Tuesday, August 19, 2014

Secular Stagnation: Useful Ideas or Hot Air?

There is an ebook available on "Secular Stagnation: Facts, Causes, and Cures," which consists of a set of papers by a group of economists, brought together in an attempt to understand secular stagnation, and how we might address the problem, if it is one. Some of the papers are summaries of published or unpublished research, while others are more speculative.

What is secular stagnation? Apparently it's frequently on the lips of some people, but according to Barry Eichengreen,
I think the problem here is that an idea cannot be understood if it's not an idea. The people who claim that the idea exists - principally Larry Summers and Paul Krugman - trace it to Alvin Hansen's "Economic Progress and Declining Population Growth," from 1939. Nicholas Crafts summarizes what Hansen had to say:
The first time around, ‘secular stagnation’ was a hypothesis famously articulated by Alvin Hansen ... Hansen argued that the US economy faced a crisis of underinvestment and deficient aggregate demand, since investment opportunities had significantly diminished in the face of the closing of the frontier for new waves of immigration and declining population growth. It was as if the US was faced with a lower natural rate of growth to which the rate of growth of the capital stock would adjust through a permanently lower rate of investment.

As we all know, these fears were completely without foundation – the delusions of a hypochondriac rather than the insightful diagnosis of a celebrated economist.
I think we could go even further than that. Not only were Hansen's writings the "delusions of a hypochondriac," but we would have a hard time making sense of his arguments in the context of the modern theory of economic growth, and what we know about the causes of growth and the reasons for differences in standards of living across countries. Suffice to say that a re-reading of Alvin Hansen won't enlighten us as to what we should expect from the world economy over the next twenty years or so.

But, what about the contents of this ebook? There are really two parallel notions of stagnation discussed in these contributed papers. For convenience, I'll call these growth stagnation and Keynesian stagnation. The growth stagnation idea appears to take conventional economic growth theory as a basis for how we should think about future economic growth, in the U.S. and in the world. From Hsieh and Klenow, empirical work on economic growth tells us that we can account for 10-30% in income differences across countries by differences in human capital, about 20% by differences in physical capital, and 50-70% by differences in TFP (total factor productivity). This should also apply to the time series. So if, for example, we are pessimistic about future TFP growth in the U.S., we then have a strong reason to be pessimistic about future real GDP growth in the U.S. On one side of the argument, Robert Gordon is a pessimist. Gordon points out that TFP growth was much lower after 1970 than in the period from 1920-1970, and he is confident that the average rate of TFP growth we experienced for 1970-2014 will persist for the next 25-40 years. Further, he is worried about four "headwinds," i.e. demographics, education, inequality, and government debt. Basically, a smaller fraction of the U.S. population will be working, educational attainment in the U.S. has plateaued and the quality of U.S. education may be in decline, inequality in incomes has increased and may continue to do so, and there are reasons to think that government debt could increase relative to GDP.

If reading Gordon's entry in this volume is inclined to make you depressed, Joel Mokyr's piece is a great pick-me-up. He says:
There is nothing like a recession to throw economists into a despondent mood. Much as happened in the late 1930s, many of my colleagues seem to believe that ‘sad days are here again’. Economic growth as it was experienced by the world through much of the 20th century, they tell us, was a fleeting thing. Our children will be no richer than we are. Some of the best economists of our age, including Larry Summers, Paul Krugman, and my own colleague Robert J. Gordon, are joining the chorus of the doomsayers. It is said that we are faced by headwinds that inevitably will slow down growth and perhaps condemn us to secular stagnation. There is no denying that the population of the world is getting older, and that the fraction of people working (and supporting the aged) is falling everywhere except in Africa. The ‘big pushes’ driven by millions of married women taking jobs and the huge increase in college graduates that drove post 1945 growth were one-off boons, but they are no more. Growing inequality exacerbates demography. Slow growth is here to stay, say the secular stagnationists.

