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“The economy fell off the cliff.” – George Soros (11/24/2008). J. Devine/Neo-Kaldorian Dynamics18/5/2011 rev.

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Presentation on theme: "“The economy fell off the cliff.” – George Soros (11/24/2008). J. Devine/Neo-Kaldorian Dynamics18/5/2011 rev."— Presentation transcript:

1 “The economy fell off the cliff.” – George Soros (11/24/2008). J. Devine/Neo-Kaldorian Dynamics18/5/2011 rev.

2 The Great Moderation and "Falling Off a Cliff": neo-Kaldorian dynamics. James G. Devine Loyola Marymount University (LA, CA) August 5, 2011 (Published as The Great Moderation and “Falling Off a Cliff”: Neo-Kaldorian Dynamics in Journal of Economic Behavior & Organization, 78(3), May 2011: 366-373. A rough draft is available at: with diagrams at The current version has been edited a lot without changing any conclusions.)The Great Moderation and “Falling Off a Cliff”: Neo-Kaldorian Dynamics 2J. Devine/Neo-Kaldorian Dynamics8/5/2011 rev.

3 Outline. I.Introduction. II.The Short-Run Model. A.the Expenditure curve (EE). B.the Actual Demand/Debt ratio curve (AA). C.Short-run equilibria. III.Medium-Run disruption of SR Equilibrium. A.The “typical” cycle. B.A Fall off the cliff. C.The Great Moderation. IV. The aftermath: Recovery or Stagnation? V. Conclusion: Policy’s role. 8/5/2011 rev.J. Devine/Neo-Kaldorian Dynamics3

4 (I) Purpose. to help to understand: Why the U.S. economy “fell off a cliff” – or threatened to do so – during the years 2008-2009.  the world economy, the housing market, and most of finance will be ignored here.  it’s possible that 2009’s stimulus package saved the economy from a Fall – but who knows? o We may not have been suffering from a Fall. 8/5/2011 rev.J. Devine/Neo-Kaldorian Dynamics4

5 (I) Theoretical Background. 1.Kaldor’s Keynesian (pre-catastrophe theory) model of the business cycle (1940):  Non-linearity implies three equilibria (two of which are stable).  Stable equilibria represent two general states of the macro- economy: high employment and stagnation.  A “Fall” is a downward leap between these. 2.Dynamic theories of Minsky (1982) and Kalecki (1933), helping to cause this Fall endogenously.  This process may have occurred due to the often-heralded “Great Moderation” (1984-2006).  In this period, the effects of financial crises and normal business- cycle recessions may have been short-circuited, so that they could not purge the economy of Minsky/Kalecki imbalances. 5J. Devine/Neo-Kaldorian Dynamics8/5/2011 rev.

6 (II) The three “runs.” long run (LR): labor-constrained potential output (Z) and the Minsky/Kalecki threshold (V) are determined.  Assumed constant in this paper. medium run (MR): the trend demand/debt ratio (  t ) and the Spending shift factor (S t ) are determined – but are held constant in the short run. short run (SR): B t (private-sector debt) and K t (industrial capacity) held constant in the short run. 8/5/2011 rev.J. Devine/Neo-Kaldorian Dynamics6

7 (II) The Subject Matter. 8/5/2011 rev.J. Devine/Neo-Kaldorian Dynamics7 Figure 1

8 (II) Three SR Equations. 1.The EE (expenditure) curve relating demand for GDP (E t ) to the expected demand/debt ratio (x t ); 2.The AA line, determining the actual demand/debt ratio (a t ) at each level of demand (E t ); and 3.Expectations adjustment, so that the expected and actual demand/debt ratios are equal in short-term equilibrium (x = a).  The adjustment equation is left implicit here.  It’s treated as merely a matter of an automatic movement to short-run equilibrium. 8J. Devine/Neo-Kaldorian Dynamics8/5/2011 rev.

9 (II.A) Aggregate Expenditure (EE). 9J. Devine/Neo-Kaldorian Dynamics8/5/2011 rev. Figure 2

10 (II.A) Short Run: movement along EE curve. E t = EE(x t, S t ); EE 1 ≥ 0; EE 2 ≥ 0 Shift Factor (S t ) is constant in the short run. The sigmoid shape of the EE curve: 1.Between the two vertical segments, spending rises with the expected demand/debt ratio. 2.But investment and total spending do not respond to x t at low demand (due to extreme pessimism, indebtedness, and unused industrial capacity) 3.Nor at high demand (due to supply-side bottlenecks). 10J. Devine/Neo-Kaldorian Dynamics8/5/2011 rev. (1)

11 (II.B) Actual Demand/Debt Line (AA). J. Devine/Neo-Kaldorian Dynamics118/5/2011 rev. figure 3

12 (II.B) The Actual Demand/Debt Line (AA) a t ≡ (E t /Z)(Z/K t )/(B t /K t ) ≡ e t ·  t /λ t The actual expenditure/debt ratio depends on three ratios:  Expenditure/potential = employment rate (e t );  The Kalecki factor: Potential/industrial capacity (Z/K t =  t ); and  The Minsky factor or the degree of leverage: Private debt/industrial capacity (B t /K t = λ t ). J. Devine/Neo-Kaldorian Dynamics128/5/2011 rev. (2)

