example.
B. larger cyclical swings in more felxible economies?
My work on the Dutch economy in the thirties leads me to believe that back then there indeed was something like a dynamic 'paradox of toil', productivity in industry rising thus fast that after 1932 increasing demand and production did not make up for earlier lay offs. It's not exactly the effect of the model, but it can be identified. And there surely was a 'paradox of flexibility': low prices very swiftly led to less business investments and large lay offs, which was not counteracted by more or less stable personal consumption and increasing government investment and consumption. But that's in fact an old fashioned Keynesian argument.
Interesting: the flexibel neo-liberal prodigies (USA, UK, Ireland) are among the western economies with the fastest deterioration in government finances during the present crisis.
So, let's use the testable ideas to analyse the past and the present instead of musing 'what did they really mean'.
Posted by: Merijn Knibbe | November 20, 2010 at 12:03 PM
Greg, there are any number of websites where people can indulge in Krugman Derangement Syndrome to their heart's content. WCI will not be one of them. If you want to talk about the paper Nick is discussing, fine. But let's keep it at that, shall we?
Posted by: Stephen Gordon | November 20, 2010 at 12:03 PM
And come to that, we could have done without the crack about David Adolfatto's hypothetical response. He has a blog; wait until he responds, and comment there.
Posted by: Stephen Gordon | November 20, 2010 at 12:07 PM
The greater than zero cognitive worth of many of these "modeling" techniques for explanatory purposes is an open question, isn't it? I.e. it hasn't been proven, leaving an open queston which hasn't been provided a cogent or compelling answer, outside of the persuasive force of an argument from authority.
Nick writes,
"It's one thing to say these things, it's another thing to model them, so we can see that the explanation is internally consistent."
If I say 5 true things, I've said 5 true things.
If these 5 true things can't be forced into a mathematically tractable "model" I've still said 5 true things. I've merely shown that a mathematically tractable system isn't going to tell us anything informative about those things -- besides what can be learned by the fact that the phenomena is lies outside the domain of mathematically tractable formal systems.
Think about what we have learned about physical systems which can't be limned by a Laplacean linear predictive math equation. Some types of phenomena lie outside the tractability demands of this formalism -- e.g. phenomena involving 3 bodies.
A Laplacean might insist therefore that the world consists of only 2 bodies -- and to imagine otherwise is impossible.
Saner minds have prevailed.
Posted by: Greg Ransom | November 20, 2010 at 12:12 PM
It's weird that I find myself in agreement with the resident Austrian---not on Krugman, but on the value of modelling. There are a whole lot of fundamental reasons why we should be skeptical of the very possibility of economic modelling in which we would put any confidence for policy-prescriptive purposes. Well, I guess it's not that weird that I agree with Greg considering that we come from the edges of the discussion, if opposite edges.
Posted by: Mandos | November 20, 2010 at 12:20 PM
I believe that there is a greater than zero cognitive worth for many of these "modeling" techniques -- but this doesn't change that fact that economics utterly lacks a coherent account of how their tautological "math" constructs produce informative causal explanations.
I take it as a simple fact that economics has yet to show how all this math helps us understand the world -- we have an essentially contested and unresolved problem here.
Until that problem is resolved, it's impossible to establish the cognitive worth of any of these modeling techniques, or even to specify what that worth might be.
Posted by: Greg Ransom | November 20, 2010 at 12:25 PM
"Greg, there are any number of websites where people can indulge in Krugman Derangement Syndrome to their heart's content."
Fair enough, Stephen, but I think it is also fair to point out the deep irony in what Krugman is doing. He's attempting to incorporate a central distinction at the core of the economics he has been trashing in a very ignorant and nasty fashion for the last few years.
There is nothing "deranged" about pointing to significant facts -- unless folks have a problem with telling the truth about what is going on here.
Krugman sees a need to incorporate explanatory elements at the core of an explanatory alternative he brutishly rejects on grounds that competent authorities have shown to be misreadings of science at issue.
This calls into question Krugman's evaluative judgment between explanatory rivals, with significant public consequence.
It's bizarre to condemn as "deranged" something at once both interesting and true -- unless you have a problem is that kind of thing.