What is wrong with this story? The one word answer is ‘technology’. The responsibility of economic historians is to remind the world what things were like before 1800. Growth was imperceptibly slow, and the vast bulk of the population was so poor that any disruption in food supply caused by a harvest failure could kill millions. Almost half the babies born died before reaching the age of five, and those who made it to adulthood were often stunted, ill, and illiterate. What changed this world was growth driven by technological progress. Starting in the late 18th century, innovations and advances in what was then called ‘the useful arts’ slowly began improving life, first in Britain, then in the rest of Europe, and eventually in much of the rest of the world. The story has been told many times over, but as Nobelist Robert Lucas once wrote, once you start thinking about it, it’s hard to think of anything else.
So, we should stop moaning, and recognize that life is pretty good and likely to get much better.

Mokyr's point is that there is much important scientific advance happening right under our noses, and that this new science will be applied in many ways that we might find hard to imagine from our 2014 viewpoint, just as Alexander Graham Bell would have a hard time imagining an I-phone. Further, the effects of current and future innovations on economic welfare may not be measured well. For example, information has become much more accessible in myriad ways that make us better off, but not all of that is captured in GDP.

Technological change does create economic problems that we need to deal with, though. It is now well-understood that an important factor in the increase in the dispersion in income in the U.S. in the last 30 years or more has been technological change. This change can bring huge rewards to innovators while depreciating particular types of human capital. For example, David Autor has written about the hollowing out of the skill-distribution because information technology makes middle-level skills obsolete. This then becomes a challenge for U.S. education. Indeed, better access to public education at all levels is a possible remedy for the income-distribution problem that Gordon seems to be concerned with.

In terms of the growth stagnation story, there is nothing in this volume that sheds new light on the growth process, and would permit us to confidently project stagnation in the medium to long term, in the U.S., or in the world. We know a lot about how TFP, human capital accumulation, and physical capital accumulation, work to produce growth in per capita incomes, but we perhaps know little about the actual process of innovation, and how to predict it.

The idea that seems to have spurred the publication of this volume, however, is not growth stagnation, but Keynesian stagnation. But Keynesian stagnation does not appear - at least to me - to be in the Keynesian tradition. Keynesians have been quite comfortable with the idea that mainstream growth theory could guide our thinking about "long-run" issues, while sticky-price and sticky-wage economics could guide our thinking about "short-run" issues. For example, Robert Solow provided us with the foundation for modern growth theory, but also wrote (with Paul Samuelson) a classic paper on how to exploit the Phillips curve tradeoff. Similarly, Mike Woodford took a several-generations-later version of Solow's growth model (with credit to Cass, Koopmans, Brock, Mirman, Kydland, and Prescott, along the way), put in some sticky prices and monetary policy, and convinced central bankers that it would be a good idea to use such a model to think about short-run monetary policy. New Keynesian models have the property that monetary policy is non-neutral in the short run, but the mechanics of the basic growth model take over in the long run.

This is definitely not what Larry Summers and Paul Krugman have in mind. Here's the basic hypothesis, as stated by Summers:
Unfortunately, almost all work in both the New Classical and New Keynesian traditions has focused on the second moment (the variance) of output and employment. This thinking presumes that, with or without policy intervention, the workings of the market will eventually restore full employment and eliminate output gaps. The only questions are about the volatility of output and employment around their normal levels. What has happened in the last few years suggests that the second moment is second-order relative to the first moment – the average level of output and employment through time.
I'll take "New Classical and New Keynesian traditions" to be represented by the ideas of Mike Woodford - prices and/or wages are sticky in the short run, and in the long run the world works according to the Solow/Cass/Koopmans/Brock/Mirman/Kydland/Prescott growth model. But what Summers sees is a world that is not at "full employment" even in the long run. He doesn't say this, but presumably he thinks that price rigidity and/or wage rigidity can persist indefinitely.

