So, I’m late to this. There’s a big link parade at the end of the post.

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LinkedIn had an IPO on May 19, priced at $45 per share. The stock briefly sold in the $120s that day, and closed at $94.25. In the lingo, there was a big “pop”.

From a certain perspective, IPO pops are puzzling, even scandalous, events. Here is the theory of the outraged:

• Shares are assets with real economic value that professional investment bankers, after communicating with “the investor community”, are capable of discerning.
• The price at which those shares will trade in public markets, on the first day and thereafter, is a reasonable approximation of real economic value, because stock markets are efficient.
• Therefore, if investment banks (who, in consultation with the issuer, set the IPO price) sell the shares for substantially less than the price at which the shares trade on the open market, they have screwed their client. The issuing firm and its original investors have “left money on the table” by failing to extract the full value their shares. Meanwhile, someone, some flipper, will have purchased shares at the IPO price and resold them after the pop, taking profits that might have gone to the issuer.
• So issuers really ought to be upset about IPO pops (even though they mostly aren’t). “I don’t understand why competitive forces don’t drive this kind of egregious underpricing out of the system,” a finance professor tells the Financial Times.

Puzzle, puzzle, toil and trouble. Here’s a tidbit to taunt the good professor: In the 1990s and especially during the tech bubble, pops tended to be larger for IPOs led by “top tier“, high market-share investment banks than when shares were offered via midlevel underwriters. It’s a topsy turvy world, apparently. During hot IPO cycles, when underpricing is especially pronounced, “competitive forces” seem actively to favor underpricers.

Pretty much every premise of the case against IPO pops is false. Shares of all but the most staid firms do not have known, predictable economic values that highly trained professionals can predict ex ante. Further, share prices are autocorrelated, which is a fancy way of saying that if a stock trades for $100 today, it is more likely to trade above $100 three months from now than a stock that trades today for $50. There are lots of ways to interpret share price autocorrelation. Perhaps markets are efficient, so that a high price today is indicative of durable economic value. Perhaps markets are not so efficient, but investors nevertheless use yesterday’s price to determine the price at which shares will trade today.

Regardless of which story you believe, consider the situation of insiders and early investors in IPO firms. These investors face a “lock-up” period of three to six months after the IPO, during which they cannot sell. (This is intended as a kind of guarantee to new buyers that the shares are not total lemons.) If you hold a share of stock that you cannot sell for several months, you are better off, in a statistical sense, if the shares that you hold trade for $100 today than if they trade for $50 today. Sure, even after a pop, share prices could wither to worthlessness by the time the lock-up period ends. And sometimes that happens. But overall, if you are a preexisting investor in an IPO firm, the expected future value of your shares is substantially higher if your shares trade at $100 now than if they trade at $50.

So, if you are an early investor in a firm now making its debut, an IPO pop is mixed news. On the one hand, discovering that the shares you continue to own are very valuable is good news. On the other hand, if it is true that you could have sold the shares that you did sell for this much higher price, you’ve been screwed. On balance, how should a rational shareholder evaluate these conflicting signals? Should she be glad or disappointed? Should she fire her shoddy investment bank or celebrate its success?

If you are sure that stock markets are completely efficient and so share prices are independent of all the schmoozing and marketing done by your underwriter, then you should be outraged. You would have learned the same good news had you gone with a different investment bank, and your underwriter, if it were more competent or less corrupt, could have set a higher price and made you a great deal more money. But if you think that the stuff investment banks do when they underwrite an IPO actually does affect the price at which shares eventually trade, you might not be so angry. You might consider the “money left on the table” to be part of the fee you pay in order to be made as rich as possible.

IPOs are not all alike. In the lingo, they are sometimes “financing events” and they are sometimes “pricing events”. When IPOs are financing events, insiders are selling substantial fractions of their firms, trying to to divest their holdings or raise large sums for corporate purposes. When they are “pricing events” insiders are selling a small fraction of their shares in order to gain various benefits that come with being a public firm. In a “financing event”, when insiders are selling a lot of stock, the money left on the table from an IPO pop might amount to a substantial fraction of total equity value, too much money to be treated as a transaction cost. But in a “pricing event”, the money left on the table in a pop — the “opportunity cost of issuance” — may not be so large.

A very good predictor of how much an IPO will pop is “overhang”, the ratio of shares retained by insiders to shares sold during an IPO. IPOs with high overhang — that is, IPOs where insiders are selling only a small fraction of the firm — are much more likely to pop than IPOs in which investors are selling a lot of their shares. (This is true even controlling for the absolute value of shares sold, so it is unlikely to be just an artifact of scarcity.) To my mind, the explanation for this regularity is simple. Investment banks behave differently for high overhang IPOs (“pricing events”) than for low overhang IPOs (“financing events”).

For low overhang IPOs, in which much of the firm is being sold, underwriters go for accuracy. Investment banks do not want clients to spread word that they lost half the value of their firm to flippers on the big day. So bankers work to keep the IPO price and the immediate market price aligned. They try to set a reasonable price in the first place, they place shares with investors likely to sell pops and buy dips, they stabilize prices directly via their own activity in the market. (Underwriters have a partial exemption from market manipulation rules that allows them to “stabilize” new issues.)

But for high overhang IPOs, investment banks, in consultation with their clients, go for broke. The “book-building” process, often described as an anodyne sounding of investor interest, becomes an occasion to market the hell out of the issue. Investment banker activity, proxied by changes (even downward changes) to the planned issue price are predictors of IPO pops. For high overhang IPOs, underwriters and their clients agree that everything that can be done should be done to get the shares trading at the highest valuation possible, despite a necessarily conservative issue price.

When only a small fraction of a firm is being sold, issuers quite rationally permit investment banks to underprice their IPOs, because doing so aligns underwriters interests with their own. Issuers want their firms to be highly valued. An issuer who makes it clear that she will hold her underwriter accountable for underpricing is behaving foolishly, threatening to punish an outcome she desires. A smart issuer understands perfectly well that money left on the table will be used as kickbacks to favored clients of the investment bank. But why should she mind? She views that money as performance pay, a transaction expense. Given the small fraction of shares sold, it represents a modest cost. Further, she understands that the reason she chose her market-leading, high reputation underwriter is precisely because of the bank’s relationships with institutional investors, the bank’s ability to persuade people in its rolodex to take up and hold (not flip) new issues. If the issuer is not naive, she knows that the underwriter’s ability to place shares comes from plum deals the bank frequently offers the people in its rolodex. With the money she leaves on the table, the issuer is paying for exactly what she is trying to buy.

Efficient markets proponents will blanche at this whole scenario. How can underwriters affect share values? Surely, investment banks can’t “fool” the market over a six month lock-up period?! But nobody is fooling anybody, exactly. Nobody — not Warren Buffett, not the firm’s CEO, not even your psychic friend at Goldman Sachs — knows the “true value” of a speculative firm. A small rejiggering of earnings growth assumptions or the appropriate discount rate can double or halve estimates of “economic value”. The dirty little secret of fundamental analysis is that it can never tell you the correct price of a stock. Fundamental analysis can indicate that a price is wrong, that it is deeply below or outrageously above any reasonable valuation. But an independent analysis (one that ignores the market and estimates value based on a discount rate and expected cash flows) will very rarely approximate actual share prices (unless the analyst cheats, and reverse engineers the market). What issuers believe a good investment bank can do, with its marketing and its reputation, is get the shares trading on the optimistic end of the range of reasonable valuations. And that, to preexisting shareholders, can be much, much more valuable than a bit of money left on the table from underpricing.

So, is there any scandal here at all? I think so, but it’s not about investment banks screwing underwriting clients. On the contrary, I think investment banks usually serve both their underwriting clients and their favored investors pretty well. The scandal, I think, is that the IPO process offers issuers, underwriters, and favored investors too much and the rest of us too little. After the first day pop, IPOs tend to underperform other issues over the long term. Not by enough to reverse the first-day pop over the lock-up period. On average, new IPOs don’t underperform the market very much in the first six months after the pop. (During the 2000s, IPOs did perform poorly even in the first six months, but that is probably because the tech bubble crashed within 6 months of many IPOs.) IPOs get optimistically priced on their first day, and whoever winds up holding the shares from the end of the lock-up period and out several years pays for that. In general, buying IPOs at the issue price is a great deal, while buying IPOs on the secondary market is hazardous even a year or two after the offering. The IPO process ends up being a boon to insiders (the issuer, its underwriter, and favored investors), which is paid for over time by less connected investors who fail to demand a sufficient premium to hold recently IPO-ed shares.

In the scheme of things, this is pretty small beans. Caveat emptor and all of that. Still, a practice that taxes investors broadly in order to reward people for systematically mispricing securities does deserve some tut-tutting.

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P.S. The academic literature on IPO underpricing is all about kickbacks. I prefer my conspiracy theories to be fringe, but this is all pretty mainstream. Famous explanations describe underpricing as a kickback necessary to induce uninformed investors to participate, or to induce informed investors to reveal what they know during the book-building process. For a real conspiracy theory, check out spinning, which has investment banks offering kickbacks to managers so that they’ll tolerate underpricing that screws their own firms’ shareholders.

So this will be an unusual post, more picture book than essay. Plus, it’s interactive! If you are willing to install the Mathematica plug-in, you can be the central banker / fiscal authority of your very own graphical economy!

As readers may have noticed, I’ve been thinking lately about Keynesian and monetarist business cycle theories. I don’t mean to wholly endorse these theories. I’ve some sympathy for Austrian-ish or “recalculationist” ideas too. But I do think there’s merit in the idea that recessions frequently occur because aggregate expenditure is, for whatever reason, inadequate. I’ve been frustrated by all the squabbles, between self-styled Keynesians and post-Keynesians, academic defenders of mainstream central banking and the more risqué internet “quasimonetarists”. My view is that these groups are more alike than different in their economic ideas, but that they manufacture controversies to signal political affiliations and institutional preferences regarding how and by whom policy decisions should be made.

So, I’ve been trying to understand the ways in which these theories are alike and different, and organize my own thinking about how to evaluate different policy proposals. I’m a pretty visual thinker, but for a variety of reasons, I’ve never found the most common ways to diagram Keynesian ideas — IS/LM and AS/AD — especially helpful. In my mind, I found myself falling back on Econ 101 style supply and demand graphs, where the commodity of interest, whose “price” and quantity is to be determined, is nominal expenditure. I’m sure this is not a novel approach, but I’ve gotten a lot of mileage out of it. Perhaps you won’t find it entirely useless.

The hardest part is to make sense of the basic set-up, so let’s talk it through.

The Basics

Below is a diagram of an economy in which demand shortfalls do not lead to output losses and money is neutral, because there are no price rigidities.

The downward-sloping yellow line is a demand curve, and the upward-sloping green line is a supply curve. Hopefully that seems familiar. However, we’re in a bit of a mirror universe, because we are graphing the supply and demand of expenditure. So the “expenditure suppliers”, represented by the green curve, are economic consumers. They supply dollars, for a “price”, which is some quantity of real goods and services. The “expenditure demanders” are economic producers. They demand dollars, but are only willing to offer so many goods and services for a buck. The equilibrium, the point where the two lines intersect, shows the price of a dollar, in real goods and services, that equalizes producers’ demand for money and consumers willingness to supply it.

For example, suppose that, at equilibrium, you can buy two widgets for a dollar. So the price of a widget is 50¢. But the price of a dollar is two widgets! Note the relationship — the dollar price of widgets is

(1 / PRICE_OF_DOLLARS_IN_WIDGETS)

This relationship is reflected on the axes if the graph. The left axis shows the price of money in real goods. If money is “expensive”, if you have to offer a lot of real stuff to get a dollar, that corresponds to a low price level, think deflation. Conversely, if money is “cheap” — if the equilibrium falls towards the bottom of the graph — then that means goods and services are expensive, think inflation. The right-hand axis shows the conventional price level, which rises as you travel vertically down the graph. As the price of money in real goods and services falls to 0, so you’d give up a dollar for next to nothing, the price level on the right-hand axis rises to infinity.

The X or quantity axis of the graph indicates how many dollars will be spent at the equilibrium. This has a very natural interpretation as nominal GDP. So, from the equilibrium point on the graph, we can read the price level (on the right axis) and the nominal GDP directly.

Real GDP is represented by the area of the bluish rectangle in the bottom left corner of the graph. To understand why, recall that real GDP is just

(NGDP / PRICE_LEVEL)

But the Y axis of the graph is

(1 / PRICE_LEVEL)

So the area of the bluish rectangle is

NGDP × (1 / PRICE_LEVEL) = (NGDP / PRICE_LEVEL) = RGDP

So what determines the shape of the expenditure supply and demand curves? Let’s start with demand. Suppose the economy produces at capacity and there are no “rigidities” to prevent the sale of all output. Producers will always accept however many dollars are on offer and sell the maximum achievable RGDP. Then

NGDP × (1 / PRICE_LEVEL) = MAX_RGDP
(1 / PRICE_LEVEL) = (MAX_RGDP / NGDP)

Since the inverse price level is our Y axis, and NGDP is our X axis, the function that describes our no-rigidity demand curve is just

Y = (MAX_RGDP / X)

which is the graph of a grade-school hyperbola. We’ll modify this shape a bit, when we start thinking about price rigidity. But let’s hold off on that.

