From Delong on macro economics and financial markets

A long one to read but entirely worth it as our classes begin…..

 

3.2. Macroeconomics and Financial Markets

Economists have argued for more than a century about just what is the financial market excess demand that produces the shortfall in aggregate demand for goods and services. As best as we can see, all these debates have been fruitless and counterproductive. It is like the parable fo the blind philosophers and the elephant: each is touching a different piece of the elephant, and each is correctly reporting what he or she feels, but all are wrong in being voiciferously sure that the piece of the animal that they have hold of is the entire beast.

Briefly, economists looking for the origins of recessions and depressions have broken up into three schools or sects. One sect, call them “Keynesians,” after the late English economist John Maynard Keynes of Cambridge University, sees the financial excess demand as an excess demand for bonds. A second sect, named “monetarists” by their intellectual leaders the late Irving Fisher of Yale and the late Milton Friedman of Chicago and Stanford, sees the financial excess demand as an excess demand for cash. And there is a third small sect which does not have a common agreed-upon name–call them Minskyites after the late Hyman Minsky, an economist at Washington University at St. Louis–sees the financial excess demand as an excess demand for safety, for high-quality places where you can put your wealth and be confident that it will not melt away and disappear.

3.2.1. Keynesians

One of the oldest sects, tracing its ancestry back to Swedish economist Knut Wicksell in the late nineteenth century, a sect now called “Keynesians” (to the great annoyance of Swedish economists) sees the financial excess demand as an excess demand for bonds. Bonds–and stocks, and loans, and other such assets–pay interest, dividends, return to you their principal or par value in the future, perhaps pay capital gains. They are all vehicles which you can use to move purchasing power from the present to the future: vehicles that people use to save. Bonds are created when businesses borrow and issue them to finance their investment spending and when the government borrows in order to finance its deficit spending.

To Keynesians–or perhaps more properly Wicksellians–downturns begin when households want to buy more bonds (and stocks, and pieces of real estate) to add to their financial wealth than businesses and the government together want to issue: when savings is greater than investment (plus the government deficit). The attempt by households to redirect their wealth from buying currently-made goods and services to buying bonds–to saving–is what produces the initial deficiency in aggregate demand that sets the downturn in motion.

Thus we reach the recommended economic policy of the Keynesians. If a downturn is the result of an excess of savings over investment plus the government deficit, take policy steps to:

  1. increase household confidence so that they are willing to spend more and save less.
  2. by reducing interest rates or otherwise improving the investment climate, induce businesses to spend more money investing to add to their capacity and so issue more bonds.
  3. expand the government deficit so that the government will issue more bonds that households can then hold.

All three sets of policies eliminate the excess demand for bonds, and so also remove the deficient aggregate demand for currently-produced goods and services that sets the downturn in motion.

3.2.2. Monetarists

The second sect, Irving Fisher’s and Milton Friedman’s monetarists, starts with the observation that cash is a very special asset in any market economy. It is what you use to buy things–you show up at the store with cash (or with your credit card which is a promise that VISA will pay them in cash, or with your checkbook with a live and valid balance which is a promise that your bank will pay them in cash), and the storekeeper will accept your cash as payment and let you buy your stuff. Economists call this asset “money.” (Note that in so doing they deviate from normal English usage, in which “money” can mean “wealth” as well as “cash”: when we say that somebody “has a lot of money” we don’t mean that they have $10,000 in their pocket.) The monetarists there that downturns in production and employment are always due to an excess demand for cash money. When something has disturbed the supply or demand for liquid cash money so that households and businesses have less of it than they wish, they slow down their spending in an attempt to build their cash balances up, and it is this slowdown in spending that launches the downturn. A number of things can trigger such an excess demand for liquid cash money:

