Going on a decade ago, Shani Schechter and I used the unique power of generalized-exchange macroeconomics to construct our extreme instability model that does a good job explaining the 2008-09 Great Recession. It seemed to us that the biggest clue to a useful theory was the collapse of market asset prices after the Lehman bankruptcy. We knew that the financial meltdown had little altered the economy’s aggregate human and physical capital, its market-oriented organization, and its robust capacity to generate and assimilate technological innovation. Those factors fundamentally supported the pre-crisis level of asset prices. It seemed clear that post-Lehman slumping investor/lender confidence was dominating the fundamentals. In late 2008 and early 2009, investors and lenders were no longer secure about the U.S. capacity to avoid a 21st-century version of the 1930s Great Depression.
The heart of our theory modeled the interaction of the two classes of asset-price determinants. The essential question became whether the stabilization authorities’ objective of trend full employment was credible. We posited a variable (denoted by Ƈ) that calibrates that credibility and critically motivates investor/lender sentiment rooted in the relative contributions of fundamentals and confidence.
The model’s framework intuitively separates adverse nominal demand disturbances (DD) into two classes, each producing distinct macro instability. In the first and most usual, macro shocks are promulgated by stationary demand disturbances (DD→SDD), which yield familiar, contained business cycles. In this class, shifts in total spending are fully corrected, after a relatively short period, by automatic stabilizers augmented by standard central-bank “lean-against-the wind” intervention. The second category, much less frequent but generating much greater welfare loss, resolves into an unchecked nonstationary demand disturbance (DD→ NDD). NDD features contracting aggregate spending sufficient to overwhelm both automatic stabilizers and orthodox central-bank interventions. If not contravened, NDD instability will induce rapidly cumulating job and income loss, collapsing profits, price deflation, broad debt default, wealth destruction, and chronic depression – a massive welfare loss. NDD is necessarily associated with a breakdown in the credibility of stabilization authorities’ real-side (employment/output) objective (Ƈ).
As modeled by Nancy Stokey (see below), the emergence of a broadly held assessment of a nontrivial likelihood of depression effectively, and cumulatively, restricts investment in asset markets and quickly morphs into reluctance to spend on equipment, buildings, software, and consumer durables. NDD circumstances, which also impair the funding for and lending by banks and nonbank financial institutions, require much more aggressive aggregate-demand management than needed in more typical SDD business cycles.
Our analysis relies on two contributions in the literature that provide crucial insight into the mechanics of asset-price collapses that damage total spending. Nancy Stokey’s perceptive model is most central, demonstrating that as investors/lenders become less certain about macro prospects simple inaction becomes increasingly rational. Acquirers of financial assets respond to uncertainty inherent in nonstationary demand contractions by moving to the sidelines, waiting for the emergence of a credible bottom for prices. (A maxim of veteran traders is not to try catching a falling knife.) Such investor/lender inaction became the driving force in collapsing investment outlays and ultimately overall spending. Microfounded MWR translates contracting demand into forced layoffs and reduced production. Collapsing total spending, if not somehow effectively contravened, does indeed threaten depression.
The second contribution has a much longer lineage. We chose to credit Roger Farmer’s (2010a, 2010b) revival of the centrality of investor/lender confidence in cyclical dynamics. He convincingly asserts that confidence, independent of economic fundamentals, significantly influences, and is influenced by, the behavior of prices on asset exchanges. Timely support for an independent role of confidence also came from Alan Greenspan in 2009 (writing in the Financial Times in 2009): “… 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.”
The purpose of this post is to add a third noteworthy contribution to our original list: the 1975 article by Barry Bosworth, “The Stock Market and the Economy,” Brookings Papers on Economic Activity, no. 2, pp. 257-300. The addition is not motivated by Bosworth’s careful and extensive analysis of the mechanisms informing the causal link between equity prices and aggregate nominal demand, although his work certainly provides useful background to the GEM extreme instability model. We were instead interested in the centrality Bosworth assigns to the precipitous drop of the stock market at the beginning of stagflation decade, a crucial fact the is almost completely lost to modern New Keynesian theorists: “The stock-market decline of 1973-74 marked the longest and steepest fall in corporate-stock prices since the depression of the 1930s. The loss of stockholder wealth in market prices amounted to $525 billion, or 43 percent.’ The magnitude of this decline in stock values, in conjunction with the subsequent collapse of aggregate demand in 1974-75, has sparked a renewed discussion of the role of the stock market in business cycle.”
Bosworth’s emphasis on the stock-market collapse at the beginning of the stagflation crisis more closely aligns his analysis with Arthur Burns’ Fed policy at that time. As described in the post three weeks ago, Burns – having closely studied mistakes made in the Great Depression – was centrally concerned with not pushing recession so severe that, using the GEM term, Ƈ would be significantly damaged. His cautious attack on high inflation paid particular attention to investor perceptions of trend real-side credibility of stabilization authorities and the associated threat of depression. He did not need our extreme-instability model to understand that reducing structural inflation caused by the 1970s price-wage-price spiral was not a short-term, cyclical problem. Our model, however, does help in correcting the badly off-base New Keynesian critique of Burns’s performance that argues for a monetary policy sufficiently tight to squeeze inflation out of the economy quickly, no matter what the damage to Ƈ.
How investors assessed central-bank credibility with respect to its trend full-employment, not low inflation, commitment is what most worried the 1970s Fed Chairman. He understood that an all-out war on the price-wage-price spiral, structurally resistant to joblessness, unacceptably threatened a loss of his real-side credibility and a consequent nonstationary contraction of total spending – the direct path to depression. Instead, he pursued a more measured policy that allowed substantial, albeit gradually weakening, inflation pressures to coexist with high unemployment. Time was needed for the structural consequences of the early 1970s labor-adverse shifts in the terms of trade to, in a significant degree, play out.
Blog Type: Wonkish Saint Joseph, Michigan