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Declining Consumption and Secular Stagnation

May 20, 2014
the Economy: Home and the World
4 Comments

Brad DeLong notes that lack of consumption is not especially responsible for currently low levels of aggregate demand. I am not so sanguine. At first approximation, this is hardly surprising. There is some truth to the Austrian principle that recessions arise from a decline  in investment during the boom. (There are many flaws to this theory, not the least that spending on consumption goods increases only in relative, not absolute, terms). Since most consumers smooth their spending over time, to the extent liquidity is not a problem (and it was), what happened is exactly what you would expect.

Unfortunately, to the extent this stagnation is secular, we can’t ignore consumption. Take a stylized accelerator model which says that I/Y_r = (K/Y)g_r, where I/Y and K/Y are the investment and capital stock to potential income ratio respectively and g is the potential growth rate. Let’s state secular stagnation as the state where an economy is (for the foreseeable future) demand constrained and g as a function of r drops by some constant amount. (That is, the real interest rate necessary to maintain some level of growth is lower than it used to be).

So, for whatever reason, when the long-run potential growth of the economy falls, firms are not as driven to invest in future profits and therefore the level of investment has to fall. This must either be accompanied by a corresponding increase in consumption or decrease in total income.

The question we should be answering then isn’t whether consumption has increased as a share of GDP, but whether it has increased enough given a lower potential growth rate. Even under generous assumptions, this is probably not the case:

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The growth in consumption as a share of GDP – which we will generously define as 1 – max_t(C)/min_t(C) – is just over 18%. Over the same period, real income grew by an average of 3.2%. Taking this as the former potential, and 2% as the new normal g has fallen by around 60%. Even with an optimistic assumption that the economy will grow at 2.5%, the fall in potential g still outweighs the increase in consumption. (This is all under the assumption that K/Y has and will remain fairly constant. Piketty says no. I don’t buy that this will be significant enough to outweigh everything else, but that is for another post). 

This is, of course, a simplistic assumption. The accelerator model is naturally stylized and investment may not fall nearly as much as suggested. Increased consumption of capital (“wear and tear”) may be one such reason, though that seems ever unlikely in an economy increasingly-oriented towards investments in intellectual property and information rather than coal mines. So if it is not the case that increasing consumption is necessary to maintain a certain level of income, it is certainly interesting to see the assumptions and model under which that is so.

The United States is simultaneously too much like China, and not enough like China. On the one hand, falling potential growth in both countries necessitate a decreasing reliance on private investment. On the other hand, unlike China, there is much the United States can and should do to increase public investment in green technology, basic research, and stronger infrastructure. 

The Problem with Pessimism

February 19, 2014
the Economy: Home and the World
3 Comments

A number of people have commented on a new paper from Robert Gordon, professional pessimist. Many people have identified the specific issues with the logic in this essay. But I think it’s important to discuss a central problem with the very idea of Gordonesque gloom.

First, distinguish between positive and negative pessimism. If NASA were to tell us, with great confidence, that an astroid will strike Earth tomorrow there is no case for disdain. This is a scientific judgement and, at least philosophically, would be akin to standing in front of a speeding train and claiming that it won’t hit you. That is not the sort of pessimism that concerns us. But Gordon is making a much more powerful claim, a pessimism about what won’t happen – that our entrepreneurs cannot create another industrial revolution, that we’ve pretty much done the most we can with robots, and artificial intelligence is limited to the grocery store.

This requires a certain knowledge about the trend of technological progress and the economic value thereof. Gordon knows much more about the former than most and may well be the reigning expert on the latter. Unfortunately that doesn’t help us out. Because, believe it or not, most any of us can make this claim without any technical skill and little more than economic knowledge.

If you knew that some form of AI was going to revolutionize the world, and that building it is tractable, there’s a good chance it already exists or will be built relatively soon. Because that’s all you need to know to make a profit from basically nothing (patent the idea and rent the rights out when someone who can build it builds it). But it’s very rare that we make something from nothing so most of us, like Gordon, don’t see anything great about the future.

