Tuesday, 1 April 2014

Palley on Keen, Demand and Debt



Thomas Palley's latest paper looks at Steve Keen's efforts to link aggregate demand with changes in debt levels. 

I think this is a good paper.  Much of what Palley has to say is in line with observations I have made before about the direction Keen seems to be going in.  He identifies that Keen's ideas on the causal relationship between money and spending are little different from old-school monetarism.  He also discusses how this simplistic approach overlooks many of the complexities of the relationship between debt and spending.  He includes a simple model that illustrates the way that debt can have an impact both through its absolute level and through the rate of change.

Palley makes some observations on how different types of debt might have different impact on spending.  This is an important issue.  However, I'm not sure I buy into the way he has reflected this in his model.

This model is based on two types of households: borrowers and lenders; and two types of lending: bank lending and direct finance.  Borrowers then spend the full amount of their new borrowings, regardless of the source of the loans, banks or otherwise.  I think this is a fairly reasonable assumption, for a model which does not include borrowing for asset purchase.

I'm less convinced though by what he says about the spending of lenders.  His function for lenders' consumption (his equation 18) is equivalent to:

                C = α1 + α2 . ( YD - DL ) + α3 . W

where C is consumption spending, YD is lenders disposable income (share of GDP plus financial income), DL is direct lending in the period and W is wealth, which includes financial assets arising from both bank lending and direct finance.

The key point where Palley distinguishes between bank lending and direct finance is in the inclusion of DL in this equation.  What Palley is saying is that " ...[lenders'] income is reduced by lending via direct (loanable funds) credit markets."

Here's a story I've used before.  I want to buy a car.  I go to the bank and ask for a loan for $10,000.  The bank decides I'm not credit-worthy and declines.  So, I go to my rich uncle and ask if he will lend me the money.  He knows me well enough to believe that I will actually repay, so he agrees to the loan.

Now, I'm prepared to accept that this may have some impact on my uncle's own consumption spending.  But, on the whole I don't think it has that much.  I certainly don't think my uncle would equate this with a fall in income of $10,000.  Most of the time, he's just going to see it as another way of investing.  He's probably just going to take some money out of the bank and give me that.  If he thought that lending me the money meant he couldn't himself buy the car he meant to buy, I don't think he'd make the loan.

On the other hand, maybe you don't like this sort of story and prefer micro-founded argument.  In which case, lenders' consumption will be based on some kind of permanent income measure.  How they invest their savings should have no bearing on this.  So the decision to make a direct loan is not going to change consumption expenditure.  Personally, I have mixed feelings on this kind of analysis, but I do think that households engage in some kind of consumption smoothing and I find it implausible that they would vary their consumption pattern on the basis of their investment choices.

What makes this point even more important, I think, is that in practice the distinction for the end investor between bank lending and other lending is a blurred one.  The non-bank sector can generate and finance itself with instruments which are very close substitutes for claims on banks.  Where do you draw the line between those where the household treats acquisition as a loss of income and those where it does not?

What Palley has done here (as he acknowledges) is to retain some element of loanable funds within his model.  I think it would be better without it, but otherwise there are some good insights in this paper into the complex way debt impacts on demand.

See also Ramanan and JKH

23 comments:

  1. Nick,

    OT – my delayed response to your last asymmetric redeemability entry:

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/there-can-be-an-excess-supply-of-commercial-bank-money.html?cid=6a00d83451688169e201a51194d1d5970c#comment-6a00d83451688169e201a51194d1d5970c

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  2. I doubt that Keen would object too strongly to Palley's criticisms , at least in the sense that I think Keen would eventually like to incorporate the variables Palley mentions into a more complete Minsky model. However , the simplified Keen model serves a useful purpose - it describes how our economy has functioned for decades , and how it's likely to function going forward , absent fundamental change.

    You can reasonably project that in a year and a half or so , we'll add another $1 trillion in ngdp. In doing so , we'll add ~ another $2.4 trillion in nonfinancial debt. If we add a lot more debt than that , it means we're re-leveraging , i.e. we're blowing another debt bubble. If we add a llot less tha that , it means we're likely to see proportionately less ngdp added during that period. Palley can't make that kind of prediction , I suspect , and I know the monetarists can't. The regularity of the debt growth / gdp growth association , ( outside of the short bubble period of the 80s and the longer one of the 2000s ) allows you to make this sort of call with some confidence.

    Now , what Palley says about alternatives to debt is true - corporations that are flush with cash could fuel an expansion all by themselves , without the necessity of any new debt. The problem is , that's not how corporations behave. Maybe the gov't could offer them some juicy incentives , but that's exactly what I meant above when I said " absent fundamental change". Similarly , the gov't could raise taxes steeply on low-MPC-millionaires and cut taxes on high-MPC-everyone-else , and possibly generate a non-debt-dependent expansion.