What determines the shape of expenditure supply? That’s where all of the action is in terms of fiscal and monetary policy, and we’ll graph lots of funky shapes below. But fundamentally, the answer to this question is easy. Imagine a world of consumers, each of whom must decide how much to spend now and how much to save for the future. Suppose we can characterize consumers’ “intertemporal preferences” with a utility function. Then we can compute how much each consumer will spend. Naturally, that utility function will take into account the current price level, among other parameters. If we hold other parameters constant, we can compute how expenditure varies with the current level of prices. We add up all consumers’s expnditures and plot them on the X axis, against (1 / PRICE_LEVEL) on the Y axis. That gives us our expenditure supply curve.

Immaculate Deflation

In the graph above, everything has been normalized to one. The graph shows one unit of real goods “buying” one dollar of expenditures, for a price level of one. Suppose that consumers become more reluctant to spend money, that is, they perceive the marginal opportunity cost of parting with money as increasing. The result would be an “immaculate deflation”, in that expenditure would fall, but so would the price level, so that the reduced expenditure would still purchase all the economy’s real product, and RGDP would not fall at all. Here’s the graph:

Note expenditures have fallen, but the quantity of goods offered for each dollar has risen. Real GDP — the area of the bluish rectangle — has not changed.

Price Rigidity

In the real world, when nominal expenditures fall, the quantity of goods offered for a dollar doesn’t rise enough to compensate. The quantity of goods purchased actually decreases. Let’s graph that:

The expenditure supply curve is identical to that in the previous graph. However, the shape of the expenditure demand curve has changed. There is now a “kink”, that begins (as I’ve drawn it) just under the original equilibrium expenditure of one. Our steepened expenditure supply hits the kinked region, forcing that the quantity of goods offered for a dollar to be lower — or the price level to be higher — than in the previous graph, with its unkinked, flexible-price expenditure demand curve. This means that, given the reduced level of expenditure (caused, as before, by the steepening of the expenditure supply curve), the quantity of goods consumers purchase is less than the economy’s capacity. We observe a fall in real GDP and a recession.

As before, the area of the bluish rectangle represents Real GDP. The dotted white line shows the flexible-price expenditure demand curve, while the yellow line is the expenditure demand curve that actually obtains, with its kink and price rigidity. The reddish rectangle represents the output gap: the area that should have formed part of GDP, but does not because of the price rigidity.

In this example, the price level has from 1 to 0.96 (a 4% deflation), and real GDP has fallen by 10%. Note that in the previous example, with the same steepened expenditure supply curve but flexible prices, the price level fell even farther (to 0.88, a 12% deflation), but RGDP was unaffected. There’s an important bit of intuition here. We often imagine that deflation causes recessions, and indeed in our graph, we can see that deflation is associated with recessions. We would only see an output gap when the equilibrium fell before the kink in the curve, which is always a price level lower than our original price level. But under flexible pricing, the deflation would have been more severe, without harming RGDP. It is not too much deflation that creates the output gap, but too little deflation given the fall in expenditures! Tepid deflation is a marker of recessions, but it is the decline in nominal expenditure, in NGDP, that drives the show.

If you are wondering where the shape of the sticky-price expenditure demand curve comes from, see my earlier post on sticky prices. Basically, to generate the expenditure demand curve with price rigidity, I assume that industry leverage is uniformly distributed over some range, that firms in industries set minimum prices based in their degree of leverage, and that firms’ capacity is constrained in the short term. If you don’t buy that story, but agree that prices are sticky downward but not so sticky upward, then you can take the shape as an arbitrary qualitative depiction of that.

The Expenditure Supply Curve

Expenditure supply is where the action is in making sense of Keynesian and monetarist interventions. The nice thing about this framework is one can posit any intertemporal utility function you like for agents in your economy and then compute the shape of the expenditure supply curve as you vary parameters.

For the purpose of this exercise, I’ll adopt an unrealistic but illustrative utility function presumed to be shared by all consumers. Consumers will face a two period, rather than infinite horizon optimization problem. Their behavior will be based upon a number of factors, all of which are treated as exogenous parameters:

• An interest rate r_i which determines the Period 2 value of money not spent in Period 1.
• An current wage w₁, in nominal dollars.
• An expected future wage μ_w2, in nominal dollars.
• Variance of the distribution of future wages, σ_w2²
• Skewness of the distribution of future wages, skew_w2
• A current price level P₁
• An expected future price level E[P₂]. (Oddly, the current price level is what we are trying do determine. The expected future price level is known, and helps to pin the present price level.)
• A current taxes-and-transfers surplus S₁.
• An expected future taxes-and-transfers surplus E[S₂].
• A discount rate r_d, which is the rate at which consumers discount future utility.

A “real” model wouldn’t treat all these parameters as free. For example, perhaps the expected price level is dependent upon current interest rates, or fiscal policy. My goal here isn’t to present a falsifiable model of consumer behavior, but to illustrate what proponents of various interventions are claiming, and explore under what circumstances they would or wouldn’t work. We will find, for example, that, running a Period 1 taxes-and-transfers deficit while holding interest rates constant increases Period 1 expenditures. However, this effect will be mostly undone if the Period 1 deficit must be balanced by a Period 2 surplus. We don’t wish to take a position here in the “Ricardian equivalence” debate. Allowing the two deficit parameters to vary freely, rather than enforcing some hypothesized relationship, permits us to illustrate the claims of partisans on both sides.

The utility function I’m using to compute the expenditure supply function is shown below.

Our variable x represents nominal dollar expenditures.

There are a bunch of things about this utility function that are crappy, but I think it’s good enough to show how changes in parameters might affect a expenditure supply curve, and offer some intuition about how various interventions might work.

Although I’m using just one utility function here, a nice thing about this framework is that it need not rely on a representative agent. What we will derive, after all, is a Marshallian supply curve. We can define populations of agents with different parameters or preferences and combine the supply curves by “horizontal addition”.

Visualizing Changes in Expenditure Supply

Let’s start with a graph of an economy characterized by price rigidity, but which is currently at “full employment equilibrium”. (The scare quotes are because I am not explicitly modeling labor, so by full employment I just mean that the economy is producing at capacity.)

Now, suppose that for whatever reason, uncertainty surrounding future wages increases:

The expenditure supply curve steepens. Consumers become more reluctant to part with dollars, as they have been made worse off in the future and prefer to save. Unfortunately, after this steepening, the expenditure supply curve now intersects with the sticky-prices region of the expenditure demand curve. The resulting equilibrium is recessionary; the economy experiences a 5% output gap.

What kind of interventions might we try to fix this? Conventionally, our first resort is to discourage financial saving and promote current expenditures by reducing interest rates:

Dropping interest rates to zero helps, but it turns out to be insufficient, a 3% output gap remains. We have entered the liquidity trap, if you believe in such a thing.

But we are certainly not out of potential of interventions. Suppose we believe that the central bank is very, very good at setting expectations. Okay, if it were really great at that, it could just reverse the shock to consumers’ expectations of wage uncertainty and we’d never leave our initial equilibrium. But suppose the central bank can’t do that, but it can manage expectations of the price level. Then…

That worked! Yay monetary policy, still potent at the zero bound! But, we should be careful. We’ve assumed the central bank could set price level expectations. That’s much less sure than assuming it can set interest rates. Plus, perhaps engineering an uptick in inflation expectations is hazardous. Perhaps the central bank cannot set expectations precisely, so that there is a hazard of overshooting and generating inflation rather than just restoring equilibrium. Perhaps there is value to keeping inflation expectations “anchored”, and the change in expectations required to restore equilibrium would upset that anchoring. So, it’s worth considering alternatives.

Let’s go back to our original disequilibrium, and let the MMT-ers have their way. Suppose that to counter the 5% output gap, the government reduced taxes and/or increased transfers, to run a deficit. Could that work? Absolutely.

However, there’s a catch. My two period setup is pretty Ricardian. Encouraging private spending through a taxes and transfers deficit in Period 1 only works if that deficit is not repaid by running a surplus in Period 2.

However, in the real world, deficits needn’t be repaid via prompt surpluses, and economies (measured in nominal dollars) often grow faster than the interest rate paid on public debt. In this case, debt effectively repays itself over time, without ever requiring surpluses. The core new debate over MMT as well as a very old debate over “Ricardian equivalence” turn on the degree to which people have (or by tax policy can be made to have) a special willingness to hold currency and government securities even when doing so implies an opportunity cost relative to a hypothetical asset that matches the economy’s growth rate. I think the case is very strong that, under many circumstances, people are willing to bear that cost, not least because a hypothetical asset that earns the economy’s growth rate with little risk does not exist, and most people are more concerned with managing risk than with maximizing return.

(Note: If you think transfers that will never be paid for in taxes must increase the expected future price level, then in the immediate term, all that does is to reduce the scale of the program necessary to eliminate the output gap! An increase future price level expectations, like the unfinanced transfer itself, renders the expenditure supply curve shallower, helping carry our equilibrium out of the recession region. Of course, we are observing a one period snapshot of the economy, and there may be long-term bad consequences to “unanchoring” the price level. That’s beyond the scope of our little visualization, but that doesn’t mean we shouldn’t worry about it.)

My little experiment is not so friendly to a taxes-and-transfers-based “hard Keynesianism“, which prescribes prompt surpluses to offset cyclical deficits. In my toy model, a reduction of expected future income is very much like a reduction of present income, as agents can borrow and save at “the” interest rate. But this is not realistic: real humans pay more to save than to borrow, and may face outright credit rationing.

I give lip service to uncertainty by calling the future surplus “expected”, but I don’t actually model it as uncertain, as wages are the only random variable in my toy utility function. If I had, the cost of future surpluses to consumers would be even greater, and it would make “hard Keynesianism” look even worse. So implemented in terms of taxes and transfers, ignoring the wedge between saving and borrowing costs, and holding wealth distribution constant, it’s hard to see how one could ease a recession by running deficits which are expected to be balanced by prompt surpluses. Of course, these assumptions needn’t hold. We do not have to restrict ourselves to taxes and transfers, but can have government deficit-spend on real goods and services directly. Savers do, in fact, face liquidity and borrowing constraints that “hard Keynesianism” can overcome by effectively using the government’s balance sheet to borrow on behalf of consumers. And when we tax-and-transfer, we can also redistribute.

I yet haven’t tried to model consumers facing borrowing constraints. But I have played with variations in which government spends, rather than transfers its deficit, and with redistribution. So let’s look at those.

Stimulus Via Direct Government Expenditure

The economy’s true “expenditure supply” includes the inclination of government to directly purchase goods and services. Thus far we’ve ignored that. If we hold government’s propensity to spend invariant to the parameters of our toy model, ignoring government purchases doesn’t much hurt our analysis. But is that a realistic assumption?

It would be hard to model how government’s inclination to spend varies, and upon what parameters that variation depends. However, governments do sometimes respond to recessions by adopting stimulus programs, which in rough approximation we can model very easily.

Here’s how we’ll do it. We’ll imagine that the government first chooses the quantity of dollars it will spend on real goods and services, and then chooses what it will purchase. That sounds unobjectionable, but it’s really very sneaky, because it means that stimulus spending is not a function of the quantity of real goods and services offered for the money. So the expenditure supply curve due to stimulus is vertical. Including expenditure due to government stimulus simply shifts the expenditure supply curve to the right by the quantity of nominal dollars appropriated!

Let’s see, in the simplest case, how a stimulus program that is not expected to be paid for from an increase in taxes can combat a recession. The dotted green represents the expenditure supply curve in our 5% output gap recession, and the solid green line illustrates the intervention.

Note that the expenditure supply curve in this graph is different from all of our previous graphs. For ordinary consumers, the quantity of expenditure supplied always goes to zero as the price of a dollar in terms of goods and services falls to zero. The curve bottoms out at the origin of the graph. To put things in more familiar terms, if the price level today is infinite — you get literally nothing for a dollar spent — and the price level tomorrow is expected to be finite, you’d spend precisely nothing today. With stimulus via direct spending, the government commits to current-period expenditure regardless of the price level. The expenditure supply curve now bottoms out to the right of the origin.

Unlike a taxes-and-transfers deficit, stimulus via direct spending “works” under our toy model even if it is paid for via a fiscal surplus. It doesn’t matter, under our model, whether the spending is paid for out of current period taxation or future taxation. That is, our model suggests that it might be possible for a government to balance its budget in the teeth of a recession and still stimulate its way out of the recession!