But that only means that me, you and Gordon don’t know what that invention will be, not that some arbitrary such invention won’t be. So Gordon is claiming that the space of all future invention is limited and the costs of finding the marginal source of technological growth are limited and, equivalently, that he knows the space of all future growth.

That’s a rather strong claim. He rather strongly asserts that the last three stagnant decades are a better indication than the last century. Choosing the postwar boom may be an outlier but, accordingly, so too would choosing a bad period like the past fifty years arbitrarily. By claiming that he understands growth will slow, Gordon implicitly declares that he understands the mechanics of future innovation. 

But that isn’t the case with optimism. As statisticians will tell you, proving a positive is possible. You an always say “something may exist that we can’t even comprehend” – how could you disprove that. It’s not objective, and you’re not going to make money off this belief but it just isn’t as philosophically flawed as a belief in perpetual stagnation.
 
Most discussion about our economic future – on the scale Gordon speaks – has been horribly wrong (read a certain John Maynard Keynes’ Economic Possibilities for our Grandchildren) and claiming that there won’t be a new digital revolution tomorrow (or even in the next decade) is trivial. In fact, a central tenet of efficient markets is that you can’t keep beating the market and those who do are probably just lucky. (If we had growth denominated bonds Gordon could literally beat the market). 
 
The probably here is key. Maybe you’re a financial trader and play golf with a certain Janet Yellen. Or maybe you heard about Steve Jobs’ cancer before anybody else. But here there’s a clear source of the insider information. 
 
Unfortunately you and me can’t be insiders with God. 

The Defining Problem of Our Age

December 13, 2013
the Economy: Home and the World
12 Comments

Ezra Klein argues that inequality should not be shaping political discourse to the extent that it is. That’s probably true. But this article misses a few important points and, I think, doesn’t do the best job of characterizing the progressive argument. Or maybe we’re in agreement, and I’ve misunderstood – it’s hard to tell (though, given that I’m commenting on a Wonkblog post, more likely than not).

A quick preface. Arguing that “unemployment and growth, not inequality, will be the defining problem” of our age is dissonant beyond the mutual causality (which is not very well founded) Ezra acknowledges simply because inequality is only a problem when growth is a problem. I don’t remember much about the 90s – intellectually, my generation really was born of financial crisis and political gridlock – but it’s hard for many Americans to think of the Clinton era, despite rising inequality, as a bad time due to high rates of job creation and growth. Polls suggest that perception of inequality and class warfare are worse than usual – vindicated by both the Occupy and Tea Party movements.

As long as your income is growing – even if not nearly as quickly as financiers on Wall Street – it’s not hard to foolishly convince yourself that you have a same shot at those riches as the millionaire next door (Americans ubiquitously believe that equality of opportunity is a worthwhile goal). But when the music stops the story changes. Inequality is a problem, politically and economically, precisely because of secular stagnation.

That, by itself at least, does not mean inequality is the defining problem of our age. It’s worthwhile dividing problems into two categories: those that are urgent, and those that are important. It is also worthwhile noting that usually one does not imply the other. Let me be absolutely clear: the most urgent problem facing America today is unemployment. This is almost incontrovertible. Both progressives arguing that inequality is and conservatives arguing that deficits are urgent do discourse a disservice.

But candidates for the most important problem are more diverse still. Existentially, there is little more daunting than the tail risks from climate change. If the United States, China, and India do not legislate strict carbon taxes into law within the next two decades many other debates will become moot.

Less apocalyptic, but important over the long run still, are rising inequality and secular stagnation. But it is difficult to argue that growth is a uniquely more challenging problem than inequality. It is easy – and right – to rail against the stale debate that we ought to tax the one percent five percent more (as if that will solve anything), but (contra Dylan) most solutions to unemployment will actually increase both opportunity and equality. The Wonkblog post suggests most of the connection between inequality and growth come from a persistent demand shortfall resulting from income earned by those with a higher marginal propensity to save.