Posted by: Greg Ransom | November 20, 2010 at 12:40 PM
Stephen Williamson and his readers are having an interesting discussion of the Krugman paper here:
http://newmonetarism.blogspot.com/2010/11/eggertsson-and-krugman.html
Posted by: Greg Ransom | November 20, 2010 at 02:20 PM
value of models. I don't think you can say 5 true things, or at least communicate them to me.
There's been a debate recently about natural language processing, wolfram alphra is making progress towards it. And a lot of criticism, is based on forgetting the value of formal symbolism, rise of first order logic.
Models get rid of rhetoric.
Posted by: edeast | November 20, 2010 at 08:55 PM
edeast has never read Wittgenstein
Posted by: Greg Ransom | November 21, 2010 at 12:29 AM
That's true, on my to do list, but I'm not looking forward to it.
I found his architecture horrible, so if you could summarize ..? I'd appreciate it.
Posted by: edeast | November 21, 2010 at 01:17 AM
Nevermind, I will read him, but I'm honest in that I'm predisposed not to like it. I think mainly cause he won the new york times favorite philosopher contest last year, + the architecture. weird.
Posted by: edeast | November 21, 2010 at 01:22 AM
I read Derrida, symbols depend on their context. I tried, to marry information-theory with Derrida, somehow, my prof was patient with me. Here's what I was expecting you to say.
I am a man.
The sky is blue.
And I was going to counter with, deconstruction,
man, biological definition? Anatomy based or chromosome based? ( some double xx'ers can have penis)
or define what wavelengths you consider blue, then go to work on interpreting sky... is... etc. The other analysis, being information theory, in limiting the number of options of messages by a rigid agreed upon structure, the information content can go up, lowers the entropy.
Posted by: edeast | November 21, 2010 at 01:47 AM
Thanks for keeping it on topic guys
Posted by: Rob | November 21, 2010 at 03:49 AM
Hi, Nick. Thank you for sharing your thoughts on the Eggertsson-Krugman paper. I have a query about your comment in B3 and Ricardian Equivalence. If cutting taxes now when unemployment is high and demand is low leads to (a) lower future unemployment, and (b) increased income among the employed, wouldn't this increase future tax revenues without the government having to raise taxes to a level that is higher than original? So Ricardian Equivalence wouldn't hold when there is significant unemployment and demand for money is too high?
Posted by: Kien | November 21, 2010 at 07:07 AM
Paul said nothing in this model. He said, here is the model and here is how it works. Everything else that Paul said was designed to be mis-interpreted favorably by his clientele.
Go back, look at the model. It tells you one thing, things go up and things go down and over the average things hang about the average. If Paul, in this model said that sometimes the government multiplier is greater than one, then by construction, he implies it sometimes is less than one. By corollary, then said that when one calibrates this model, it will give an approximate time in the cycle when multipliers are greater than one.
What is new in this model, vs the other ten million square integrable models of the world that go up and down? Paul uses the forces of patience and impatience. Maybe be useful, but so far it is nothing but a proposal.
Posted by: Matt Young | November 21, 2010 at 03:10 PM
Kien: That's what's called the "demand-side Laffer Curve" argument. Tax cuts pay for themselves, through their effect on aggregate demand (as opposed to aggregate supply for the normal Laffer Curve argument).
It only works if the equilibrium is unstable, or metastable. If the initial equilibrium is stable, then it won't work. The equilibrium is (locally) stable in the GE/PK model.
Damn! I ought to be able to explain clearly why this is true. But I can't right now. (My brain is mush. I just spent today replacing an axle seal, only to find they sold me the wrong part, and I have to do it over again tomorrow morning.)
Posted by: Nick Rowe | November 21, 2010 at 03:20 PM
Sorry, Rob. Greg if you care, you can correct me over here
Posted by: edeast | November 21, 2010 at 03:30 PM
The equilibrium is globally stable period for the GE/PK model, it has to be globally stable by construction. What the model is doing is peering at that data point when the original assumptions don't hold, when persistent illiquidity forces a debt spiral as in part one, for example.
As long at is well calibrated for a short term forward look it works. What is new is the classification between he patient and impatient.
Posted by: Matt Young | November 21, 2010 at 09:34 PM
Matt: Yep. But this is what I had in mind, but my brain wasn't working:
The GE/PK model *assumes* that the economy will revert to normal (escape the liquidity trap) in the future. If you took the GE/PK model, and modified it along the lines of one of George Evans' models, you could get it stuck in a permanent liquidity trap. But fiscal policy could get it out of the liquidity trap, into the normal equilibrium. A purely temporary fiscal boost could cause a permanent increase in income, with enough tax revenues to pay for the temporary boost. It becomes a "pump priming" model. It's no longer globally stable. But in that case, even the *belief* that the economy will escape the liquidity trap could become self-fulfilling.
