In a recent post Paul Krugman challenged the “rationale” for the Minneapolis Fed appointment of Neel Kashkari.
His objection lay with “the view” of the new chair (Kashkari) that growth prior to the breaking of the financial crisis was artificially fast due to the leveraging of the economy. Krugman’s point was that just “because we had a bubble, in which some people were borrowing too much,” does not mean that the output produced from 2000 to 2007 wasn’t real and therefore the problem we have now is 100% one of insufficient demand as opposed to supply.
Factors such as increasing income inequality and offshoring (a transitional issue with respect to global investment, production and consumption imbalances) have probably helped lower income growth relative to GDP growth in the US and hence part of the debt bubble itself could be seen as an accommodation and not necessarily wholly unjustified in the context of long term global output potential, but this is dependent on the time frame in which developing economies own domestic demand matures and the imbalances leading to lower wage growth readjust. I discuss these transitional issues in a prior post.
But not all the supply for US consumers during the bubble years , as implied otherwise by Krugman’s article (“We really did produce all the goods and services counted in GDP”), came from within the US economy: the US had a significant trade deficit during this period and much manufacturing production had been shunted off to developing economies. This critically separated production, investment and employment from consumption meaning that we lacked the necessary attendant links between wages and salaries generated from production and investment to consumption, especially given that high levels of production was in economies with much less developed consumer markets.
US consumers had to borrow to finance additional consumption and investment. Additionally, much of the growth in developing economies was itself financed with new loan finance that itself became dependent on leveraged revenue flows from developed economy consumers, flows that came increasingly from debt and not the more balanced and stable income flows. It was the exposure of these developing economies to debt financed consumption that led to the increasing importance of debt financed gross fixed capital investment post the financial crisis. Indeed, given that developed economy stability was brought about by tremendous asset price support operations by world central banks strongly suggests an asset/GDP growth imbalance, an imbalance which Krugman seems to ignore. Much of the prior excess remains held above the economic frame and it was this excess coming back through the frame that was the issue in 2007 to 2009.
I agree with Kashkari in the sense that the economy relative to incomes was growing at an unrealistic rate and that this growth was indeed made possible by unsupportable increases in debt. Much of the decline in mortgage debt seen in the US was in fact written off and not paid off. If consumers had not borrowed to the extent they had, had the property market and mortgage lending not exploded, growth would likely have been much lower. The feedback loop to developing economies would also have been reduced. A more sustainable and lower trend rate of growth would have been much more likely. The fact that the crisis broke with considerable magnitude also strongly suggests material unsupportable imbalances: unconventional monetary policy has likely been more influential to financial stability and asset prices than to fundamental economic activity. We still have a very strong latent demand shock built into the financial/economic infrastructure.
We also need to note that population growth has moved down a considerable notch as has employment growth and productivity growth and that these are all key factors driving real incomes and GDP. Growth ex outsized financial leverage was clearly slowing and income growth was not only slowing but becoming skewed towards a very small percentage of the population. Exaggerated global structural imbalances impacting the necessary direct loop between output and income exacerbated the resultant shock.
The crisis that unfolded during 2007 and finally broke with a vengeance in late 2008 was first and foremost a financial and a debt crisis, a crisis brought about by the imbalance between leverage and economic growth and in particular income growth. Merely spending our way out of the problem is likely going to lead to those very same financial risks that burst onto the scene during 2007/2009. Krugman points to the period 2000 to 2007 as being the period at issue, but the rise in debt had been a steady one prior to the 2000s, and especially so post the early 1990s’ recession. Imbalances build up over time and incremental differences between appropriate and inappropriate monetary policy cumulate over time.
I do have sympathy for Krugman’s invocation of the supply argument in as much as the organics of demand and supply should allow for economic activity without the significant risks that we currently have: debt loads are restricting the type of expenditure profiles that we had seen in the decades leading up to the breaking of the crisis, as is increasing income inequality and changes in the distribution of national income, but the reality is historical growth profiles were built on a growing mountain of debt and deepening structural imbalances. The issue is not merely one of insufficient demand, although the distribution of demand is clearly one important issue.
