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Not Spending is Not Investment

July 25th, 2013 12 comments

I see this logical error so constantly, almost every day, that I feel the need to reiterate. Personal saving, virtuous and useful as it is for individuals, does not increase investment. This is what I call the “lump of money” fallacy (a.k.a. the loanable funds model).

Ask yourself:

If you transfer $10K from your bank account to mine for a vacation package (spend), do the banks have more money to lend for investment?

If you don’t transfer the $10K to my account (save), do the banks have more money to lend for investment?

In which scenario am I more likely to invest in cabaña improvements? In which scenario will my employees produce more massages?

A huge amount of the thinking you see out there re: spending, saving, consumption, and investment is crippled by this simple error of composition.

“Saving” ≠ “Saving Resources”

“Saving” Versus Saving for the Future

Cross-posted at Angry Bear.

Understanding Effective Demand with Edward Lambert

July 25th, 2013 8 comments

A few people have asked me to provide a quick introduction to Edward Lambert’s recent work on Effective Demand, which work I’ve mentioned a few times. That’s ironic, because I made those mentions  in hopes that more-accomplished others would do the same for me.

That help hasn’t been forthcoming, because quite a bit of work and thinking is required to plumb the depths of Edward’s model. So I’ve asked Ed to help me put together a basic introduction. Hopefully I’ll benefit from the blowback of ensuing discussions.

In Chapter 3 of General Theory, Keynes bruits the notion of effective demand. It’s very much the centerpiece of his thinking, but it is almost uniformly ignored in textbooks. He describes it as the intersection of the aggregate demand and aggregate supply curves. Edward adheres to that notion.

While I grasp that thinking in an abstract way, Keynes fails to provide what I need; he’s neither general nor specific enough for me to really grok it. (Dictionary.com: “to understand thoroughly and intuitively.”)

In a general sense, I want to understand what effective demand is, in narrative, descriptive terms explaining human incentives: why people and groups act as they do.

In a specific sense, I want to know the formula to calculate effective demand, so I can plug in publicly available measures (or watch others do so), plot changes in this measure over time, and see what happens.

Edward’s work particularly stands out for me in providing that formula. Whether his formula is “right” or useful remains to be seen. But it’s important; to my knowledge (and Edward’s), no effective-demand theorist, including Keynes, has provided a workable formula. It seems to be the very thing Paul Krugman was asking for four years ago in his lecture on effective demand.

Here’s the formula:

Effective Demand = Real GDP x Labor Share of Income / Capacity Utilization x (1 – Unemployment Rate)

I’ll unpack that below. But first my explanation and understanding.

First: Effective Demand is not a straightforward accounting measurement like Personal Consumption Expenditures or Corporate Profits. It’s much more like estimates of the non-accelerating inflation rate of unemployment (NAIRU) or Potential GDP. It’s an analytical construct, an economic concept that’s useful for sussing out what’s happening in the economy.

With that as background, here’s a shot at providing what Keynes and Edward don’t: an explanation of what effective demand is, at least in this construct. (Note that throughout, here, “capital” means real capital, not “financial capital.” I’m talking about drill presses and such.)

Effective Demand is a measure of how much the economy at a given point in time can, could, increase utilization of labor and capital from current levels, before that increase in utilization (and new real-capital creation) slows or stops due to insufficient demand.

It gives us a measure of the extent to which an economy can use more of its raw production capacity (its labor and capital, working full tilt) — before that increase slows due to the disincentives of insufficient demand/sales.

Effective demand helps us determine the “potential” production in the economy — its potential to employ and create capacity within that demand constraint – the extent to which producers seeking profits will 1.) employ unused and available capacity (mostly by employing more workers, perhaps bidding up wages to do so), and 2.) create new capital/capacity.

Note that “capacity” and “potential” are very different here.

Edward has said that effective demand could be called “opportunity demand.” The concept characterizes the magnitude of the sales and profit upside that producers see ahead when considering whether to expand production by utilizing more capital (by hiring more workers) and creating new capital (also hiring in the process).

Normally in the “good” parts of the business cycle, effective demand does not constrain the utilization of labor and capital. Businesses in aggregate can employ (and create) more resources at the margin, producing more output that they can sell at a profit. But there comes a point at the end of a business cycle where effective demand sets a limit upon the profitable utilization rates of labor and capital, and (hence) restricts the incentives to create and employ new capital.