That's probably still not clear.
Posted by: Nick Rowe | November 21, 2010 at 09:51 PM
Once you start seeing world without your neo-classical filter, you will start making sense of people like Steve Keen. You can also check other Post-Keynesians such as Bill Mitchell (http://bilbo.economicoutlook.net/blog/) and Randall Wray (http://neweconomicperspectives.blogspot.com/).
Cheers,
Sriram
Posted by: Sriram | November 22, 2010 at 12:13 AM
Greg,
doesn't basic empiricism (looking out the window), tell you this:
"If you have people who are differentially impatient, if you have production processes which are differentially productive depending on production time, and if people will not choose longer production processes unless those processes promise greater output, then the changing price of credit and the changing quantity / flow structure of money, and the changing structure of leveraged liabilities can produce systematic malinvestment and disequilibrium in the whole of the economy, across the time structure of production, and involving an incompatibility of production and consumption plans across time."
is wrong. The magnitudes don't work. The level of background uncertainty (about income, tastes, technology, market share) make marginal interest rate effects relatively insignificant. And besides, the proximate causes of problems is always changes in demand, not supply shortfalls. I don't know why you keep pushing this on us without any convincing evidence. You may be able to say 5 true things, but how can we tell they are true?
But me, I'm a disequilibrium guy - I think "produce systematic malinvestment and disequilibrium in the whole of the economy" is perfectly normal. If the economy can't cope with it, we need a different economy.
Posted by: reason | November 22, 2010 at 04:15 AM
Simon K.
"The other source of the debt constraint is asset values,..."
yes I noticed that was missing as well. Given that it was the obviously key contributing factor to our current "balance sheet recession". It seemed a strange thing to omit.
Posted by: reason | November 22, 2010 at 04:23 AM
As for the approach used in the paper of using exogenous shifts in credit constraints, isn't really using a very primitive device to model Minsky effects - i.e. shifts in risk perception and risk appetite. A proper model should not have an interest rate, but a whole range of interest rates gradated by risk. That curve should become much steeper when the Misky moment hits. Yeah, but I suppose that would make the maths more difficult.
Posted by: reason | November 22, 2010 at 04:29 AM
Nick thanks for the interesting discussion. I realize that models are helpful for economist to think through complex problems but, as the discussion here shows those assumptions that make the math possible are sometimes at least as problematic the issues the model is intended to illuminate. Such as the usual implicit assumption that the financial system is so perfectly functioning as to be invisible in the model. Yikes!
That's what I do like about this one though, at least they've managed to throw debt into the equation. Interesting is that all it takes is the introduction of heterogeneous beliefs. I wish Rajiv Sethi blogged more, his work on heterogeneous beliefs is some of the most interesting stuff out there.
On the monetarist response:(I'm trying to guess what Scott Sumner would say): It was the Fed, by having too tight a monetary policy, so that expected future nominal income fell, that caused the borrowing constraint to tighten. It wasn't exogenous at all.
Two things. First if the stock of debt and the flow of debt service payments were growing faster than NGDP expectations for the impatient group it woudn't take a fall in NGDP expectations necessarily for them to hit a credit limit.
Also, if I remember correctly Sumner likes to use the analogy of the Fed as ship's captain and the housing crunch as a wind. He says we should blame the captain for failing to correct for the wind. But, that assumes both that the Fed can correct for the wind and as the tools to recognize the magnitude of wind shift.
I'd also prefer to think of the housing crunch as something more endogenous to the 'economic ship,' like an engine or propeller, but I grew up in the midwest and do not know enough about ships to make a sensible analogy.
Posted by: OGT | November 22, 2010 at 09:17 AM
reason: Keeping the math simple is always good. But even ignoring that, I'm always of the view that when it comes to formal models: "if in doubt, leave it out". If you can tell the story without adding a whole spectrum of interest rates, then just have one rate of interest.
OGT: It's not really heterogeneous beliefs that are driving debt in the model; it's heterogeneous preferences.