So what's the problem? Summers points out that the real rate of interest has declined over time, and argues - in typical New Keynesian fashion - that this has created a zero-lower-bound problem. The actual real rate has fallen, but it should be lower than it is (the "natural rate" is lower than the actual real rate), but monetary policy cannot lower the real rate further, because the short-term nominal interest rate is at its lower bound of zero. Summers argues that this problem could persist long into the future. Stagnation is then essentially a nagging output gap, that monetary policy cannot correct in the "usual" fashion. Paul Krugman is basically on the same wavelength.

If you are a young macroeconomist, you might be thinking of Summers and Krugman as some creaky dinosaurs blowing hot air. Where is your model, Summers and Krugman, you might say. Well, Eggertsson and Mehrotra have fleshed out a theory that they think captures what Summers and Krugman are trying to get at. The Eggertsson and Mehrotra chapter in this volume is a summary of a formal academic paper that I discussed in this post. The gist of that blog post is that Eggertsson and Mehrotra - as with Eggertsson/Krugman, which is closely related - focus on the wrong problem. The key inefficiency in their model arises from a credit friction, but they are focusing their attention on the secondary zero-lower-bound inefficiency that the credit friction creates. Basically, the problem is insufficient government debt, and the solution is straightforward.

Now we are getting somewhere. The contribution in this volume from Cabellero and Farhi gives a nice synopsis of safe asset shortages and why such shortages produce the low real interest rates we have been observing. Before the financial crisis, high savings in the world combined with financial innovation created a high demand for safe assets - as stores of wealth, as collateral, and for exchange in asset markets. Governments can supply safe assets, but the private sector can also do it. So, if governments do not increase their outstanding debt in the face of an increased demand for safe assets, then the price of safe assets rises and real interest rates fall. This creates a profit opportunity for the creation of safe private assets. Indeed, asset-backed securities could perform such a role. But the financial crisis showed us that, in the face of poor regulation, the capacity of the private sector to produce safe assets can be limited. Further, when the private sector builds up a stock of "safe" assets which proves not be safe, the ensuing destruction and loss of trust can result in persistent inefficiencies.

The private sector is rebuilding its capacity to produce safe assets, but changes in private sector regulation are also serving to increase the demand for safe assets. For example, the liquidity coverage ratio included in Basel III banking regulation will create an additional demand for safe assets by commercial banks. Though there are things that central banks can do in the face of safe asset shortages (as I show here and here), a safe asset shortage is basically a fiscal problem. The safe asset shortage is reflected in binding financial constraints that imply the economy is non-Ricardian. Government debt matters, and an expansion in the stock of government debt can be welfare improving. Presumably this also implies a lower net cost of financing government projects, meaning that a safe asset shortage provides an opportunity for the government to finance education and infrastructure on the cheap. Note that we can come to that conclusion without ever invoking stickiness, multipliers, fallacy-of-this, or fallacy-of-that.

An interesting feature of this paper is that it captures some of Larry Summers's concerns about monetary policy and financial stability. In the model, when there is a shortage of safe assets, low real interest rates can create incentive problems in asset markets. Basically, creating safe private assets is profitable when the real interest rate is low, but misrepresenting unsafe assets as safe ones is potentially even more profitable. Conventional monetary easing acts to reduce the real interest rate, and therefore aggravates incentive problems. Indeed, if incentive problems are severe enough, a safe asset shortage induces a situation in which the central bank should not push the nominal interest rate to zero.

The editors of this volume, Coen Teulings and Richard Baldwin, seem convinced that the potential for secular stagnation, whatever it may be, requires some radical rethinking of policy approaches. I don't think so. While there is much we don't know about how economies work, and we continue to learn, normal economics is certainly not at a loss in dealing with the problems we face, or will face.


  1. "So, we should stop moaning, and recognize that life is pretty good and likely to get much better."