    Palley's criticisms are correct in a technical sense , but in the economy we have today , and that we've had for decades , I don't think they matter very much. The simple Keen model gets close to the reality we're likely to experience , and that's better than anything else out there that I'm aware of.

    Marko

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    1. I do think Keen has something to say. My concern about his most recent approach is that he seems to be taking a route that, if extrapolated into a richer model, is going to lead to some wrong conclusions. I think Palley's analysis is quite useful in setting out why, even though as I say in the post I wouldn't agree with all his assumptions.

      The main risk with Keen's approach, I think is that he focuses on bank lending and thinks debt incurred outside of banking is not an issue. I think that's a big mistake and that non-bank lending is potentially more damaging, because it can more volatile. This is the sort of issue that Palley is also trying to highlight.

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    2. I don't think Keen's data is restricted to bank loans. His graphs are comparable to what you get with FRED using FOF data , which includes all forms of debt.

      I think Keen makes a big deal about bank loans mainly so he can pull Krugman's chain about "loanable funds" , but I haven't seen any evidence that it enters into his modeling.

      I do think it would be useful to determine the differential impact of bank loans vs nonbank on gdp and asset prices. I read somewhere that bank loans were 60% of total lending in 1970 compared to only 30% in the late 2000s. During that same time span we also halved the gdp bang for the debt buck. I'd guess that the reduction in the share of bank loans has something to do with this.

      Marko

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    3. What bugs me about Keen is that he seems to disregard public debt , unless he needs to mention it to explain why gdp didn't collapse as much as expected when private debt tanked. I think you need use the broadest debt measure , although I think financial sector debt is a different animal , and should either be excluded or treated separately.

      I know why he likes to focus on private debt - the co-movements of private debt with private demand are easier to demonstrate , and you can show that debt leads output with the credit impulse graphs. However , I think the relative lack of response to public debt is mainly an artifact - public debt rises during recessions , but often it's not enough to offset the fall in private borrowing.

      Marko

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    4. I think Keen definitely makes the distinction between bank debt and other debt, because that's the whole basis for his endogenous money / loanable funds distinction. He thinks bank lending has a special impact because it creates money, whereas other lending just transfers existing money around. If he didn't take that view, I would have much less objection to what he is saying.

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    5. Maybe he thinks all of the FOF data represents bank lending. If so , that would be pretty bad. Here's an example of what I was saying about his graphs - look at Fig 3 in his most recent article , where he shows debt/gdp of the household and business sectors , and the combined total :

      http://www.businessspectator.com.au/article/2014/3/31/economy/why-us-cant-escape-minsky

      I reproduced this using the FOF data in FRED ( I didn't show the combined figure ) :

      http://research.stlouisfed.org/fred2/graph/fredgraph.png?g=vO9

      It's pretty clear that the data matches , so he's getting all of the sources of debt. The question is whether he understands that most of the debt isn't bank debt , i.e. "endogenous".

      I have no idea where he's getting the data in his Table 1 in the above article. I can't make sense out of it using the FOF.

      Marko

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    6. I haven't examined his data too closely, I confess. I've simply gone through his theoretical analysis.

      I think I recall him saying something at one point about having mistakenly used the wrong debt data, either including or excluding non-bank debt when he didn't mean to, but I don't have the reference. But hopefully he is using what he means to in his most recent article.

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  3. Nick, JP Koning does a great recap of the debate between Rowe and Glasner on reflux:
    http://jpkoning.blogspot.com/2014/04/rowe-v-glasner-round-33.html

    It seems like it's just crying out for one of your simulation models? :D

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    1. There's a lot going on there. For myself, that's the sort of thing where I'd need to set out some kind of balance sheet analysis and maybe a few behavioural equations, just to check that it all hung together as suggested. Describing it in words is fine, but it's easy to miss some less obvious consequence. Without that, I'm not sure whether I agree with JP's conclusion or not. So maybe I will do something.

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    2. Nick, I agree completely. So many moving parts there... I think what you suggest is exactly what this discussion needs. Then we should get different results depending on how the parameters are set... ... or perhaps we'll find that the answer is insensitive to some of the parameters and assumptions. Trying to reason all that out with words can perhaps help with gut checking pieces of the model, but putting it altogether makes a word analysis tough.

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    3. Nick Edmonds, what do you think of this short thread on JP's post on Rowe vs Glasner:
      http://jpkoning.blogspot.com/2014/04/rowe-v-glasner-round-33.html?showComment=1396994355524#c998191596828127387
      I end it by trying to answer my own question.