"First if the stock of debt and the flow of debt service payments were growing faster than NGDP expectations for the impatient group it woudn't take a fall in NGDP expectations necessarily for them to hit a credit limit."
Agreed. But, in equilibrium, the debt limit will always be binding for some people. A fall in expected NGDP growth would suddenly shift the debt limit to make it bind more tightly and affect more people.
Posted by: Nick Rowe | November 22, 2010 at 04:02 PM
Mancur Olson claimed in "The Rise and Decline of Nations" that he had the only explanation for the "sticky wages/prices" which cause Keynesian "involuntary unemployment". What do you think of his explanation?
Posted by: TGGP | November 23, 2010 at 10:06 AM
TGGP, citing authors without describing what theory of theirs that you are citing doesn't make you mysteriously sophisticated, it just makes you annoying.
Posted by: david | November 23, 2010 at 10:38 AM
Sorry, I was thinking Rowe would be familiar with it and didn't think about other readers. Quoting from Wikipedia:
The idea is that small distributional coalitions tend to form over time in countries. Groups like cotton-farmers, steel-producers, and labor unions will have the incentives to form lobby groups and influence policies in their favor. These policies will tend to be protectionist and anti-technology, and will therefore hurt economic growth; but since the benefits of these policies are selective incentives concentrated amongst the few coalitions members, while the costs are diffused throughout the whole population, the "Logic" dictates that there will be little public resistance to them. Hence as time goes on, and these distributional coalitions accumulate in greater and greater numbers, the nation burdened by them will fall into economic decline. Olson's idea is cited as an influence behind the Calmfors-Driffill hypothesis of collective bargaining.
The "stickiness" comes in because such coalitions take time in order to act collectively. Unexpected inflation means the above-market (nominal) price they have previously set is now closer to the market-clearing price.
Posted by: Wonks Anonymous | November 23, 2010 at 02:15 PM
TGGP/Wonks: Ah! That's what you meant! I don't think of that as a theory of *nominal* stickiness. I don't see it as a theory of stickiness at all. I see it as a generalisation of the monopoly union theory of why real wages are too high, and why there's unemployment in equilibrium. As a theory of why the natural rate of unemployment is high, it makes sense. It's another way of thinking about what I've been saying about why monopolistically competitive firms will have excess supply. It's doesn't explain why nominal wages and prices are sticky, so that monetary shocks have real effects.
Posted by: Nick Rowe | November 23, 2010 at 02:58 PM
But are wages and prices really sticky? I think there is good data out there (pdf warnings) that says that prices are not sticky at all. But rather that prices don't respond to macro monetary shocks and output declines in the way that theory predicts, and so they appear to be "stuck" at a level that is not optimal according to the theory. Perhaps the models are wrong, and the prices are not too sticky.
The whole concept of sticky prices is a bit strange. Imagine if physics took this approach, and their response to the Kepler problem was to declare that Mercury was "sticky", rather than deciding that there was a theoretical deficiency in their current understanding of the laws of motion.
Posted by: RSJ | November 23, 2010 at 07:36 PM
there is good data out there (pdf warnings) that says that prices are not sticky at all
Yes, the concept has always bothered me too, but I attributed that to my relative macro-ignorance.
My personal supermarket experience matches that of the Bank of England ;)
Posted by: vjk | November 23, 2010 at 08:25 PM
Olson argued in his book that there's empirical evidence that wages have gotten more "sticky". He cites Phillip Cagan on the tendency for prices to fall during recessions gradually declining over time from 1890. The endnote refers to an essay titled "Persisten Inflation". He also writes that deflation did not have the present association with unemployment (in a more provocative note he argues that before the 1890s our concept of unemployment wasn't common enough to have a term) or reduction in output, and that modern societies which have not developed a multitude of distributional coalitions also manage to combine lower unemployment rates with low inflation.
His explanation for why it is a sticky nominal wage which monetary policy can alleviate (or exacerbate) is that when distributional coalitions set prices (as in a collective bargaining agreement) it is in nominal terms. Such coalitions act slowly & deliberately to keep its members on board and they cannot quickly readjust the nominal prices they have set. But some "flexprice" sectors are more open to entry and so the unemployed may all try to rush to them, driving down prices in that sector much further than normal (agriculture and "selling apples on streetcorners" are his examples from the Great Depression).
Olson seemed to lump his theory in with Clower's disequilibrium view, even using the term "Clower-Olson". I've yet to come across any good popularization of the Clower/Leijonhufvud "post-walrasian" paradigm for laymen (possibly asking too much). I'd be interested in any pointers readers have.
Apologies for the two nicks. I blog under this name but decided I'd rather not have all my writings linked to a computer I use at the office.
Posted by: TGGP | November 23, 2010 at 08:59 PM
TGGP,
I think wages have to be more sticky. The uncertainty costs of getting up each morning and not knowing how much you will earn that day are pretty high. We can't all wait an interminable period of time, constantly revising our reversible bids, before the walrassian auctioneer finally announces what it costs us to buy a car into to drive to work, and earn enough money to buy the car ex-post. And in that case, we need some certainty of what our wage will be before we put in a bid for the car. Something has to break the loop and allow us to purchase long lived durable goods.
I also think that you have to have coalitions and rents, because there are many increasing return industries in which average costs are above marginal costs at pretty much all conceivable quantity levels, and unless you have labor coalitions that insure that average wages are above marginal product of labor, then you are not going to get market clearing. But that does not mean that the rents are split fairly in all cases. Look at managerial or CEO pay, for example, for a good example of out of control coalitions, in this case the cross membership on boards of directors.
And there are other examples of "natural" sticky prices -- for example, many prices reflect expectations over longer periods of time. For example, a long term interest rate, or a long term cost of capital. By definition, when the price of something represents inputs that cover many time periods, then it cannot move as quickly in response to a current period demand shock. That's not true for the price of eggs, obviously.
But none of that means that sticky prices prevent reaching some optimal output equilibrium. The optimal equilibrium could require some stickiness in some categories of goods in order to be reached in the first place.
Posted by: RSJ | November 23, 2010 at 09:24 PM
The normative issues you bring up are more complicated than I'd care to get into right now (though I do agree that CEOs are overpaid, and Olson repeatedly noted that distributional coalition is not synonymous with labor union but they are merely a commonly recognized example), but I'd like for you to elaborate on the failure of markets to clear in the absence of labor coalitions. It's a theory I hadn't come across before (in the simplest classical models, markets always clear and frictions are introduced to explain why they might not). Is this some kind of monopsony theory, whose deadweight loss is analogous to the more well known monopolist who cannot price discriminate? Jobs aren't exactly fungible goods whose differentials can be arbitraged away.
Posted by: TGGP | November 24, 2010 at 12:44 AM
"Is this some kind of monopsony theory, whose deadweight loss is analogous to the more well known monopolist who cannot price discriminate?"
Yes, even without frictions, the assumption that workers are paid their marginal product relies on constant returns to scale, and doesn't necessarily hold when there are different industries with different labor productivity levels hiring from the same labor pool.
For example, assume you have farming and manufacturing in a developing nation. Nothing forces the manufacturing wage to be bid up to the level that reflects the higher labor productivity in that sector. It could be just slightly higher than the agricultural wage. A "small" manufacturing firm would have lower labor productivity, so you cannot argue that some other firm will come along and bid up the wage. That argument pre-supposes scale-invariant labor productivity.
The natural monopoly, or oligopoly depending on the elasticity of substitution, will be able to pay a wage just slightly higher than the less productive industries. Historically, industrialization was accompanied by natural monopolies and oligopolies *not* paying a substantially higher wage, and hence the birth of organized labor in the same era.
"Jobs aren't exactly fungible goods whose differentials can be arbitraged away."
That's the key issue. There is no a priori reason to believe that differentiations in competency and skill will exactly match the differing labor productivities across industries, as the latter changes quickly with technology. When they don't match, coalitions are formed to further differentiate the labor force by requiring certain levels of training or group membership that are not strictly required in order to perform the job, but whose purpose is to differentiate the labor force.
It doesn't matter that workers are not perfect substitutes for each other. What matters is whether the full differential in labor productivity is passed onto the worker when they are pulled out of the less productive sector. If the costs of training someone to transition from the agricultural sector to the manufacturing sector are not too high -- and they would need to be very high in NPV sense -- then you can earn a profit by paying someone just a bit more than they are making in the less productive sector.
