I Love Larry Kotlikoff(Partly Because He Can't Stand Krugman)

[Gone4Good]

A Detailed Example

Laziness has prevented me from walking through a full-blown example of what I’m talking about, so I suspect much of what I’ve been saying sounds like gobbledy-gook (queue snide remarks from the usual characters). But here goes, for those who have the patience for it:

At the macro level the world is a closed system. Inputs equal outputs. The simplest way to see this is that for every borrower, there is a lender. One person’s debt is another person’s asset. At the macro level, we don’t act in isolation. Your Yin is my Yang.

With that in mind, consider a world with only two people Brad and Sarah. This world has only two products, Widgets and Gazzoos. Brad produces Widgets, Sarah produces Gazzoos and they trade with each other. In this world, GDP equals the total amount of Widgets and Gazzoos produced. Brad uses his Widgets to trade for Gazzoos and vice versa. The more Widgets he produces, the wealthier he is. This is the basis of “Classical” economics, and the underlying rationale to focus on the economy’s “Supply side.”

Now add money and an interest paying bond for savings. Suppose Brad doesn’t want to use all of his income to buy Widgets and Gazzoos? In that case, he can make his extra income available to Sarah, who wants to consume more. Sarah borrows from Brad, and consumes the production Brad doesn’t want. The interest rate charged reflects the balance between how much consumption Brad is willing to forego, and how much extra consumption Sarah wants. Let’s say 5% is the equilibrium rate.

If Sarah decides she’s borrowed too much, she starts consuming less and repaying Brad’s loan. Brad isn’t interested in consuming more when he can lend at 5%, but Sarah wants to consume less if she’s got to borrow at 5%. So the interest rate declines. At 4% Sarah is still willing to borrow and consume, but less than she did before. At 4% Brad is still willing to lend and save, but less than he was before. Output of Widgets and Gazzoos remain unchanged.

Now let’s assume something dramatic scares Brad & Sarah (space aliens?) to the point where Sarah wants to repay her loan but Brad doesn’t want to decrease his savings. Sarah starts trying to repay her loan but Brad wants to keep lending, so interest rates decline further . . . from 4%, to 3%, 2%, 1% and finally down to 0%.

Even when Sarah can borrow at 0% she feels she already has too much debt and wants to pay Brad back. Those space aliens are really scary. But Brad is also scared and wants to maintain his savings. But now he has an alternative. With loans only paying 0% interest, Brad is indifferent between loaning to Sarah and simply sitting on cash. So that is what he does, he hoards cash.

But Sarah is trying to save too. She cuts the amount she buys from Brad to repay her loan. The cash Brad receives from loan repayment he sits on, he doesn’t buy any extra Gazzoos from Sarah nor does he loan that money to her. But now Brad’s income has declined (Sarah is buying less of his Widgets). If Brad doesn’t want to reduce his savings, he must also cut his purchases from Sarah, so her income declines too.

Sarah’s debt ratio doesn’t meaningfully change as both the numerator (her debt) and denominator (her income) declines. The only way for Sarah to fix her balance sheet is if Brad is willing to spend some of his savings, allowing her to maintain income. But he’s comfortable sitting on cash at 0%. What he requires to spend more (save less) is a negative interest rate on his money, but the market can’t provide that.

So Brad & Sarah find themselves stuck in the liquidity trap.

What would help them get out of the trap? Inflation, because it creates a negative return on Brad's money and also depreciates the value of Sarah's debts. A third party who was willing to increase their spending on Gazzoos and Widgets would also do the trick, because it would allow Sarah to repay Brad while keeping overall production (income) unchanged. Cutting taxes would be beneficial by allowing Brad to consume more and Sarah to save more. More directly, a third party who was willing to pay Brad to reduce Sarah's loan would work.

What wouldn't work? Higher interest rates and a third party also trying to increase their savings (e.g. government austerity). Deregulating Brad's widget production wouldn't do any good either because Sarah doesn't want to buy any more of his widgets.

 

[Texas Proud]

Gone4Good...

Nice example...

...but are the products produced the basics such as food and gas etc. Or are they extras such as big screen TVs

Because if they are basics, then there is a level of consumption that will occur no matter what... IOW, Sarah has to eat... and at some point if her income gets to low she will raise her price to get more income so she can eat...