    1. Yes, and read the stuff that comes after that to put that sentence in perspective.

  2. It would be useful if you could reconcile the concept of "safe asset shortage" with the ongoing boom in risk assets. How are the two compatible? For instance, High Yield issuance is quite strong. Companies clearly have no trouble financing themselves by issuing risky liabilities. Further, both realized and expected volatility implied by option premia in markets from FX to equities show a high level of expected stability in prices. Again, this is not an environment in which borrowers are generally constrained from undertaking projects by a generalized risk aversion. The notion that the real interest rate is "too high" to support investment needed to create full employment also runs counter to the data on non-structures investment to gdp, which has recovered to pre-Crisis levels. A generalized risk aversion would inhibit all kinds of investment, not just in structures.

    I sense that the "safe assets" concept is just tautological. Why are real rates low? Excess demand for safe assets. How do we know there is excess demand for safe assets? Real rates are low.

    1. "The notion that the real interest rate is "too high" to support investment..."

      Different interest rates. The safe asset shortage implies that the real rate on safe assets is too low. But the real rate of return on capital can be high, with investment impeded by the shortage of liquidity.

    2. "...investment impeded by a shortage of liquidity"

      Where is the evidence of liquidity premia impeding investment?

    3. According to the data published by the St. Louis Fed, until 2013 the spreads between Baa and Aaa bonds and between below-grade and Aaa bonds were still higher than they had been before the crisis. In 2013 they returned to pre-crisis levels, and I think we did see an improvement in economic conditions, but the spread between credit card rates and Aaa bonds remains higher than before the crisis, which is consistent with the fact that the market for securitized consumer loans remains subdued. Finally, I think one would also have to look at the evolution of spreads between traditional versus non-traditional Asset Backed Securities of the same rating. My guess is that they have increased, but I do not have the time to look at them now. In any case, in my opinion there is some evidence of a shortage of liquid assets, but how big its contribution is to the stagnation is unclear.

    4. In the models, firms supposedly won't fund high return projects because illiquidity harms their financing cost/access.

      In reality, corporations face enormous demand for their supposedly illiquid debt, and they issue it in droves to fund share buybacks instead of what presumably are low return competing projects.

      The burden is on the safe asset theorist to reconcile the two.


      Stocks are more liquid than a new factory or production line, so I do not think it contradicts the model if a company tries to boost the return on its equity by buying back its shares rather than investing in various projects. But, in any case, in the models the problem is that the shortage of safe assets reduces transactions within the banking sector because of the role these assets play as collateral in repos and other transactions among banks. Greater issuance of low grade bonds does nothing to ameliorate this problem as such bonds cannot perform this function. If banks have harder time selling to other banks consumer and commercial loans issued by themselves or other banks and can't find other safe assets to buy they are likely to hold more reserves and reduce credit. This should have an adverse effect on investment as well as consumption. At least, this is my understanding, but I defer to Steve.

    6. Ultimately, the collateral shortage has to affect intermediation. If credit is readily accessible at normal spreads, what, exactly, is the problem?

    7. The idea is that a fraction of depositors engage in purchases using monitored transactions (debit cards, checks, etc.) rather than withdrawing cash. These purchases generate claims from the bank of the seller against the bank of the buyer. To settle these transactions, banks do not need to hold reserves, provided that the financial instruments generated when a bank lends out its reserves are liquid, meaning that a bank can settle a claim by transferring to the other bank ownership of loans or of derivatives that have bank loans as underlying assets (e.g., mortgage-backed securities). Now suppose that some types of financial instruments generated by banks lose their liquidity, meaning that they are no longer acceptable by other banks. In this case, banks need to hold excess reserves in order to settle even some of their monitored transactions. In turn, this means that they reduce credit. Because there are fewer liquid loans supplied, their price rises (and their interest rate falls). But consumption and investment fall below what is Pareto optimal because there exist borrowers who are willing to pay an interest rate high enough to entice depositors to supply the demanded funds but banks refuse to intermediate between the two because the terms of the loans that these borrowers are willing to accept render them illiquid within the banking sector, This results in a deadweight loss. And while corporations can tap bond markets, individuals and small businesses cannot. As in other models with asymmetric information and liquidity constraints, a possible solution is for the government to borrow on behalf of the individuals, for example by giving a tax cut financed by a deficit. In essence, the government issues liquid financial instruments on behalf of the private sector who has lost the ability to do so.