And let's be honest, there is nothing intrinsically more difficult about doing repetitive tasks in a factory than working on a farm. And the manager of such a factory is not particularly more skilled than a manager of a farm. A lawyer is not particularly more skilled than a school teacher, etc. You can see this in the "training phases", from apprentice to laborer journeyman to "wright" or master crafstman. It's the same person, with more or less the same talents, but they have jumped through more hoops. They is learning, of course, but that learning is not strictly required to perform most of the daily tasks of the job. You don't need someone with a PhD to teach econ 1. You require it because of coalitions.
The majority of daily tasks that most people perform can be replaced by someone with much less training and fewer skills. The remaining 10% can be handed off to a superstar. Coalitions exist to prevent this so that the doctor is not replaced by a registered nurse, even though the RN can do 90% of what a GP does. And an LPN can do 90% of what an RN does. And an orderly with a few semesters of training can do can do 90% of what an LPN does. You can can replace professors with instructors, etc. But when this happens, the savings will not be passed onto the consumer, but will appear as rents in the various sectors.
The "efficient" level of coalitions is when the coalition-augmented labor force is exactly as differentiated as the labor productivity differentials within industry, so that the wage differential of hiring a unionized factory worker is equal to the greater labor productivity in that industry. Note that this has nothing to do with "how hard" the union worker works, or what their natural talents are. The whole point is that there isn't going to be a significant differential in natural endowments, and yet due to technology, labor productivity is higher in some industries.
Posted by: RSJ | November 24, 2010 at 10:55 PM
They "is" learning! sorry for the Bush-ism :)
Posted by: RSJ | November 25, 2010 at 12:22 AM
RSJ: "The whole concept of sticky prices is a bit strange. Imagine if physics took this approach, and their response to the Kepler problem was to declare that Mercury was "sticky", rather than deciding that there was a theoretical deficiency in their current understanding of the laws of motion."
We (sticky price macroeconomists) *know* it's a bit strange. We "know* there is a theoretical deficiency in our current understanding of the laws of motion (of prices). We want a theory which explains sticky prices. We don't have one yet. So we patch our existing theory. It's the best we can do. It's crap, but it's better than ignoring the problem with the orbit of prices.
"And there are other examples of "natural" sticky prices -- for example, many prices reflect expectations over longer periods of time. For example, a long term interest rate, or a long term cost of capital. By definition, when the price of something represents inputs that cover many time periods, then it cannot move as quickly in response to a current period demand shock. That's not true for the price of eggs, obviously."
Long-term interest rates move more slowly than short-term interest rates. That doesn't mean they are sticky. They aren't sticky at all (almost). There is (almost) never excess demand or supply of government bonds. The interest rates on long bonds moves less than on short bonds for the same reason that averages move more slowly than each of the items that makes up the average.
"Yes, even without frictions, the assumption that workers are paid their marginal product relies on constant returns to scale, and doesn't necessarily hold when there are different industries with different labor productivity levels hiring from the same labor pool."
If firms takes wages as given, in a competitive labour market, wages (for identical workers) will be equalised across all sectors, and will be equal to the Marginal *Revenue* Product (= Marginal Revenue x Marginal product) in each sector. But a firm that has monopoly power in its output market (it faces a downward-sloping demand curve) will have Price greater than Marginal Revenue. So the *Value* Marginal Product (= Price x Marginal Product) will be higher in firms that have monopoly power.
The assumption of constant returns to scale is not needed for this result. The only relevance of constant returns to scale is that increasing returns to scale is incompatible with long run equilibrium perfect competition in the output market.
Posted by: Nick Rowe | November 25, 2010 at 06:20 AM
"The recession is not caused by an excess of desired savings over investment."
Yes, it is.
Posted by: Adam P | November 25, 2010 at 06:59 AM
"they choose to save in the form of money instead. It is the excess demand for the medium of exchange that causes the recession."
No, this is false for two reasons. Both sentences are completely wrong.
First, in the recession nobody increases their savings. The patient *reduce* their savings.
Secondly, the recession happens even in a world with no outside money. So the second sentence can't be correct.
Posted by: Adam P | November 25, 2010 at 07:38 AM
Adam: we disagree on the first, and have argued it over without a resolution.
On the second, the net stock of outside money can be zero in the limiting case of a Woodfordian NK model. But that does not mean that the net demand for outside money is identically equal to zero.
By analogy, the stock of net debt is identically equal to zero in any economy (barter or monetary). But that does not mean the net demand for debt is identically equal to zero.