Brad has no choice but to pay the higher price because he can not produce what Sarah produces and also needs the basics.... yes, this is inflation... but it will create an equilibrium after awhile...


OR, Sarah can just say "Brad, I will not pay you back as I do not have any money except for basics"... Brad has to write off the loan and they are now back to the beginning where there were no loans... IMO, this is what is happening now... banks have been writing down real estate and will continue to do so.... also CC debt and other loans have been written down over the last few years.... eventually, we will get back to an equilibrium and things will start to pick up....


We already have tried the 'third party to pay off Sarah's loan' with the mortgage modifications.... that did not work so well... not sure how much it cost us either....

 

[Gone4Good]

Adding Flight to Quality

If we want to see how "Flight to Quality" fits in with the above example, we need to add more elements. Simple is better for illustrative purposes, but you can make this as complicated as you want.

But lets just say that the interest rate mentioned above isn't the rate at which Brad & Sarah lend and borrow from each other, but the risk free rate. And lets assume that it isn't "space aliens" that have everyone scared, but Sarah's solvency. The basic story stays the same except now we can say interest rates are driven to zero by a "flight to quality."

The overall thesis still holds.

 

[Gone4Good]

..but are the products produced the basics such as food and gas etc. Or are they extras such as big screen TVs

Because if they are basics, then there is a level of consumption that will occur no matter what...

The products reflect everything that is produced.

And yes, eventually you reach some kind of equilibrium, but what does that mean?

Basically it means that income will fall until indebted agents reach a point where they either can't, or have stopped trying to, cut spending anymore. Those agents are still constrained by debt meaning growth is slow and fragile, production is well below potential (unemployment is high and capacity utilization is low) but we've stopped falling.

Sound familar?

FWIW, I don't think we hit the point in the economy where the indebted can't cut spending. I think what we've done is broken the panic that caused everyone to rush to the exits at the same time. We did that with bank bailouts, and a whole host of currently unpopular government intervention. That doesn't mean we can't have another panic and another nasty leg down. We're in a precarious spot right now.

We already have tried the 'third party to pay off Sarah's loan' with the mortgage modifications.... that did not work so well... not sure how much it cost us either....

We actually haven't in any meaningful way. Yes, there is a program, but the actual modifications number in the low hundreds of thousands. Not a very big program. And it's also not one that reduces principal balances. Cutting interest rates isn't enough. There are good ideas floating around that involve cutting loan balances in exchange for home appreciation rights. I'd rather see money spent doing that on a very large scale then on most of the other things being suggested.

 

[Texas Proud]

The products reflect everything that is produced.

And yes, eventually you reach some kind of equilibrium, but what does that mean?

Basically it means that income will fall until indebted agents reach a point where they either can't, or have stopped trying to, cut spending anymore. Those agents are still constrained by debt meaning growth is slow and fragile, production is well below potential (unemployment is high and capacity utilization is low) but we've stopped falling.

Sound familar?

I guess you missed where I said Sarah was not going to pay back Brad... so no more debt constraint...

But I do agree that you can get into this lower equilibrium... I would suggest that is where Japan has been for over 20 years... I would also suggest that the spending their gvmt did did not fix the problem... their debt to GDP ratio is way over 200% and approaching 300%... and their interest rates continue to be zero....

If gvmt spending did work, Japan would not be in the situation they continue to be in... it would have fixed the problem many years ago.... but they probably are still in a debt constraint (not sure, just remembering what I have read)....

I would also suggest that we can not get back to the production 'potential' that we had before.... it was a false production based on excessive debt... workers now produce more than before... heck, we might be getting to a point where we will not have everybody with a job...

 

[Texas Proud]

We actually haven't in any meaningful way. Yes, there is a program, but the actual modifications number in the low hundreds of thousands. Not a very big program. And it's also not one that reduces principal balances. Cutting interest rates isn't enough. There are good ideas floating around that involve cutting loan balances in exchange for home appreciation rights. I'd rather see money spent doing that on a very large scale then on most of the other things being suggested.

I can agree with that... but how much money would you suggest If we were spending tax dollars, I would want the appreciation to go toward paying back the taxpayer and not the bank. Or at least a share of the appreciation...

 

[Texas Proud]

Another problem is that this is a worldwide slowdown... this tends to show that the causes are not just the US mortgage problems...


