The GEM Project’s rational-behavior model of the 2008-09 Great Recession, an outline of which occupies this post, is enabled by its microfounding of meaningful wage rigidity in large, highly specialized firms. Macro theorists know that such firms produce a substantial share of total income and output. More need to learn that downward nominal wage rigidity (DWR) is a structural feature of those firms’ profit seeking, a powerful fact that properly focuses policymaker management of macro instability on the behavior of aggregate nominal demand.
Heterogeneous Demand Disturbances
In generalized-exchange theory, adverse macro shocks are centrally promulgated by aggregate-demand disturbances (DD). The most common DD class is stationary demand disturbances. SDD are associated with garden-variety business cycles that are relatively quickly correcting, helped by automatic fiscal stabilizers augmented by central-bank “lean-against-the-wind” intervention.
The second propagation category, much less frequent but much more 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 rapidly cumulating involuntary job and income loss, collapsing output and profits, impaired lending by and funding for financial institutions, gathering price deflation, debt default, and wealth destruction – in short, cataclysmic depression. Given brewing NDD, depression prevention requires very aggressive nominal-demand management.
Building on the fundamental heterogeneity of spending disturbances, the following extreme-instability modeling draws on Roger Farmer, Nancy Stokey, Eugene Fama, and the GEM Project.
Demand-Disturbance Mechanics
Confidence. Farmer (2010b, p.18) revives the venerable argument that confidence exerts a “separate, independent” influence on rational spending behavior. In his contribution, he assumes that investor confidence is rooted in a positive feedback relationship with mark-to-market financial asset prices and is effectively tracked as an increasing, nonlinear function of those prices. In effect, asset prices are posited to be an effective proxy for the varied determinants of investor/lender confidence. The assumption is particularly sound in NDD circumstances, in which confidence plays its most critical role.
An illustrative enhanced version of Farmer’s feedback mechanism 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 discounted, inflation-adjusted expectations of future profits (subject to a stable probability distribution), and Ƈ measures notional investor perceptions of the real-side trend credibility of the stabilization authority. As identified in the Nobel-honored work of Fama, P is the familiar neoclassical determinant that fundamentally drives asset pricing. Ƈ is the contribution of the GEM Project. It mediates the relative power of P and ₡ in the determination of V, providing the critical DD link to stabilization policy. An important insight of Lucas is that expectations about policymaking rooted in available information must not be ignored in the analysis of rational behavior.
Investor inaction. Stokey (2009) persuasively argues that, as investors/lenders become less certain about macro prospects, simple inaction becomes increasingly rational. This is an inherent source of demand collapse in highly specialized economies. In the GEM stabilization model, 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 prices. (A maxim of veteran traders is not to try catching a falling knife.) The GEM Project critically enriches Stokey’s analysis by rooting rational inaction in the breakdown in stabilization authorities’ trend real-side credibility. Asset buyers’ moving to the sidelines provides low-risk opportunities for short-sellers, imposing outsized downward pressures on mark-to-market asset pricing.
Stabilization authorities’ real-side credibility, once damaged, introduces uncertainty into the asset valuation process. When credibility is high (Ƈ near one), investor/lenders’ expectations of the macro future are governed by stable 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 acute-instability analysis. In the enriched framework, investment outlays are already described, determined by P, ₡, and Ƈ, with policymaker credibility mediating the relative influence of profit fundamentals and confidence. In the wider model, 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 unleashed by contracting employment and income. Putting the pieces together, broad macro uncertainty produces a second, more extensive destabilizing feedback, this time between the interacting confidence/credibility measures (₡ and Ƈ) and aggregate 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, however, 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 (most notably the Lehman bankruptcy) to become uncertain about 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 wage rigidities to produce hemorrhaging job loss in the many millions.
From the acute-instability model’s perspective, investors’ distrust of monetary/fiscal competence is clearly manifest in the 50% collapse in equity prices, a deterioration that cannot, repeat cannot, reflect economic fundamentals. Some sort of confidence feedback is needed to explain the collapse, and relatively quick rebound, of equity prices in 2008-09. The fundamental message is that the proper design of measures to prevent/contain extreme instability must take the evident feedback mechanisms rooted in ₡ and Ƈ into account.
Asininity
In closing, note that the GEM extreme instability model accommodates a wide variety of triggering shocks. This Blog has identified subprime mortgages, the breakdown in the reliability of bond credit ratings, and the Fed’s timidity when confronting the Lehman bankruptcy as central triggers for the 2008 Ƈ breakdown. Some 17 years later shockingly asinine U.S. government policy is making its bid to trigger nonstationary spending collapse. Remember all it takes is for investors to adopt the intuitive strategy of waiting to see how the crisis plays out.
The amateurish announcement two days ago of broad, onerous, inexplicable tariffs on U.S. trade unsurprisingly threatens global investors’ confidence in the capacity of Washington policymakers to prevent global depression. The direct harm from the tariffs themselves is brutally augmented by the Ƈ damage motivated by the stupidity of the highest levels of the U.S. government on naked display.
Blog type: Extreme Instability
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