Irrelevant equilibriums

While I agree with Ari Andricopoulos’s observation of the danger of the Taylor rule as well as the utter ineptitude and irrelevance of the whole orthodox macroeconomic profession, this post somehow tends to remind me of Princess Leia pointing out how the tighter the Empire grasped, the more star systems would slip through its hands.

Equilibrium: γ*ES  = (1-αd)*d + (1-αi)*i + (1-αw)*w + (1-αC)*C  (3)

This means that the spending of existing savings exactly matches the amount being saved without any new debt being taken out. This is the true equilibrium in an economy that we need to aim for.

In any case, you can see how the dividends, interest and wages from GDP at time t, as well as the external sources of money (from existing savings, new loans and new central bank money) make up the next period nominal GDP.

What has gone wrong:

I would say that during the 1945 to 1975 period, a period of excellent growth across the developed world, we were broadly in equilibrium. The savings broadly matched the spending of exisiting savings. Governments, using Keynesian policy tools would increase their spending (the government component of L) when savings were too high and reduce when more savings were being spent than new savings made. It all worked pretty well.

What changed in the 1970s was the rise of credit. Looking at the Equilibrium equation (3) above, the share of GDP going to interest and dividends went up relative to the share going to wages. The coefficients of consumption (α) for the interest and dividends is lower than that for wages so we had the following inequality:

γ*ES  < (1-αd)*d + (1-αi)*i + (1-αw)*w + (1-αC)*C

This means that the economy is out of equilibrium. The GDP shown in figure 1, will now go down because of the excess savings.

Previously fiscal policy would have been used to stimulate growth and return the system to equilibrium.

Increased government debt is far more efficient at stimulating the economy than increased private sector debt. I show here that a 10% net increase in private sector debt stimulates the economy and adds approximately 1.1% to GDP growth in the year that the debt is taken out. So the multiplier of private sector debt to GDP here is 11%. However, the cost in future years due to the increase of interest repayments at the expense of wages is 0.15% of GDP for every year going forwards.

The same amount of increased government debt costs only 0.9% of GDP going forwards, but crucially the multiplier on this spending is much higher. Therefore much less government debt is needed to create the same amount of economic stimulus as private sector debt. In fact, I estimate that government debt is an order of magnitude more efficient.

 One problem with the Taylor rule is that it uses a linear trend extrapolation. But the increase in debt means that the growth potential of the economy is lower each year so trying to keep it at the previous trend means more and more debt.

Another point which I disagree on, is that the inflation targeting does not separate inflation with a domestic source compared to that with a foreign source. I discuss the error that I believe that they are making here.

But the main problem is that, as with the whole orthodox macroeconomic profession it seems, is that IT IGNORES PRIVATE SECTOR DEBT.

I can not stress how obvious this is. It assumes that debt can grow indefinitely. It assumes that previous debt has no impact on growth. It creates a positively reinforcing feedback mechanism that ends in stagnation.

This is the real danger of the Taylor rule, Dr Bernanke.

Far from the mainstream notion that private sector debt is irrelevant, I would argue that it makes more sense to measure the macroeconomy – to the extent that we bother pretending it even exists, which is the subject for another day – in credit money. This method would have its flaws, of course, because credit money can evaporate in a heartbeat, but it would have the benefit of providing a much more accurate snapshot of any given moment in macroeconomic activity than the woefully irrelevant Samuelsonian GDP model.

This observation on the negative correlation between private sector debt and GDP growth by Dr. Andricopoulos should be particularly educational for empiricists:

A few weeks ago I wrote this post which showed the results of my empirical study on the effect of private sector debt on the economy. It found that a 10% increase in the level of private sector debt corresponded to a 0.15% decrease in GDP growth every year going forwards. Considering that the levels of private sector debt in many advanced economies is around the 200% level, this is a pretty big drag and on its own would explain the current secular stagnation.

Now, according to the Keynesians and Neo-Keynesians, this shouldn’t be any more possible than the stagflation of the 1970s. Once more, even by its own supposedly empirical standards, Keynesianism, or more properly, Samuelsoniansim, is seen to be a failure.

It’s also worth noting that even Dr. Andricopoulus’s history is an inaccurate summary, at least as far as the USA goes. Below is a chart showing the annual growth of total public and private sector debt, aka “credit money”, in the US economy from 1948 through 2014. Where is this sudden “rise of credit” that is supposed to have taken place in the 1970s? Is it the increase from 8.58 percent in 1969 to a peak of 16.03 percent in 1985?