I did see an clip that showed a number of teachers taking jobs overseas... to me, that is also a way that will help fix things... migration... but since there are very few 'hot spots' of jobs, that is not a great solution right now.... however, gvmt support makes it easier to not move to a place where there are jobs, or a job that you qualify for...

I just did a search on Monster and there are over 300 jobs for accountants listed... not a huge number, but jobs are out there... I also looked in NY and there are about 300 there... there were over 1,000 engineer jobs....

 

[Gone4Good]

I guess you missed where I said Sarah was not going to pay back Brad... so no more debt constraint...

I did see it. You had two valid scenarios and I chose to comment on just one.

But what happens when Sarah defaults? Brad loses an asset - some of his savings. If he's trying to maintain savings, which is our sceanrio, he cuts spending further to try to rebuild his pile. The downward spiral continues. The only way to avoid this is if Brad agrees to "dis-save" which is what we've been saying all along.

Taken to the extreme, you get back to the point you sugget - no more debt. But think about the implications of a cash only economy. What's the value of the average home if there is no borrowing? $40K? Less? Consider how much further down we have to go to get to that equilibrium.

 

[Gone4Good]

I can agree with that... but how much money would you suggest If we were spending tax dollars, I would want the appreciation to go toward paying back the taxpayer and not the bank. Or at least a share of the appreciation...

I don't have a number in mind. Large enough to meaningfully move consumer leverage statistics, so we're talking about principal reductions in the many hundreds of billions or more. Some of that would be offset by the value of the home appreciation rights, so it's hard to take a swag without some serious number crunching.

Principal reduction would show up as losses to lenders, but then we have the same problem we had with Brad writing down his loan to Sarah. The bulk of those losses would need to be shouldered by the government, or it's probably a pointless exercise.

 

[haha]

What will China do with their two adults producing one child policy? Their aged will really suffer. Our problems are dwarfed by what they face. Catholic countries and emerging nations will have the worker populations.

Emerging nations maybe, but Catholic countries have some of the planet's lowest birth rates.

Ha

 

[FinanceDude]

The solution to the problem is to find another way to allow folks to deleverage - inflation (if it can be manufactured), forced loan modification with bank recapitalization if necessary, etc.

So, why again do you chide people like me that suggest inflation is a way to get out of this mess

 

[Gone4Good]

So, why again do you chide people like me that suggest inflation is a way to get out of this mess

Please link to a quote where I've done any such thing. I'm confident you won't find one. You probably have mistaken me for someone else.

 

[M Paquette]

So, why again do you chide people like me that suggest inflation is a way to get out of this mess

I'm not entirely sure that inflation would cover the whole situation. We could inflate the costs of goods sold, by pushing more money into circulation. (Cash tucked in mattresses or Treasury bills doesn't help, as it's not chasing goods in the marketplace.) The econo-speak for this would be increasing the velocity of money.

The gotcha here is that wages that consumers are paid won't automatically rise to match. There's not a shortage of workers, not by a long shot, so there is no real reason for employers to offer more pay to workers. There's not even enough demand for labor to significantly restore hours to part time workers lost since the 2007 peak. (Just restoring part time worker hours to the 2007 peak would be the equivalent to adding 950,000 new full time workers.)

I suppose we could make some sort of Nixonian fiat to alter this. Somehow I don't think that would get very far.

Inflation gets us a higher cost of goods, to be paid by workers with a fixed debt load and effectively fixed income. Workers who have been able to pay debts up til now must choose between feeding and clothing their family and defaulting on loans.

Now, a modest level of inflation, combined with real growth in the gross domestic product could reduce government debt relative to GDP over a sufficiently long period of time, but that's not the debt that is causing this particular balance sheet recession. Consumers drive 70% of our economy, and it's their high debt level relative to income that has throttled their spending and reduced their access to easy credit.

 

[Gone4Good]

Inflation gets us a higher cost of goods, to be paid by workers with a fixed debt load and effectively fixed income. Workers who have been able to pay debts up til now must choose between feeding and clothing their family and defaulting on loans.

Absolutely true.

The working assumption many of us have is that we can't get a generalized inflation without also having wage inflation. Too many dollars chase all things, including workers.