There is a hitch, of course. Our balanced budget is stimulative if and only if spending is increased and balance is accomplished by increasing current taxes. Cutting spending to balance the budget would be contractionary under our framework, while increasing taxes to fund spending is expansionary.

The intuition is pretty straightforward: Consumers divide current wealth between spending and saving. If consumer saving decisions compose to insufficient current spending to avoid recession, the government can preempt those choices by taxing current wealth and spending the entirety of the proceeds.

A few issues and caveats —

• Compare the graph above to the previous graph, where the stimulus spending is not funded by taxes. The X intercepts show how large the government’s spending program must be to eliminate the output gap. Unsurprisingly, government must commit to a great deal more spending to render a funded stimulus effective than it would need to for an unfunded stimulus.
• If the spending program were funded by future period taxes rather than current period taxes, the graph would look nearly identical, given the near-perfect substitutability of present and future money in our model. However, as we discussed above, in the real world, consumers find it expensive or impossible to borrow from the future in recessions, so transferring wealth to current consumers and taxing in the near future to pay for it may be directly expansionary. If that is so, then the scale of government spending required to cover the output gap would be smaller if the spending is paid for out of future taxes rather than out of present taxes.
• If a government commits to large nominal expenditures irrespective of what is to be purchased, indiscriminate spending decisions might degrade the quality and value of current output. If so, effect of the increase on current expenditures might be undone, partially or completely or worse than completely, by a supply-side losses. See “supply and technology shocks” below for an example.

Distributional Effects

Part of my motivation in developing this framework was to come up with a way of conveniently analyzing distributional effects. We can compute different expenditure supply curves for subpopulations of different wealth levels, and “horizontally add” those curves to get the economy-wide expenditure supply. I thought I would easily be able to define some very rough distribution parameter, and show how redistribution affects expenditure supply.

I began with a very strong prior: I believed, and still believe, that the poor are much more likely to spend out of current income than the rich, so that redistribution from rich to poor would increase current expenditures (that is, render the slope of the expenditure supply curve more shallow). To get a quick and dirty take on distribution, I compared two economies, one in which all the wealth was held by a single individual, and a second in which the wealth was equally distributed among many individuals. I expected a shallower curve in the second case.

But that is not what I found, under the utility function above. In fact, it is easy to show that, holding total real wealth (both current and expected future) constant, the expenditure supply curves are identical if the economy contains just one spender (while everyone else starves) or a perfectly equal distribution of wealth. So have I revised my priors?

No, not at all. Instead, I’ve understood deficiencies in my utility function, deficiencies that I think are shared with most utility functions used to build macro models. Why is expenditure supply constant, regardless of distribution? It’s pretty simple really. Under the terms of the model, agents are perfectly forward-looking and all wealth must be spent eventually. Intuitively, we think poor people will spend money today if we put it in their hands because the absolute cost of not spending — going hungry, for example — is large. But, given the structure of my and most macro models, agents don’t evaluate current expenditure against absolute gains in present utility, but against opportunity costs in future utility. If an agent is poor, sure, not eating today has a large cost. But eating today exacts a similarly large cost from the still-poor-me of tomorrow. A rich agent gains little by eating a bit more today, but her cost in future consumption for that benefit is similarly low. Under my utility function, as long as the two agents discount future utility identically, they will make precisely the same tradeoff between expenditures today and expenditures tomorrow. So a poor person, despite starvation, will be just as disinclined to spend current wealth as a rich person. The poor person will balance starvation tomorrow against hunger today, and save some fraction of her wealth. The rich person will balance the pleasures of a bon bon tomorrow against a cookie today, and save precisely the same fraction.

I think this is entirely unrealistic, but what’s interesting is to articulate why. Let’s think about it. In my model, all agents live for precisely two periods, no matter how much or how little they consume. In the real world, insufficient consumption today implies death and zero consumption in the future, regardless of how much a person might have saved. So a realistic model needs some concept of subsistence, such that as present consumption falls and the probability of death increases, the value of future savings is increasingly discounted. More generally and less drastically, future wages in my model are stochastic, but independent of present consumption. But that makes no sense. My ability to earn future wages depends upon my current expenditures. My distribution of future wages is dramatically different if I have a home, decent clothing, a telephone, or an education, than if I do not have these things. Ultimately, I need to add to my consumers’ utility function some notion of investment expenditure that impacts future wealth, rather than restricting the choices to pure consumption and financial savings for interest. And there should not be a single, economy-wide investment return, but each individual’s returns should (usually) be diminishing in wealth. My first dollar of expenditure buys me the ability to survive into tomorrow and enjoy potential future wages; its return is very high. Direct investment of my millionth current dollar might buy me an additional nice suit or make some marginal contribution to a business, but its effect on my future wealth is likely to be small. If I include this sort of direct investment in my model, I think I’d generate the expected relationship between poverty and a bias towards current expenditure. But that’s an exercise I’ve not yet done.

Technology and Real Supply Shocks

The supply side of our economy is graphical represented by the yellow expenditure demand curve. That curve is based on a hyperbola, whose numerator is the capacity of the economy in units of real output. A negative real supply or technology shock yields a recession, without any change in consumers’ willingness to spend:

Note that the output gap is 5%, just like demand-shock recession we’ve illustrated in previous graphs. However, this recession is actually much worse. The real output of our economy has fallen by 13%, not by 5%. The negative supply shock eliminated almost 9% from our potential output. Plus, even though the expenditure supply curve has not changed at all, the shift in the expenditure demand curve pushed the equilibrium onto that curve’s rigid price region, generating an output gap of 5% of our diminished potential output (about 4% of our original output) in addition to the loss of real capacity. In response to a negative supply shock, increasing consumers’ willingness to spend can eliminate the loss of output due to price rigidity, but cannot affect the loss of real capacity:

It’s worth commenting on how the shape of the expenditure demand curve as it shifts in response to a supply shock. By hypothesis, the “kink” in the curve is a function of nominal indebtedness. A firm that requires a dollar of revenue to service its debts doesn’t reduce the price of its total output below a dollar, even if a technology shock diminishes the quantity or quality of that output. So the kink stays where it began, at nominal expenditure of 1.

Yet consumers’ willingness to spend is a depends on the value of real output provided. Holding constant expectations about the future, consumers are less willing to provide that dollar of current expenditure for less or worse stuff. So despite a higher current price level — which you might think would ease the burden of servicing on nominal debt — the diminishment of nominal expenditure occasioned by transiently higher prices (the left-shift of the equilibrium) means that firms have a significantly harder time servicing their debts.

Note that, perhaps counterintuitively, our output gap arises because consumers are optimistic that the real supply shock is temporary. If consumers expect the supply shock were permanent, and therefore that the future price level would rise along with the present price level, a demand effect offsets the supply effect, and the output gap disappears. Consumers become more willing to supply expenditures now because they no longer expect tomorrow’s money to be more valuable than today’s. (The shift in the yellow expenditure demand curve is the real supply shock. The shift in the green expenditure supply curve shows the increase in current spending due to expectations of future high prices.)

“Stagflation” comes from any sort of negative real supply or technology shock, but is magnified when consumers believe the shock to be temporary!

This is an important difference between demand and real supply side shocks. If consumers’ inflation expectations are “adaptive”, that is, if we learn from experience to predict the future, then for supply shock, changes in expectations help stabilize the current price level and eliminate any output gap. For a demand shock, adaptive expectations about prices are destabilizing. If a demand-driven deflation means we expect future deflation, that diminishes our willingness to spend, which renders our current output gap and deflation even worse. Supply shocks self-heal, demand shocks self-destruct. (Remember, “supply shocks” are shifts in the the expenditure demand curve of our framework; “demand shocks” are shifts in expenditure supply!)

Of course, even if consumers do believe a real shock to be temporary, the output gap can be eliminated by expansionary monetary or fiscal policy. However, no amount of monetary or fiscal policy can undo the real shock. If potential real GDP has fallen by 10%, encouraging people to spend can eliminate the output gap due to price rigidity, but cannot (in a static sense, at least) bring back the lost potential output.

Until the last graph, we’ve considered changes ceteris paribus, adjusting one or two parameters and imagining that all the rest can be held constant. But of course, most of the controversy surrounding proposed policy interventions is about the way in which various changes are interrelated. So, for example, earlier we showed a graph in which stimulus spending eliminated the output gap from a demand shock. However, those who oppose stimulus often argue that poorly targeted government spending will reduce the quality of real output delivered by the economy. Thus, a demand-side remedies will provoke a reduction of real supply. Let’s illustrate that claim:

Point A on the graph represents a demand-driven recession, the same recession we graphed in Figure 5. If we left it alone, the economy would face a 5% output gap. That sucks, so we try fiscal stimulus, exactly as we did in Figure 9. Unfortunately, although we successfully shift the expenditure supply curve, poorly targeted government spending leads to suboptimal real production. The expenditure demand curve shifts downward. We end up in a different recession, a worse recession in this example, at Point B.

So what does our analysis say? If we use stimulus spending to counter a recession, will it lead us towards the happy outcome diagrammed in Figure 5 or the terrible outcome diagrammed above? I don’t know. As we said at the outset, our toy model is designed to illustrate possibilities, not to choose among them. But he have learned something about how to consider the question. If government spending is of sufficiently high quality that it doesn’t much reduce the value of aggregate output, then it likely can counter demand-shock recessions. If government spending is of such poor quality that the value of aggregate output is impaired by its psychotic purchaser, than stimulus spending may prove badly counterproductive. People’s views on the quality of government expenditures tend to correlate with tiresome political affiliations. My own view is that we have free will, collectively as well as individually, that governments sometimes do deploy resources wisely, but sometimes they make choices that are awful and corrupt. Our work is not to estimate the odds, but to shape the context in which government acts so that it is likely to act well.

If you think this story argue for monetary expansion as opposed to fiscal stimulus, think again. We can tell almost exactly the same story. Expansionary monetary policy, like government spending, increases our aggregate propensity to spend. But who says it has no effect on the production side of the economy? My own view, with the Austrians and other cranks, is that stimulating demand via low interest rates does cripple real supply over time, in part by favoring producers of durable goods, but more insidiously by altering the incentives of holders of financial assets, who diversify to capture monetary policy subsidies rather than discriminate between worthy and unworthy enterprises. I would rather take my chances with more transparent (if transparently corrupt) fiscal policy than with status quo monetary policy.

But that’s just me. The framework we’ve set up can illustrate happy and tragic stories, for both monetary and fiscal interventions. Further, if we come up with models that specify relationships between the parameters, or between the demand side and the production side of the economy, we can illustrate those models with the same sort of graphs we’ve shown here.

We’ve been working with a discrete, two period toy model. However, that’s limiting. For example, if poor government spending harms the supply side of the economy, the effect may not be simultaneous. We’ve crammed several non-instantaneous effects into “Period 1”. But we can draw graphs like this as “snapshots” of models that evolve over time. We can even combine graphs into annoying little movies to watch the economy evolve under various scenarios.

This has been a long exercise, and I’m grateful to readers who’ve made it this far. I’ve learned a lot from playing around with these graphs, but I’ve no idea whether doing so will help others. I hope so!

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If you haven’t yet, do try playing around with the interactive graphs here. (You’ll need to install the Mathematica plug-in.)

RSJ, whose excellent blog is windyanabasis, takes issue with my claim that financial leverage is a source of sticky prices. Not only that, but he’s performed an impressive experiment to test and disprove the hypothesis. Check it out.

I am not persuaded that I am wrong, for reasons that I describe in a lengthy comment. But I am hardly an impartial reviewer. What do you think?

Update: RSJ has updated his experiment in response to some of my comments.

In Keynesian / quasi-monetarist of explanations of depression, sticky prices play an essential role. If prices were not sticky, a deficiency of expenditure would just lead to a reduction of the price level, and nothing very bad would happen. There are (at least) two channels by which sticky prices can harm production:

1. Sticky relative prices distort patterns of economic activity, preventing the economy from achieving the optimal level of production. Following a sharp change in nominal expenditure, the sluggishness with which some prices adjust leaves activity badly distorted, and so observed real production falls relative to the expenditure-stabilized trend.
2. Sticky absolute prices allow changes in nominal expenditure to affect levels of economic activity more directly. Suppose we set all relative prices correctly, and then fix them in stone. Now, if we scale up the willingness of all agents to part with money, we might not observe a decline in aggregate production, but markets would fail to clear and we would observe shortages. If we scale down aggregate expenditure, we would observe a glut of capacity and a fall in production (as measured by transactions).

I’m interested here in the second channel. [1] Except under politically imposed price controls, we rarely observe what absolute price-stickiness would predict in an expenditure boom — production at capacity but shortages at offered prices. The relevant case is asymmetrical. Absolute prices adjust upward easily, but they are “sticky downward”. They do not fall.