      Disclaimer: The models are much richer and somewhat different than the story above, but this is the best I could do to tie them to what is going on in the real world and also keep the length of the comment reasonable. I hope I have not butchered what Steve had in mind when he wrote them.

    8. Thanks for the clear summary. I don't think it holds together though. The nut of it is that individuals/SME credit is illiquid. Let's take these one by one. Subprime auto lending is booming. Credit card receivables are easily securitized. Agency mortgages are easily securitized. Within the consumer space, only non-Agency mortgages have an issue. Now take SME's. Some portion of SME credit was always securitized (SBA). Another portion, the lion's share, is why community/regional banks exist in the first place: to take on the information costs of extending non-securitizable credit to this sector.

      Summing up: there is no evidence that lending to individuals is constrained by, "excess demand for safe assets". There is no evidence that, on the margin, "excess demand for safe assets" makes it harder for SME's to get credit.

      There is, however, a big problem. SME's and individuals can no longer easily obtain credit via non-Agency cash-out mortgages or HELOC's. This is not evidence of "demand for safe assets". It is evidence that the technology of those two products was a failed one, something that we did not discover until 2008.

    9. I forgot to mention that there is an additional reading to the models, which is probably closer to what Steve had in mind. The idea is that assets like Treasuries, loans, etc. have an advantage over reserves in that they can be used in structured finance, for example to construct asset-backed securities, CDO's, etc. A reduction in the availability of assets that can be used in structured finance has the effect of reducing the production and trading of such products, and therefore the income generated in this sector. In turn, this results in lower demand by the finance sector for goods and services produced by other sectors.

      Of course, this is a concern only if one believes that much of what structured finance was doing before the crisis had positive social value!

    10. And, as far as the data are concerned, some evidence is that the securitization of mortgage, C&I and consumer loans remains subdued relative to pre-crisis levels (if I remember correctly especially for consumer loans) and that in surveys the vast majority of banks reported a tightening of lending standards for all types of loans through 2008 and 2009 even as demand for loans was weakening. Some of this has been reversed recently, but not to the extend that existed before the crisis.

    11. If something remains subdued relative to pre-crisis levels, this is just as easily evidence that the pre-crisis levels were abnormal. A great example is household liquid assets as a % of total assets. The percentage is elevated today compared to 2007, but not compared to 1997. In 1997, the economy was doing great, and no one claimed there was, "excess demand for safe assets".

    12. Actually, I don't think that liquid assets as a % of total assets is a good gauge. A nice feature of Steve's model is that you can use the interest rate as a gauge of how low the supply of safe assets is relative to demand. If the supply of safe assets is abundant relative to demand, then the interest rate will have to be high and equal to the rate of time preference. In lame terms, the amount that people deposit for the purpose of buying things gradually until their next paycheck is not enough to meet the demand for loans, so borrowers must offer an interest rate that convinces people to save for the long run (sacrifice current consumption to consume more in the future). If the supply of safe assets is low relative to demand then the interest rate can fall below the rate of time preference because people still deposit their paycheck at the bank but spend all of it gradually until they get paid again. Therefore, borrowers can still obtain funds even if depositors do not save for the long run. This cool feature of the model, which reminds me of the Baumol-Tobin model of transaction demand, allows the interest rate to fall below the rate of time preference.

      So, to get to the point, a key difference is that in 1997 the real rate of interest was quite high by historical standards. This means that the supply of safe assets was abundant, and the high interest rate motivated depositors to buy more assets. According to my own published research, part of the increase was due to a high rate of innovation through its effect on the demand for investment. But today, the interest rate on safe assets is very low. The alternative explanation of why this is the case requires us to believe that people have become so patient that they are indifferent between consuming now or later. I do not think anyone buys into that.