Recently we have experienced an issue of commodity price inflation. I think that is largely due to international growth and is not reflective of U.S. monetary policy (except to the extent that some countries - namely China, but others as well - have outsourced their monetary policy to the Fed). But inflation at both headline and core levels have been running hotter than I would have thought given the other cool economic readings.

Unless wages also inflate, this other inflation adds to the problem rather than addresses it.

But I have a problem reconciling goods inflation with a lack of wage inflation and credit creation. In this environment, won't higher prices just cause demand destruction, forcing prices down? Seems unsustainable.

 

[MichaelB]

Inflation does not solve a debt overhang problem for an economy, it just determines who will end up footing the bill.

 

[M Paquette]

But I have a problem reconciling goods inflation with a lack of wage inflation and credit creation. In this environment, won't higher prices just cause demand destruction, forcing prices down? Seems unsustainable.

It is unsustainable. In an environment where there's no pressure to drive up wages, and plenty of surplus production capacity, about the only items that can raise prices are those with inelastic demand, like food and energy. (Oh, hey, look what just went up...)

That's why I had to resort to the magic handwave to inflate costs:

We could inflate the costs of goods sold, by pushing more money into circulation. (Cash tucked in mattresses or Treasury bills doesn't help, as it's not chasing goods in the marketplace.) The econo-speak for this would be increasing the velocity of money.

It's a one time spike if the velocity of money doesn't stay up. Since the workers can't reasonably be expected to get a pay raise, we can't get a good old fashioned inflationary spiral fired up. The higher prices on inelastic demand goods like food and energy divert buying from other goods, demand drops, there's more idle production capacity and maybe some layoffs, and prices 'deflate' back to the original level.

 

[MichaelB]

Absolutely true.

The working assumption many of us have is that we can't get a generalized inflation without also having wage inflation. Too many dollars chase all things, including workers.

Recently we have experienced an issue of commodity price inflation. I think that is largely due to international growth and is not reflective of U.S. monetary policy (except to the extent that some countries - namely China, but others as well - have outsourced their monetary policy to the Fed). But inflation at both headline and core levels have been running hotter than I would have thought given the other cool economic readings.

Unless wages also inflate, this other inflation adds to the problem rather than addresses it.

But I have a problem reconciling goods inflation with a lack of wage inflation and credit creation. In this environment, won't higher prices just cause demand destruction, forcing prices down? Seems unsustainable.

Wages do rise, and track inflation, but only skilled labor. Unskilled labor falls behind. This is probably one reason avg real wages are falling over time in the US. Inflation would reduce the debt overhang if a substantial part of consumer debt is owed by skilled labor. I've seen no statistics on outstanding mortgage debt by income tier but I would guess it would be substantial.

Inflation might effectively delever the economy but it would crush pensions and savers. The outcome would likely be an economy with ever greater inequality than we have now.

 

[GusLevy]

I shouldn't have posted because I'm not really sure what this thread is about, and that's always a bad sign. Kinda like the roads in West Virginia - forever winding all over the place.

My sensibilities tell me to stay away from this, ummm, enlightening discussion but unfortunately it is like a train wreck that is harder to avert the eyes from than not to at this point - hopefully this is the last reference from me to Vizzini in this particular train wreck. We have officially gotten out of the winding roads of West Virginia but have somehow ended up in the high desert of Pahrump with talk of space aliens and whatnot as the Black Knight from Monthy Python continues to defend his little stream despite having lost both his arms and legs.

"You have a dizzying intellect..." - Dread Pirate Roberts to Vizzini

1) This discussion apparently began last year with a modest enough reference to Krugman and his annoying smugness. Fair enough - the Bearded One knows that being a polarizing figure has made him both famous and wealthy so he runs with it. The trouble here is that a commenter actually suggested that Krugman's thesis that massive federal stimulus for the US economy has been successful by pointing out that we have low interest rates - "Krugman was right!" is the claim. Krugman argued his Keynesian belief that massive stimulus would shift the supply function and that the demand function would follow such that we have higher employment, higher economic output, stable price levels and controlled interest rates. The fact that we have low interest rates in the US suggests anything but the fact that fiscal policies have been successful here, of course - in fact, they are a repudiation of fiscal and economic policies as investors believe things are so bad that they would rather take the nil interest/guaranteed principal promise of Uncle Sam than to invest it anywhere in the World.