A while back I had a post that described the price of extinguishing old debt as “the stickiest price”. After a wonderful comment exchange with Nick Rowe and others, we came, I think, to some agreement that sticky nominal debt contracts were both like and unlike sticky goods prices in important ways. However, I’ve recently come to think that, besides the direct but distinct distortions associated with rigid nominal debt, indebtedness might be an important source of downward stickiness in the prices of goods and services.

The argument is a form of Pascal’s wager. Suppose that I own a firm which generally operates at capacity. The firm is leveraged in the expectation of achieving a certain level of nominal income, out of which my debt will be serviced. Should I fail to service my debt, I will face outcomes that are very dire. Perhaps my firm will be out of business, perhaps I will have to surrender the firm to creditors. Perhaps I’ll manage to squeak by after a very radical downsizing that allows me to service my debts but destroys the long-term value of the firm. Let’s refer to any of these catastrophes as “bankruptcy”.

Suppose there is a shock to nominal demand, and people become less willing to part with money. I have two choices. I can cut prices to maintain my expected volume of sales, or I can leave prices alone. In the first case, I condemn myself to bankruptcy with certainty. I was already operating at capacity, so there is no hope that an increase in volume will save my bacon if I reduce prices.

If I do not cut my prices, my expected level of sales will fall due to the recession. On average, I will still be bankrupt. But I could get lucky. In any economic environment, sales are a fickle random variable. It is possible, if I stick with my old prices, that sales will prove robust despite the dowturn. So the rational thing for me to do is to refuse to adjust my prices and hope for the best.

Now this is a perverse outcome, from an economic perspective. Considered without regard to financing, my firm fails to maximize expected profits by failing to adjust its pricing. It instead maximizes the value of the right tail of the profit distribution, because as the owner of a leveraged firm, the right tail of the distribution is all that I have claim to. Not reducing prices is a form of screwing creditors, but I don’t care. As the owner of a highly leveraged firm operating near capacity, I will be disinclined to reduce prices.

This tale of an overleveraged entrepreneur would be insignificant, if it were an idiosyncratic occurrence. One overextended entrepreneur might refuse, but her less leveraged competitors would cut prices, and observed market prices would fall. But suppose our entrepreneur is in an industry where intense leverage is the norm. As Hyman Minsky famously pointed out, if an industry is competitive and at least some players are not foresighted about risk, levering up in good times ceases to be optional. More levered firms gain a cost-of-capital advantage that permits them to undercut financially conservative rivals over what may be prolonged periods of tranquility. So we might expect to competitive forces to drive whole industries into similar capital structures. And empirically we do find this — firms in general choose wide varieties of capital structures, but within industries, capital structures are more alike.

In highly leveraged industries then, we’d expect downward price stickiness. Following a negative shock to nominal expenditures, we would observe production losses, but not in the form of evenly distributed cutbacks. Instead, some firms would seem to thrive despite the weather, while others are forced into bankruptcy. Perhaps the firms that survive would be the “best” firms, and certainly differences in quality and ex ante leverage would affect the distribution of outcomes. But even among perfectly identical firms, if the distribution of sales is stochastic, we’d expect “consolidation” to occur. Firms that are lucky early in a depression survive. It gets easier to stay lucky as time goes on. The failure of competitors eliminates supply, helping to support your sticky price (which becomes less sticky as you retain earnings to delever).

From a macroeconomic perspective, this account suggests that, even putting aside systemic fragilities introduced by cascading bankruptcies and financial accelerators running in reverse, financial leverage leaves an economy vulnerable to depression through a price rigidity channel. This strikes me as relevant to our current situation. Policymakers have effectively guaranteed the debt of highly interconnected borrowers and successfully eliminated the threat of cascading defaults. But if my account is correct, reducing leverage at “Main Street” firms may be at least as important as ensuring the stability of interconnected financials. Policymakers have put tremendous effort into ensuring the continuous availability of credit to firms that wish to expand. But promoting debt-financed expansion may be self-defeating, if it reduces the ability of the economy to adapt to fluctuations in nominal expenditure by making prices sticky. [2]

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Notes:

1. This will be an intramural point. Footnote 2 is more interesting.

   I think that explanations of the business cycle based on relative price stickiness ought not be classified as Keynesian or monetarist at all. Relative price stickiness is really a recalculation story of the sort favored by Arnold Kling (and to which I am also sympathetic). If you think of markets as calculators of equilibria, and that after a large shock computing a new equilibrium takes time, then there must be some sort of friction that prevents the computation from being instantaneous. Sticky prices offer one plausible source of friction.

   I won’t speak for Kling, but I think that some proponents of recalculation-ish theories would object to this characterization, because they view economic calculation as something deeper than a rejiggering of relative prices. They’d focus instead on inspired entrepreneurship, creative destruction, entirely new practices and products. I agree with all that, but when making up models we do have to reduce a variegated and multicolored world to symbols, and modeling recalculation as a laborious price vector computation is more expressive than it first appears. For example, we can imagine a space of potential new products whose prices begin at infinity and adjust downward with difficulty, as we learn by doing or as a stochastic function of entrepreneur effort.

   It might seem odd to expel relative-price-stickiness-based explanations from the Keynesian pantheon. After all, aren’t New Keynesian models almost defined by incorporation of relative price stickiness? Well yes, and they use relative price-stickiness to achieve monetary non-neutrality. However, at risk of stepping on toes (which is really not my intention), I think that by construction New Keynesian models are poorly suited to the analysis of extreme business cycles. New Keynesian models, like their Real Business Cycle progenitors, are usually characterized in log-linear approximation around a long-run equilibrium. Even if we believe the models to be perfectly correct, the conclusions we draw from log-linear approximations become less and less reliable as variables depart from equilibrium values. Log linearized models, if they are useful, are useful at describing near-equilibrium dynamics. If extreme business cycles involve severe departures from the presumed equilibria, or worse yet, if they involve multiple equilibria so that the economy might be durably drawn away from the presumed steady state, common New Keynesian models just aren’t helpful. To invoke Hyman Minsky again (via Steve Keen), if you want to answer questions about extreme business cycles

   it is necessary to have an economic theory which makes great depressions one of the possible states in which our… economy can find itself.

   Perhaps I am overharsh. I am certainly no expert on New Keynesian macro, and I’d be delighted to learn that I am wrong. But the New Keynesian models I have encountered simply don’t live up to Minsky’s very sensible criterion. Monetarist and Old Keynesian models, though hydraulic and not-microfounded they may be, incorporate in their design the possibility of durable and severe depressions. [ back ]

2. The story I’ve told isn’t particularly novel. It complements commonplace accounts of why unemployment occurs in depressions. In theory, firms could simply cut employee hours and wages rather than fire people in response to a downturn. But they don’t. Employment adjusts on the “extensive” margin of layoffs much less than it adjusts on the “intensive” margin of reducing work or pay. This is often attributed to employee morale. It is better, the story goes, to have a small workforce of happy people than a big workforce of bitter people.

   But consider the same situation from employees’ perspective. Families are often highly leveraged. Even when they are not explicitly in debt, many families take on operating leverage. That is, for many families, the fixed costs of ordinary living (e.g. rent, day care, food) approach their total household income. With high leverage (whether explicit debt or operating leverage), a reduction of wages and hours translates quickly to financial and personal crisis, and ultimately to a disruptive reorganization of living arrangements. A cutback in wages and hours may leave families unable to afford their mortgage or their rent, and force a move to less desirable digs or “doubling up” with family, usually after a lot of confusion and juggling and bills and shame and collection agencies.

   Getting fired will do all that too, of course. But if firms hold wages steady and cut back by firing workers, then some workers will avoid the reorganization entirely. When firms cut wages or hours, all highly leveraged workers must reorganize. If the severity of crisis is not so different for those who are fired versus those who see pay cuts (a big if), then workers rationally prefer a layoff lottery to universal pay cuts. Their reasoning would be identical to that of leveraged firms who hold prices steady and take their chances.

   So firms find layoff lotteries to be better ex ante, because employees prefer them, and ex post because only the happy winners remain with the firm. A perennial suggestion among reformers is that we substitute some form of work-sharing for cyclical unemployment, so that the burden of downturns is evenly shared instead of falling disproportionately on an unlucky few. That sort of reform only makes sense when household leverage is generally modest. [ back ]

Ezra Klein, Karl Smith, and Ryan Avent today debate the merits and demerits of muddling though vs “grand bargains” and bold solutions. Here’s Smith, insightful as always:

The opportunity to muddle through is a gift. It allows one to make changes at the margin, to monitor their effects and to update accordingly. It allows us to avoid massive often useless sacrifice. It allows our knowledge, understanding and resources to race ahead opening up new ways to deal with our problems… We don’t always have that opportunity. Sometimes we are forced to deal with things in a big way. Indeed, this is much of what we mean by crisis. However, you don’t want to avoid an externally inflicted crisis by creating a self-inflicted one. If you have a chance to make your way with adjustments at the margin, take it.

I think this is right, and important. But even true words can lead us astray if we are not careful. To say that muddling through is a gift because it permits certain advantages can mutate into a case for incrementalism where there are clear disadvantages.

Further, which changes constitute “adjustment” and which would be disruptive are themselves contested. Consider Scott Sumner‘s view of the world. Sumner claims that the stance of monetary policy, when properly defined, turned sharply contractionary in 2008. However, what Sumner would have proposed in order to “stay the course” would have seemed bold and radical to status quo central bankers. Generally, what constitutes measured and incremental changes and what constitutes a sharp turn gets defined according the the conventions of dominant interests. Consider the TARP vs bank nationalization debate. The case against nationalization was often made on grounds of continuity and nondisruption, and that certainly reflects the perspectives of people inside the banking system and the Treasury department. And yet to me and many others like me, the no-accountability/no-more-Lehmans policy regime that was crystallized as TARP represents a wrenching and violent alteration of previously settled social arrangements.

Today’s conversation began with US fiscal policy. Klein tells us

The wish for a grand bargain that’ll take care of the deficit all at once is probably just that: a wish. The likelier outcome is a slew of deficit-reduction measures passed over the next decade or so. That’s even truer for health-care spending, which is both the biggest fiscal problem we face and the one that most requires a decades-long process of trial-and-error in which we test out new ways of delivering care, of paying for care, of separating useful treatments from useless ones and of modernizing the sector’s IT infrastructure.

Overall, this seems sensible. There is a problem, but we won’t hubristically predetermine a 30 year plan,. We’ll make small adjustments in real-time until the problem is solved. That sounds wise.

But is it true? Is that how US fiscal issues are likely to play out? I don’t think so. I’d bet on one of the following three scenarios:

1. We will experience a boom and/or create technical efficiencies in health care delivery such that the US fiscal trajectory seems to stabilize on its own.
2. The US fiscal situation will fail to durably stabilize at anywhere near the levels we now deem reasonable, but nothing catastrophic will happen. The MMT-ers will turn out to be right that any inflation or yield pressure associated with a growing stock of public debt will prove manageable in real time. It will feel like we are muddling through perpetually, but nothing bad will ever come of it.
3. A crisis will force bold changes on the political system. This might take many forms — an inflation, a sharp spike in bond yields, a disruptive depreciation of the dollar, popular revolt against the distributional effects of fiscal largesse, etc.

At the moment, Klein’s scenario seems plausible. After all, despite elevated chronic unemployment — which in our society constitutes almost unthinkably severe human tragedy — we are making genuflections towards deficit reduction. Surely this means we are committed, and bit by bit we will adjust. Right?

No. For better or for worse, we are not adjusting. The small changes our political system proves capable of are promises of future chastity and cuts that disproportionately harm the disenfranchised. Historical experience suggests that even this degree of restraint depends upon an ephemeral configuration of political authority — a Democratic president, a Congress divided or Republican. There is little evidence that our government is capable of adjusting, incrementally but intelligently. It follows paths of least resistance and responds to crises. That might work out all right, or it might lead us to catastrophe.

So is it wise to muddle through? I think we all can agree that not all paths of least resistance end up in places one would wish to go. At the same time, Karl Smith is still wise. Sharp, bold changes are ipso facto crises, and there’s no sense creating pain willy-nilly to deal boldly with inexhaustible phantoms.

So what’s the right strategy? I’m not sure, but I’ll tell you what I used to think. I used to think that the right strategy was to muddle through in a context created by sophisticated financial markets. Human beings, as individuals and as policymakers, have limited information and are prone to flawed choices. Markets aggregate the information and foresight of millions, weighted by confidence expensively signaled via degrees of financial risk assumed. Such markets would always be current, would produces prices reflective of the best available information at any point in time, and would be forward looking. Markets would ensure that, on the path of least resistance, peoples’ incentives would be to make smart adjustments in real-time. Muddling through under these circumstances would leave us where Smith suggests: With “knowledge, understanding and resources…opening up new ways to deal with our problems…[we’d make our] way with adjustments at the margin.”

