Thursday, 14 February 2013


I don't want to give the impression I am picking on Pr. Raghu Rajan but he has published another article I am going to comment in extensive details.

I blame Tyler Cowen for this :) . He's the one, through his Marginal Revolution blog, who keeps attracting my attention to the Prof. Raja's work.

That being said, supply siders should breathe with a little bit of relief before starting reading - As it happens, I think that Prof. Rajan does have a bit of a point here when it comes to the efficacy of fiscal stimulus.

"Two fundamental beliefs have driven economic policy around the world in recent years. The first is that the world suffers from a shortage of aggregate demand relative to supply; the second is that monetary and fiscal stimulus will close the gap.

Is it possible that the diagnosis is right, but that the remedy is wrong? That would explain why we have made little headway so far in restoring growth to pre-crisis levels. And it would also indicate that we must rethink our remedies.

My comment: Interesting premise as it's hard for Keynesians to disagree with the set-up. People like Krugman would probably immediately counter-argue that it's because we haven't stimulated enough but, okay, let's see where this is going...

High levels of involuntary unemployment throughout the advanced economies suggest that demand lags behind potential supply. While unemployment is significantly higher in sectors that were booming before the crisis, such as construction in the United States, it is more widespread, underpinning the view that greater demand is necessary to restore full employment.

My comment: A point well worth re-emphasizing. We too often see people arguing that it's all about some sectorial/structural unemployment and 'nothing can be done'. Don't we, Pr. Rajan?

Policymakers initially resorted to government spending and low interest rates to boost demand. As government debt has ballooned and policy interest rates have hit rock bottom, central banks have focused on increasingly innovative policy to boost demand. Yet growth continues to be painfully slow. Why?

What if the problem is the assumption that all demand is created equal? We know that pre-crisis demand was boosted by massive amounts of borrowing. When borrowing becomes easier, it is not the well-to-do, whose spending is not constrained by their incomes, who increase their consumption; rather, the increase comes from poorer and younger families whose needs and dreams far outpace their incomes. Their needs can be different from those of the rich.

My comment: You know, few people feel that their spending is not constrained by their income. You really have to go up the social scale. However, yeah, sure, the spending patterns of the well-heeled and the poor are likely to differ...

Moreover, the goods that are easiest to buy are those that are easy to post as collateral – houses and cars, rather than perishables. And rising house prices in some regions make it easier to borrow even more to spend on other daily needs such as diapers and baby food.
The point is that debt-fueled demand emanates from particular households in particular regions for particular goods. While it catalyzes a more generalized demand – the elderly plumber who works longer hours in the boom spends more on his stamp collection – it is not unreasonable to believe that much of debt-fueled demand is more focused. So, as lending dries up, borrowing households can no longer spend, and demand for certain goods changes disproportionately, especially in areas that boomed earlier.

Of course, the effects spread through the economy – as demand for cars falls, demand for steel also falls, and steel workers are laid off. But unemployment is most pronounced in the construction and automobile sectors, or in regions where house prices rose particularly rapidly.

My comment: But is that true? First, people did treat their houses as ATMs i.e. borrowed and spent against them on all kind of goods. So, in that respect, housing wealth, via the mechanism of 'home equity extraction', acted just as an increase in disposable income would. Second, as the Prof. Rajan himself noted, the job losses cut across sectors even if the ones closest to the deflagration (housing and finance) logically suffered most.

It is easy to see why a general stimulus to demand, such as a cut in payroll taxes, may be ineffective in restoring the economy to full employment. The general stimulus goes to everyone, not just the former borrowers. And everyone’s spending patterns differ – the older, wealthier household buys jewelry from Tiffany, rather than a car from General Motors. And even the former borrowers are unlikely to use their stimulus money to pay for more housing – they have soured on the dreams that housing held out.

My comment: This is mixing too many things. One is about expectation - "they have soured on the dreams that housing held out" and the other is about spending patterns but, again, without reasons or context being given as to why it matters.

As to why a one-off or temporary income boost might not be spend, it's easy to explain by noting that people are not fools and treat windfalls differently than they would an increase in long term projected earned income.

Indeed, because the pattern of demand that is expressible has shifted with the change in access to borrowing, the pace at which the economy can grow without inflation may also fall. With too many construction workers and too few jewelers, greater demand may result in higher jewelry prices rather than more output.

My comment: One, it'd be almost as easy to target stimulus than to make it all-encompassing and, two, it seems pretty obvious to me that the risks, right now and for the past years, have been geared towards deflation. Indeed, without the constant actions of Central Banks the world over, I really doubt we wouldn't have seen actual persistent deflation... If there are sectors that are suffering from demand-led inflation, I would like to know and Pr. Rajan should have no problem finding examples.