      Of course, I agree with you that something was different in the pre-crisis era relative to 1997, and if I were Robert Gordon I would tell you that what is different is that the impact of the IT-revolution is winding down and that the impact of this winding down was masked by the false belief that we had found a better way to deal with asymmetric information with the use of derivatives (e.g. through trenching) , and that now that this belief is gone we are seeing the true nature of things.

    13. The real rate is a complex dynamic. If the real rate was low in the late 70's, did that signify a safe asset shortage? Similarly, in Japan for much of the past twenty years, the real rate has been higher than it has been in the U.S. for the past fifteen. Does that mean the U.S. had a safe asset shortage relative to Japan? If so, how should that have impacted their relative rates of growth?

      I do agree with Steve's model in that savers should earn a positive real rate to postpone consumption. The question is how the Fed is able to maintain stable inflation expectations while, in effect, taxing safe asset savers. The "safe asset shortage" explanation says this is not a tax, but a scarcity premium. I think it is more complicated than that. There are agency effects and carry trades, plus global central banks have targeted low rate volatility. Put all those together and you have front running and herding effects that depress the real rate. Does all that square with EMH? Well, there are agency effects that drive market failures. The PBOC's willingness to hold term Treasuries with negative real rates is a glaring one. Is this "demand for safe assets" or merely a byproduct of the country's mercantilist development strategy? Similarly, if pension funds are still shooting for an 8% return to hold down plan contributions, and so therefore must lever cap-gains bets on 30yr Treasuries, is that "excess demand for safe assets"? Again, no, it is an agency effect.

    14. "If the real rate was low in the late 70's, did that signify a safe asset shortage?"

      Well, it is not a crazy idea. On one hand you had fast rate of growth of government liabilities, resulting in high inflation. This tends to increase the demand for interest-baring safe assets as it raises the cost of holding reserves. On the other hand, we had negative productivity shocks that reduced the expected profitability of the private sector. This tends to reduce the supply of safe assets by the private sector. The two effects reinforce each other in creating a relative scarcity of safe assets, thus reducing their real rate of interest. Pretty cool, huh?

    15. Lots of leaps there. Supply of private sector safe assets at the time was a function of the stability of the banking system, which did not see a hicup from the 40's through the 70's. Further, "demand for interest bearing safe assets" does not rise during high inflation, or Brazil/Argentina would have had well functioning long term bond markets in the early 90's. High inflation countries tend not to have long-duration fixed income markets because of the the volatility of long term rates.

      In short, the real rate is a complex function. Tying it to "demand for safe assets" in one period: 1) amounts to a tautology as the evidence for that demand is, in turn, low real rates; and 2) does not explain the real rate in other periods/geographies.

    16. "private sector safe assets at the time was a function of the stability of the banking system"

      Not true! As in the model (see Steve's 2012 AER paper) so in real life the supply of safe assets is related to the distribution of returns of the investment opportunities available to the private sector. A shifting down of this distribution reduces the ability of the private sector to supply safe assets.

      ""demand for interest bearing safe assets" does not rise during high inflation"

      Sure it does! If you go by the Keynesian liquidity preference theory, demand for money is negatively related to the nominal rate of interest (which includes the rate of inflation), since the latter is the opportunity cost of holding money instead of interest-baring assets. In Steve's model (see his 2012 AER, section 3.3.3) when inflation is high, people would rather spend the money right away rather than deposit it at the bank where it loses purchasing power faster. This results in a higher price level for goods at all dates (lower price level for money), which reduces the real stock (purchasing power) of outstanding government bonds that serve as safe assets. In turn, this reduces their real interest rate! Now, are the bonds of Brazil and Argentina really safe assets? Come on now!

      You seem too eager to dismiss the theory. I think you should spend more time thinking/reading about it. Anyway, I am calling it quits at this point.

    17. I wonder if Steve would claim his model applies to Brazil in 1992 (negative real rate), the U.S. in 1979 (negative real rate), and Japan in 1998 (positive real rate). Would make for an interesting post though.