So let’s go back to the formula, and the terms therein. What story can we tell about effective demand?

Real GDP. When this goes up, effective demand goes up. This seems intuitively obvious.

Labor Share. This is at the heart of the model. Labor share determines the relative power of labor to purchase finished goods. The sale of finished goods determines production and investment in capital capacity. So, when labor share rises, effective demand increases due to more relative power for household consumption demand. Producers see more upside potential, expressed in sales.

Capacity Utilization. This is somewhat counterintuitive. When capacity utilization increases, it decreases effective demand. This is because effective demand is a measure of the demand-incentives for producers to increase utilization. When capacity is already heavily utilized, it’s more expensive (less profitable) for producers to utilize more.

Unemployment Rate. This is even more counterintuitive. When unemployment declines (employment increases), effective demand also declines. Why? Because as the economy reaches the full-employment limit, it’s harder for the whole economy to increase output to the full-tilt limit. And it’s that potential increase that incentivizes producers. The decline in unemployment eventually constrains the potential future rate of that very decline, and the future rate of economic growth. See Edward’s post on this here.

Effective Demand Limit. Real GDP will tend to increase as more capital and labor is utilized. However, there is a limit set by the relative power of labor’s share of income to purchase production. Reductions in that buying power reduce producers’ incentives. The concept here goes back to Keynes’ original statement that employment of the factors of production will be limited at the point of effective demand where “the entrepreneurs’ expectation of profits will be maximised.”

The intuition behind this, in particular the key privileging of labor share in the equation: ultimately, economic activity is directed to producing goods that humans can consume. The desire for that consumption is the ultimate source of demand, hence the driving force behind economic activity (including capital production). Labor income — a very large proportion of which is devoted to consumption spending — is at least a good measure or index of that final demand, and at most the driving force of that demand.

I want to keep this post short (oops, too late), but before leaving I want to return to the key virtue of Edward’s work: the ability to plot this explicitly formulated measure of effective demand over time, and see how it has moved in relation to other measures. The graphs below, from this post, show how it has moved over several business cycles, plotted relative to 1. real GDP and 2. utilization of capital and labor.

As you can see, the ends of business cycles (beginnings of recessions), are characterized in this model by a stylized fact: real GDP approaching or exceeding this measure of effective demand. Capacity utilization increases quite smoothly up to that point (the “good” part of the business cycle), then declines (often after a chaotic period that can last quite a while; see 1995-2000).

These graphs seem to tell a very consistent and compelling story. I’ll leave it to Edward’s post to explain the individual dynamics of these periods in more detail.

Leading up to the Recession of 1974

Pot demand 1

Leading up to the Recession of 1980

Pot demand 2a

Leading up to the Recession of 1991

Pot demand 3

The almost Recession of 1994 and the Recession of 2001

Pot demand 4

Leading up to the 2008 Recession

Pot demand 5

Leading up to the next Recession

Pot demand 6

Pot demand 7

Engineers and others with similar bent might find it useful to think of the intersecting aggregate supply and aggregate demand curves as the X and Y arms of a 2D plotter. The effective demand paths you see above are the lines that plotter draws over time.

Another physical metaphor, characterizing the lines/measures as pulling and pushing on each other: effective demand as portrayed here seems to act like an attractor, pulling up both real GDP and capacity utilization. But unlike a magnet, for instance, the attraction effect gets weaker as the lines converge. And when real GDP exceeds effective demand, we see a very strong attraction effect pulling those two measures back down again.

Cross-posted at Angry Bear.

An Important New Book on Income and Wealth Inequality

July 10th, 2013 Comments off

I just got an email from LIS (the group that runs the Luxembourg Income Study and Luxembourg Wealth Study) giving notice of a new book:

Income Inequality: Economic Disparities and the Middle Class in Affluent Countries

Contrary to the title, there’s a whole section on wealth inequality.

The book’s 17 chapters by 17 established researchers/research teams all draw on the extensive LIS databases of micro-level income and wealth data from 28 affluent countries 1980–2004. That large-sample, carefully normalized database holds promise of delivering insights that have been unavailable from previous data sets.

Given my interest in inequality and growth in advanced countries, I’ve been watching LIS for a while. I’ve tried working with their data, but it’s so micro-level that a great deal of work would have been required — more than I as an interested amateur was prepared to devote. I’m excited to see what these researchers have done with it.