I think that this view, once my view, is now completely discredited. Financial markets, as they exist in the world we live in, have proven liable to catastrophic and foreseeable mistakes. The instruments we trade hide information and prevent adjustments as frequently as they reveal and promote them. Plausible mechanisms of self-correction have been weakened rather than strengthened during the crisis, so we can expect even poorer performance looking forward. Our financial institutions are best understood as means by which certain groups within our society protect and perpetuate themselves, and as mechanisms by which covert prerequisites of stability are maintained. Of course markets were never going to be perfect — no human institution is. But existing market institutions have fallen in my estimation from “good enough, the best we’ve got” to “incompetent and hopelessly corrupt”.

Absent some context that shapes incentives and links muddling through with intelligent adjustment, accepting muddling as a default position is unsatisfactory. It becomes a means of drifting towards hazards unknown and an excuse for attending to the interests of the powerful. The alternative of bold, flawed, improvisations is also unattractive. The choice between moldy bread and rancid stew is best made on a case-by-case basis, with a lot of unscientific sniffing.

The only way out is to recreate some context in which we’ve reason to expect our muddling will be smartly shaped. Our existing political and financial systems strike me as a poor place to start, but here we are. In the end, I’d like to agree with Karl Smith about the virtues of muddling through. But it all hangs on the quality of the muddling.

The excellent Kindred Winecoff considers the troubled periphery of the Eurozone:

[A]usterity must occur. It’s only a matter of how it occurs. The alternative to an internal devaluation through wage cuts, tax increases, and reduction of social services is external devaluation (exit from euro) and default. Call it the Iceland Alternative (Iceland was never in the euro, but it did devalue/default, which is what we’re talking about). In that scenario, the new drachma and Irish pound will collapse in value and the government will be unable to borrow from international capital markets. This is austerity too. The government budget will have to be balanced almost immediately, and unless there’s a full default will likely need to run a primary surplus for many years.

Moreover, small open economies like Greece and Ireland are heavily reliant on imports to maintain standards of living. Ireland imported about 40% of its GDP in 2009; Greece about 1/3. For comparison, the U.S. imported about 14% of its GDP. If the post-euro currencies drop 50% in those countries (as Iceland’s did, and it was never attached to the euro), then those imports become 100% more expensive. That’s a big price increase. True, there will be some substitution into domestically-produced goods, but such a large adjustment will take time and cause pain. These are not large, diversified economies and there’s a reason domestic production wasn’t being consumed before; overall standards of living will have to drop if there’s a currency devaluation. And while exporting industries may benefit from a cheaper currency, boosting employment in those sectors, the importing industries will suffer, contracting employment in those sectors. Even if overall employment goes up, it will be at much lower relative wages. This is why Iceland is applying for EU membership, including adoption of the currency, despite the sacrifice of policymaking autonomy that entails.

In other words, there will be austerity. The only question is how it’s distributed.

Winecoff makes an important point, but I think he needs to cut his analysis a bit more finely. Economies run two very different kinds of deficits, a government fiscal deficit and an international current account deficit. Although the two deficits are related, there is no mechanical connection between the two. They do not reliably move together.

A country that defaults on its international debt will find its paper shunned international capital markets for a while. In countries that have grown accustomed to running current account deficits — that is, countries whose citizens have grown used to consuming more imports than they pay for with exports — a forced return to international balance will undoubtedly be perceived as a form of austerity.

But Winecoff is wrong to claim that “[t]he government budget will have to be balanced almost immediately, and unless there’s a full default will likely need to run a primary surplus for many years”. As long as the country, post-default, issues its own currency, and as long as the country’s citizenry is interested in accumulating domestic currency and debt, the government can run a budget deficit after the restructuring. The capacity of a country to run budget deficits post-crisis will depend largely on the citizenry’s confidence in domestic institutions after the fall. (Countries can also employ controls to prevent capital flight and support domestic currency. But in cosmopolitan, habitually integrated Europe, I suspect that won’t work unless people have some measure of confidence in the project. Wise governments would implement technocratically credible monetary institutions and simultaneously encourage patriotic enthusiasm for the country’s newly independent scrip.)

Winecoff’s example of Iceland is a great case in point. Following its collapse and quasi-default in 2008, the Iceland ran a budget deficit of 9.3% of GDP in 2009 (a primary deficit of 6.6%), and has continued to run deficits since, gently drifting towards balance. Iceland has also been able to sustain large current account deficits as well for a while after the crisis, which helps to cushion the adjustment. Iceland received loans from the IMF and several European countries, which partially financed its continuing international deficit. Also, private citizens of Iceland may have had foreign asset holdings which they could pledge or sell to finance imports while the economy shifted towards international balance.

Iceland’s circumstances were, perhaps, unusually benign. Other crises (Argentina in 2002, Russia in 1998) proceeded much as Winecoff describes, with sharp, simultaneous moves towards fiscal balance and current account surplus. But would crises in the Eurozone look more Argentina or like Iceland? I don’t know, but I can make a strong case for Iceland. Savers in the Eurozone periphery inhabit a world of open financial borders, and have already been diversifying out of home-country bank deposits. (Importantly, this forces governments and the ECB to cover financing gaps left by fleeing depositors.) Argentine savers perceived dedollarization as expropriation, which was corrosive to the legitimacy of domestic institutions. Citizens of the Eurozone periphery, on the other hand, might support their governments’ bid to escape impossible foreign debt. The drawn out, slow motion nature of the Euro crisis has made it easy for private citizens to prepare for Euro exit by sending funds abroad. This practice shifts the costs of default to governments, who in turn can shift costs to external creditors. If domestic publics support the move and believe Euro exit to be a one-off event rather than the start of recurrent devaluation cycles, governments may well be able to run deficits and use Keynesian fiscal policy to smooth the aftershocks of Euro exit.

There may be important differences of institutional credibility between Greece and, say, Ireland or Spain. An Irish exit might be more Icelandic, while a Greek exit might be more Argentine. (It’s worth pointing out that, a decade later, Argentina’s default seems to have worked out very well.) As in Iceland, the (growing) foreign savings of private citizens might cushion the shift from international deficit. (Euro drop-outs could not expect the post-crisis IMF support that Iceland enjoyed, though.) There is a hazard that the furious Eurozone core would try to hold the private wealth of citizens of the periphery as security against the defaulted debt of sovereigns. But that would be a stronger violation of current norms than sovereign default.

Suppose that it will be possible for a drop-out to run a fiscal deficit, but as Winecoff predicts, a sharp shift to international balance proves inescapable. Winecoff is absolutely right to point out that

small open economies… are heavily reliant on imports to maintain standards of living… If the post-euro currencies drop 50% in those countries (as Iceland’s did…), then those imports become 100% more expensive. That’s a big price increase… [S]uch a large adjustment will take time and cause pain. These are not large, diversified economies

Undoubtedly, ending an era of persistent current account deficits will prove painful to consumers accustomed to cheap imports. However, that is not ultimately an incremental cost of leaving the Euro. After all, the purpose of staying and suffering austerity would be to pay down indebtedness, which is more costly than a shift to balance. Contrite borrowers have to pay interest on past debt and run (primary) surpluses. Deadbeats just need to pay for what they buy now. Quantities matter. Staying within the Eurozone offers the palliative of stretching the pain out over time, but increases the ultimate burden of the adjustment. Exiting front-loads costs, but reduces their size, as much of the work is done by the act of default. Undoubtedly, jilted creditors would punish “Euro deadbeats”, and exact non-financial costs, so the benefits of debt write-offs would be counterbalanced, at least in part, by new costs. There’d have to be some cost-benefit analysis. But the options are not, as Winecoff suggests, a zero-sum shift in how countries take their lumps. Countries may find they have a lot fewer lumps to take if they repudiate their debt than if they don’t.

Losing the capacity to run a current account deficit and losing the capacity to run a fiscal deficit have very different implications. Shifting international accounts from deficit to balance harms citizens in their role of consumers, but serves them in their roles as workers and savers. If you view the current crisis as driven by the challenge of maintaining consumers’ standard of living measured in tradable goods, then losing the ability to run current account deficits seems harsh. But if you view the crisis as driven by frustration within countries over insufficient opportunity and employment, then shifting to international balance or even to surplus helps. Losing the capacity to run a fiscal deficit has the opposite effect. Where current account austerity increases labor demand, fiscal austerity reduces it. So if you think that underemployment is the pressing problem in the Europeriphery, current account austerity plus continued fiscal deficit is a golden combination.

Lots of countries, obviously emerging Asia but also Germany, seem to prefer the social goods that come with full employment and financial security to the consumer purchasing power gains that accompany current account deficits. The countries of the Eurozone periphery have so far “chosen” the path of excess consumption, but it’s not clear whether that represents a genuine preference or a historical accident. This isn’t to minimize the pain and disruption that would undoubtedly attend import scarcity. Changing human habits hurts. But, as Joni Mitchell might say, something’s lost but something’s gained. This would not be a novel sort of transition. It would be a reprise of the aftermath of the Asian financial crisis.

Leaving the Euro would not be all bows and flows of angel’s hair. But it would not necessarily be catastrophe, and there is no fixed quantity of austerity that Europeriphery countries have to face one way or some other. These countries have difficult choices before them, and should think carefully about the tradeoffs and just what sort of outcomes they hope to engineer.

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Note: I have very mixed feelings about any break-up of the Eurozone. This piece was not intended as advocacy of that. I do think the European core is being foolish and shortsighted in its dealings with the periphery. In a better world, the core countries would equitize their claims against the periphery by, for example, adopting some variation of Warren Mosler’s frequent suggestion that the ECB issue per capita grants to all member states, that surplus nations would use as they see fit but debtor states would use to reduce indebtedness.

First, I want to make clear that the critiques I’ll offer below are not intended to discredit or dismiss MMT. As I’ve said before, I think MMT offers a coherent and important perspective on fiscal and monetary issues that ought to be understood, on its own terms rather than in dismissive caricature, by anyone serious about macroeconomics. MMT is not “true”, but then no theory is “true”. We ultimately judge theories by how useful they are, both in making sense of “the data” we already know and in offering guidance for policy going forward. In my opinion MMT is one of the most useful perspectives in thinking about fiscal and monetary questions.

However, it is still just a perspective. Enthusiasts sometimes present MMT in a manner that’s too complete and hermetically sealed. While some MMT theorizing is based on “double entry accounting” or “obvious, unarguable facts”, when MMT adherents offer non-trivial conclusions, they rely upon assumptions about human behavior that are in fact contestable. I continue to place non-zero weight on theories of government insolvency that MMT-ers have persuaded me are, in a sense, incoherent. Life is complicated, and even absurd prophesies can prove self-fulfilling.

This will be a long post. I’ll discuss each of the seven points I outlined in my summary of MMT stabilization policy. Then I’ll offer some general comments. Before you continue, you should understand the point of view being examined. Please read my previous post first. Or much better yet, read Chapter 1 (Tymoigne and Wray) and Chapter 5 (Tcherneva) of A handbook of alternative monetary economics (ed. Arestis & Sawyer). These essays offer a polished, concise introduction to the MMT perspective. Then spend some time with the “mandatory” or “101” readings on Warren Mosler and Bill Mitchell’s websites.

The summary points from my previous post are repeated below in bold. New comments then follow. I am critiquing my own distillation of MMT stabilization policy, so there is the danger I have set up straw men. If I have, I apologize and look forward to being set straight in the comments. As usual, almost nothing I say will be original. Many of the points I’ll make have been made better by others, for example, in the comments to the previous post, which are extraordinarily good. At a Kauffman Foundation blogger convention last week, I discussed MMT informally but at some length with David Beckworth, Megan McArdle, Mish, and Mark Thoma. My comments will undoubtedly be informed by those conversations.

1. The central macroeconomic policy instrument available to governments is regulating the flow of “net financial assets” to and from the private sector. The government creates private sector assets by issuing money or bonds in exchange for current goods or services, or else for nothing at all via simple transfers. Governments destroy private sector financial assets via taxation. MMT-ers tend to view financial asset swaps, whereunder the government issues money or debt to buy financial assets already held by the private sector (“conventional monetary policy”) as second order and less effective, although they might acknowledge some impact.

   While the flow of net private sector financial assets does strike me as an important and powerful tool for macroeconomic policy, it is not a uniquely effective tool. Changes in the relative price of financial assets (the object of conventional monetary policy) and in the distribution of financial assets can also powerfully affect behavior, and there are costs and benefits associated with each lever. What is the justification for focusing almost exclusively on managing the level of “net financial assets”?

2. A government that borrows in its own currency cannot be insolvent in the same way as private businesses. That is, such a government will never face a sharp threshold where it cannot meet promised payments, leading to a socially unanimous or even legal declaration of insolvency and an almost certain run on its liabilities.