Posted by: Nick Rowe | November 25, 2010 at 10:29 AM
Clarification on the first part of my above comment: (Actually scrap what I said in the first sentence above):
It depends whether we are talking about desired saving the existing rate of interest or actual saving at the new equilibrium rate of interest. It also depends on whether we interpret the actions of the impatient when the debt limit is reduced as something they *choose* to do or are *required* to do.
When the debt-limit is reduced: the patient do not change their desire to save (at the previous rate of interest); when the rate of interest falls, they desire to save less as a result. In the new equilibrium, they do actually save less. The impatient are required to save more (dissave less).
Posted by: Nick Rowe | November 25, 2010 at 10:39 AM
"But that does not mean that the net demand for outside money is identically equal to zero."
But the demand for outside money, in equilibrium (even in the recession equilibrium) is zero!
You need to work through the appendix to see this but what actually happens is that as the debtors pay back the debt (denominated in the consumption good) the savers use the added consumption to simply maintain consumption and work less.
They don't try to save more! (they don't want to save in any medium).
Posted by: Adam P | November 25, 2010 at 12:14 PM
Adam: "But the demand for outside money, in equilibrium (even in the recession equilibrium) is zero!"
Agreed. Normally, the central bank adjusts the rate of interest to ensure that the demand for money equals zero, at that rate of interest. But if the bank can't or won't adjust the rate of interest, income adjusts until the demand for money equals zero, at that level of income.
The debtors (the impatient) don't really want to save more, but they are required to save more. It would be better if I said "planned" saving increases, rather than "desired" savings increases, (...and so interest rates fall or income falls until planned savings is zero.
Posted by: Nick Rowe | November 25, 2010 at 12:31 PM
The point here is that the proximate cause of the recession here is manifestly not an excess demand for or hoarding of the medium of exchange.
In this model, the recession happens even if it's a barter economy. Even if their is no medium of exchange.
Posted by: Adam P | November 25, 2010 at 03:40 PM
Adam: OK. That's where we disagree. The GE/PK model *is* a model of monetary exchange. If it were a barter economy, firms would simply increase output and swap their output with other firms' outputs.
Posted by: Nick Rowe | November 25, 2010 at 03:45 PM
NO! You're wrong! It's not a model of monetary exchange.
The firms don't do that because the patient workers won't supply more labour! They prefer to work less and use the labour of the deleveraging debtors to maintain their consumption.
And the debtors of course can't consume more, they work as much as ever and hand over some of their output to the savers.
The firms *can't* increase output and barter it.
Posted by: Adam P | November 25, 2010 at 03:57 PM
Actually your last comment was also wrong for a more basic reason which is that firms don't consume, the firms don't desire the output of other firms, but I guess that's not literally what you meant.
Posted by: Adam P | November 25, 2010 at 04:00 PM
I know that we've already argued this and failed to agree. I'm just bringing it up again because it just hit me that when you construct examples you usually assume that labour is supplied inelastically.
But this model has a standard neoclassical labour market, workers have a disutility of supplying labour.
Posted by: Adam P | November 25, 2010 at 04:06 PM
Nick,
"Long-term interest rates move more slowly than short-term interest rates. That doesn't mean they are sticky. They aren't sticky at all (almost). There is (almost) never excess demand or supply of government bonds. "
Yes, the financial markets always clear -- so what? Interest rates are not going to be set by the intersection of a supply curve of *final* borrowers with a demand curve of *net* savers. The prices will be set by *all* sellers of assets transacting with *all* buyers of assets. Moreover, in aggregate, the increase in savings necessary to fund investment comes from the investment itself.
The motivations of the sellers and buyers (e.g. whether they plan on spending the proceeds of their sale on the purchase of goods, or on the purchase of another financial asset) is not going to affect the auction price. Yet your argument crucially rests on someone *only* borrowing in order to spend, and *only* lending as a result of prior new savings.
One way to imagine this distinction is to look at the housing market. Most house purchases are by people already selling their existing home and moving into another used home. They could be moving to another location, trading up, trading down, etc. But in the vast majority of transactions, people are just swapping the houses that they currently have with each other, and in this way they are setting the overall price of housing. The price of housing is not going to be set by the supply of *new* homes being built by homebuilders intersecting with the demand of people without a house to buy one. Both of the above are insignificant, in terms of volume.
Therefore supply and demand of new home-builders and the new home buyers will have little effect on the price of house. And in the same way, the supply and demand of final borrowers and final lenders will have little effect on the price of a financial asset.