Put differently, the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand. Unlike a normal cyclical recession, in which demand falls across the board and recovery requires merely rehiring laid-off workers to resume their old jobs, economic recovery following a lending bust typically requires workers to move across industries and to new locations.

My comment: As I said, there is no evidence that any specific sector is facing too much demand i.e. demand hasn't changed beyond cratering then recovering albeit slowly but leaving behind residential housing (though that may be changing, slowly).

Furthermore, while it is certainly true that some workers might have to move across industries, we could easily have eased the process in the USA where the infrastructure seems to be crumbling (oft-quoted 70,000 bridges in desperate need of repairs). That could have used tons of construction workers thus easing off the pain of some of them having to move to other industries.

There is thus a subtle but important difference between my debt-driven demand view and the neo-Keynesian explanation that deleveraging (saving by chastened borrowers) or debt overhang (the inability of debt-laden borrowers to spend) is responsible for slow post-crisis growth. Both views accept that the central source of weak aggregate demand is the disappearance of demand from former borrowers. But they differ on solutions.

The neo-Keynesian economist wants to boost demand generally. But if we believe that debt-driven demand is different, demand stimulus will at best be a palliative. Writing down former borrowers’ debt may be slightly more effective in producing the old pattern of demand, but it will probably not restore it to the pre-crisis level. In any case, do we really want the former borrowers to borrow themselves into trouble again?

My comment: No but it's not exactly clear how Pr Rajan's views of debt-driven demand actually differ from the neo-Keynesian explanation in any sense. We all recognize that debt had driven the pre-crisis demand.

Writing down the debt would have beneficial effects - even if chastised borrowers don't immediately jump back on the borrowing bandwagon - but it's true that nothing would work as well as getting people to change their expectations about their future earned income path...

The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand – to ease the way for construction workers and autoworkers to retrain for faster-growing industries. The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit.

My comment: But of course. Pr Rajan actually accepts the neo-Keynesian (or, hey, old Keynesian) views on the mechanisms destroying demand right now, he accepts that we are in a balance sheet recession and his only proposal is 'do nothing, let the supply side work it out'. I can only guess that such a hand-off approach is made easier by the cushy safety of a for-life professorship.

There are two or three ways governments could help right away, especially in the case of the USA (or could have helped, rather).

1- Targeted infrastructure spending. Shovel ready projects weren't so shovel ready, it seems. Still one would imagine that there are limited downsides to addressing crumbling bridges. Again, in this respect, the USA seems to be in the 'luckier' position, compared to Europe, on having many worthwhile infrastructure projects. In Europe, a lot of projects would have to be about trying to convert existing infrastructures to green(er) ones. Worthwhile, for sure, but harder to sell to hard-pressed taxpayers who might reply that 'if it ain't broke, don't fix it'...

2- Debt relief for home-owners. Apart from the genuine human relief aspect of such programs, I do believe that reducing the need for people to prioritise debt reduction above consumption/investment could only be beneficial to AD, without even requiring people to start re-inflating their debt load. They'd just slow down the deleveraging.

3- Create the conditions for income growth. Nothing will beat that. If people can see income growth in their future, they will immediately slow down on debt reduction and consume/invest.

Income growth is obviously not something the government can decree but there are many ways in which it could contribute to making it happen, from protecting what's left of the unions to penalising profitable companies paying their workforce too little.

Supply-side adjustments take time, and, after five years of recession, economies have made some headway. But continued misdiagnosis will have lasting effects. The advanced countries will spend decades working off high public-debt loads, while their central banks will have to unwind bloated balance sheets and back off from promises of support that markets have come to rely on.

Frighteningly, the new Japanese government is still trying to deal with the aftermath of the country’s two-decade-old property bust. One can only hope that it will not indulge in more of the kind of spending that already has proven so ineffective – and that has left Japan with the highest debt burden (around 230% of GDP) in the OECD. Unfortunately, history provides little cause for optimism".

My comment: I don't always agree with Krugman. But he recently published an blogpost on Japan, re-iterating the well known fact that, per capita, Japan GDP doesn't look too bad. They have lost a decade, not two. So, in that respect, Japan fiscal stimulus was efficient. If Japan had a stable or growing population, the GDP would have been growing in absolute number and the debt load would look more manageable.

Bottom line: As per standard operating procedure, even when they recognise the importance of AD and its present weakness, supply siders want us to do what they always want us to do: nothing!

Sorry but that's not good enough. Not till someone explains me very clearly why the three options I mentioned for actions are either not feasible or will not result in a clear macro-economic improvement. 

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