13 (II.B) Simplifying… Let  t /λ t ≡ α t so that: a t ≡ e t ·α t The actual demand/debt ratio (a t ) reflects  the utilization of potential (e t ); and  α t ≡ the trend value of a t (held constant in the SR) which reflects:  the Kalecki factor (  t ); and  The Minsky factor (λ t ). 8/5/2011 rev.J. Devine/Neo-Kaldorian Dynamics13 (2A)

14 (II.B) Short run: movement along AA curve. Since B t and K t are held constant in the short run, λ t (the leverage ratio), ρ t (potential output/capital ratio) and α t, the trend output/debt ratio are constant. The actual demand/debt ratio(a t ) varies only with the utilization of labor (e t ): a linear relationship. J. Devine/Neo-Kaldorian Dynamics148/5/2011 rev.

15 (II.C) Short-run equilibria. a t = x t, so that E t (a t, S t ) = E t (x t, S t ) The process of adjustment of expectations (x t ) to actual values (a t ) indicates that  equilibria L and H are stable, while  M is unstable. In figure 4, the small arrows show the direction of disequilibrium adjustment. J. Devine/Neo-Kaldorian Dynamics158/5/2011 rev. (3) (3A)

16 (II.C) Short-Run Equilibria. J. Devine/Neo-Kaldorian Dynamics168/5/2011 rev. figure 4

17 (III) Medium Run: Shifting EE curve. S t changes and EE shifts due to  fiscal and/or monetary policy,  changes in expected inflation, and/or  changes in long-term profit expectations. Stimulus (the shift to EE’) means that a lower x than before is associated with the same amount of expenditure. 17J. Devine/Neo-Kaldorian Dynamics8/5/2011 rev.

18 (III) Medium Run: Shifting EE curve. The limits to Stimulus.  Near Z, the curve cannot shift to the right (only downward) due to labor-supply constraints.  and demand-side stimulus can only be temporary (since only inflation results in the end). to describe the “Great Moderation,” S t is held constant with a high E t – indicating effects of the trend underlying EE fluctuations. 18J. Devine/Neo-Kaldorian Dynamics8/5/2011 rev.

19 (III) Minsky/Kalecki Dynamics. Persistent high E t above Minsky/Kalecki threshold V implies that either or both:  leverage (λ t ) rises (Minsky). o Extended prosperity encourages more and more borrowing as prosperity is expected to continue and memories of the Great Depression and past financial crises fade. o This assumes that the financial system is poorly regulated.  the potential-industrial capacity ratio (  t ) falls (Kalecki). o High demand encourages fixed investment while the fixity of Z means that effective “capital productivity” (Z/K t ) falls as not all of the industrial capacity can be used to produce. o Persistent high demand may cause “disproportionalities” as the wrong kind of investment is done, given the structure of demand. J. Devine/Neo-Kaldorian Dynamics198/5/2011 rev.

20 (III) Minsky/Kalecki Dynamics. α t = –M(E t – V); with constant M > 0 Persistent high E t above Minsky/Kalecki threshold V implies that  λ t rises and/or  t falls.  And α t falls, flattening AA, as in figure 3. Going the other way: persistent E t < V rotates AA counterclockwise. J. Devine/Neo-Kaldorian Dynamics208/5/2011 rev. (4)

21 (III) The Economist’s Holy Grail. In theory, medium-run equilibrium exists where E t = V (with constant α). But can this holy grail be both attained and maintained? The answer depends on the relationship between V and the AA/EE tangency point T (introduced below). J. Devine/Neo-Kaldorian Dynamics218/5/2011 rev.

22 (III) Endogenous Disequilibration. Equation (4) and E t > V imply falling α t in the MR, which  leads to endogenous disruption of any short- run equilibrium attained. This in turn implies either A.a “mild” recession or B.a Fall off a Cliff. J. Devine/Neo-Kaldorian Dynamics228/5/2011 rev.

23 (III.A) A “Mild” Recession. J. Devine/Neo-Kaldorian Dynamics238/5/2011 rev. figure 5

24 (III.A) Mild Recession & Cycle. Holding EE constant, falling α t leads to clockwise rotation of the AA line to AA 2. Because the AA/EE tangency point HM at E t = T is below the threshold V,  the recession (declining E t ) causes endogenous reversal of decline in α t as soon as E t < V.  Spending recovers as AA rotates counterclockwise. A “typical” cycle involves repeated clockwise and counterclockwise rotation of the AA line  … along with a lot of other considerations such as the inventory cycle. J. Devine/Neo-Kaldorian Dynamics248/5/2011 rev.

25 (III.A) MR equilibrium maintained? Attainment of MR equilibrium can occur (at H 2 ). This is a stable SR equilibrium with constant α t. However, this MR equilibrium requires maintenance of relatively high unemployment of labor to prevent the Minsky/Kalecki trend.  This is a “reserve army of labor” theory (à la Marx). Standard business cycle theory suggests reasons why the economy might oscillate around MR equilibrium.  Nonetheless, this equilibrium is stable. J. Devine/Neo-Kaldorian Dynamics258/5/2011 rev.

26 (III.B) Falling Off A Cliff. J. Devine/Neo-Kaldorian Dynamics268/5/2011 rev. figure 6

27 (III.B) The Fall. Holding EE constant, falling α t again implies clockwise rotation of AA to AA 2. In this case, E t at the tangency point T is above the threshold V.  The same result occurs with equality of these two points. Thus, the recession causes points H and M to converge to the tangency point HM, which is unstable downward. Because V is low, α t continues to decline. So even if equilibrium at HM is maintained, the SR equilibrium point disappears entirely. J. Devine/Neo-Kaldorian Dynamics278/5/2011 rev.

28 (III.B) The Fall and MR equilibrium. The medium-run equilibrium at E t = V cannot be attained because it does not correspond to a stable SR equilibrium. The model instead implies a Fall to point L (stagnation). J. Devine/Neo-Kaldorian Dynamics288/5/2011 rev.

29 (III.B) Does a Fall occur? We cannot say a priori what the relationship between points T and V is in the real world – so we can’t say which of the two cases occurs. But T is likely to be relatively high due to an extended period of relative prosperity (such as the “Great Moderation”) which allows imbalances to accumulate, lowering α t for long periods. With T associated with a higher level of E t, a Fall is more likely. This kind of trend is seen in figure 7, even if the “Moderation” was anemic from labor’s perspective. J. Devine/Neo-Kaldorian Dynamics298/5/2011 rev.

30 (III.C) The Great Moderation and Falling α t. J. Devine/Neo-Kaldorian Dynamics308/5/2011 rev. figure 7

31 (III.C) Illustrative regression: the trend. ln (a t ) = 0.3704 – 0.0027·(time index) Adjusted R 2 0.5848 Standard Error 0.0623 Observations 95(Great Moderation only) Coefficientst-stat Constant 0.370427.0460 Time coefficient –0.0027–11.5499 Data Source: Federal Reserve Flow of Funds accounts. J. Devine/Neo-Kaldorian Dynamics318/5/2011 rev.

32 (III.C) A Major Caveat. Even though the trend in  t is statistically significant, that does not mean that we can conclude that the fall was large enough to explain the 2008-9 collapse of the U.S. economy. To say that would require that we know much more about the shape of EE and the structure of the economy. 8/5/2011 rev.J. Devine/Neo-Kaldorian Dynamics32

33 (V) Recovery or Stagnation? J. Devine/Neo-Kaldorian Dynamics338/5/2011 rev. figure 8

34 (IV.A) the aftermath & Recovery. In figure 8, because E t at point L 3 < T, there is an automatic tendency toward recovery due to deleveraging (λ t  ) and purging of unused capacity (ρ t  ). So α t rises, rotating AA counterclockwise. Equilibrium points L and M converge to ML, which is unstable upward: the economy leaps up the cliff. J. Devine/Neo-Kaldorian Dynamics348/5/2011 rev.

35 (IV.B) the aftermath & Stagnation E t at point L might exceed T, so the Minsky/Kalecki trend continues, making matters worse. More importantly, recovery can be counteracted by the MR results of extreme unused capacity and indebtedness, which encourages waves of deflation, default, and rapid-onset despair.  These shift EE up and left to EE’: higher x is required to induce the same amount of spending as before.  Continued or deepening stagnation results. J. Devine/Neo-Kaldorian Dynamics358/5/2011 rev.

36 (V) Policy’s Role. Policymakers can be “villains” by maintaining high demand – encouraging the accumulation of imbalances as in a Great Moderation. But in a stagnation period, they can become “heroes” by stimulating demand.  Fiscal policy (if politically possible) and monetary policy (if it works) can “prime the pump,” spurring recovery.  This shifts EE downward, moving the tangency point to the left, making recovery more likely. J. Devine/Neo-Kaldorian Dynamics368/5/2011 rev.

37 (V) To Create a New Prosperity. What encourages the creation of new prosperity? 1.Efforts to lower the leverage ratio (λ t ), via mass bankruptcy and the like. 2.Efforts to raise “capital productivity” (ρ t ) by scrapping excess and/or inappropriate industrial capacity. Both of these artificially raise α t rather than waiting for the “automatic” process. 8/5/2011 rev.J. Devine/Neo-Kaldorian Dynamics37

38 Preventing falling α t Increased leverage can be prevented using improved financial regulation. Decreased capital productivity cannot be prevented without raising Z or avoiding disproportionalities. 8/5/2011 rev.J. Devine/Neo-Kaldorian Dynamics38

39 (V) To Preserve the New Prosperity. What can encourage the persistence of new prosperity, preventing the negative effects of a new “Great Moderation”? 1.Raise Z by increasing the supply of labor. 2.Raise Z by increasing labor productivity. If successful, both of these allow persistently high demand by increasing supply in step. 8/5/2011 rev.J. Devine/Neo-Kaldorian Dynamics39

40 Finis 8/5/2011 rev.J. Devine/Neo-Kaldorian Dynamics40

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