“The economy fell off the cliff.” – George Soros (11/24/2008).

1. “The economy fell off the cliff.” – George Soros (11/24/2008). J. Devine/Neo-Kaldorian Dynamics

2. The Great Moderation and "Falling Off a Cliff": neo-Kaldorian dynamics. James G. Devine Loyola Marymount University (LA, CA) jdevine@lmu.edu August 5, 2011 (Published as The Great Moderation and “Falling Off a Cliff”: Neo-Kaldorian Dynamicsin Journal of Economic Behavior & Organization, 78(3), May 2011: 366-373. A rough draft is available at: http://myweb.lmu.edu/jdevine/JD-2010-neoKaldorianModel.pdf with diagrams at http://myweb.lmu.edu/jdevine/neoKaldorian-Figures.docx. The current version has been edited a lot without changing any conclusions.) J. Devine/Neo-Kaldorian Dynamics

3. Outline. • Introduction. • The Short-Run Model. • the Expenditure curve (EE). • the Actual Demand/Debt ratio curve (AA). • Short-run equilibria. • Medium-Run disruption of SR Equilibrium. • The “typical” cycle. • A Fall off the cliff. • The Great Moderation. • The aftermath: Recovery or Stagnation? • Conclusion: Policy’s role. J. Devine/Neo-Kaldorian Dynamics

4. (I) Purpose. to help to understand: Why the U.S. economy “fell off a cliff” – or threatened to do so – during the years 2008-2009. • the world economy, the housing market, and most of finance will be ignored here. • it’s possible that 2009’s stimulus package saved the economy from a Fall – but who knows? • We may not have been suffering from a Fall. J. Devine/Neo-Kaldorian Dynamics

5. (I) Theoretical Background. • Kaldor’s Keynesian (pre-catastrophe theory) model of the business cycle (1940): • Non-linearity implies three equilibria (two of which are stable). • Stable equilibria represent two general states of the macro-economy: high employment and stagnation. • A “Fall” is a downward leap between these. • Dynamic theories of Minsky (1982)and Kalecki (1933), helping to cause this Fall endogenously. • This process may have occurred due to the often-heralded “Great Moderation” (1984-2006). • In this period, the effects of financial crises and normal business-cycle recessions may have been short-circuited, so that they could not purge the economy of Minsky/Kalecki imbalances. J. Devine/Neo-Kaldorian Dynamics

6. (II) The three “runs.” • long run (LR): labor-constrained potential output (Z) and the Minsky/Kalecki threshold (V) are determined. • Assumed constant in this paper. • medium run (MR): the trend demand/debt ratio (t) and the Spending shift factor (St) are determined – but are held constant in the short run. • short run (SR): Bt (private-sector debt) and Kt (industrial capacity) held constant in the short run. J. Devine/Neo-Kaldorian Dynamics

7. (II) The Subject Matter. Figure 1 J. Devine/Neo-Kaldorian Dynamics

8. (II) Three SR Equations. • The EE (expenditure) curve relating demand for GDP (Et) to the expected demand/debt ratio (xt); • The AA line, determining the actual demand/debt ratio (at) at each level of demand (Et); and • Expectations adjustment, so that the expected and actual demand/debt ratios are equal in short-term equilibrium (x = a). • The adjustment equation is left implicit here. • It’s treated as merely a matter of an automatic movement to short-run equilibrium. J. Devine/Neo-Kaldorian Dynamics

9. (II.A)Aggregate Expenditure (EE). Figure 2 J. Devine/Neo-Kaldorian Dynamics

10. (II.A)Short Run: movement along EE curve. Et = EE(xt,St); EE1≥ 0; EE2≥ 0 • Shift Factor (St) is constant in the short run. • The sigmoid shape of the EE curve: • Between the two vertical segments, spending rises with the expected demand/debt ratio. • But investment and total spending do not respond to xt at low demand (due to extreme pessimism, indebtedness, and unused industrial capacity) • Nor at high demand (due to supply-side bottlenecks). (1) J. Devine/Neo-Kaldorian Dynamics

11. (II.B)Actual Demand/Debt Line (AA). figure 3 J. Devine/Neo-Kaldorian Dynamics

12. (II.B) The Actual Demand/Debt Line (AA) at ≡ (Et/Z)(Z/Kt)/(Bt/Kt) ≡ et · t /λt • The actual expenditure/debt ratio depends on three ratios: • Expenditure/potential = employment rate (et); • The Kalecki factor: Potential/industrial capacity (Z/Kt =t); and • The Minsky factor or the degree of leverage: Private debt/industrial capacity (Bt/Kt = λt). (2) J. Devine/Neo-Kaldorian Dynamics