  3. Hi Stephen,
    The cause of what appears to be stagnation is lower labor share throughout the advanced countries. Even in China, labor share has fallen substantially over the past 15 years which is hard to fathom. In the UK, labor share has fallen too causing their productivity puzzle. But there is no puzzle. Productivity is constrained by the lower effective demand from lower labor share. This is what my work is showing.
    Labor must have a better share of the economic pie to support their consumption and grassroots innovation and investment. When labor has less economic leverage, an economy slows down and its potential decreases.
    The issue of safe assets becomes a symptom of the effects of low labor share. The incentive to invest depends upon the demand for final production, which leads us back to labor's share of production.

    If we were to see a coordinated effort among many advanced countries to revive labor share, this aura of secular stagnation would dissipate like a morning dew fog.

    1. "Labor must have a better share of the economic pie to support their consumption and grassroots innovation and investment..."

      I can understand arguments for income redistribution as a cure for poverty, where we have to somehow trade off equity and efficiency, but your argument certainly isn't obvious.

      (i) How can I think about a reduced labor share as somehow independently leading to some kind of stagnation problem. Surely the reduced labor share is a symptom - something caused that to happen.

      (ii) Now, suppose that we could somehow increase labor share. Why would that be a good thing? Surely it matters what policies we implement to increase labor share.

      (iii) What's the optimal labor share in an economy?

    2. Apparently evidence is not in Edward Lambert's toolbox. Effective demand? No such thing, or rather it can be anything you want it to be? People aren't buying? Their effective demand must be low. People are buying? Their effective demand is still too low. Go away, crackpot.

    3. Hi Steve,
      I have been reading the ebook that you link to... They mention Effective Demand in the section titles, but they do not even describe what the term means or even use it in any article of the book. People do not understand effective demand, but the concept is working its way into the understanding.

      Answers to your questions...
      i... Think of Germany where they reduced labor share and national savings increased. The result was an increase in their exports to zero out their balance of payments. If there is no one to absorb the excess production, what would have happened to Germany? Stagnation.

      ii... Increasing labor share would increase demand for final consumption goods. But the key is to see that increasing labor share increases effective demand. So you would need to understand what effective demand is. Effective demand is a limit upon production. The easiest way to describe it is like this... firms will not produce beyond labor's share of total productive capacity. So if total productive capacity is $20 trillion, and labor share is 75%. Then the economy will not want to produce beyond $15 trillion. This has been the pattern for as long as I have data (since the 1960's).
      Imagine a baker who has 15 potential customers. The baker can produce enough for 20 customers. The baker will always lose if he bakes for more than 15 customers. There are reasons to have excess capacity for production. As long as the baker produces for less than 15 customers, he has pricing power to increase profits. You will see a similar reasoning by Keynes on page 220 of this link. (in the full paragraph on that page)

      iii... The optimal labor share depends on the optimal and sustainable growth path of your economy. As an economy matures, optimal labor share will increase. The same used to happen in business. As a business matures, it will hold less retained earnings and pay out a larger share to management and the workers.
      We now see labor share reversing in advanced countries from Germany, China, Japan, UK, Euro area to the US. The problem is that our economies have matured and don't have incentive for investment like they used to years ago. Our economies have come to rely on stable demand. But when demand weakens due to income, there is less incentive to invest and more incentive to hoard profits. Then you see a secular decline.


    I will let Edward answer his own way, but I think if we think of societies in Africa/South America - there are large concentrations of wealth among oligarchs. Potential labor is underutilized. Investment gets concentrated in unproductive areas as it chases too few opportunities.

    By contrast Japan and China developed with a fairly egalitarian base (especially due to critical land reforms which allowed peasants to accumulate to keep a surplus and save or invest it). These savings created new markets and new demand for labor. This also became the basis of a broad tax base - not just one reliant on a few oligarchs (who probably wouldn't pay it anyway.)

    In contrast in failed states oligarchs buy up the land of heavily indebted unproductive tenancies forcing them into unemployment, and in the process, shrink the economy and the taxbase.