Unfortunately it’s $65, and I don’t see any indication that the researchers have made their compiled/analyzed data sets (much less spreadsheets/stata files,etc.) available in electronic form for vetting and consideration by the likes of me (and more-competent others). But I’ll probably break down and buy it anyway.

Cross-posted at Asymptosis.

The Appalachia Map, Yet Again

July 9th, 2013 1 comment

Lots of desperation talk these days by Republicans hoping to win future national elections by increasing their share of the “missing” white vote, while ignoring all those brown people. (Sean Trende’s piece seem to be the epicenter at this moment.)

Nate Cone drives a very effective stake through the heart of that zombie ambition here, with a single map (below). Yes: that (“Southern“) strategy worked brilliantly for decades. (Johnson said that civil-rights legislation would lose the South to Democrats “for a generation,” and he was only wrong in underestimating the duration.) And it’s the only thing that’s kept Republicans from utter humiliation and abject collapse over the last decade or so. But Judis and Texeira will be right eventually; demographics is destiny, and there are only so many white people — an ever-decreasing percentage. Courting whites may be the most effective method of stemming the hemorrhage, but it’s nothing more than that.

Faithful readers will remember seeing this basic map here multiple times. This latest version shows Obama’s gains/losses in share of the white vote compared to Gore (this by a black man):

Change in Share of White Vote: Obama 2012 Increases (Red)/Decreases (Blue), Compared to Gore 2000

We saw the same basic map here in 2008, in the strong Red countermovement among Appalachians and Okies:

 

And here, showing where Clinton dominated over Obama among Democrats in the primaries:

Both Steve Sailer and Senator Jim Webb link this pattern directly to the dominance of (white) Scots-Irish character and culture in Appalachia:

Sailer:

John McCain did best relative to Bush in 2004 in Scots-Irish states like Tennessee, Arkansas, and Oklahoma. McCain is Scots-Irish himself and is very much in the Andy Jackson Scots-Irish tradition of patriotic pugnacity.

Webb:

As Webb says in his 2004 book, Born Fighting: How the Scots-Irish Shaped America (here characterized by , the Scots-Irish are a particularly pugnacious people, self-reliant and hyper-individualistic, who place honor above profit.

If you want to understand that character and culture, I can’t do better than  recommend a darned good novel: The Candlemass Road by George Macdonald Fraser of Flashman and Steel Bonnets fame (himself an utterly unreconstructed reactionary of Scottish descent who nevertheless, rather paradoxically characterizes the book by saying it’s “a rather dark morality tale – at least I meant it to have a moral.”)  “Dark” hardly says it; “bleak” is more like. It portrays a Scottish border culture of unrelenting, murderous revenge battles among clans. (One of the leading clans in the novel being…the Nixons! On which subject of political reactionaries/warrior types with Scottish names — George McLellan, Douglas MacArthur, Stanley McChrystal, John McCain — see this post: Obama’s McMoment? McMaybe.)

Maybe that culture is transmitted…culturally, but reading Fraser’s fiction and nonfiction on the Scottish border wars, it’s not hard to understand how it could have emerged genetically through natural selection. The non-“pugnacious” clans simply didn’t survive; selection pressures were strong.

Or read Steven Pinker in The Better Angels of our Nature on the “culture of honor.” Here from  NYT review of the book:

Pinker argues that at least part of the reason for the regional differences in American homicide rates is that people in the South are less likely to accept the state’s monopoly on force. Instead, a tradition of self-help justice and a “culture of honor” sanctions retaliation when one is insulted or mistreated. Statistics bear this out — the higher homicide rate in the South is due to quarrels that turn lethal, not to more killings during armed robberies — and experiments show that even today Southerners respond more strongly to insults than Northerners.

Whatever the source, nature or nurture, patriotic pugnacity doesn’t seem to be making those Scots-Irish Appalachians very happy:

Self-Reported Well-Being

Maybe eventually Scots-Irish Appalachians will stop clinging to guns, religion, “honor,” revenge, and shallow, self-satisfying, supposedly “patriotic” pugnacity. Maybe they’ll accept the fact that they lost the Civil War a century and a half ago, that we’re not going to “take the country back” to that time. In other words, maybe they’ll join some semblance of the modern world. Now that would be a disaster for the Republican Party.

And arguably the single most effective long-term strategy Democrats could adopt would be somehow convincing Appalachian voters to vote their own (and everyone else’s) economic self-interests. Turn the corner on a dozen or so counties in Indiana, Virginia, and North Carolina (and Florida), and Republicans will be permanently relegated to the wilderness that they seem so hell-bent on occupying and (re)constructing.

Cross-posted at Angry Bear.

Humans’ Comparative Advantage: Wanting Things

July 9th, 2013 Comments off

Frances Coppola sums up and expresses a great deal of great thinking in her recent Pieria piece, The wastefulness of automation.

I’d like to highlight one point, one that I’ve been pondering for a long time. There’s one area where machines — until they get sentient — can’t replace people (here from her response in comments):

only humans desire to consume in excess of basic living needs. Show me a robot that wants a Gucci handbag. Or a Shire horse that wants an iPad.

Or…an expert system or drill press that wants a massage. As she concludes the article:

Maybe capitalists DO need a large labour force. Their survival depends on it.

Which leads me, once again, to wonder why I’m not hearing a lot more people discussing Ed Lambert’s work on “effective demand” and its relation to labor’s share of income.

Cross-posted at Angry Bear.

 

 

The So-Called Credit Crunch, Again Some More

July 4th, 2013 2 comments

It’s really hard to kill this meme. Note the label on this graph from today’s Free Exchange post:

Now change that heading to read “Business borrowing.” Sort of gives a different impression, right?

The idea that the problem’s on the supply side is pervasive, and false or at least wildly overblown. Lending rates are at historic lows. But the credit-crunch storyline gives very effective aid and cover to the financial industry in justifying its inordinate size and power.

I tried to drive a stake through the heart of this vampire squid back when we saw that first dive, back in 2009, and the situation is much the same today. (See also Related Posts at the bottom of that post.)

The Sky Is Falling! Business Lending Down 1.2 Percent!

Cross-posted at Angry Bear.

 

Asset Reflux Disease: Explaining Koo to Krugman

July 1st, 2013 9 comments

Or: Why Banks Aren’t Like People

Steve Keen does a good job of addressing Paul Krugman’s befuddlement with Richard Koo’s balance-sheet-based thinking, here, with detailed models showing how funds flow and stocks change over time.

I’d like to address it more succinctly and I hope intuitively, by pointing out a simple misunderstanding that Paul shares with Scott Sumner, Nick Rowe, and many other very smart people who I don’t think have really internalized the notion of “endogenous money.”

Let’s start with Nick. I often spend years thinking about his posts. One that I’ve been worrying at forever, have read at least half a dozen times, is this one:

All money is helicopter money. Against the Law of Reflux

It’s about the idea that money supply in excess of what people want to hold “refluxes” to the issuer, which Nick doesn’t believe. (Emphasis here and throughout, mine).

This very old debate over the Law of Reflux is what is at the root of the very modern debate about whether Quantitative Easing can work.

Sounds important, right? Nick’s cutting to the crux, as is his wont.

I’ve finally decided that the post makes no sense at all, that all its very smart equilibrium thinking is obfuscatory rather than illuminative. Why? Because it’s based on a fundamentally flawed understanding:

The suppliers decide how big a stock [of money] will be held, regardless of the desire to hold it. People will pick it up whether they want to hold it or not. If they don’t want to hold it they will spend it, to try to get rid of it in exchange for something they do want to hold.

Ye Olde Hot Potato.

This is exactly the notion that Scott Sumner bruits here, calling it “the concept that lies at the heart of money/macro”:

Individuals can get rid of the cash they don’t want, but society as a whole cannot

And it’s the very notion that makes Krugman incapable of understanding Koo:

…an economy in which everyone is balance-sheet constrained, as opposed to one in which lots of people are balance-sheet constrained. I’d say that his vision makes no sense: where there are debtors, there must also be creditors, so there have to be at least some people who can respond to lower real interest rates even in a balance-sheet recession

Those people can respond, presumably, by borrowing more, and spending what they borrow.

Here’s why that doesn’t make sense: Nick forgot about option #2:

If households and nonfinancial businesses (the real sector) are holding more money than they want, they can use it to pay off debt to the financial sector. That money disappears.

Just start using your debit card instead of your credit card, and keep making your monthly payments (or more).* Voila: you’re returning money to the issuer. Nothing prevents everyone  in the real sector from doing this at the same time. (Except the lure of low interest rates causing de-refluxing, but…how’s that working out for us? How did it work for us in the ’30s?)