After 2.5 years and $4 Trillion (the latter amount referenced by poster ClifP - I stopped counting after $3 Trillion) of various federal stimulus actions we are today perilously close to a double-dip recession and unemployment is greater than 9% (7.6% in Jan 2009). $4 Trillion is also approximately $20K for all breathing adults - not merely the productive ones, but ALL - from the ages of 18 to 62 (Social Security eligible) which is clearly a lot of money by anyone's standards so if the argument is that the recent massive stimulus wasn't massive enough then give us a ballpark idea of how much more - even a bad plumber would do that.

Is it truly crazy to argue that $4 Trillion should be enough to get us at least some positive feedback in the economy? If the opposing viewpoint would argue that we need more stimulus then I will remind them that you are risking other people's money which should never be forgotten.

2) Somehow the discussion evolved from simply debating whether Krugman was correct into a stream of consciousness which argues that not only does the Keynesian "liquidity trap" exist, but also how to solve it! Conveniently, the solution is to - queue the drumroll! - print and inject more money into the economy!

Keynesians believe that liquidity traps exist when people make the apparently unconscionable and irrational decision to hoard cash during times of deep recession like today. Keynesians then argue that since the Demand for Money curve is somehow flat during these occasions that the Fed Govt must print so much money that you, me, Sarah and Brad will be effectively compelled to jump off the flat Demand for Money curve and quickly run to the mall to buy Nike shoes, iPads and fine leather attaché cases while stopping at the Food Court for lunch - you know, before our cash becomes worthless.

The obvious problem with this theory is that this pretty and shiny thing called Gold exists in this world as insurance against Fed Govt foolishness. You, me, Sarah and Brad will keep our cash in the bank when we believe that fiscal and economic policies from our Fed Govt are so bad that the risk of making a positive return by investing it is simply too risky. If, however, the Fed Govt then attempts to shake the money out of our hands by considerably devaluing our money then you, me, Sarah and Brad will run to the mall...to buy Gold jewelry, while perhaps still stopping for lunch at the Food Court.

The economy will grow if you, me, Sarah and Brad invest the money in companies and projects that are productive. Printing so much money with the threat of devaluing our cash will not compel us to invest in the Vanguard Total Stock Index nor will it compel us to go out and buy shoes or widgets. If a "Third Party", who sometimes goes by the name of "Uncle Sam", decides to devalue the currency with the intent to make Brad buy Sarah's wazoos or for Sarah to buy Brad's gizoos each will do what you or I would do - raise the price on Brad or Sarah and run to the jeweler to clear out the jeweler's Gold with the sales receipts before the other one gets there first. The first one there will intuitively understand that they will be out of their inventory and own Gold versus holding worthless "Third Party" currency.

We will be convinced to part with our cash or Gold in times like today when we are convinced that our potential return on investment is substantial enough to justify parting with our cash or Gold. The Fed Govt hiring people to dig holes, printing more cash, etc. are not things that are going to convince us that investment opportunities are thusly created. The "liquidity trap" theory presumes that you, me, Sarah and Brad are stupid - so stupid that we would do such an irrational thing like keeping cash safe until the world situation clears up. Here is a novel concept: Reduce the corporate tax rates and see how fast Sarah and Brad are running to their nearest stock broker to purchase the Vanguard Total Stock Index. This money will then go directly to corporations that are in the business of making profits - unlike some Third Party that is out buying gidgets, whozits, whatzits - which will be a lot easier when their tax rates are lower.

Japan's Corp tax rate is approx 40%. The US Corp tax rate is 35%. The Chinese Corp tax rate is 25%. If the Japanese and Americans are mired in "liquidity traps" perhaps they should try the crazy concept of lowering their Corp tax rates to a level that even a Communist Govt deems acceptable before trying the lucid approach of giving all citizens $20K to thoughtlessly spend, no?!

 

[GregLee]

Keynesians believe that liquidity traps exist when people make the apparently unconscionable and irrational decision to hoard cash during times of deep recession like today.

From the preceding discussion, I gathered that the Keynesians were appealing to people's rationality. Could you please give a reference for these economic decisions being "unconscionable and irrational"? Who said that?