13. (II.B) Simplifying… Lett /λt≡ αtso that: at ≡ et·αt • The actual demand/debt ratio (at)reflects • the utilization of potential (et); and • αt≡ the trend value of at(held constant in the SR) which reflects: • the Kalecki factor (t); and • The Minsky factor (λt). (2A) J. Devine/Neo-Kaldorian Dynamics

14. (II.B) Short run: movement along AAcurve. • Since Bt and Ktare held constant in the short run, • λt(the leverage ratio), ρt(potential output/capital ratio) and αt, the trend output/debt ratio are constant. • The actual demand/debt ratio(at) varies only with the utilization of labor (et): a linear relationship. J. Devine/Neo-Kaldorian Dynamics

15. (II.C) Short-run equilibria. at= xt, so that Et(at, St) = Et(xt, St) • The process of adjustment of expectations (xt) to actual values (at) indicates that • equilibria L and H are stable, while • Mis unstable. • In figure 4, the small arrows show the direction of disequilibrium adjustment. (3) (3A) J. Devine/Neo-Kaldorian Dynamics

16. (II.C) Short-Run Equilibria. figure 4 J. Devine/Neo-Kaldorian Dynamics

17. (III)Medium Run: Shifting EE curve. • St changes and EE shifts due to • fiscal and/or monetary policy, • changes in expected inflation, and/or • changes in long-term profit expectations. • Stimulus (the shift to EE’) means that a lower x than before is associated with the same amount of expenditure. J. Devine/Neo-Kaldorian Dynamics

18. (III)Medium Run: Shifting EE curve. • The limits to Stimulus. • Near Z, the curve cannot shift to the right (only downward) due to labor-supply constraints. • and demand-side stimulus can only be temporary (since only inflation results in the end). • to describe the “Great Moderation,” Stis held constant with a high Et – indicating effects of the trend underlying EE fluctuations. J. Devine/Neo-Kaldorian Dynamics

19. (III) Minsky/Kalecki Dynamics. • Persistent high Et above Minsky/Kalecki threshold V implies that either or both: • leverage (λt) rises (Minsky). • Extended prosperity encourages more and more borrowing as prosperity is expected to continue and memories of the Great Depression and past financial crises fade. • This assumes that the financial system is poorly regulated. • the potential-industrial capacity ratio (t) falls (Kalecki). • High demand encourages fixed investment while the fixity of Z means that effective “capital productivity” (Z/Kt) falls as not all of the industrial capacity can be used to produce. • Persistent high demand may cause “disproportionalities” as the wrong kind of investment is done, given the structure of demand. J. Devine/Neo-Kaldorian Dynamics

20. (III) Minsky/Kalecki Dynamics. αt= –M(Et – V); with constant M > 0 • Persistent high Et above Minsky/Kalecki threshold V implies that • λt rises and/or t falls. • And αt falls, flattening AA, as in figure 3. • Going the other way: persistent Et < V rotates AA counterclockwise. (4) J. Devine/Neo-Kaldorian Dynamics

21. (III) The Economist’s Holy Grail. • In theory, medium-run equilibrium exists where Et = V (with constant α). • But can this holy grail be both attained and maintained? • The answer depends on the relationship between V and the AA/EE tangency point T (introduced below). J. Devine/Neo-Kaldorian Dynamics

22. (III) Endogenous Disequilibration. • Equation (4) and Et > V imply falling αt in the MR, which • leads to endogenous disruption of any short-run equilibrium attained. • This in turn implies either • a “mild” recession or • a Fall off a Cliff. J. Devine/Neo-Kaldorian Dynamics

23. (III.A) A “Mild” Recession. figure 5 J. Devine/Neo-Kaldorian Dynamics

24. (III.A) Mild Recession & Cycle. • Holding EE constant, falling αt leads to clockwise rotation of the AA line to AA2. • Because the AA/EE tangency point HM at Et= T is below the threshold V, • the recession (declining Et) causes endogenous reversal of decline in αtas soon as Et < V. • Spending recovers as AA rotates counterclockwise. • A “typical” cycle involves repeated clockwise and counterclockwise rotation of the AAline • … along with a lot of other considerations such as the inventory cycle. J. Devine/Neo-Kaldorian Dynamics