And while this has dominated some progressives corners of the blogosphere over the past week, it’s hardly the most important link between the two. Curing unemployment results in a tighter labor force which eventually results in what economists call a wage-price spiral as workers expect inflation to rise, and demand higher wages, forcing inflation to rise. As the unit cost of labor rises quicker than that of capital, we would hopefully see a return of labor share and general prosperity.

The best way to increase wages, employment, and equality would be for the government to contract labor supply by hiring all unemployed workers who want a job in menial, labor-intensive positions. This would increase inflation, reduce the primary balance, and force unskilled wages to increase more rapidly than cost of capital (human or physical).

Most things we do to reduce inequality would also increase growth, at least in the economic model (thematically, not rigorously) employed by proponents of secular stagnation like Paul Krugman or Larry Summers. The best way to deal with inequality would be to increase some form of handout, financed by a deficit, which would aid inequality and growth at the same time. In fact, other than the second-best solution of the minimum wage, it’s not easy to think of something that – within the Keynesian model many people in this conversation favor – would reduce inequality without improving growth.

Neither inequality nor growth are the “defining problem of our time”, but they are born of the same ill, low aggregate demand. In times when demand is high, society will tolerate much more inequality and growth will be limited by supply-side factors. In fact, that’s the reason growth per se is not a problem of our time. If we were experiencing inflation despite low growth rates, it is difficult for the wonks of the world to do anything about it. That is the realm of science and engineering.

But we’re not there yet and, as far as I can see, the most convincing arguments suggest that both inequality and growth are first cousins. You would really need a Republican to find a way to better one without bettering the other (and, arguably, the farm bill is a perfect example to this effect).

The Supply Constrained US Economy

November 13, 2013
the Economy: Home and the World
1 Comment

Not:

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I’ve read a lot of posts recently claiming that the Fed should throw in the towel, because “US growth is not what it used to be”. That could be true. It’s very difficult to suss out structural changes, but it’s unreasonable to be puritanical that our problems can be solved with, and only with, more aggregate demand. At least if you define “solve” as returning to the 1990s boom. However, it’s a bit aggravating when people insist that this has anything to do with what the Fed should or should not be doing.

The Fed’s not in the business of increasing productivity growth or managing real GDP. As far as I know, no model suggests that the economy is hitting its potential when inflation is unanchored well below its long-run trend. In fact, aggregate supply doesn’t even matter right now. When consumers are leveraged to the hilt a fall in prices from a productivity boom would just increase balance sheet constraints in the economy as the real-value of debt rises. 

The camp of economists that talks about monetary policy juicing up a dead economy – or whatever it is – likes model heuristics like NAIRU or the natural rate of unemployment, potential output, whatever:

Weak payroll growth, despite a speedy drop in joblessness, forced Bernanke in September to backtrack from a June statement in which he said the Fed expected to halt its bond-buying by mid-2014, when joblessness would be around 7 percent.

But some economists argue easier policy is not the answer given the economy’s shifting fortunes.

“Easy money will likely lead to asset bubbles or higher inflation, because policy is miscalibrated relative to … the economy’s underlying potential,” said Joseph LaVorgna, chief U.S. economist at Deutsche Bank.

He said potential GDP growth had “meaningfully downshifted” and warned of “potentially serious negative long-run implications” of current monetary policy.

It’s not clear to me what monetary policy has to do with asset bubbles. We should either not care about those or, preferably, outsource that to the macroprudential regulators. Asset prices shouldn’t be a cornerstone of any monetary policy (which, incidentally, is why we should be skeptical of the wealth effect from quantitative easing). But let’s go back to what Deutsche Bank is saying. Quantitative easing and zero interest rates will cause inflation because potential GDP isn’t what it was. However, this would require accelerating inflation as “artificial” demand competes for a shrinking stock of free labor. We’ve got precisely the opposite phenomenon. Either demand is not high or the growth potential of the US economy has surged (and while that’s good for the future, it doesn’t do squat for us today).

