Heterogeneous Demand Disturbances
In generalized-exchange macroeconomics, featuring microfounded meaningful wage rigidity and the rational suppression of labor-price recontracting, a broad variety of adverse shocks are centrally promulgated by nominal demand disturbances (DD). Stationary demand disturbances are the most common DD class. SDD are associated with garden-variety business cycles. They are inherently self-correcting, helped along by automatic stabilizers augmented by central-bank “lean-against-the-wind” intervention.
The second propagation category, much less frequent but extraordinarily costly and important, is nonstationary demand disturbances. NDD features contracting total spending that overwhelms automatic stabilizers and orthodox central-bank intervention. If not contravened, extreme instability induces collapsing asset prices, output, and profits, rapidly cumulating forced job and income loss, impaired lending by and funding for financial institutions, debt default, nominal wealth destruction, gathering price deflation, and cataclysmic depression. Given NDD, prevention of depression requires very aggressive and broadly targeted total-spending management.
The stabilization theory that follows builds on fundamental demand-disturbance heterogeneity. It draws on contributions by Roger Farmer, Nancy Stokey, Eugene Fama, and the GEM Project.
Confidence. Farmer (2010b, p.18) revives the argument that confidence exerts a “separate, independent” influence on spending behavior. His specific contribution is that investor/lender confidence is rooted in a positive feedback relationship with mark-to-market financial asset prices and, as a result, is most effectively calibrated as an increasing, nonlinear function of those prices. In short, Farmer posits asset prices to be an effective proxy for the varied determinants of investor/lender confidence that have been identified in market behavior. This is not a new idea. The intertwined reduced-form nature of the stock market and overall confidence has been noted by many economists. From Alan Greenspan (2009) during the worst of the Great Recession: “… a significant driver of stock prices is the innate human propensity to swing between euphoria and fear, which, while heavily influenced by economic events, has a life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but major causes of it.”
An illustrative (GEM enhanced) version of Farmer’s feedback mechanism, which I believe to be especially relevant in NDD circumstances, is:
₡(t)=ƒ(V(t-1),ΔV(t-1)) such that Δ₡/ΔV>0, Δ₡/Δ(ΔV)>0, and
V(t)=ƒ(P(t), ₡(t), Ƈ(t)) such that ΔV/ΔP>0, ΔV/Δ Ƈ >0, 0≤ Ƈ ≤1,
where ₡ is investor/lender confidence, Ѵ represents composite asset prices, Δ denotes change, P represents – as modeled by Fama – market-equilibrium expectations of future profits (subject to a stable probability distribution), and Ƈ measures notional investor/lender perceptions of the credibility of stabilization authorities’ trend real-side objective. P is rooted in neoclassical fundamentals (capital stock, labor force, technology, etc.) that in the Efficient-Market Hypothesis drive asset pricing. Ƈ is the contribution of the GEM Project. It mediates the relative influence of P and ₡ in the determination of V, providing a critical DD link to stabilization policy. An insight of Robert Lucas is that expectations about policymaking rooted in available information must not be ignored in rational-behavior analysis.
Investor inaction. Stokey (2009) persuasively argues that, as investors/lenders become less certain about macro prospects, simple inaction becomes increasingly rational. She has identified a crucial characteristic of demand collapse in highly specialized economies. In the GEM stabilization model, many buyers of financial assets respond to uncertainty inherent in a nontrivial possibility of unchecked NDD by moving to the sidelines, waiting for the emergence of a credible floor under falling asset prices. (A maxim of veteran traders is not to try catching a falling knife.) The GEM Project enriches Stokey’s analysis by motivating rational inaction in the breakdown of credibility of stabilization authorities’ trend full-employment objective. Asset buyers’ moving to the sidelines provides low-risk opportunities for short-sellers, imposing outsized downward pressures on asset pricing. Moreover, if and when stabilization policymakers’ credibility is restored or the NDD threat otherwise dissipates, the rebound in asset prices will be relatively rapid.
Stabilization authorities’ trend real-side credibility, once damaged, introduces uncertainty into the valuation process. When credibility is high, investor/lenders’ expectations of the macro future are governed by stable neoclassical probabilities; and asset pricing is driven by expectations of profit fundamentals. As credibility erodes, investors become uncertain; and asset-price dynamics are increasingly driven by investor confidence. A linear version of the feedback system is:
V(t)= Ƈ (t)P(t)+(1- Ƈ (t))[a1 Ƈ (t-1)+a2ΔV(t-1)], such that a1+a2=1.
The GEM Project easily extends C–V feedback from asset pricing to total nominal spending, the focus of its NDD analysis. In the enriched framework, investment outlays are already determined by P, ₡, and Ƈ, with policymaker credibility mediating the relative influence of economic fundamentals and confidence. In addition, consumption spending is influenced by household wealth and is, therefore, sensitive to mark-to-market asset prices. Finally, in episodes of contracting aggregate demand, incomes throughout the economy are destabilized by powerful multipliers unleashed by contracting employment, output, and income. Putting the pieces together, broad macro uncertainty produces a second, more extensive destabilizing feedback — this time between the interacting confidence/credibility (₡ and Ƈ) and aggregate nominal demand.
The Great Recession
In garden-variety SDD business cycles, the credibility of stabilization authorities’ trend real-side objective remains robust, significantly containing the welfare loss from the demand disturbance. NDD circumstances fundamentally differ, making it a huge mistake to rely the same intervention policy for both. As emphasized, extreme instability crucially features a breakdown in central-bank real-side credibility, causing investor/lender uncertainty and consequent inaction to become the driving force in collapsing investment and overall spending. Farmer’s confidence dominates Fama’s fundamentals. Identifying triggers for Ƈ breakdowns seem to me to be matters of art, rooted in the ability to read the mood of markets in given circumstances.
In the 2008-09 crisis, investors/lenders were surprised by policymakers’ failure to prevent the Lehman bankruptcy. The event fostered uncertainty about the credibility of the trend real-side objectives of stabilization authorities. After all, even Bernanke was openly talking about depression. The crucial question was government’s capacity to manage nominal demand, halting and reversing the rapid contraction in total spending that was interacting with rational MWR to produce hemorrhaging job loss in the many millions.
Remember that investor/lender inaction does not require the belief that a depression is in fact beginning, only increased uncertainty that it can be prevented – a much lower bar. From the acute-instability model’s perspective, investors/lenders’ uncertainty about monetary/fiscal competence is clearly manifest in the actual 50% collapse in equity prices, a deterioration that cannot reflect economic fundamentals. Fama no longer mattered. Some sort of confidence feedback is needed to explain the collapse, and quick rebound, of equity prices in 2008-09. The proper design of measures to contain/prevent extreme instability must take evident ₡ and Ƈ feedback mechanisms into account.
Blog Type: Policy/Topical San Miguel de Allende, Mexico