   It is unassailably true that a government cannot be forced into insolvency for want of capacity to pay in its own currency. But a government might find itself politically or institutionally unable to meet an obligation despite access to the printing press, and there might be a sharp run on government obligations even without the focal point of formal insolvency that usually occasions private sector runs. It strikes me as an open question the degree to which protection from formal insolvency protects government obligations from disruptive races to redeem. Point #7 below strikes me as stronger protection.

3. However, the value of money and government claims in real terms is absolutely variable. Governments do and properly should manage their flow of obligations with an eye to supporting that value, among other competing objectives (such as, especially, full employment).

   I think almost no one would argue with this point.

4. The real value of money and government debt is not reliably related to any theory of government balance sheets. In particular, the stock of outstanding government obligations is largely irrelevant. The value of government obligations is a function of financial flows.Government claims will retain their value so long as the private and foreign sectors wish to expand their holdings of those claims at the current price level, that is so long as agents are willing to sacrifice real goods and services today to reduce their indebtedness, improve their financial position, or stimulate their export sectors. The value of government claims will come under pressure when agents, on net, seek to increase indebtedness or redeem existing claims for real goods and services.

   This is a place where MMT-ers, quite rightly, call out conventional economists on adherence to dogma ill-supported by the data. Empirically, the relationship between government balance sheet quantities and either the price level or private/foreign willingness to absorb government claims is weak. Conventional economists intone seriously about our growing debt-to-GDP, and discuss solvency criteria that no one believes as though they were real. (I don’t think any sensible person believes indebted governments will ever run surpluses of present value greater than the accumulated stock of public debt. Yet that is the party line solvency criterion. [Update: See below]) Theories of the public balance sheet that have proven unreliable continue to be endorsed to avoid inconsistency in the edifice of neoclassical finance. It is true, in extreme cases, that governments that experience hyperinflations go through periods of high indebtedness relative to GDP, but what is cause and what is effect there is murky.

   Macroeconomic theory is often stupid about debt. Common models impose a “no Ponzi condition” that is absurd not only for governments, but also for private firms. All firms and governments eventually end, and when they do, they usually leave substantial claims unsatisfied. Agents lend to corporations and governments not because they believe the debt will be paid down, but because they believe the almost certain eventual default or debasement of claims is unlikely to happen within their investment time horizon. In the real world, governments and corporations balance actual gains from the transfer component of increased borrowing against increased hazard that the end will come quickly and potential “distress costs”. Typically, governments and firms find these costs easy to manage as long as indebtedness grows no faster that “size” (whether measured in terms of revenue or asset values). While it is risky to “lever up” — to increase debt faster than size — many firms and governments do so successfully. We have no reliable criteria of maximum leverage even for firms, let alone for governments. Governments are special. Their core asset is their taxing power. Their liabilities, whether notionally bonds or money, are best understood as preferred equity rather than debt. They face very diffuse liquidity constraints.

   All of that said, I think MMT-ers sometimes err in the opposite direction. They are right that ultimately it is flows (actual or desired) between private agents in aggregate and governments that determine the value of government obligations. But the whole purpose of balance sheet analysis, in the private sector and the public sector, is to predict future flows. That conventional theories of public balance sheets are foundationally stupid and overstate the hazards associated with large stocks of outstanding debt doesn’t invalidate the intuition that flow volatility is likely to be proportional to the outstanding stock of government claims. Suppose, because of a sunspot, private holders of government claims get nervous and try to redeem them for current goods. If the net stock of claims in private sector hands is small, it takes very little taxation to offset that flow. If the net stock of government claims is large, than the desired flows might be massive, and governments might be faced with unappetizing choices between taxation or accommodating inflation. There is little evidence that increasing the stock of government obligations, by itself, increases the likelihood that the private sector will seek (impossibly but disruptively) to divest itself of those claims. But there are undoubtedly fluctuations in the private sector’s enthusiasm for holding money and government debt, and it strikes me as implausible that the difficulty of managing those fluctuations is entirely unrelated to outstanding stock of those claims.

   Also, although MMT-ers are typically regarded as “left” economists, I think they underplay the distributional costs that attend expanding the stock of government obligations. Government obligations, like all financial assets, are disproportionately held by the wealthy. If the government did not accommodate the private sector’s demand for net financial assets, preferring different policy levers to stabilize the economy, wealthy people might be forced to store wealth in the form of claims on real resources, and would have to oversee the organization of those resources into value-sustaining projects. A large stock of “risk-free” financial assets allows people wishing to carry wealth forward to shirk their duty to steward resources carefully and bear the consequences of investment failure. Thus, the availability of government obligations simultaneously degrades the quality of real investment (by disincentivizing supervision) and magnifies the distributional injustice that attends failures of aggregate investment by shifting the burden of those shocks onto risk investors and workers. In theory, governments can mitigate this injustice by careful transfers and expenditures ex post, and that might be the right policy, but in practice those who disproportionately hold existing government obligations disproportionately hold political power, and resist the issue of new obligations which might put dilute the value of existing claims. In practice, a large stock of government claims serves as the lifeboat through which prior wealth inequality carries itself into the future. Absent an accommodative stock of government obligations, recessions would be crucibles that separate the deserving from the undeserving rich, and would thin the ranks of the rich generally. Recessions should be periods that decrease inequality, but the availability of default-risk free claims whose purchasing power is politically protected inverts the dynamic.

   MMT-ers are right, I think, to argue that, for fiat-money issuers who borrow in their own currency, conventional government solvency criteria are false. They are right to argue that such governments have a great deal more latitude to issue money and debt than conventional theories suggest. But that shouldn’t be taken as license to defend carelessness in the distribution of new claims, or to treat expansions of money or debt as entirely cost-free. To be fair, this is a bit of a straw man. Serious MMT-ers think about distributional issues and quality of expenditure, and don’t claim that deficits should be “carelessly” expanded. But in the heat of current policy debates, rhetoric about “deficit terrorists” and money being nothing more than spreadsheet entries unhelpfully obscures that. At its best, a deep point of MMT is that the absence of short-term fiscal constraints creates space for government to craft policy that focuses on the productivity of the real economy. If the mobilization of real resources is wise, fiscal maneuvers will be rendered sustainable ex post. If the real economy will be mismanaged or let to languish and decay, no amount of “fiscal discipline” will save us. The version of MMT that I like best is, oddly, wedded to an almost Austrian sensibility about real investment.

5. The “solvency” of a government is best understood as its capacity over time to manage the economy in a manner that avoids net outflows. “Net outflows” here means attempts by nongovernment actors in aggregate to redeem government paper for current goods and services.

   I agree entirely. I think this is the best definition of government solvency.

   The MMT-sympathetic Traders Crucible objects, however, to my use of the word “solvency” here, even with the scare quotes. After all, what currency issuing governments must concern themselves with is not insolvency per its dictionary definition (an inability to pay debts), but something quite different, a decay in the value of its claims in terms of real goods and services. Here’s TC:

   [T]he impossibility of insolvency does not mean the fiat currency will have value. A government might be fully solvent even with a worthless currency… This distinction between insolvency and debasement is at the heart of MMT…

   Why is the Traders Crucible going nuts…about the difference between insolvency and debasement?

   Well, we can directly observe the debasement of a currency in an economy through the inflation rate. We can directly observe the process of debasement and loss of value of the currency through inflation. We cannot directly observe the risk of insolvency — it must be inferred from bond price action… the resulting process is one of guesswork, misstatements, boneheaded plans, wild specualtion, and dumbassery, because there is no way to observe the risk of insolvency directly even though it is one of the ideas that govern our spending. …[B]y removing the fear of insolvency, we can more directly observe the risk of debasement… [W]e don’t need to rely on the bond market to “give us signals” about the potential loss of access to their club to determine if we need to lower spending, or raise spending. We can just witness inflation and unemployment and make decisions on these two variables, instead of the three variables of unemployment, inflation, and insolvency… This is a much simpler task, and is perhaps the core strength of the MMT paradigm.

   This is an important point, but contestable. We know with some confidence that the threat of traditional insolvency can lead to powerful and unpredictable runs and a lot of turbulence in the value of private claims. I’m glad to concede that, at the margin, absence of a sharp solvency threshold reduces the likelihood of such events. But does the lack of a sharp solvency threshold eliminate the possibility of sudden stops, Wile E. Coyote moments, etc? Can we be confident that, absent the danger of outright default, any debasement of fiat claims would take the form of an observable spiral, which would start slowly and thereby offer time to apply a policy antidote? Would we in fact observe and recognize the signs, and would they be different than, for example, a 500% increase in the price of gold in the span of a few years and recurring bouts of commodity inflation? Are employment pressure and labor costs the sole true and perfectly reliable indicators of debasement hazard?

   One can make a strong case that increases in labor costs are in fact the sine qua non of uncontrollable inflation, that absent labor income to “ratify” price rises, inflation in inherently self-limiting. But you can make other cases too. Perhaps transfers and deficit spending can substitute for wage power, bidding up commodity prices and the capital share of income even while wages are held back by the reserve army of the unemployed. I’m not sure about any of these stories. But my experience as a trader in capital markets makes me wary of accounts that suggest sharp swoons in the price of any asset cannot happen, or would definitely be preceded by warning signs that would permit one to get out early.

   So, I’ll to acknowledge TC’s objection as important and potentially valid, but defend my positing of an MMT “solvency” constraint, at least with scare quotes in place. I don’t think it’s reasonable for MMT-ers or anybody else to write off the possibility of sharp and unexpected changes in the value of a fiat currency. The possibility is dangerous enough that it should focus the mind in a precautionary way. If MMT policy advice is to be taken seriously, it must offer a some assurance of safety against that scenario. The absence of formal default hazard provides some assurance, but without Point #7 as a backstop, not enough.

6. Avoiding net outflows is easy in times like the present, when i) low quality and difficult to service debt in the private sector leaves many agents eager to reduce indebtedness and increase their holdings of financial assets; ii) there has been little inflation or devaluation in the recent past; and iii) resource utilization is slack, as evidenced especially by high unemployment. Avoiding net outflows is more difficult when private sector agents’ balance sheets are healthy, or when agents come to expect inflation or devaluation, or when real resources (especially humans) are fully employed.

   I think this point is unobjectionable.

7. However, a sovereign government can always create demand for its money and debt via its coercive ability to tax. That is, if optimistic agents with strong balance sheets start up a spending spree, or if gold bugs fearful of devaluation ditch government paper for commodities, a government can reverse those flows by forcing private agents to surrender real goods and services for the money they will owe in taxes.

   On the one hand, I consider this point is one of MMT’s deepest insights, and its secret weapon. So long as a government’s taxing power is strong, so long as it is capable of persuading individuals to surrender highly valued real goods and services for the ability to escape liabilities imposed by fiat, exercise of that taxing power creates a floor beneath which the value of a currency, in real goods and services, cannot fall.

   However, relying too overtly on taxation to give value to a currency strikes me as dangerous and potentially counterproductive. A government’s taxing power is limited and socially costly. Governments must maintain a patina of legitimacy so that people pay taxes “voluntarily” or else they must intrusively or even brutally force compliance. In a decent society, it’s perfectly possible that governments will find it politically impossible to tax at the level consistent with price stability goals. A wise, MMT-savvy government would try very hard to regulate the issue of government obligations over time in a way that avoids the need for sharp fiscal shifts in order to stabilize the price level. Avoiding the need for sharp contractions later on might imply slower issue of obligations than would be short-term optimal during recessions. But once you acknowledge this kind of forward-looking dynamic, MMT starts to sound very conventional. We start having to trade off the short-term benefits of fiscal demand stimulation with long-term “exit costs”.

   Two other points are worth making here:

   • Even though, in principal, taxation could be used to regulate economic activity and put value underneath the currency, the institutions that would be necessary to do this successfully are simply not in place in existing democratic polities.

     Within the MMT community, smart people have given a great deal of thought to institutional forms under which which fiscal policy might be used to regulate activity. As far as I know, they have mostly converged upon the institution of a “job guarantee (JG)” or an “employer of last resort (ELR)”, whereunder the size and wage of a “buffer stock” of public labor would become the economic instrument of macro stabilization. This is an ambitious idea, both politically and technically. Not only must one develop appropriate policies for stabilizing the economy on the fiscal side (i.e. the equivalent of a Taylor Rule for ELR wage levels), but one must also plan and implement real-world projects for a variable-sized pool of (hopefully) transient workers. These projects should usefully employ and develop the productive capacity of ELR participants, while remaining distinct from and and not interfering with the ordinary private and public sector workforces. (As I understand the proposal, ELR employees would be distinct from other public employees, in that they’d be paid a standard, low but livable, package of wages and benefits. ELR employment would always be viewed as a backstop that individuals would be encouraged to transition out of, rather than as permanent employment.)