In terms both more precise and more broadly descriptive: loan payoffs by the real sector cause both real- and financial-sector balance sheets to shrink.

In Nick’s terms: The only thing those payer-offers get to “hold” “in exchange” for those payoffs is a reduction in their liabilities. Alert to the media: that’s not “spending.”

You know Krugman’s “patient” lenders? The technical term for them is “banks.” They’re not transparent intermediaries between real-sector borrowers and lenders. They are the lenders. And they’re nothing like real-sector actors:

1. They’re licensed to print new money for lending. And when it’s paid back they, collectively, burn it. Sound like your household?

2. Banks don’t lend (“save”) because they’re patiently “saving instead of consuming, deferring spending for the future.” Your credit-card company doesn’t lend less because it wants to spend and consume/invest more today. (Banks’ actual “spending” on newly-produced real goods and services is trivial in magnitude.)

Scott Fullwiler’s recent piece on banks’ capital/leverage structures and return-on-equity business models (wildly different from real-sector goods and services companies, not to mention households) does a good job of explaining what does drive banks’ lending decisions.

Here’s an inevitably imperfect metaphor: From the real-sector perspective, the financial sector is a magical, bottomless money-hole in the ground. New borrowing draws money out of that hole, and loan payoffs “retire” money back into the hole. Got reflux?

So yes: real-sector entities can all get rid of money at the same time. It’s called debt deleveraging, and the shrinking balance sheets that result (financial- and real-sector) are what Koo’s referring to in his discussions of “balance-sheet recessions.” (Maybe better termed “debt” or “deleveraging” recessions, per Fisher and Minsky.) This explains in quite simple terms why (as Steve Keen is so keen to point out) high real-sector debt levels make an economy so unstable: because all those real-sector actors can and often do stop spending at once, instead pouring that money back into the financial-sector money shredder/black hole.

When the impatient borrowers of the real sector go all patient on us, paying down their debt to banks, the banks don’t get impatient, or spend more, like Krugman’s imaginary counterparties.

And you’re going to have to get rather tortuous if you want to claim that more loan payoffs, less borrowing, means the banks do more lending (which would presumably lead to more spending…).

This is essentially the argument Nick’s making (and Paul’s assuming) with his equilibrium discussions — that  “the” interest rate will adjust so that all those payer-offers stop paying off/start borrowing — de-reflux! See, they can’t all get rid of their money! “They [collectively] will pick it up [some will borrow more as a result of others borrowing less and lowering interest rates] whether they want to or not.”

This goes right back to the crazy “loanable funds” notion, that savers “fund” borrowers, and that people spending less (saving more) means other people can borrow more, at lower rates. I’ve taken to calling this The Lump of Money Fallacy. (Dean Baker told me once in person that Paul “doesn’t believe in loanable funds.” I’m finally feeling confident enough to respectfully disagree. IS/LM is all about the logic of loanable funds, even while acknowledging that banks create new money for lending. Schizo?)

This interest-rate-equilibrium notion is obviously problematic at the zero lower bound, where rates can’t go low enough to lure payer-offers into becoming impatient borrowers. But Nick also knows, I think, that elasticity complexities in many different (and interacting) credit markets, at many rates, under many different conditions (both “natural” and “government-imposed” conditions) make that de-reflux rather a long-term pipe dream. Credit-card rates went up ’08-’10, for instance (lots relative to the Fed Funds rate, which dove), in the midst of massive real-sector deleveraging, a.k.a. low borrowing demand, a.k.a. everyone getting rid of money at the same time.

Nick and Scott: Households and nonfinancial businesses — the real sector — can all get rid of money at the same time. People should stop suggesting that they can’t.

And Paul: For every borrower, there’s…a bank.

Finally, I can’t resist pointing out: a very smart and very curious Nick Rowe, who blesses us regularly with his knowledge of economists of yore, felt the need to write a very lengthy post worrying at this “very old debate” that is central to “whether Quantitative Easing can work.” And Scott says “the concept [though not the word] lies at the heart of money/macro.” Sounds important, right? Worth knowing what people have thought and written about it over the decades and centuries, no?

Now search Scott’s site for this word, and also that of Lars Christensen, who coined the term “market monetarist.” How many hits?

Count ’em: zero.

And Krugman? His one usage is referring to a different kind of reflux.

I’m sure glad Nick brought it up.

——————

* Question for monetarists: Is your unused credit-card limit “money”?

 

Cross-posted at Angry Bear.