  1. Under a gold standard, the shipment of gold bars abroad to pay for imports reduces the money supply, and so creates an excess demand for money–and thus to deficient demand for goods and services.
  2. Open-market sales of government bonds by a central bank like the Federal Reserve by which the central bank trades government bonds for cash diminishes the supply of and so creates an excess demand for money–and thus to deficient demand for goods and services.
  3. A loss of confidence by households in the banking system or in finance leads them to trade interest-earning assets for cash and then to stuff that cash under their mattresses increases their demand for cash money, and so leads to an excess demand for money–and thus to deficient demand for goods and services.
  4. A failure of or runs on important banks that eliminate or freeze the checking-account deposits of households leads them to try to get more cash in their pockets and leads to an excess demand for money–and thus to deficient demand for goods and services.
  5. A loss of confidence and a failure of nerve on the part of businesses that leads them to think that they need to have larger cash balances to deal with economic uncertainty creates an excess demand for money–and thus to deficient demand for goods and services.

Everybody needs cash–and/or a checking account at a reliable bank with cash, and/or an unspent balance on a credit card–in order to carry out their normal day-to-day transactions. What happens when people find that they have less cash than they wish? They cut back on their spending and divert some of their income to trying to build up their cash balances. That cut back on their spending is, monetarists say, the thing that produces the initial fall in aggregate demand that sets the downturn in motion.

Thus we reach the recommended economic policy of the Monetarists: have a central bank that uses open-market operations to keep the supply of cash money in balance with demand, they say. Without any excess demand for cash, there will be no deficient aggregate demand for goods and services. And so there will be no downturns: no depressions, no recessions, no “general gluts.”

3.2.3. Minskyites

There is a third sect, until recently too small and too disorganized to have a name. We call them Minskyites. This sect says that, for big downturns at least, the key is not that the economy has too little cash money or too few bonds, but instead that it has too few high-quality safe assets. It is not that people are cutting back on spending on currently-produced goods and services because they want to have more cash in their pockets or more bonds in their portfolio than exist. Instead, people are fearful that their wealth is unsafe: that they need to sell their risky assets and buy safe ones or else their wealth might simply melt away overnight as whatever partnerships, companies, banks, or governments they have invested in shut their doors, fail, and default on their debts.

Thus the policy recommendation of the Minskyites: bailout. The problem is that the economy does not have enough safe high-quality assets, and the private sector cannot create more because nobody trusts any partnership, company, or bank to be good for its current debts let alone for any new ones it might create. The solution is for the government to step in: to support shaky banks so that they can meet their obligations, to take over shaky companies and recapitalize them, to issue its own safe high-quality bonds and use the proceeds to buy up risky private assets, to generally calm the panic.

There are many problems with bailout as a policy. It is unfair, and it sets the stage for more trouble down the road. It is unfair in that it enriches those very financiers and investors whose reckless, speculative, and heedless portfolio strategies that triggered the panic and the general rush by everybody to move a greater proportion of their portfolio into safe, secure, high-quality assets. Those whose actions set the stage for the downturn should not profit. It sets the stage for more trouble down the road because every time Minskyite policies of bailout are adopted risk-loving financiers become more confident that the government will bail them out the next time as well, and so see even more of an incentive to engage in reckless, speculative, and heedless portfolio strategies.

As the late MIT economist Charles Kindleberger put it, writing of the need for a “lender of last resort” to perform the bailouts, but:

if the market is sure that a lender of last resort exists, its self-reliance is weakened…. The lender of last resort… should exist… but his presence should be doubted…. This is a neat trick: always come to the rescue in order to prevent needless deflation, but always leave it uncertain whether rescue will arrive in time or at all, so as to instill caution in other speculators, banks, cities, or countries…. some sleight of hand, some trick with mirrors… [because] fundamentalism has such unhappy consequences for the economic system…

Or as former Federal Reserve Vice Chair Don Kohn put it, the lender of last resort should act because teaching a few thousand investment bankers a lesson that they deserve is not worth doing if the cost is the jobs of millions.