     I’m interested in and sympathetic to the project of designing a government-guaranteed full employment policy that would be complementary to a vibrant private sector and that would anchor rather than disrupt macroeconomic stability goals. But however richly MMT-ers have outlined such an institution in theory, we are very far from implementing such a thing in practice. MMT-ers participate actively in current fiscal policy debates, arguing that “sovereign” governments have sufficient space to let fiscal concerns be secondary to resource utilization goals given their power to tax. Yet the power to tax is next to worthless if we do not have well understood and broadly legitimate means of exercising it in a timely manner.

     Taking a page from status quo macro management — that is, from the world of central banks — the least costly way to meet macro stabilization goals is to maintain credible expectations among the general public that tax policy will in fact be managed with sufficient dexterity and force that those stabilization goals are rarely tested. Existing fiscal institutions are mostly quasidemocratic legislatures that act in sporadic and highly politicized bursts. Their policy ventures typically mix interventions on the liability side of the public balance sheet with ad hoc changes to programs on the asset side that are often difficult to reverse. These institutions seem poorly suited to the task of credibly managing expectations and ensuring, in high-frequency real time, an appropriate fiscal stance. Promoting fiscal license in actual policy while the institutions that would render such license sustainable do not exist strikes me as reckless. When participating in practical debates about fiscal policy, it would be better if MMT-ers would bundle their support for “fiscally loose” stabilization policy with advocacy of institutional changes that could be plausibly implemented in time to matter and that could ensure support of the value of government claims, should that become necessary.

     Some MMT-ers (Warren Mosler and Winterspeak come to mind) have proposed less ambitious institutions than an employer of last resort program, specifically using the level of existing payroll taxes as the instrument of discretionary macro policy. A government can stimulate by reducing the level of payroll taxes (and thereby increasing the flow of net financial assets to the public sector in a manner that directly encourages job formation), and could fight inflation by raising payroll taxes, rather directly reducing wages and putting pressure on employment. Macro policy by unemployment is detestable, despite its long, proud tradition at the Federal Reserve. If it can be made practical, I’d much rather we work out an effective ELR program. But ELR is not an achievable option in the time frame of the current business cycle. Delegating management of the level of the payroll tax to a “technocratic, independent” institution, whether the existing central bank or some new entity, is practically achievable on a short time frame (although the politics would be rough). Perhaps there are better easy-to-implement means of conducting credible, high-frequency macro policy. I’ve no special attachment to payroll taxes as an instrument. (I’d prefer that we use transfers as an instrument.) Whatever the specifics, relying on ad hoc interventions by Congress to thread the needle between inflation and underemployment strikes me as unlikely to work out.

   • This is a technical point that would usually apply mostly to small, open economies, but that arguably applies to the United States today. Taxation can support the value of government claims, when priced in domestically produced goods and services. Taxation cannot support the foreign exchange value of a fiat currency, except to the degree that foreigners desire to purchase domestically produced goods and require expensive domestic currency to do so. A country that runs a large current account deficit owing to decisions by foreign governments to accumulate its currency and that faces competitive export markets cannot rely on taxation to support its currency, should foreign governments revise their policy of accumulation. For a country like the United States which is structurally “short” tradables, one may view the possibility of a difficult-to-counter fall in the value of the currency as a good thing or a bad thing. People like Dean Baker and Paul Krugman argue that a weaker dollar is exactly what the US needs to eliminate the structural gap in tradables production and spur domestic demand. People like Warren Mosler argue that a very weak dollar would be a bad thing, an adverse terms-of-trade shock and a loss of opportunity to trade cheap nominal claims for valuable real resources. Regardless of how you view the event, the taxing power of the government will not be able to undo it.

8. Therefore, a government’s “solvency constraint” is not a function of any accounting relationship or theories about the present value of future surpluses. A government’s solvency constraint ultimately lies in its political capacity to levy and and enforce the payment of taxes.

   I think this is true, a deep and powerful way to think about public finance. Note that a government’s “political capacity to levy and and enforce payment of taxes” depends first and foremost on the quality of the real economy it superintends. The value that a government is capable of taxing if necessary to sustain the value of its obligations increases with the value produced overall. A government that wishes to be solvent should first and foremost interact with the polity in a manner that promotes productivity. Secondly, the political capacity to levy taxes depends upon either the legitimacy of or the coercive power of the state. A government that wishes to sustain the value of its obligations must either gain the consent of those it would tax or maintain an infrastructure of compulsion. In theory, either choice could be effective, although along with the libertarians, I like to imagine excessively coercive regimes are inconsistent with overall productivity, so that legitimacy is a government’s best bet. The two strategies are not mutually exclusive — a government could be sufficiently legitimate as to be capable of taxing some fraction of the population without resistance and sufficiently coercive as to force the other fraction to pay up. That probably describes the best we can hope for in real governments.

I’ll end with a few miscellaneous comments:

• I’d like to see more attention paid to quality-of-expenditure concerns. That is, if a stable economy requires continuing government deficits to accommodate growing private sector’s demand for financial surplus, then the government must actually make choices about how to spend or transfer money into the economy. These choices will undoubtedly shape the evolution of the real economy, for better or for worse. Should we rely on legislators to make direct public investment choices? Should we put funds in the hands of individuals and then allow consumer preferences and private capital markets to shape the economy? How? Via tax cuts? A job guarantee? Direct transfers? Perhaps the government should delegate management of public funds to financial intermediaries, and rely upon banking professionals to find high value investments? While MMT focuses mostly on the liability side of the public balance sheet, many critics fear that ever increasing public outlays imply increased centralization of economic decisionmaking that will lead to low quality choices. Whether that is true depends entirely on institutional and political choices. These concerns can be and should be specifically addressed.

• MMT-ers sometimes blur the distinction between “private sector net savings”, which is necessarily backed by public sector deficits or an external surplus, and household savings, which need not be. In doing so, MMT-ers rhetorically attach the positive normative valence associated with “saving” to deficit spending by government. This is dirty pool, and counterproductive. The vast majority of household savings is and ought to be backed by claims on real investment, mediated by the liabilities (debt and equity) of firms. There is no need whatsoever for governments to run deficits to support household saving. When household savings increases, an offsetting negative financial position among firms represents increase in the amount or value of invested assets, and is usually a good thing. Household savings is mostly a proxy for real investment, while “private sector net financial assets” refers to a mutual insurance program arranged by the state. It is a category error to confuse the two. Yet in online debates, the confusion is frequent. Saving backed by new investment requires no accommodation by the state. It discredits MMT when enthusiasts claim otherwise, sometimes quite aggressively and inevitably punctuated by the phrase “to the penny”.

• In general, the MMT community would be well served by adopting a more civil and patient tone when communicating its ideas. I’ve had several conversations with people who have proved quite open to the substance, but who cringe at the name MMT, having been attacked and ridiculed by MMT proponents after making some ordinary and conventional point. Much of what is great about MMT is that it persuasively challenges a lot of ordinary and conventional views. But people who cling to those views, even famous economists who perhaps “ought to” know better, are mostly smart people who simply have not yet been persuaded. Neither ridicule nor patronizing lectures are likely to help.

  My complaint is a bit unfair. The MMT community has been sinned against far more than it has sinned, especially within the economics profession. Whether you ultimately agree with them or not, the MMT-ers have developed a compelling perspective and have done a lot of quality work that has pretty much been ignored by the high-prestige mainstream. But a sense of grievance may be legitimate and still be counterproductive.

  The internet is a fractious place. Many MMT-ers are civil and patient, and devote enormous energy to carefully and respectfully explaining their views. There’s no way to police other peoples’ manners. Still, even by the standards of the blogosphere, MMT-ers have a reputation as an unusually prickly bunch. That might not be helpful in terms of gaining broader acceptance of the ideas.

Anyway, that was a lot. I hope that it’s not entirely useless. Despite my complaints and critiques, learning about MMT has added enormously to my thinking about economics. In practical terms, I think that MMT offers the most promising toolkit for crafting a desperately needed replacement of status quo central banking.

With that, I’ll shut up. Feel free to be as nasty as you wanna be in the comments.

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Update: The always great Nick Rowe calls me out:

(I don’t think any sensible person believes indebted governments will ever run surpluses of present value greater than the accumulated stock of public debt. Yet that is the party line solvency criterion.)

No, that’s not the party line. In fact, the party line would say that is impossible. The party line says that the *expected* present value of *primary* surpluses (plus seigniorage, if that’s not included) is *equal to* the existing debt. That party line is perfectly consistent, in a growing economy, or in an economy with positive inflation, with perpetual deficits, as conventionally measured (i.e. non-primary, to include interest on debt). Basically, if Nominal GDP is growing at rate n%, then a government can run a conventional deficit of n% times the outstanding debt forever. (Because that means the debt will grow at the same rate as NGDP, so the debt/NGDP ratio stays constant over time.)

Rowe is right to call me out — my wording was sloppy. It was especially unforgivable that, in characterizing the conventional intertemporal goverment budget constraint, I omitted the modifier “primary” before surpluses.

But I was only sloppy, not mistaken. Rowe suggests that, when accurately characterized, the conventional intertemporal government budget constraint is something that sensible people actually believe. I cede no ground at all on this point. Rowe himself does not believe it. He gives himself a partial way out just in the part quoted above, when he writes “plus seigniorage, if that’s not included”. In most macro models, it is not included. There are two ways that you can incorporate seigniorage:

1. You can treat seigniorage as a cost expected by borrowers and holders of money, in which case it is not disruptive to conventional models. It is equivalent to reducing the interest rate and taxing the value of real money balances, if those are in your model.

2. You can treat seigniorage as a form of sporadic default. That is, you can claim that at some point the government will simply write down the real value of accumulated nominal debt, in practice by allowing debt or money growth without sufficient yield to prevent an increase in the price level.

The second view is disruptive of conventional models. Rowe may argue that we account for everything by the use of expectations rather than certain values in conventional models. That could be true, but broadly, it’s not. There are some models of default inspired by third-world debt crises, but outside of that, explosive growth in the price level and/or default are modeled are presumed or constrained not to occur. Monetary policy models are a partial exception, in that they derive conditions under which the constraint would hold, which then come to guide central bank policy. But in the limit, under standard equilibria in a decent country, it is assumed or derived that real primary surpluses will (in expectation) be generated in sufficient quantity to offset the real existing stock of debt. I view that as a very unlikely characterization for many existing governments.

Suppose that we do include the possibility of default. What happens? Rowe and I agree furiously on this:

Suppose there’s a 1% chance every year that a firm of government will disappear and default totally on its debt. The probability of default approaches 100% in the limit, going forward. But a risk-neutral investor will happily hold the debt with a 1% risk premium on the yield.

But what does this do to the intemporal government budget constraint? There is no constraint whatever in this characterization. Suppose that the government offers a 2% premium over investors’ cost of borrowing, and the probability of default is exogenously 1%. Then investors borrow and invest without limit! Obviously, we need to “close the model” somehow to make things realistic, but there are lots of ways to do so that violate any ordinary interpretation of the conventional intemporal government budget constraint.

I claim that realistic models, which incorporate consumers who face liquidity constraints and idiosyncratic risk in an economy subject to systematic risks of production shortfalls, do not conform to an intertemporal government budget constraint of remotely the conventional form. I’ve already described half of such a model here. I should add the other half, and write the math down in a way that economists can understand. The key insight is one that both quasimonetarists like Rowe and MMT-ers accept but rarely state explicitly — much of our motivation in “lending to the government” is not to capture growth, bit to self-insure against idiosyncratic risk. There is nothing novel about this — conventional treatments of the permanent income hypothesis characterize the conditions under which individuals will engage in precautionary saving. Redemption of precautionary savings in the form of money or government debt usually works not by government provision of goods and services when an individual faces shortfalls, but by virtue of transfers of real goods and services to those who face shortfalls from those experiencing surpluses. In other words, money and government debt are the medium by which we conduct a mutual insurance program. The stock of government debt then grows as a function of determinants of precautionary savings, which include income, but also risk preferences, the idiosyncratic risk that agents face, and the degree to which borrowing constraints bind. In all periods where the government does not default, participating in this insurance program is straightforwardly beneficial. The risk of rare government defaults, due to systematic shocks, may be insufficient to offset the benefits of participation in the mutual insurance program, and government debt need only be the least risky available medium, conditional on its use for insurance purposes, to rationally attract insurance-motivated lending. Under some circumstances (satiable preferences, steep reduction of incomes post-government-default combined with rationing based on prior savings, little relationship between the scale of insurance borrowing and the likelihood of default), I claim, it is reasonable to expect government debt to grow without bound. I consider these circumstances to be pretty realistic.

It is good to see Paul Krugman prominently discussing “modern monetary theory”, although I don’t think his characterization is quite fair.