Now why would houses just sit in foreclosure, unsold? A bank forecloses on a houses and the new buyer can only afford a cheaper price. Why wouldn't the bank sell the house to the buyer at the lower price? Is it because we don't barter?
No, it's because the seller believes that next period, a higher bid will appear. It may well be in their economic interest, in the sense of expected utility, to leave the resource idle, rather than transacting at the current price. And in this sense the prices will appear to be "sticky", as you have empty houses waiting to be sold, as well as willing buyers waiting to buy, but they cannot agree on a price. The price doesn't fall enough for the market to clear *in the current period*, because of possibly of a divergence of expectations of the future prices.
OK, that is a partial equilibrium analysis. But the general case holds as well. Because the cost of capital is not the intersection of the demand of net investors with the supply of net savers, but is determined by expectations of the future return on capital over many periods, it could be that, in a give period, the rate demanded is higher than the return available for increasing the capital stock in that period. In that case, it would be better, from the point of view of the individual investor, to defer investment and wait until the situation improves. But that deferral of investment means that the current period of would-be savers will be disappointed -- they will not receive the income arising from the investment that they need to save, and if they require that level of savings in order to repay debts, then they will try to save even more, causing current periods to be even lower, curtailing investment in the present period even further, etc, up until a default occurs or their income adjusts to a sufficiently low level that they do not wish to save anymore.
None of this has anything to do with a desire to "hold the medium of exchange". All of the above works equally well in a barter economy with long lived (real) assets purchased with long term debt.
Posted by: RSJ | November 28, 2010 at 01:49 AM
Thank you, Nick and Matt, for your replies to my query about Ricardian Equivalence. I don't completely understand your answers, but at least I know that you have good reasons for thinking that the demand-side Laffer Curve argument doesn't work in the E-K model, but may work in a different model.
Posted by: Kien | November 28, 2010 at 03:31 AM
Adam: "I know that we've already argued this and failed to agree. I'm just bringing it up again because it just hit me that when you construct examples you usually assume that labour is supplied inelastically.
But this model has a standard neoclassical labour market, workers have a disutility of supplying labour."
That's true. I ought to be able to make essentially the same argument even when the supply of labour is not perfectly inelastic. But it does make it harder for me to put that argument into words. And when firms are imperfectly competitive, it's even harder for me. (Actually, thinking about Bertrand Competition in a Barter economy is conceptually hard as well, because what is the medium of account in which each of the n firms sets its price? I would have to re-formulate it as Cournot equilibrium, plus I would need the proof that Bertrand and Cournot converge in the limit as n approaches infinity, with or without differentiated products (which I did prove once, decades ago).
Posted by: Nick Rowe | November 28, 2010 at 09:23 AM
"That's true. I ought to be able to make essentially the same argument even when the supply of labour is not perfectly inelastic."
But you can't because your argument won't end up being true and the Krugman/Eggertson paper is a counter example.
Now, I imagine that you're thinking that the recessionary outcome must involve hoarding money because it's caused by the debtors retire some debt and thus reducing their expenditure on new production while the savers don't increase their expenditure by the full amount of the transfer that they receive. If there is money in the economy and the debt contracts are paid off by monetary transfer then you'd be right, the savers would end up increasing their money holdings as a saving medium and that could be correctly taken as the cause of the recession.
However, suppose it is a barter economy and the debt contracts are settled by a transfer of a specified nominal quantity of the consumption basket (the index). Here we have some nominal unit of account (numeraire) which we can call dollars but dollars are *not* the medium of exchange. (this works because if the individual wants a basket different from the index he can trade to the basket he wants).
Now, when the deleveraging comes the debtors pay back some of their debt aquiring the consumption basket in the market and transfering it to the savers. What do the savers do?
If the savers supplied labour inelastically then you'd be right, no recession, there'd be extra output available and the savers would consume it instead of throwing it away (suppose consumption basket is entirely non-storable).
In this model though that isn't what happens. The savers optimality conditions mean that they simply use the consumption goods they receive in payment of the debt to maintian their consumption while supplying less labour. Since they supply less labour there is no excess of consumption goods available.
There is no money, nobody hoards the medium of exchange since it doesn't exist. The economy is pure barter yet has a recession.
Posted by: Adam P | November 28, 2010 at 11:02 AM