I believe we have been manufacturing growth against the pull of some very powerful economic forces and the reality is that the financing of this growth had become outsized relative to income distribution, demographic and productivity trends as well transitional dynamics of developing economies: just because at some future point in time there is a given supply potential does not mean that we can safely discount it back to the present.
Additionally, it is debatable whether short term stimulus to maximise demand so that it fills the bounds of the production frontier can be safely extrapolated over time: the focus on unabridged consumption and resource evisceration does concern me.
Clearly interest rates should not need to be so low and growth and the financial system should not be so sensitive to small changes in interest rates and large swings in asset prices. This sensitivity is largely due to the imbalance between debt and asset values and income/GDP growth potential as well as its distribution. In this context Krugman is ignoring the financial world that parallels the organic demand and supply fundamentals of the whole economic infrastructure.
I do question how we can derive Krugman’s implied manufactured rate of growth within the asset price/GDP divergence. What I mean is that during Greenspan’s and Bernanke’s reigns we have traded off financial stability for growth, and Krugman seems to suggest that we can continue to do more of the same.
Should we really be playing god and setting a preferred growth rate relative to a set of fundamentals that historically only served to stress the economic, financial and market system we live in? To me the the asset price/GDP growth divergence is as much a confirmation that growth rate of funding had exceeded the natural growth rate of economic demand given the emergent economic structure .
While GDP growth may depend on expenditure, just how much consumption is optimal is a good question. Much of our push for higher growth rates is driven by the instability lower growth rates would wreak on asset markets: i.e. the discounted present value of future flows may fail to match up to current asset values. The is a latent financial shock that then translates into a demand shock: critical here is that demand over and above the ability of GDP structure and income distribution to support ultimately builds up as asset price/default risks to GDP.
Yes organic growth should not be held hostage to financial markets, yes, stable financial growth without the need to resort to ever lower interest rates is also something that our resources (capital, labour, commodities, technology) should be able to accomplish, but actual growth rates and financialisation should be reconsidered.
And some graphical data analysis:
First of all we need to acknowledge the impact of broad money supply growth driven by the creation of new bank deposits. Money supply growth finances expansion of GDP (C+I) as well as asset prices and we have seen significant increases in money supply growth from the 1990s onwards, rates of increase that dwarf historical relationships by a wide margin. As the two charts below show the rate of growth has become increasingly asset focused, a trend which is I feel an emergent property of a declining interest rate environment. Lower interest rates helped finance both an increase in expenditure and asset focussed money supply growth that helped create significant structural divergences and imbalances within the financial/economic framework. Krugman either ignores these forces or considers them to be immaterial, a point which Steve Keen, Professor of Economics at Kingston University has long since pointed out.
We can clearly see that that personal consumption expenditures in the US have been outpacing wage and salary growth for some time, and the relationships are likely to be even more heavily skewed outside of the higher echelons. Is this not evidence of an unsupportable expansion of demand?
And PCE growth relative to GDP growth, which is significant given that GDP growth is itself highly dependent on the PCE component: note the jump early 1990s, which coincides with the jump in debt levels.
Note also the expansion of the PCE component relative to equipment investment, itself an indication of imbalance:
We can also see a very large jump in real net domestic business investment over the same period of high growth in debt: something was clearly happening in the 1990s and 2000s.
And similarly so for residential property investment. Just because loan finance allowed for large increases in new supply does not necessarily mean that this was a valid trend growth rate that should have been strapped to the GDP body and cumulated thereafter for all eternity.
Even now, we see that consumption expenditures continue to exceed GDP growth rates, so we still have considerable imbalances in the US:
And look at the change in consumer credit relative to personal consumption expenditures: while the mortgage bubble became pronounced post 2000, debt financed consumption expenditure has a much longer pedigree:
And asset prices, the value of both debt and equity have continued to growth relative to both GDP….
Relative to GDP growth…..
Relative to non financial corporate gross fixed investment…..
and relative to income growth:
And other reading: