“The economy fell off the cliff.” – George Soros (11/24/2008).

J. Devine/Neo-Kaldorian Dynamics 18/5/2011 rev.

The Great Moderation and "Falling Off a Cliff": neo-Kaldorian dynamics.

James G. DevineLoyola Marymount University (LA, CA)

jdevine@lmu.eduAugust 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: http://myweb.lmu.edu/jdevine/JD-2010-neoKaldorianModel.pdf with diagrams at http://myweb.lmu.edu/jdevine/neoKaldorian-Figures.docx. The current version has been edited a lot without changing any conclusions.)

2J. Devine/Neo-Kaldorian Dynamics8/5/2011 rev.

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 Dynamics 3

(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?oWe may not have been suffering from a Fall.

8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 4

(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.

(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 (St) are determined – but are held constant in the short run.

• short run (SR): Bt (private-sector debt) and Kt (industrial capacity) held constant in the short run.

8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 6

(II) The Subject Matter.

8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 7

Figure 1

(II) Three SR Equations.

1. The EE (expenditure) curve relating demand for GDP (Et) to the expected demand/debt ratio (xt);

2. The AA line, determining the actual demand/debt ratio (at) at each level of demand (Et); 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.

(II.A) Aggregate Expenditure (EE).

9J. Devine/Neo-Kaldorian Dynamics8/5/2011 rev.

Figure 2

(II.A) Short Run: movement along EE curve.

Et = EE(xt, St); EE1 ≥ 0; EE2 ≥ 0

• Shift Factor (St) 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 xt 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)

(II.B) Actual Demand/Debt Line (AA).

J. Devine/Neo-Kaldorian Dynamics 118/5/2011 rev.

figure 3

(II.B) The Actual Demand/Debt Line (AA)

at ≡ (Et/Z)(Z/Kt)/(Bt/Kt) ≡ et · t /λt

• The actual expenditure/debt ratio depends on three ratios:Expenditure/potential = employment rate (et);The Kalecki factor: Potential/industrial capacity

(Z/Kt = t); andThe Minsky factor or the degree of leverage: Private

debt/industrial capacity (Bt/Kt = λt).

J. Devine/Neo-Kaldorian Dynamics 128/5/2011 rev.

(2)

(II.B) Simplifying…

Let t /λt ≡ αt so that:

at ≡ et·αt

• The actual demand/debt ratio (at) reflects

the utilization of potential (et); and

αt ≡ the trend value of at (held constant in the SR) which reflects: the Kalecki factor (t); and

The Minsky factor (λt).

8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 13

(2A)

(II.B) Short run: movement along AA curve.

• Since Bt and Kt are held constant in the short run,

• λt (the leverage ratio), ρt (potential output/capital ratio) and αt, the trend output/debt ratio are constant.

• The actual demand/debt ratio(at) varies only with the utilization of labor (et): a linear relationship.

J. Devine/Neo-Kaldorian Dynamics 148/5/2011 rev.

(II.C) Short-run equilibria.

at = xt,

so that Et(at, St) = Et(xt, St)

• The process of adjustment of expectations (xt) to actual values (at) 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 Dynamics 158/5/2011 rev.

(3)

(3A)

(II.C) Short-Run Equilibria.

J. Devine/Neo-Kaldorian Dynamics 168/5/2011 rev.

figure 4

(III) Medium Run: Shifting EE curve.

• St 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.

(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,” St is held constant with a high Et – indicating effects of the trend underlying EE fluctuations.

18J. Devine/Neo-Kaldorian Dynamics8/5/2011 rev.

(III) Minsky/Kalecki Dynamics.

• Persistent high Et above Minsky/Kalecki threshold V implies that either or both:

leverage (λt) 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/Kt) 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 Dynamics 198/5/2011 rev.

(III) Minsky/Kalecki Dynamics.

αt = –M(Et – V); with constant M > 0

• Persistent high Et above Minsky/Kalecki threshold V implies that

λt rises and/or t falls.

And αt falls, flattening AA, as in figure 3.

• Going the other way: persistent Et < V rotates AA counterclockwise.

J. Devine/Neo-Kaldorian Dynamics 208/5/2011 rev.

(4)

(III) The Economist’s Holy Grail.

• In theory, medium-run equilibrium exists where Et = 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 Dynamics 218/5/2011 rev.

(III) Endogenous Disequilibration.

• Equation (4) and Et > V imply falling αt in the MR, whichleads 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 Dynamics 228/5/2011 rev.

(III.A) A “Mild” Recession.

J. Devine/Neo-Kaldorian Dynamics 238/5/2011 rev.

figure 5

(III.A) Mild Recession & Cycle.

• Holding EE constant, falling αt leads to clockwise rotation of the AA line to AA2.

• Because the AA/EE tangency point HM at Et = T is below the threshold V,

the recession (declining Et) causes endogenous reversal of decline in αt as soon as Et < 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 Dynamics 248/5/2011 rev.

(III.A) MR equilibrium maintained?

• Attainment of MR equilibrium can occur (at H2).

• This is a stable SR equilibrium with constant αt.

• 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 Dynamics 258/5/2011 rev.

(III.B) Falling Off A Cliff.

J. Devine/Neo-Kaldorian Dynamics 268/5/2011 rev.

figure 6

(III.B) The Fall.

• Holding EE constant, falling αt again implies clockwise rotation of AA to AA2.

• In this case, Et 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, αt continues to decline.

• So even if equilibrium at HM is maintained, the SR equilibrium point disappears entirely.

J. Devine/Neo-Kaldorian Dynamics 278/5/2011 rev.

(III.B) The Fall and MR equilibrium.

• The medium-run equilibrium at Et = 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 Dynamics 288/5/2011 rev.

(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 αt for long periods.

• With T associated with a higher level of Et, 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 Dynamics 298/5/2011 rev.

(III.C) The Great Moderation and Falling αt.

J. Devine/Neo-Kaldorian Dynamics 308/5/2011 rev.

figure 7

(III.C) Illustrative regression: the trend.

ln(at) = 0.3704 – 0.0027·(time index)

Adjusted R2 0.5848

Standard Error 0.0623

Observations 95 (Great Moderation only)

Coefficients t-stat

Constant 0.3704 27.0460

Time coefficient –0.0027 –11.5499

Data Source: Federal Reserve Flow of Funds accounts.

J. Devine/Neo-Kaldorian Dynamics 318/5/2011 rev.

(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 Dynamics 32

(V) Recovery or Stagnation?

J. Devine/Neo-Kaldorian Dynamics 338/5/2011 rev.

figure 8

(IV.A) the aftermath & Recovery.

• In figure 8, because Et at point L3 < T, there is an automatic tendency toward recovery due to deleveraging (λt) and purging of unused capacity (ρt ).

• So αt 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 Dynamics 348/5/2011 rev.

(IV.B) the aftermath & Stagnation

• Et 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 Dynamics 358/5/2011 rev.

(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 Dynamics 368/5/2011 rev.

(V) To Create a New Prosperity.

• What encourages the creation of new prosperity?1. Efforts to lower the leverage ratio (λt), via

mass bankruptcy and the like.2. Efforts to raise “capital productivity” (ρt) by

scrapping excess and/or inappropriate industrial capacity.

• Both of these artificially raise αt rather than waiting for the “automatic” process.

8/5/2011 rev. J. Devine/Neo-Kaldorian Dynamics 37

Preventing falling αt

• 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 Dynamics 38

(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 Dynamics 39

Finis

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