More importantly, people obsessed with asset markets are confusing noise and signal. Yes, real estate and equity markets have picked up much quicker than the economy itself. This is a byproduct of their own demon – slowing population and productivity growth. Let’s go back to the simple and elegant Harrod-Domar-(Solow) model. The wealth-to-income ratio (which determines asset prices) is determined as:

b = s/g where s is the national savings rate and g is the growth rate. The lower the growth rate the higher the wealth to income ratio. This is important because it suggests all this whining about interest rates and asset prices has very little to do with monetary policy. Interest rates have been in secular decline since the ’80s:

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As Piketty and Zucman thoroughly confirm, the wealth-to-income ratio increases as would be expected under conventional models. Any observer notices that this trend in interest rates is completely independent of monetary policy in the past few years. Growth has been slowing down which means much more wealth is chasing much less capital, resulting in a falling labor share, and low interest rates.

It is a tautological position to suggest the Fed should change course because low growth will cause asset market bubbles and hyperinflation. However, with the long-run supply side costs of persistently low demand (hysteresis) it might just be self-fulfilling. Let’s hope it doesn’t get there.

India’s Tryst with Destiny…

March 28, 2013
the Economy: Home and the World
42 Comments

…So is the name of Jagdish Bhagwati and Arvind Panagariya’s book, subtitled Debunking myths that undermine progress and addressing new challenges. While it lives up to its subtitle well, this forceful argument for trade liberalization fails to match the watershed after which it is named, Jawaharlal Nehru’s famed speech. In many ways, Bhagwati and Panagariya deliver a nicely edited review of literature on India’s growth since its reforms. Even as someone fairly well-read on India’s economic history, the sheer collection of empirics in Bhagwati and Panagariya’s arsenal is baffling – enough to give serious pause to anyone skeptical of free trade.

What Bhagwati et al. deliver in evidence and reason, they lack in insight (the true measure of their fantastic scholarship can be found in the plethora of self-citations riddled throughout the book – while the rest of this review may be critical, I don’t kid, their work is rich and informative). There are precious few comments on the underlying idea of India, and its tryst with destiny. While the thorough treatment of liberalization and its positive effects is much needed in our political discourse, perhaps the American version has a more apt, and humble, title: Why Growth Matters.

The method in which Bhagwati et al. focus their argument also leaves much to be desired. Presumably to magnify the import of their claim, the text is saturated with a vast embellishment of what the Left actually believes. Further, Bhagwati et al. fall prey to the stereotypical liberals (in the Indian sense) who chant growth is good, with little appreciation for nuances or caveats. For example this book has not a mention of hugely depleted aquifers in North India, the condition of our rivers, and that of our skies.

Indeed, when in their favor, Bhagwati et al. readily accept that there are subtleties to every question:

Then again, the causes of suicides are many. This is so even in the case of farmer suicides. It is, therefore, unlikely that a single cause like BT seeds would emerge as the main factor.

I agree completely though, am left wondering, why the same doubt cannot apply to a hugely more complex phenomenon, India’s growth itself. But perhaps the most striking flaw in the book is the devious representation Bhagwati et al. make of economists on the Left. The reader is made to believe that Brad DeLong and Dani Rodrik were somehow content with the level of liberalization before 1991. They, further, claim that DeLong and Rodrik believed that the most important reforms happened during Rajiv Gandhi’s tenure:

Unfortunately, both the statistical assertion by DeLong about allegedly robust pre-1991 growth and its explanation by Rodrik are wrong.

However, in a 2001 paper, here is what DeLong has this to say:

What comes next for India? The governments that followed the Rao government–first the United Front and now the BJP-led coalition–have continued reform and liberalization, albeit not as rapidly as one might have hoped given the pace of economic reform in the first half of the 1990s. But the amount that is still left to be done is staggering. 

