Tag Archives: Aggregate demand

Pecuniary Externalities and Aggregate Demand Externalities

In Econometrica, Emmanuel Farhi and Iván Werning neatly summarize how their work on demand externalities fits in the literature.

… pecuniary externalities, which were first shown to arise when a simple friction, market incompleteness, is introduced into the Arrow–Debreu framework (see, e.g., Hart (1975), Stiglitz (1982), Geanakoplos and Polemarchakis (1985), Geanakoplos, Magill, Quinzii, and Dreze (1990)). The logic is as follows. When asset markets are incomplete and there is more than one commodity, a redistribution of asset holdings generically induces relative price changes in spot markets, in each state of the world. These relative price changes, in turn, affect the spanning properties of the limited assets that are available, potentially improving insurance. Such a pecuniary externality is not internalized by private agents. As a result, the equilibrium is generically constrained inefficient: it can be improved upon by interventions in the existing financial markets. Similar results obtain in economies with borrowing constraints that depend on prices of goods and assets, or when contracting is constrained by private information (see, e.g., Greenwald and Stiglitz (1986)). … [Other work in this literature includes Caballero and Krishnamurthy (2001), Lorenzoni (2008), Farhi, Golosov, and Tsyvinski (2009), Bianchi and Mendoza (2010), Jeanne and Korinek (2010), Bianchi (2011), Korinek (2011), Davilla (2011), Stein (2012), Korinek (2012a, 2012b), Jeanne and Korinek (2013), Woodford (2011).]

… Instead of pecuniary externalities, our theory emphasizes aggregate demand externalities. In addition to providing a new foundation for macroprudential policies, our framework, focusing on monetary policy and nominal rigidities, is well posed for the joint study of monetary and macroprudential policy.

… using a perturbation argument similar in spirit to that in Geanakoplos and Polemarchakis (1985), we show that equilibria that are not first best can be improved upon by interventions in financial markets, except in non-generic knife-edge cases. … In [the pecuniary externality] literature, the key frictions lie in financial markets themselves; in our baseline model, we assume complete markets. Pecuniary externalities rely on price movements; in our framework, price rigidities tend to negate such effects. Our results are instead driven by aggregate demand externalities that arise from nominal rigidities.

Secular Stagnation Skepticism

I was asked to play devil’s advocate in a debate about “secular stagnation.” Here we go:

Alvin Hansen, the “American Keynes” predicted the end of US growth in the late 1930s—just before the economy started to boom because of America’s entry into WWII. Soon, nobody talked about “secular stagnation” any more.

75 years later, Larry Summers has revived the argument. Many academics have reacted skeptically; at the 2015 ASSA meetings, Greg Mankiw predicted that nobody would talk about secular stagnation any more a year later. But he was wrong; at least in policy circles, people still discuss and worry about secular stagnation. As we do tonight.

In his 2014 article, Summers does not offer a definition of “secular stagnation,” in fact the article barely mentions the term. But Summers tries to offer a unifying perspective on pressing policy questions. The precise elements of this perspective change from one piece in the secular stagnation debate to the other.

Summers (2014) emphasizes a conflict between growth and financial stability: He argues that before the crisis, growth was built on shaky foundations that resulted in financial instability; and after the crisis, projections of potential output were revised downwards.

Summers frames this conflict in terms of shifts in the supply of savings on the one hand and investment demand on the other, which are reflected in lower real interest rates.

He identifies multiple factors underlying these shifts:

  • The legacy of excessive leverage
  • Lower population growth
  • Redistribution to households with a higher propensity to save
  • Cheaper capital goods
  • Lower after tax returns due to low inflation
  • Global demand for CB reserves
  • Later added: Lower productivity growth
  • Risk aversion which creates a wedge between lending and borrowing rates

All this, Summers argues, is aggravated by the fact that nominal interest rates are constrained by the ZLB, and that low rate policies induce risk seeking and Ponzi games—that is, new financial instability—by investors.

I am not convinced by the diagnosis. First, I feel uncomfortable with “secular” theories of “lack of aggregate demand.” I guess I believe in some variant of Says’ law; I agree that the massive surge of CB reserves is relevant in this context but even this cannot rationalize “secular” demand failure (presumably, the surge will stop and may even be reversed or prices will adjust).

Second, I disagree on population growth. We have two workhorse models in dynamic macroeconomics, the Ramsey growth model and the overlapping generations model. In the former, population growth does not affect the long-term real interest rate (R = gamma^sigma / beta). In the latter, population growth can have an effect by changing factor prices; but in this model the real interest rate is unrelated to the economy’s growth rate.