25. (III.A) MR equilibrium maintained? • Attainment of MR equilibrium can occur (at H2). • This is a stable SR equilibrium with constant αt. • However, this MR equilibrium requires maintenance of relatively high unemployment of labor to prevent the Minsky/Kalecki trend. • This is a “reserve army of labor” theory (à la Marx). • Standard business cycle theory suggests reasons why the economy might oscillate around MR equilibrium. • Nonetheless, this equilibrium is stable. J. Devine/Neo-Kaldorian Dynamics

26. (III.B) Falling Off A Cliff. figure 6 J. Devine/Neo-Kaldorian Dynamics

27. (III.B) The Fall. • Holding EE constant, falling αt again implies clockwise rotation of AAto AA2. • In this case, Etat the tangency point T is above the threshold V. • The same result occurs with equality of these two points. • Thus, the recession causes points H and M to converge to the tangency point HM, which is unstable downward. • Because V is low, αtcontinues to decline. • So even if equilibrium at HM is maintained, the SR equilibrium point disappears entirely. J. Devine/Neo-Kaldorian Dynamics

28. (III.B) The Fall and MR equilibrium. • The medium-run equilibrium at Et= V cannot be attained because it does not correspond to a stable SR equilibrium. • The model instead implies a Fall to point L (stagnation). J. Devine/Neo-Kaldorian Dynamics

29. (III.B) Does a Fall occur? • We cannot say a priori what the relationship between points T and Vis in the real world – so we can’t say which of the two cases occurs. • But T is likely to be relatively high due to an extended period of relative prosperity (such as the “Great Moderation”) which allows imbalances to accumulate, lowering αtfor long periods. • With T associated with a higher level of Et, a Fall is more likely. • This kind of trend is seen in figure 7, even if the “Moderation” was anemic from labor’s perspective. J. Devine/Neo-Kaldorian Dynamics

30. (III.C) The Great Moderation and Falling αt. figure 7 J. Devine/Neo-Kaldorian Dynamics

31. (III.C)Illustrative regression: the trend. J. Devine/Neo-Kaldorian Dynamics

32. (III.C) A Major Caveat. • Even though the trend in t is statistically significant, that does not mean that we can conclude that the fall was large enough to explain the 2008-9 collapse of the U.S. economy. • To say that would require that we know much more about the shape of EEand the structure of the economy. J. Devine/Neo-Kaldorian Dynamics

33. (V) Recovery or Stagnation? figure 8 J. Devine/Neo-Kaldorian Dynamics

34. (IV.A)the aftermath &Recovery. • In figure 8, because Et at point L3 < T, there is an automatic tendency toward recoverydue to deleveraging (λt) and purging of unused capacity (ρt). • So αt rises, rotating AA counterclockwise. • Equilibrium points Land Mconverge toML, which is unstable upward: the economy leaps up the cliff. J. Devine/Neo-Kaldorian Dynamics

35. (IV.B)the aftermath & Stagnation • Et at point L might exceed T, so the Minsky/Kalecki trend continues, making matters worse. • More importantly, recovery can be counteracted by the MR results of extreme unused capacity and indebtedness, which encourages waves of deflation, default, and rapid-onset despair. • These shift EE up and left to EE’: higher x is required to induce the same amount of spending as before. • Continued or deepening stagnation results. J. Devine/Neo-Kaldorian Dynamics

36. (V) Policy’s Role. • Policymakers can be “villains” by maintaining high demand – encouraging the accumulation of imbalances as in a Great Moderation. • But in a stagnation period, they can become “heroes” by stimulating demand. • Fiscal policy (if politically possible) and monetary policy (if it works) can “prime the pump,” spurring recovery. • This shifts EE downward, moving the tangency point to the left, making recovery more likely. J. Devine/Neo-Kaldorian Dynamics

37. (V) To Create a New Prosperity. • What encourages the creation of new prosperity? • Efforts to lower the leverage ratio (λt), via mass bankruptcy and the like. • Efforts to raise “capital productivity” (ρt) by scrapping excess and/or inappropriate industrial capacity. • Both of these artificially raise αt rather than waiting for the “automatic” process. J. Devine/Neo-Kaldorian Dynamics

38. Preventing falling αt • Increased leverage can be prevented using improved financial regulation. • Decreased capital productivity cannot be prevented without raising Z or avoiding disproportionalities. J. Devine/Neo-Kaldorian Dynamics

39. (V) To Preserve the New Prosperity. • What can encourage the persistence of new prosperity, preventing the negative effects of a new “Great Moderation”? • Raise Z by increasing the supply of labor. • Raise Z by increasing labor productivity. • If successful, both of these allow persistently high demand by increasing supply in step. J. Devine/Neo-Kaldorian Dynamics

40. Finis J. Devine/Neo-Kaldorian Dynamics