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“The economy fell off the cliff.” – George Soros (11/24/2008). 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 1 The Great Moderation and "Falling Off a Cliff": neo-Kaldorian dynamics. James G. Devine Loyola Marymount University (LA, CA) [email protected] August 5, 2011 (Published as The Great Moderation and “Falling Off a Cliff”: Neo-Kaldorian Dynamics in Journal of Economic Behavior & Organization, 78(3), May 2011: 366-373. A rough draft is available at: http://myweb.lmu.edu/jdevine/JD-2010-neoKaldorianModel.pdf with diagrams at http://myweb.lmu.edu/jdevine/neoKaldorian-Figures.docx. The current version has been edited a lot without changing any conclusions.) 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 2 Outline. I. Introduction. II. The Short-Run Model. A. B. C. the Expenditure curve (EE). the Actual Demand/Debt ratio curve (AA). Short-run equilibria. III. Medium-Run disruption of SR Equilibrium. A. B. C. The “typical” cycle. A Fall off the cliff. The Great Moderation. IV. The aftermath: Recovery or Stagnation? V. Conclusion: Policy’s role. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 3 (I) Purpose. to help to understand: Why the U.S. economy “fell off a cliff” – or threatened to do so – during the years 2008-2009. the world economy, the housing market, and most of finance will be ignored here. it’s possible that 2009’s stimulus package saved the economy from a Fall – but who knows? o We may not have been suffering from a Fall. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 4 (I) Theoretical Background. 1. Kaldor’s Keynesian (pre-catastrophe theory) model of the business cycle (1940): 2. Non-linearity implies three equilibria (two of which are stable). Stable equilibria represent two general states of the macroeconomy: high employment and stagnation. A “Fall” is a downward leap between these. Dynamic theories of Minsky (1982) and Kalecki (1933), helping to cause this Fall endogenously. This process may have occurred due to the often-heralded “Great Moderation” (1984-2006). In this period, the effects of financial crises and normal businesscycle recessions may have been short-circuited, so that they could not purge the economy of Minsky/Kalecki imbalances. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 5 (II) The three “runs.” • long run (LR): labor-constrained potential output (Z) and the Minsky/Kalecki threshold (V) are determined. Assumed constant in this paper. • medium run (MR): the trend demand/debt ratio (t) and the Spending shift factor (St) are determined – but are held constant in the short run. • short run (SR): Bt (private-sector debt) and Kt (industrial capacity) held constant in the short run. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 6 (II) The Subject Matter. Figure 1 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 7 (II) Three SR Equations. 1. The EE (expenditure) curve relating demand for GDP (Et) to the expected demand/debt ratio (xt); 2. The AA line, determining the actual demand/debt ratio (at) at each level of demand (Et); and 3. Expectations adjustment, so that the expected and actual demand/debt ratios are equal in short-term equilibrium (x = a). The adjustment equation is left implicit here. It’s treated as merely a matter of an automatic movement to short-run equilibrium. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 8 (II.A) Aggregate Expenditure (EE). Figure 2 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 9 (II.A) Short Run: movement along EE curve. Et = EE(xt, St); EE1 ≥ 0; EE2 ≥ 0 (1) • Shift Factor (St) is constant in the short run. • The sigmoid shape of the EE curve: 1. Between the two vertical segments, spending rises with the expected demand/debt ratio. 2. But investment and total spending do not respond to xt at low demand (due to extreme pessimism, indebtedness, and unused industrial capacity) 3. Nor at high demand (due to supply-side bottlenecks). 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 10 (II.B) Actual Demand/Debt Line (AA). figure 3 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 11 (II.B) The Actual Demand/Debt Line (AA) at ≡ (Et/Z)(Z/Kt)/(Bt/Kt) ≡ et · t /λt (2) • The actual expenditure/debt ratio depends on three ratios: Expenditure/potential = employment rate (et); The Kalecki factor: Potential/industrial capacity (Z/Kt = t); and The Minsky factor or the degree of leverage: Private debt/industrial capacity (Bt/Kt = λt). 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 12 (II.B) Simplifying… Let t /λt ≡ αt so that: at ≡ et·αt (2A) • The actual demand/debt ratio (at) reflects the utilization of potential (et); and αt ≡ the trend value of at (held constant in the SR) which reflects: the Kalecki factor (t); and The Minsky factor (λt). 