Third, productivity growth clearly is relevant. Gordon would support the view that the outlook is bleak on that front, others would disagree and predict the opposite. We will know only in a few decades.

Fourth, domestic factors cannot be the dominant explanation. With open financial markets, global factors shape savings and interest rates.

Fifth, real interest rates have trended downward for thirty years, including in decades when no one worried about “demand shortfalls.” (Nominal rates trended downward too, but that is easy to explain.) But it is true that historically, low real rates tend to coincide with low labor productivity growth. Over the last years, low real rates have gone hand in hand with a stock market boom; this suggests financial frictions or increased risk aversion.

There are competing narratives of what is going on. For example, Kenneth Rogoff argues that we are experiencing the usual deleveraging process of a debt supercycle; in Rogoff’s view, the secular stagnation hypothesis does not attribute sufficient importance to the financial crisis. Bob Hall has identified an interesting structural break: Since 2000, households and in particular, the teenagers and young adults in those households supply less labor (they play video games instead).

Summers discusses three policy strategies in his 2014 article:

  • Wait and see (he associates this with Japan)
  • Policies that lower nominal interest rates to stimulate demand; Summers mentions various risks associated with this strategy, related to bubbles, redistribution, or zombie banks
  • Fiscal and other stimulus policies: Fiscal austerity only if it strongly fosters confidence; regulatory and tax reform; export promotion, trade agreements, and beggar thy neighbor policies; and public investment

I am not convinced by the medicine either. In general, I miss a clear argument for why policy needs to respond. We might be very disappointed about slower future growth. But this does not imply that governments should intervene. The relevant questions are whether we identify market failures; whether governments can improve the outcome (or whether they introduce additional failures); and whether it’s worth it. And this must be asked against the background that some of the trends described before may reverse sooner than later. For example, aggregate savings propensities are likely to fall when baby boomers start to dis-save, and Chinese savings have started to ebb.

More specifically, the Japanese approach over the last decades strikes me as following the third, stimulus strategy favored by Summers rather than the first, wait and see strategy that he dislikes. So we should discount this argument. (In any case, Japan might be a bad example since its per capita growth is not that low.) I agree that I don’t see much scope on the monetary policy side. Monetary policy also has the problem that interest rate changes have income in addition to substitution effects, and that it has lost effectiveness, both fundamentally and in terms of public perceptions. I believe that our views on monetary policy transmission will dramatically change in the next ten years (think for example about the discussion on Neo-Fisherianism). The interesting thing about Summers’ third, stimulus strategy is that it is much less demand focused than conventional wisdom would have it (think of regulation and taxes and confidence to some extent as well).

Finally, the argument for public investment as the instrument of choice is much weaker than Summers suggests. One can think of a situation where private investment is held back for various reasons and as a consequence, interest rates are low and public investment is “cheap.” Nevertheless, the optimal policy response need not be to invest; it could be preferable to eliminate the friction on private investment. For example, with excessively tight borrowing constraints, tax cuts for private investors could be appropriate. If we believe that demographics is the problem then investment could be counter productive as well (dynamic inefficiency in the OLG context). And public investment as an instrument for stimulus is problematic for politico-economic reasons. Low interest rates do not imply that debt is “for free.” It indicates that the supply of risk-free savings is ample, for example because markets are very concerned about tail risks.


Lawrence H. Summers (2014), “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound,” Business Economics 49(2), 65—73.


Economics: The Core

The Economist reviews core ideas in economics. The introductory article to a new series points out that

economists’ fundamental mission is not to forecast recessions but to explain how the world works.

It argues that economists have delivered and it discusses six exemplary areas of economic research:

  • Nash equilibrium (article, August 20);
  • Mundell-Fleming trilemma (article, August 27);
  • Minsky financial instability (article, July 30);
  • Stolper-Samuelson trade effects on wages (article, August 6);
  • Keynes fiscal multiplier (article, August 13); and
  • Akerlof et al information asymmetries (article, July 23).

Refreshingly, the article argues that

[t]hese breakthroughs are adverts not just for the value of economics, but also for three other things: theory, maths and outsiders.

I agree. But the value of economics also derives from more elementary insights, related to, for example,

  • budget and resource constraints;
  • the information content of prices;
  • public choice; or
  • the link between monetary aggregates and the general price level.

Today, these latter insights might appear even more trivial than those picked by The Economist. But they are central, and emphasizing them might lead to different policy conclusions than the common focus on economic frictions and aggregate demand.