Back in the nineteenth century, London Economist editor Walter Bagehot had a plan for how to deal with such panics and crises. The central bank and the government should, he argued, support the market by buying up risky assets and issuing safe ones and so satisfying the market demand for extra safe-high quality assets. But it made sure that those whose excessive speculation had caused the problem did not profit. “Lend freely” to banks and other financial institutions that needed safe assets in order to avoid banruptcy themselves, “but at a penalty rate”–at a high rate of interest which would make them poor in the long run as they were forced to hand over their cash or ownership stakes in their firms to the government, and would make them wish that they had not been so reckless in the first place.

In the late financial crisis central banks and governments have followed the first half of Walter Bagehot’s plan. They have indeed “lent freely” in order to increase the supply of safe, high-quality financial assets. But they have been unable or unwilling to implement their policies in such a way that their support for financiers is “at a penalty rate,” and leaves financiers poor and wishing they had been more prudent before the crisis.

3.2.4. Who Is Right?

Which of these three sects is right?

All of them–sometimes. Each has been right at at least one moment in the past generations.

We can see when there is an excess demand for liquid cash money that you can use to purchase things in the economy. When there is an excess demand for liquid cash money, savers and investors are trying to sell all their other financial assets at whatever prices they can in order to get their hands on cash. Thus the prices of stocks, real estate, and bonds are low–which means that the interest rates on all kinds of bonds are very high, for when the price of a bond is low the interest coupon it pays every six months is a large proportion of its value. In 1982 there was such a liquidity squeeze in the U.S. economy: pretty much everybody was attempting to build up their cash balances and trying to sell other financial assets to do so, and interest rates reached their highest levels of the post-World War II period.

Where did this liquidity squeeze–this excess demand for liquid cash money–come from in 1982? It had been deliberately created by the Federal Reserve, which believed that it had to break the cycle by which Americans had come to expect that each year would see 10% inflation. The only way to do that, then Federal Reserve Chair Paul Volcker and his colleagues concluded, was to create a situation of high unemployment, slack capacity, low production, and depression economics so that neither firms nor workers would dare to ask for the price and wage increases that they had planned. It worked: the 1970s had been a decade of accelerating and the 1980s were a decade of low inflation. It came at a high cost: the unemployment rate peaked at 10.8% at the end of 1982.

We can see when there is an excess demand for bonds–for vehicles to carry purchasing power forward from the present into the future, when there is a savings glut. When there is an excess demand for bonds, savers are willing to pay almost any price for bonds and as a result the interest rates on pretty much all kinds of bonds are very low, for when the price of a bond is high the interest coupon it pays every six months is a low proportion of its value. In 2003 there was such a savings glut in the U.S. economy and indeed worldwide: pretty much everybody was attempting to buy up bonds to hold so that they could shift spending on goods and services from the present into the future, and interest rates as a group reached their lowest levels of the post-World War II period.

And over the past three years we have seen an excess demand for safe, high-quality assets. That has been the excess demand that has triggered pretty much everybody to cut back on spending on current goods and services as they try to build up more wealth in vehicles in which they can be confident it will not melt away. When there is an excess demand for high-quality assets, then the prices of risky assets– stocks, real estate, and corporate and other bonds seen as possible candidates for default–will be low, which means that the interest rates on risky bonds will be high, for when the price of a bond is low the interest coupon it pays every six months is a large proportion of its value. By contrast when there is n excess demand for high-quality assets, then the prices of safe assets–bonds issued by governments regarded as credit worthy, and private loans guaranteed or backed in some way by governments or by ample collateral–will be high because savers are willing to pay almost any price for high-quality bonds, and as a result the interest rates on high-quality bonds will be low, for when the price of a bond is high the interest coupon it pays every six months is a low proportion of its value. Credit spreads–the difference between the interest rates on high-quality bonds and risky bonds–will be extraordinarily high. And whenever a set of bonds shifts in investors’ expectations from being high-quality to low-quality–as the bonds of the government of Greece did–the interest rate on those bonds will jump massively. That is what we have seen over the past three years.

No pure types…

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