The most costly macro breakdowns are always associated with extreme nominal-demand instability, making mainstream inattention to that problem class a puzzle. The GEM Project is an exception, supporting a coherent acute-instability model consistent with relevant evidence. (Chapter 6) Beginning with a fundamental heterogeneity of spending disturbances, the analysis builds on two recent contributions, by Nancy Stokey and Roger Farmer, that enhance our understanding of the causes and consequences of collapsing demand.
Demand disturbances. In usual circumstances, macro shocks are promulgated by stationary demand disturbances (SDD) that combine with the Project’s keystone meaningful wage rigidity (MWR) to yield familiar, contained business cycles. Adverse shifts in total spending are corrected, after a short lag, by automatic stabilizers augmented by central-bank “lean-against-the wind” intervention. Stabilizers include lower interest rates and higher public deficits, income-support programs triggered by involuntary job- and income-loss, and other counter-cyclical transfer payments. Meanwhile, the central bank seeks to speed recovery via open-market purchases of short-term Treasury debt, increasing system liquidity and further reducing interest rates. Both outcomes encourage investment and consumer-durables spending.
The second propagation category, much less frequent but extraordinarily costly, is nonstationary demand disturbances. NDD features contracting aggregate spending that overwhelms automatic stabilizers and orthodox central-bank intervention. If not contravened, extreme instability combines with the MWR Channel to induce rapidly cumulating forced job and income loss, collapsing profits, price deflation, debt default, wealth destruction, and cataclysmic depression. NDD circumstances, which also impair lending by and funding for financial institutions, require very aggressive, very prompt total-demand management to prevent massive welfare loss. (Chapters 5, 10)
Modeling NDD. The behavior of market-traded financial assets influences wealth, investment prospects, corporate valuation, and creditworthiness, factors that in turn influence total spending. Their mark-to-market nature furthermore makes them especially vulnerable to volatility. Such markets are a promising hunting ground for NDD-propagation mechanics.
In the first innovation, Stokey (2009) contributes to our understanding of asset-market dynamics in highly stressed macro circumstances by demonstrating that, as investors/lenders become less certain about macro prospects, simple inaction becomes increasingly rational. In particular, 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 prices. (A maxim of veteran traders is not to try catching a falling knife.) Rational inaction is critically rooted in the breakdown in stabilization authorities’ real-side credibility, which then provides low-risk opportunities for short-sellers. Outsized downward pressures are imposed on mark-to-market asset pricing. Moreover, if and when stabilization policymakers are successful or the NDD threat otherwise dissipates, the rebound in asset prices will be correspondingly rapid and large.
In the second contribution, Farmer (2010b, p.18) argues that confidence exerts a “separate, independent” influence on rational behavior. In particular, he posits investor confidence to be an increasing, nonlinear function of mark-to-market financial asset prices, rooted in a positive feedback relationship with those prices. An illustrative version of Farmer’s feedback mechanism is:
C(t)=ƒ(V(t-1),ΔV(t-1)) such that ΔC/ΔV>0, ΔC/Δ(ΔV)>0, and
V(t)=ƒ(P(t),C(t), F(t)) such that ΔV/ΔP>0, ΔV/ΔC>0, 0<F≤1,
where C denotes investor confidence, V represents composite asset prices, Δ denotes change, P represents discounted, inflation-adjusted expectations of future profits (subject to a known probability distribution), and F (0<F≤1) notionally measures investor perceptions of the real-side credibility of the stabilization authority. Note that F mediates the relative power of P and C in the determination of V. Stabilization authorities’ real-side credibility, once damaged, introduces uncertainty into the valuation process. When credibility is high (F=1), investors’ expectations of the macro future are governed by known probabilities; and asset pricing is wholly driven by profit fundamentals. As credibility erodes (0<F≤1), investors become uncertain; and asset-price dynamics are increasingly driven by investor confidence. An instructive linear version of the feedback system is:
V(t)=F(t)P(t)+(1-F(t))[a1V(t-1)+a2ΔV(t-1)], such that a1+a2=1.
It is easy to extend C–V feedback from asset pricing to total nominal spending, the focus of the acute-instability analysis. In the enriched framework, investment outlays are also determined by P, C, and F, with policymaker credibility again mediating the relative influence of profit 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 macro multipliers. Putting the pieces together, broad macro uncertainty produces a second, more extensive destabilizing feedback, this time between confidence (C) and aggregate demand.
In garden-variety SDD business cycles, the credibility of stabilization authorities’ real-side objective remains robust, significantly containing the welfare loss from the spending disturbance. NDD circumstances, however, inherently feature a breakdown in such credibility, causing investor/lender uncertainty and consequent inaction to become the driving force in collapsing investment and overall spending. In the 2008-09 crisis, investors used existing information to negatively assess the credibility of real-side stabilization policies. The real-time question was government’s capacity to manage nominal demand, halting and reversing the rapid contraction in total spending that was interacting with MWR to produce hemorrhaging job loss. From the acute-instability model’s perspective, investors’ distrust of monetary/fiscal competence is manifest in the 50% collapse in equity prices, a deterioration that cannot reflect economic fundamentals. (Chapter 6) 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 prevent/contain extreme instability must take the evident feedback mechanisms into account.
Space limits this blog to a bare-bones outline of GEM thinking on acute demand instability in highly specialized economies. For elaboration on the theory, see Chapters 6 and 10 as well as Annable and Schechter, “Modeling Extreme Instability” in the paper-exchange page of this website.
Blog Type: Wonkish Chicago, Illinois