Whether Indian real economic growth continues at the rapid pace of the past decade even if reform slows down and government budget deficits continue will tell us much about the resiliency of the growth process.

If Indian real economic growth does continue to be rapid even in the face of erratic public-sector performance, that will suggest to us that the most important factors were those that changed in India in the 1980s. (Emphasis added)

DeLong clearly admits that India is a far cry from a liberal democracy. It’s interesting that Bhagwati et al. paint DeLong’s conditional, predicated on continued successful growth without further reform, as an assertion. Indeed, it is unfair to the reader who does not check the full extent and qualification of DeLong’s opinion.

There is another oddity in criticizing Rodrik and DeLong’s purported belief that the sea-change in liberalization happened during the 1980s, in no small part because Bhagwati et al. make this argument themselves. There are numerous instances in which the authors respond to “critics” that don’t believe growth in the past two decades can be attributed to liberalization, because of high growth rates during the second Gandhi’s tenure as prime minister. Their (correct) reply to this (false) claim is that reform had started silently in the ’80s itself, and the Narasimha Rao policies only deepened the change.

This sort of exaggeration is common throughout the book. For example, the authors claim that:

A common refrain of the left-wing critics is that the post-1991 ‘neo-liberal’ reforms have led to an exponential increase in corruption.

They cite, for this claim, an article from New Age Weekly – the loud-horn of India’s Communist Party. To ascribe a “common refrain” to “left-wing” critics from the most ideologically radical publication in the country is edging on absurd. There are very good reasons to distrust anything and everything Vandana Shiva has to say. There are very good reasons to be skeptical of anti-BT cotton activists. There is very little reason to equate all left-wing thinkers in this category.

A similar vein of disingenuous argument is littered throughout the book. The most striking example to this effect is a graph following the authors’ cliam that:

The difference is so huge between the measured farmer and non-farmer suicide rates that one may question the validity of the data.

Right beneath this claim is a figure depicting the vast difference in the total suicides among farmers and the total population. This would, of course, be expected noting that India is, well, not an entirely agrarian nation. Unfortunately, the placement of this graph would trick a reader merely skimming the book for ideas (as I initially did) – removing credence from their greater point that there is no connection between liberalization and agricultural suicide.

By quibbles with the rest of this book rest on dispute not with the method of their argument, but the argument itself. I am a firm believer in liberal trade policy and, as I’ve mentioned, I believe Bhagwati and Panagariya have done a great service in conveying the sheer absurdity of the argument against. We disagree in large part, however, regarding the role Indian government has to play in its growth. The authors’ divide India’s economic future among tandem tracks:

Track 1: Reforms aimed at accelerating and sustaining growth while making it even more inclusive.

Track 2: Reforms to make redistributive programs more effective as their scope widens.

From the way in which the authors interpret the above goals, Track 1 (labor market reform, land acquisition, infrastructure, and higher education) and Track 2 (direct transfers, public work provision, guaranteed employment, healthcare, nutrition, and elementary education) represent supply-side versus demand-side policies, respectively.

There is a clear, (expected), and understandable preference given to the former. However, the evidence and assumptions of their argument do not hold ground. For one, they believe that any real growth implicitly requires formalization of India’s workforce:

There are many indicators of the inefficiencies that constrict growth. For instance, according to a 2007 Government of India report, the high-productivity formal sector […] employed just 13.7 percent of the workers in 2004. Besides, employees who are in the formal sector are not just small in number but have hardly been growing.

For someone not familiar with the Indian context, let me explain what “formal” and “informal” entail. When I go to a mini-Walmart like grocery shop (think Nilgiris, Reliance Fresh, or Spencer’s), I’m confronted with “formal” workers with absolutely no idea how to use the fancy cash registers at their disposal. It’s not uncommon to wait 5-10 minutes for a simple checkout because of how unbelievably incompetent these workers are.