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 13 (II.B) Short run: movement along AA curve. • Since Bt and Kt are held constant in the short run, • λt (the leverage ratio), ρt (potential output/capital ratio) and αt, the trend output/debt ratio are constant. • The actual demand/debt ratio(at) varies only with the utilization of labor (et): a linear relationship. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 14 (II.C) Short-run equilibria. at = xt, so that Et(at, St) = Et(xt, St) (3) (3A) • The process of adjustment of expectations (xt) to actual values (at) indicates that equilibria L and H are stable, while M is unstable. • In figure 4, the small arrows show the direction of disequilibrium adjustment. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 15 (II.C) Short-Run Equilibria. figure 4 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 16 (III) Medium Run: Shifting EE curve. • St changes and EE shifts due to fiscal and/or monetary policy, changes in expected inflation, and/or changes in long-term profit expectations. • Stimulus (the shift to EE’) means that a lower x than before is associated with the same amount of expenditure. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 17 (III) Medium Run: Shifting EE curve. • The limits to Stimulus. Near Z, the curve cannot shift to the right (only downward) due to labor-supply constraints. and demand-side stimulus can only be temporary (since only inflation results in the end). • to describe the “Great Moderation,” St is held constant with a high Et – indicating effects of the trend underlying EE fluctuations. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 18 (III) Minsky/Kalecki Dynamics. • Persistent high Et above Minsky/Kalecki threshold V implies that either or both: leverage (λt) rises (Minsky). o Extended prosperity encourages more and more borrowing as prosperity is expected to continue and memories of the Great Depression and past financial crises fade. o This assumes that the financial system is poorly regulated. the potential-industrial capacity ratio (t) falls (Kalecki). o High demand encourages fixed investment while the fixity of Z means that effective “capital productivity” (Z/Kt) falls as not all of the industrial capacity can be used to produce. o Persistent high demand may cause “disproportionalities” as the wrong kind of investment is done, given the structure of demand. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 19 (III) Minsky/Kalecki Dynamics. αt = –M(Et – V); with constant M > 0 (4) • Persistent high Et above Minsky/Kalecki threshold V implies that λt rises and/or t falls. And αt falls, flattening AA, as in figure 3. • Going the other way: persistent Et < V rotates AA counterclockwise. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 20 (III) The Economist’s Holy Grail. • In theory, medium-run equilibrium exists where Et = V (with constant α). • But can this holy grail be both attained and maintained? • The answer depends on the relationship between V and the AA/EE tangency point T (introduced below). 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 21 (III) Endogenous Disequilibration. • Equation (4) and Et > V imply falling αt in the MR, which leads to endogenous disruption of any shortrun equilibrium attained. • This in turn implies either A. a “mild” recession or B. a Fall off a Cliff. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 22 (III.A) A “Mild” Recession. figure 5 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 23 (III.A) Mild Recession & Cycle. • Holding EE constant, falling αt leads to clockwise rotation of the AA line to AA2. • Because the AA/EE tangency point HM at Et = T is below the threshold V, the recession (declining Et) causes endogenous reversal of decline in αt as soon as Et < V. Spending recovers as AA rotates counterclockwise. • A “typical” cycle involves repeated clockwise and counterclockwise rotation of the AA line … along with a lot of other considerations such as the inventory cycle. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 24 (III.A) MR equilibrium maintained? • Attainment of MR equilibrium can occur (at H2). • This is a stable SR equilibrium with constant αt. • However, this MR equilibrium requires maintenance of relatively high unemployment of labor to prevent the Minsky/Kalecki trend. This is a “reserve army of labor” theory (à la Marx). • Standard business cycle theory suggests reasons why the economy might oscillate around MR equilibrium. Nonetheless, this equilibrium is stable. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 25 (III.B) Falling Off A Cliff. figure 6 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 26 (III.B) The Fall. • Holding EE constant, falling αt again implies clockwise rotation of AA to AA2. • In this case, Et at the tangency point T is above the threshold V. The same result occurs with equality of these two points. • Thus, the recession causes points H and M to converge to the tangency point HM, which is unstable downward. • Because V is low, αt continues to decline. • So even if equilibrium at HM is maintained, the SR equilibrium point disappears entirely. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 27 (III.B) The Fall and MR equilibrium. • The medium-run equilibrium at Et = V cannot be attained because it does not correspond to a stable SR equilibrium. • The model instead implies a Fall to point L (stagnation). 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 28 (III.B) Does a Fall occur? • We cannot say a priori what the relationship between points T and V is in the real world – so we can’t say which of the two cases occurs. • But T is likely to be relatively high due to an extended period of relative prosperity (such as the “Great Moderation”) which allows imbalances to accumulate, lowering αt for long periods. • With T associated with a higher level of Et, a Fall is more likely. • This kind of trend is seen in figure 7, even if the “Moderation” was anemic from labor’s perspective. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 29 (III.C) The Great Moderation and Falling αt. figure 7 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 30 (III.C) Illustrative regression: the trend. ln(at) = 0.3704 – 0.0027·(time index) Adjusted R2 0.5848 Standard Error 0.0623 95 (Great Moderation only) Coefficients t-stat Constant 0.3704 27.0460 Time coefficient –0.0027 –11.5499 Observations Data Source: Federal Reserve Flow of Funds accounts. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 31 (III.C) A Major Caveat. • Even though the trend in t is statistically significant, that does not mean that we can conclude that the fall was large enough to explain the 2008-9 collapse of the U.S. economy. • To say that would require that we know much more about the shape of EE and the structure of the economy. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 32 (V) Recovery or Stagnation? figure 8 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 33 (IV.A) the aftermath & Recovery. • In figure 8, because Et at point L3 < T, there is an automatic tendency toward recovery due to deleveraging (λt) and purging of unused capacity (ρt ). • So αt rises, rotating AA counterclockwise. • Equilibrium points L and M converge to ML, which is unstable upward: the economy leaps up the cliff. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 34 (IV.B) the aftermath & Stagnation • Et at point L might exceed T, so the Minsky/Kalecki trend continues, making matters worse. • More importantly, recovery can be counteracted by the MR results of extreme unused capacity and indebtedness, which encourages waves of deflation, default, and rapid-onset despair. These shift EE up and left to EE’: higher x is required to induce the same amount of spending as before. Continued or deepening stagnation results. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 35 (V) Policy’s Role. • Policymakers can be “villains” by maintaining high demand – encouraging the accumulation of imbalances as in a Great Moderation. • But in a stagnation period, they can become “heroes” by stimulating demand. Fiscal policy (if politically possible) and monetary policy (if it works) can “prime the pump,” spurring recovery. This shifts EE downward, moving the tangency point to the left, making recovery more likely. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 36 (V) To Create a New Prosperity. • What encourages the creation of new prosperity? 1. Efforts to lower the leverage ratio (λt), via mass bankruptcy and the like. 2. Efforts to raise “capital productivity” (ρt) by scrapping excess and/or inappropriate industrial capacity. • Both of these artificially raise αt rather than waiting for the “automatic” process. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 37 Preventing falling αt • Increased leverage can be prevented using improved financial regulation. • Decreased capital productivity cannot be prevented without raising Z or avoiding disproportionalities. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 38 (V) To Preserve the New Prosperity. • What can encourage the persistence of new prosperity, preventing the negative effects of a new “Great Moderation”? 1. Raise Z by increasing the supply of labor. 2. Raise Z by increasing labor productivity. • If successful, both of these allow persistently high demand by increasing supply in step. 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 39 Finis 8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 40