 

[urn2bfree]

First of all people digging holes make roads that exist for improved transport of goods a payoff benefitting all for years to come. The salaries the hole diggers get lead to people buying engagement rings, weddings, flowers, houses, car seats, minivans all of which have to be produced, moved and sold all of which require employees earning salaries all of which end up buying engagement rings, etc. etc. This also increases govt revenues... But as Krugman predicted correctly the original stimulus was too small remember it was over one third middle class tax cut- a fact conveniently ignored by conservatives begging for my tax cuts) so it was not $800b in stimulus, but 2/3 that at best. And it did prevent a depression. Meanwhile the opposition wanted to let the auto industry die- which would have created HUGE job losses across many sectors... And the money used to save that industry is already repaid.
Finally anytime someone complains about US Corp taxes they are either lying or misinformed... The effective rate on corps avg around 24% no matter what the book rate is...it's like hotel rack rates... Few pay that. And The top corps like GE pay less like... Oh what is that round number with the circle called? Oh yeah ZERO! ZERO percent Corp tax. ZERO. PERCENT. They paid nothing in fed corp taxes. please -The Big lie about Corp tax rates is one of the most blatant Propaganda campaigns of all time. That lie needs to be stamped out not repeated here if there is going to be an honest discussion on tax reform.

 

[GusLevy]

From the preceding discussion, I gathered that the Keynesians were appealing to people's rationality. Could you please give a reference for these economic decisions being "unconscionable and irrational"? Who said that?

Mahalo.

Fair enough, I sense that you are not a dogmatic person. I suppose that we can try a deductive argument approach:

1) Keynesians believe in changing the irrational and unconscionable economic behavior of citizens.
2) The hoarding of cash by citizens in times of economic distress is irrational and unconscionable economic behavior.
3) Therefore, Keynesians will attempt to change the irrational behavior by citizens of hoarding cash in times of economic distress.

The bottom line is that if hoarding cash during times of economic and political distress is rational behavior, then why would Keynesians believe in forcibly changing that behavior: Either the cash hoarder is rational or the Keynesian is rational, but logic dictates that both cannot be rational since one party is attempting to change the behavior of the other. IMO, and apparently the opinion of many others out there that are parked in safe investments and Gold, it's eminently rational behavior today to remain in safe and liquid investments such as cash and Gold but the premise of the "liquidity trap" theory is that it is either irrational or, worse yet, perhaps evil to the broader economy. "Liquidity trap" theory promotes the penalizing of those who would remain in cash during times of economic and political distress through various devaluation methods to compel spending and investment. I believe that Govt should instead promote policies which increase the viability of investing my cash instead of devaluing it in the hopes of making me spend it.

 

[GregLee]

Mahalo.

Fair enough, I sense that you are not a dogmatic person. I suppose that we can try a deductive argument approach:

1) Keynesians believe in changing the irrational and unconscionable economic behavior of citizens.
2) The hoarding of cash by citizens in times of economic distress is irrational and unconscionable economic behavior.
3) Therefore, Keynesians will attempt to change the irrational behavior by citizens of hoarding cash in times of economic distress.

I was asking about grounds for your 2), which is a premise of your argument above. Even if your 3) does follow from 1) and 2), that does not help to establish 2).

... Either the cash hoarder is rational or the Keynesian is rational, but logic dictates that both cannot be rational since one party is attempting to change the behavior of the other.

I can't follow that. What logical principle could dictate such a thing?

 

[FinanceDude]

Meanwhile the opposition wanted to let the auto industry die- which would have created HUGE job losses across many sectors... And the money used to save that industry is already repaid.

Really? http://www.politifact.com/truth-o-m...re-auto-companies-paid-up-american-taxpayers/

And since when is someone with a different political view from you "the opposition"??

I am sure another $3 trillion or more in stimulus for non-infrastructure spending will only raise the unemployment rate to about 11% or so............

 

[GregLee]

And since when is someone with a different political view from you "the opposition"??

Since always.

 

[Gone4Good]

Inflation does not solve a debt overhang problem for an economy, it just determines who will end up footing the bill.

True inflation transfers value from creditors to debtors. Whether it solves the problem depends on what the problem is. If the problem is that debtors can't deleverage because creditors won't dis-save, as we outlined in detail a couple of posts back, than transfering value from creditors to debtors, by inflation or some other means, absolutely solves the problem.