On the other hand, “informal” includes the roadside bookshop or chai-kadai – where one man is serving about ten people at once, with remarkable quality and efficiency. It includes bookkeepers who make the idiots at formal stores look like a joke – for they can manually search the stacks of novels at their disposal in a tenth of the time it takes a so-called “high-productivity” formal worker to access his computer and direct me to the necessary book.

That Bhagwati et al. so casually assume that the formal sector is superior is just, simply, false. As far as services are concerned, this is evident to anyone who’s spent much time in India. I’m no maudlin sob-story who yearns for the “good old days” or the way “things used to be”. I’m all for technology, liberalization, and modernity – but the evidence that formality somehow aids growth (as far as services are concerned) has yet to be demonstrated. And, if you don’t believe me, I invite you to deal with the useless nuts at your local Spencer’s as opposed to the vegetable cart next door.

In their criticism of the Indian labor market, Bhagwati et al. are eager to repeal even the most sensible laws, including:

  • “Benefits related to sickness, maternity, disability, dependents” for employees earning below Rs. 10,000 a month
  • The right for “trade unions to strike and represent their members in labour courts in disputes with the employer”
  • Limiting “work without a day of rest to ten days”
  • Requiring “Proper disposal of waste”
  • “Extensive provisions for worker safety, including fencing of machines and moving parts, use of goggles to protect against excessive light and infra-red and ultra-violet radiation; precautions against fire; and the weight permitted to be carried by women and young persons”.

While they agree that the real culprit of labor rigidity in India is the Industrial Disputes Act (IDA) which makes it well-nigh impossible for factories to fire workers (and, consequently, hire them) – they seem to have fallen the the supply-side myth that grasped most of the USA during the Reagan era that somehow dismantling every worker protection would lead to increased aggregate supply and, hence, economic growth.

Indeed, the very flippant manner in which they claim these crucial provisions increase the “marginal cost” of labor and hence cause unemployment is ridiculous. The theoretical economic argument against this claim is so obvious. Economists argue that few industries are perfectly competitive (the stock market being one, which explains why it’s so hard to “beat” the market). In imperfect markets, the firm earns significant economic rent. This means that even decreased profit will not cause a reallocation of associated factors of production. In other words, a slightly higher marginal cost of labor will have no effect on employment.

Indeed, the greater cost is not even marginal in nature, but rather fixed. Provision of toilets and flow of water are largely independent of the number of workers employed. Similarly, the basic premise on which Bhagwati et al. approach education is flawed:

In contrast to elementary education, which is also a predominantly social objective and for that reason belongs to the Track II policy agenda, higher education belongs to the Track I agenda.

In other words, better universities somehow have supply-side effects in a way that primary education does not. This is simply not the case. For this to be true, Indian universities would necessarily be bottlenecked due to the huge number of highly-qualified Indian high school graduates. However, there are many private universities that are ready to be filled, suggesting a more broken educational infrastructure than the authors assume. A higher education system that can work independent of a weak primary system would need the flow of skilled immigrants the United States sees. Short of this influx, India needs to fix education from the bottom-up to achieve any sizable supply-side effects the, it seems, holy grail of liberalization advocates.

Overall, India’s Tryst with Destiny is a highly worthwhile read. Bhagwati et al. stick to the point, rendering the book a very short (but informative) read. As the authors are acutely aware, myths and lies about India’s reforms abound, and not just among the intellectual Bengali cafes, but even liberals abroad. Bhagwati and Panagariya make a strong case for continued liberalization. I believe I have made a strong case for my ultimate criticism of the book. As a reader fairly in touch with the beliefs of India’s left-wing, I believe the authors unfairly, and to their disadvantage, exaggerated the claims against liberalization. Indeed, I believe they directly misrepresented the opinion of two very respected economists. As an Indian, there is also a little pang that Bhagwati and Panagariya copyrighted the natal utterance of India – it’s very heart and soul – in a book advocating the ultimate removal of labor protections and unions. Contrary to the authors’ belief, Jawaharlal Nehru would not be all to happy with the thrust of this book.