    Try and think in a Post Keynesian framework now. There is no equity-efficiency trade-off. Some level of equity is a precondition for balanced and sustained growth.

    Now you may be able to begin to understand why it may be desirable to improve labor's share, not just on equity grounds, but efficiency grounds too.

    Anyway there is a big literature on this. Try Gunnar Myrdal first. It will require however that you throw away a lot of the framework you are used to using and a lot of artificial clutter.

    Yes it does matter what policies are pursued! Clearly the Chinese and the Japanese did a better job of land reform than the Russians. When it comes to income redistribution policies, personally I think we need to take a close look at north European case studies. This requires perhaps the consideration of direct prices and incomes policies.

    1. Seems you think property rights are important.

    2. They are. And so occasionally are their redistribution. Preferably this is not done through a reorganization of power that involves violent revolution ;).

    3. Except that in Latin America, which you bring as an example, the problem is not property rights per se, but their weak enforcement. Hate to self-promote, but here is some evidence: http://onlinelibrary.wiley.com/doi/10.1111/rode.12013/abstract

    4. For sure, power is central.

      What I hope to see in the Summer/Krugman book is a clarification of the issues. I am not expecting anything new here. These issues have been talked about a very long time. For example there has been a lot of discussion among historians about the causes of deindustrialization and long term unemployment in advanced countries, why there was a slowdown in growth since the 1970s and how this environment led to less effective multiplier effects from macro-economic policy. Angus Maddison particularly comes to mind.

    5. "Except that in Latin America, which you bring as an example, the problem is not property rights per se, but their weak enforcement."

      It is rather the other way around. One problem in many South-American countries is the unequal distribution of land and everybody who read his Stiglitz (Incentives and Risk-Sharing in Sharecropping) knows that this has negative incentive effects. Not to mention the "political externality" of inequal land distribution, right-wing land owners supporting antidemocratic policies and so on.

    6. Is the last comment an exercise in postmodernism? Or the product of an utterly confused mind?

    7. Last time I checked incentive problems due to asymmetric information literature has nothing to do with postmodernism. Somebody is indeed utterly confused ...or shall I say economically illiterate?

    8. What is postmodernist is citing in every post the same Stiglitz paper regardless of whether the topic of discussion is business cycle, the underdevelopment of Latin America, Picasso's Guernica or loop quantum gravity. We read Stiglitz paper; we get it! You obviously don't!!

    9. You have obviously not read this seminal paper, otherwise you would not become so mad when somebody mentions it and its implications concerning land inequality in the third world.

  5. Beautiful post.

    A small quibble. You write, about the Eggertson model(s): "Basically, the problem is insufficient government debt, and the solution is straightforward."

    It seems to me the same reasoning can be applied to your paper as well. If the costs of "cheating" are high enough, the financial system operates efficiently and we're back to the best of all possible worlds.

    So, again, the "solution" appears "straightforward": let's prosecute white collar crimes with an iron fist.

    Am I missing something important here?

  6. As John Cochrane wrote "when Daron Acemoglu, who seems to know everything about everything, has to preface his comments on macro papers with repeated disclaimers of lack of expertise, it's clear that the two fields really have gone their separate ways. Perhaps it's time to merge fluctuations with finance, where we seem to be talking about the same issues and using the same methods, and growth to merge with institutions and political or social economics. "

    Solow and Romer-Jones endogenous growth models have run smack into a dead-end in other words.

    1. Interesting, I think that was a particularly prescient comment by Cochrane.

  7. This was everything I wanted in a Stephen Williamson post. Meandering, original, and self-confident enough not to hold back on the crazy. Bonus points for casting Summer's horrendous proposal for the Fed to worry about financial instability instead of inflation and unemployment in positive light. I'd have like to see more name-calling directed at Krugman and his ilk "creaky dinosaurs blowing hot air" wasn't enough for me. Stephen, did you have your better half edit this first? Is that why you pulled your punches?