Arnold Kling  

The Debt-Fueled Binge Story, Keynes, and PSST

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Mark Thoma gives us Tim Duy:


What was more important in holding the economy close to potential output, residential construction itself, or the housing price bubble? I tend to believe the price-driven balance sheet effects were driving dynamics over this past business cycle.

I still think that the best charts demonstrating this are Timothy Taylor's. The point that housing construction per se is too small to account for the swing in GDP growth is well taken.

The way I would tell the story is that the causal factor was the loosening of mortgage credit standards. Lenders found ways to enable borrowers to take cash out of their homes, through home equity loans and cash-out refinances. Moreover, they found ways to enable borrowers to obtain homes with little or no down payments in the first place. This credit expansion fueled a bubble in housing prices, which in turn allowed more lending against this (artificially-inflated) home equity.

The way I see it, the principal culprit is mortgage lending standards, not monetary policy. As I argued in Not What They Had in Mind, the loosening of mortgage lending standards was encouraged by various regulatory policies that reduced the capital requirements for banks holding mortgage-backed securities. Thus, the balance sheet boom was created by regulatory policy.

The macroeconomic effects of balance-sheet phenomena can be told in either Keynesian or PSST terms. In Keynesian terms, aggregate demand goes up because of debt-fueled consumption and then goes down when the stimulus is withdrawn. The answer is to find another stimulus drug to inject into the economic system.

In PSST terms, the balance-sheet bubble created unsustainable patterns of trade. Businesses built up supply chains to deliver goods and services to people who were living beyond their means, and now those patterns of trade have to change. However, unlike the Keynesian story, there is no simple remedy. Patterns of sustainable specialization and trade have to emerge organically, instead of being artificially created by government living beyond its means.

In the Keynesian model, borrowing money to maintain high public-worker salaries will create trickle-down prosperity for the private sector. In the PSST model, it won't.


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CATEGORIES: Macroeconomics



COMMENTS (5 to date)
Ben Brennan writes:

That might be the dumbest representation of the keynesian analysis of the financial crisis.

A better analysis would look like this:

On the one hand you had stagnating wages for median workers, yet you had rising productivity. This meant that for aggregate demand to be sufficient it would need to be financed by consumer debt.

Additionally, the expected rate of profit for production was declining so investors were moving into asset speculation instead of productive investments. This led to the asset bubble.

When this bubble finally burst, investors chose to hold on to cash because aggregate demand was so low now due to households trying to pay down debts.

Now according to legit keynesians (and not "prime the pump" keynesians) the correct response here would be for the government to invest in public capital projects that would increase overall productivity - transit improvements, electrical grid improvements, making sure that teachers and other public workers don't get fired since states have taken a hit in revenue (because if they do get fired there will be a negative multiplier), investing in schools themselves. Not what the stimulus actually was, which was blind spending on tax cuts and "shovel ready projects".

Additionally, government debt is different from private sector debt. Government debt isn't real debt since the government can always print more money.

Chris Koresko writes:

Arnold Kling: In the Keynesian model, borrowing money to maintain high public-worker salaries will create trickle-down prosperity for the private sector. In the PSST model, it won't.

To what extent do you believe that the economic performance over the last several years represents a clear test of the relative merit of these models?

Robert Hurley writes:

The argument that any Kensian has advocated borrowing money to maintain HIGH worker salaries is fallacious. There is no proof that the teachers, firemen and police who have been laid off are HIGH salaried workers! I think this is a case of using a straw man to win the argument.

Chris Koresko writes:

Ben Brennan: On the one hand you had stagnating wages for median workers, yet you had rising productivity. This meant that for aggregate demand to be sufficient it would need to be financed by consumer debt.

Not necessarily. Is it not true that the stagnating wages are due mostly to the rising fraction of total compensation going into benefits, especially health insurance? If that's so, then the "missing" demand really represents money flowing into the medical industry and creating demand there, correct?

Ben Brennan: Additionally, the expected rate of profit for production was declining so investors were moving into asset speculation instead of productive investments. This led to the asset bubble.

I thought that the asset bubble was mostly a housing bubble, and the origin of that is pretty well demonstrated to lie in a set of regulatory policies designed specifically to raise home-ownership. It's not clear to me how low expected profits for productive investment lead to higher speculation, since for true speculation the expected gains have to average close to zero, correct?

Ben Brennan: When this bubble finally burst, investors chose to hold on to cash because aggregate demand was so low now due to households trying to pay down debts.

In other words, it became difficult to identify profitable investments, correct?

This kind of story seems awfully shaky to me -- it feels as if every step in the logic rests on a potential accounting error or an unsubstantiated claim about details of the history of the crisis. Of course that may not be fair, since there's not enough space in a blog comment to fill in all those details if they're available.

Barry S. writes:

"On the one hand you had stagnating wages for median workers"

This never happened. Wages are increasing. The two reasons people think wages are not increasing is that they ignore the fact that the household size is shrinking (ergo more wages per person) as well as the fact that the cost of benefits (ie healthcare) has increased, crowding out cash compensation.

So, no, compensation is not stagnating. It is rising commensurate with productivity.

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