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    4. Tom,

      I think it's a very good question because, as you say, you can't really work through the full consequences of this sort of change without knowing exactly what it is that has changed. I was trying to work out whether there were other consequences of JP's assumed reduction in bank costs. Does that mean less labour cost? Does that mean there is now an excess labour supply? If it's not a lower labour cost, what is it? Who is being paid less?

      I'm sure that one could come up with a scenario where banks are increasing loans and increasing deposit rates, even if it has to involve more than one thing changing.

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    5. Nick, do you think the simple algebraic model you presented in Nick Rowe's "Deflationary banks" article here
      http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/04/deflationary-banks.html?cid=6a00d83451688169e201a3fceafa3e970b#comment-6a00d83451688169e201a3fceafa3e970b
      could be expanded to cover the case where both deposit interest rates (Rd) are increased and lending is increased (D) say because a new pool of previously overlooked creditworthy borrowers is discovered, basically the example reason I write on JP Koning's blog here:
      http://jpkoning.blogspot.com/2014/04/rowe-v-glasner-round-33.html?showComment=1397005294113#c809789614390463886
      or perhaps for some other change in circumstances which makes the banks want to leave the old (no-longer) equilibrium and move to a new profit maximizing equilibrium by increasing their stock of loans? Thanks.

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    6. I guess your model already covers the circumstance I mention above, but what it does not address specifically is the price changes in durable and perishable goods. Or maybe it does. You do include PY, so the price level P is in there. Also it does not address any profit maximizing by the banks. JP mentions in the 1st part of this post a scenario whereby deposit interest rates are increased to take advantage of some cost savings. As you point out that savings on the rest of the economy is not explored. But then the elevated profits fade away as the banks must compete with each other for deposits by raising the deposit interest rate, which then results in lowered prices for durable and perishable goods, and a shift in the breakdown of base money away from cash and to reserves (simultaneously increasing deposits by equal measure).

      Also you're using a constant money multiplier, b, whereas I don't think that's what JP is assuming, at least in the 1st part of his post.

      BTW, do loans (that banks buy from borrowers) count as durable goods?

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    7. Yes it could be expanded, but I think it would need quite a lot more equations to cover everything JP is talking about, so it wouldn't look much like my 4 equation version. Also, JP likes to analyse things by equating yields (including cash yields and non-pecuniary yields), so I think I'd probably want to follow that approach as well.

      Sorry, but I'm probably not going to do this. I'm just looking at other stuff right now.

      No, I don't think loans are durable goods. Goods are physical, produced objects.

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    8. Nick Edmonds, thanks for your feedback. The reason I asked about loans was because JP counted the following as durable assets (I guess I should have written "assets" rather than "goods"):

      "durable assets (i.e. gold, houses, stocks, and bonds)"

      So JP counts stocks and bonds as durable assets, which makes me think loans might be too.

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    9. I guess if he includes stocks and bonds there, he should also include loans.

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  4. Keen responds to Palley , sorta :

    http://www.businessspectator.com.au/article/2014/4/7/economy/how-not-win-economic-argument

    Marko

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    1. Thank you for that reference. It's more of the same. Note a couple of bits. The reason he gives for the different results in his two scenarios is hat in e second ".....the growth of loans by he banking sector caused the money supply to grow as we'll".

      He also explains that what he has done in the model is to "....relate all rates of spending to the money in bank accounts". If you make the assumption that the amount people spend depends only on he amount of money they hold, it is hardly surprising if your model tells you that expenditure depends on the amount of money people have. That is all Keen has succeeded in demonstrating.

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    2. It's still a crucial distinction , I think. Monetarism as managed by the central bank says nothing about the formation of debts. Monetarism , in reality - as practiced by commercial banks , explicitly requires creation of debts. Bank-created "new money" which can be spent into the economy without requiring other money-holders to not-spend , nevertheless implies that future spending by a given borrower will be reduced , as debts must be repaid. Debt-based spending from the future at rates exceeding that of income growth is unsustainable. Not only is it unsustainable longer-term , but debt-based growth as it occurs sends invalid signals about the economy's health if rising leverage is simply ignored , as has been the case for several decades. If Keen's model does no more than make these concepts a part of public policy discussions , it will have accomplished a great deal.

      Marko

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    3. I agree that debt led growth raises important sustainability issues. Also, as I have said before, Keen does deserve credit for highlighting this when many economists fail to recognise its importance. However, others have done so in a much more rigorous way (notably Godley and Lavoie). Keen is floundering between various flaky formulations of the issue and it makes it easy for the mainstream to dismiss it. That I think is my main concern.

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