I am an MMT dilettante, so I’ll apologize in advance for my own mischaracterizations. But I think the MMT view of stabilization policy can be summed up pretty quickly:

1. The central macroeconomic policy instrument available to governments is regulating the flow of “net financial assets” to and from the private sector. The government creates private sector assets by issuing money or bonds in exchange for current goods or services, or else for nothing at all via simple transfers. Governments destroy private sector financial assets via taxation. MMT-ers tend to view financial asset swaps, whereunder the government issues money or debt to buy financial assets already held by the private sector (“conventional monetary policy”) as second order and less effective, although they might acknowledge some impact.

2. A government that borrows in its own currency cannot be insolvent in the same way as private businesses. That is, such a government will never face a sharp threshold where it cannot meet promised payments, leading to a socially unanimous or even legal declaration of insolvency and an almost certain run on its liabilities.

3. However, the value of money and government claims in real terms is absolutely variable. Governments do and properly should manage their flow of obligations with an eye to supporting that value, among other competing objectives (such as, especially, full employment).

4. The real value of money and government debt is not reliably related to any theory of government balance sheets. In particular, the stock of outstanding government obligations is largely irrelevant. The value of government obligations is a function of financial flows. Government claims will retain their value so long as the private and foreign sectors wish to expand their holdings of those claims at the current price level, that is so long as agents are willing to sacrifice real goods and services today to reduce their indebtedness, improve their financial position, or stimulate their export sectors. The value of government claims will come under pressure when agents, on net, seek to increase indebtedness or redeem existing claims for real goods and services.

5. The “solvency” of a government is best understood as its capacity over time to manage the economy in a manner that avoids net outflows. “Net outflows” here means attempts by nongovernment actors in aggregate to redeem government paper for current goods and services.

6. Avoiding net outflows is easy in times like the present, when i) low quality and difficult to service debt in the private sector leaves many agents eager to reduce indebtedness and increase their holdings of financial assets; ii) there has been little inflation or devaluation in the recent past; and iii) resource utilization is slack, as evidenced especially by high unemployment. Avoiding net outflows is more difficult when private sector agents’ balance sheets are healthy, or when agents come to expect inflation or devaluation, or when real resources (especially humans) are fully employed.

7. However, a sovereign government can always create demand for its money and debt via its coercive ability to tax. That is, if optimistic agents with strong balance sheets start up a spending spree, or if gold bugs fearful of devaluation ditch government paper for commodities, a government can reverse those flows by forcing private agents to surrender real goods and services for the money they will owe in taxes.

8. Therefore, a government’s “solvency constraint” is not a function of any accounting relationship or theories about the present value of future surpluses. A government’s solvency constraint ultimately lies in its political capacity to levy and and enforce the payment of taxes.

I think this is a clever and coherent view of the world. I do not fully subscribe to it — in my next post, I’ll offer point-by-point critiques. But first, let’s see where I think Paul Krugman is a bit off in his characterization:

As I understand the MMT position, it is that the only thing we need to consider is whether the deficit creates excess demand to such an extent to be inflationary. The perceived future solvency of the government is not an issue.

I disagree. A 6 percent deficit would, under normal conditions, be very expansionary; but it could be offset with tight monetary policy, so that it need not be inflationary. But if the U.S. government has lost access to the bond market, the Fed can’t pursue a tight-money policy — on the contrary, it has to increase the monetary base fast enough to finance the revenue hole. And so a deficit that would be manageable with capital-market access becomes disastrous without.

The real question here is why a deficit that would be inconsistent with price stability with “loose money” would be transformed into something sustainable with “tight money”. From an MMT-perspective, it is the flow of net financial assets from public sector to private, relative to the private sector’s willingness to absorb, that matters. Whether those net financial assets take the form of liquid cash or still very liquid Treasury securities is second order. As Krugman himself has pointed out, conventional monetary policy is just a shift in the maturity of government obligations. If the private sector is unwilling to hold the expanding stock of dollar-denominated obligations at prices (in terms of real goods and services) consistent with our definition of price stability, the private sector will be unwilling to hold those obligations whether they are bonds or money.

An obvious objection is that bonds pay yields that might induce private sector agents to hold government paper at current prices (again in terms of real goods and services), while money historically did not. Krugman’s sustainable “tight money, loose fiscal” scenario basically amounts to pointing out that the private sector can be induced to hold more paper if the public sector promises to make large ongoing transfers to holders of its paper. MMT-ers have mixed feelings about using interest payments to increase the willingness of the private sector to hold government paper. Regardless, since most central banks now pay interest on reserves, these payments no longer serve to demarcate “fiscal” obligations of the Treasury and “monetary” obligations of the central bank. Rather than being divided into “fiscal” and “monetary” policy, we end up with “flow” policy and “yield” policy. In order to stabilize the price level and real spending in the face of changes in private sector demand for government paper, the public sector can either modulate supply (by adjusting the size of the deficit / surplus), or modulate demand via the yield (by altering the interest paid on reserves or selling term bonds). As MMT-er Bill Mitchell puts it, “Our preferred position is a natural rate of zero and no bond sales. Then allow fiscal policy to make all the adjustments. It is much cleaner that way.”

MMT-ers view the size of the flow itself — that “6 percent deficit” — as the primary instrument of stabilization policy. By holding the deficit constant in his thought experiment, Krugman deprives MMT of the means by which it would manage demand. MMT-ers do not claim that fiscal policy can ignore private willingness to hold government assets. On the contrary, they take from Wynne Godley’s sectoral balance analysis that fiscal policy should do a jujitsu to accommodate the changing net demand of the private and external sectors. MMT-ers very much agree that it is important not to lose access to the bond market, broadly construed. But they suggest that the government’s power to tax is sufficient to maintain the private sector’s appetite to hold government paper, whether in the form of bonds or of money. Therefore, there is little need to fret about “confidence” and undead theories of government solvency. The government can issue paper — make transfers, deficit spend, whatever — when the private and external sectors are willing to buy, and reduce deficits or even run a surplus when those appetites have been sated.

Anyway, this is long enough. I’ll post critiques of the view I have summarized later.

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Much of my understanding of MMT comes from conversations with the excellent Winterspeak. Obviously, any mischaracterizations are my own and any insights due him. I owe Winterspeak a contentious post highlighting our argument about whether it is detestable for wealthy people to maintain large holdings of money and government debt. I say, for the most part, that it is. If you want to read that argument in raw, unhighlighted form, see the comments here. I’ve also learned a lot from the mysterious JKH.

Some writers of note about MMT include Marshall Auerback, Scott Fullwiler, James Galbraith, Bill Mitchell, Warren Mosler, Rob Parenteau, Pavlina R. Tcherneva, Eric Tymoigne, and L. Randall Wray. You can find the writing of several of these authors in Levy Institute’s working paper series and at Economic Perspectives from Kansas City. Some blogs that occasionally offer an MMT perspective include Credit Writedowns, Naked Capitalism, New Deal 2.0, and Pragmatic Capitalism. See also the related links below.

So, call me a philistine, but I really think that the Tea Party types have gotten a bum rap over their whole “Keep Government Out Of My Medicare” slogan. Yes, Medicare is a government benefit. One’s Medicare card represents a claim on the government that can be redeemed for goods and services, usually delivered by private sector providers.

You know what else is a claim on government that can be surrendered for goods and services from private sector providers? Money. Yet there is no part of the political spectrum that considers it incoherent to say “Keep Government Out Of My Pocketbook”, even though the only relevant thing your pocketbook contains is government scrip. If the money analogy seems to forced, consider a retirement account chock-full of government bonds. The account contains nothing more or less than government promises to pay, but that doesn’t render it incoherent to object to the government’s altering the terms of the bundle of promises, whether by restructuring the debt or more aggressive taxation.

What the Tea Partiers are accurately if not artfully expressing is that Medicare feels a lot like a property right. Our most important property rights are often claims on people or institutions. This includes all financial wealth — dollar bills, stocks and bonds, pensions and 401-K plans, every form of insurance we buy for ourselves or others provide for us. Medicare and Social Security are, from users’ perspective, property, no different from a privately funded health or pension plan. Why should users think of them as “government benefits” any more than they think of interest payments on a Treasury bond that way? Human beings are notoriously territorial about property. All it takes to turn a human being into a urinating canine is the combination of 1) a readily comprehensible set of nonuniversal rights; and 2) some account that legitimizes differential claims to those rights. Medicare and Social Security have all that in spades. They provide rights to tangible, extraordinarily valuable, transfers and services. People endowed with those rights believe themselves to have earned them, by virtue of having contributed to the programs specifically and to society generally in a quasicontractual arrangement. People consider themselves “entitled” to their entitlements because they view them as property.

Matt Yglesias writes:

Any effort to reduce government spending on health care for the elderly is intolerable socialism, and any effort to increase government spending on health care for the non-elderly is also intolerable socialism. That’s cynical, but it also reflects the objective difference in the age structure between the parties.

I think it’s fair to point out that it’s cynically exploited, but I think the underlying feeling is not really so cynical. The meaning of socialism in American politics is government action to redistribute property rights. It is socialism in America to tax the rich and it is socialism in America to give to the poor. Similarly, it is socialism for the government to change the terms of the extraordinarily valuable set of rights that constitute property to Medicare incumbents, and it is socialism to extend those extraordinarily valuable rights to people who haven’t “earned” them. That may be objectively bizarre for a program that is universal after age 65. But the median Medicare recipient has worked and paid taxes most of those 65 years, views her benefits as earned, and takes herself as representative of Medicare recipients as a class.

Americans, for better and for worse, are unreasonably — almost limitlessly — respectful of what they understand to be property rights. That’s just a fact on the ground. Some interest groups get this: Consider the decades long project of recasting copyright, patent, trademark, and trade-secret protection into “intellectual property” that can be “stolen”, rather than narrow government dispensations intended to advance specific social purposes. People trying to design policy that will actually work in America have to keep this property fetish in mind. It creates both constraints and opportunities, but it is there.

So oil prices are rising, and, inevitably, a debate is heating up about the role of speculation versus that of “fundamentals”. Ryan Avent makes a point that was commonplace last time our collective heads were on fire about oil prices and it was all the speculators’ fault:

[T]he easiest and most effective way to speculate on the price of oil is to leave the stuff in the ground, and there’s not a thing the American government can do about that.

I thought this was a good point in 2008, the best rejoinder to Paul Krugman’s recurring query that, if it’s speculation, where was the inventory build? But it strikes me as a less compelling point now.

Suppose you are the House of Saud. Like anyone with a position in a traded asset, you face a sell or hold decision. If you expect that the real value of your asset will rise faster than the real value of financial investments you could make at equivalent risk if you sold, then you should hold. Otherwise, you should sell.

But there’s a wrinkle. The House of Saud really must compare the private value of oil in the ground to the private value of alternative investments. Like a middle American muni investor maximizing after tax returns, the House is looking to maximize the value it can actually appropriate. Ordinary taxes aren’t that big a deal to the Saud’s, who after all run the state. But the House of Saud faces a different sort of “tax” on future oil: the possibility that by the time it is exhumed from the desert, it will no longer be theirs to sell. The expected private value of future oil to the House is proportional to the expected future oil price and inversely proportional to the probability of revolution. I’d guess that events of the last few months have significantly reduced their expected private value of oil in the ground, the current oil price spike notwithstanding.

One might even argue that current circumstances amount to a natural experiment by which we might test the question of whether Saudi Arabia in fact has 3.5M barrels a day of spare capacity they can easily bring on line, or whether they’ve basically been running full tilt already. As the probability of revolution — or else a permanent increase in wealth-sharing to forestall revolution — increases, the private value of oil in the ground falls. If flows don’t increase, that could be taken as evidence that the Saudi Arabia is pumping at capacity.

Of course, life is messy, and natural experiments are never perfect. Lots of caveats: The pump-or-store decision should be based on the relative private values of oil and financial investment. If the princes think that, after a revolution, their financial wealth would be frozen by fair-weather patrons in the West, that would tilt things in the opposite direction. The princes might believe that defending their claim to oil in the ground is a better bet than relying upon recently less than reliable Swiss bankers to protect the interests of unpopular clients. (A strange corollary of all this is that if the West wants to maximize current oil flow, it should credibly promise to recognize the House of Saud’s claims on private and sovereign wealth, come what may on the Peninsula. I do not advocate this — I think we should put longer-term interests before concerns about the moment’s oil price. But the logic is clear.)

Also, the princes would have to be mindful of potential backwards causality from pumping decisions to revolution. If it looks like the rulers are ramping production in a panic, that might signal fear and undermine the government’s legitimacy, aiding the revolutionaries’ cause. However, the current price spike and concerns of oil consumers would provide cover. There are lots of reasons besides fear of regime change why the Saudi government might choose to increase production now, if they can.

Obviously, all of this is, um, speculation. Interfluidity is not the The Oil Drum. I know little about the details of oil production or of Saudi politics. But from the perspective of several Middle Eastern regimes, I’d guess that “oil in the ground” seems less of a safe bet than it might have a few years ago.