Investment, consumption and business cycles

The following is taken from a piece in the FT by Samuel Brittan

Railway buffs will be familiar with trains that have a locomotive behind as well as in front of the carriages. But a train with only a rear locomotive? Maybe in some remote part of the Andes, but hardly a normal phenomenon…

…So far the government has focused mainly on stimulating business investment, equivalent to trying to drive from the rear locomotive. There have been bouts of investment-led growth – such as the US and UK 19th-century railway booms. But the normal process is for consumption to lead. The latest project – the funding for lending scheme –seems better designed than most. But it cannot be large enough to lift the whole economy.

Samuel is spot on. The pattern of recession and recovery is historically led by movements in consumption, both on the way down and the way up. Don’t get me wrong, reducing red tape and making our economies more competitive and addressing structural issues like the UK’s pensions funding shortfall are big issues that will need to be addressed over the medium to long-term. But cutting back on government expenditures at the same time that private expenditures are simultaneously decreasing is like trying to run up an escalator which is going down.

Politicians arguing for public sector spending cuts often use phrases such as ‘we are reducing the deficit so as to encourage private sector investment’ . The argument of the austerity brigades (and austerity light brigades such as the UK and US) usually centers around the fact that for recovery, we need strong private investment to pull us out of the slump with private incomes and thus consumption following, and in order to do so it is usually argued that government must ‘get out of the way’. Again my argument is not with the idea of reducing government expenditures. My argument is that we shouldn’t be reducing them now (at least not with further monetary easing that is effective), and we certainly shouldn’t be doing so in anticipation that private investment will pull us out of the slump and back to better times. Take a look at the following two graphs;


Both plot the annual percentage change in real personal consumption expenditures (multiplied by 6 for scaling) in the US, but each plots an alternative measure of private investment (again – annual percentage change).  In each graph you’ll notice that all the major peaks and troughs (bar one or two) in consumption precede those in investment by approximately 1-3 quarters. So for the US to have an investment driven recovery, it would seem that it would be a major break from previous trends. Furthermore, with extremely similar economic structures, I think it would not be unreasonable to extend such an argument to the UK, the other major developed economy currently undergoing ‘voluntary austerity’.

Remember those two graphs next time you hear a politician use the ‘government needs to get out of the way’ spiel as an argument for current economic austerity programmes.

The sticking point

Gavyn Davies has an interesting post up discussing the possible size of the output gap, and hence whether demand management policies can be used to increase output in the short run. To see why the size of the output gap is important for current policy, consider two extremes. If current output is actually well below potential output, then expansionary monetary or fiscal policy would be capable of increasing output back up to potential without significantly increasing inflation. If on the other hand potential output is in fact much lower than the pre-recession trend (see Gavyn’s excellent group of diagrams for various countries) and output is currently equal to potential, expansionary monetary and fiscal policy would just lead to higher inflation with no change in output or employment. These are the two extremes but they show the basics of the problem for anyone unfamiliar with the theory.

Gavyn discusses an interesting issue relating to the breaking down of this relationship when inflation decreases (i.e. disinflation sets in). Take this quote from Gavyn in which he discusses a previous study;

In 2010, Andre Meier at the IMF published an analysis of persistently large output gaps, which I have previously summarised, in which he concluded that global inflation should be dropping each year by about 0.5 per cent, but that this would stop happening as the rate of wage and price inflation approached zero. The estimated impact of the output gap on inflation would therefore be expected to decline as inflation falls. This prediction seems to have proven accurate.

This is part of a larger body of literature on asymmetric price adjustment originating from such work as this by Greg Mankiw. What I would like to do is explain the theory without getting too wonkish, so here goes.

Consider a starting point where the economy is at full employment, inflation is on target and GDP is equal to potential. Then consider some negative aggregate demand shock. Most of us would instantly assume this aggregate demand shock would cause the prices of goods in the economy to fall, as firms respond to the falling demand for their goods by reducing their price in order to retain market share and sell their output.   If goods in the economy are imperfect substitutes i.e. if consumers place higher value on other aspects of products other than price (think of the brand effect of owning an iPod compared to other mp3 players), then when a firm decreases its price below its competitors it gains only a fraction of the additional market share that it would receive if goods were perfect substitutes.

If the additional market share for a given price decrease is sufficiently small, it is optimal for the firm to simply leave its price as it is and maintain a higher revenue per good sold, but sell fewer goods. When we aggregate this over firms, this provides an explanation of why in the face of negative aggregate demand shocks, output may decrease significantly without any appreciable fall in prices. Thus by extension, if such a situation arises, expansionary fiscal and monetary policy can expand output back to potential without an appreciable increase in inflation.

The beauty of the theory is that we still retain the result that expansionary policy when output is equal to potential leads to increases in inflation rather than increases in output i.e fiscal and/or monetary policy cannot lead to permanent increases in output growth. But why? Given that a firm gains very few customers from cutting prices below its customers, it similarly loses few when raising prices above customers. Hence when a positive aggregate demand shock hits the economy from our starting point of full employment, firms have every incentive to increase prices as the demand for their product increases. Hence on aggregate, output responds very little and inflation increases.

If the theory holds, then it is entirely plausible that the weak output growth that many developed economies are now experiencing could be reversed by expansionary monetary (if you think such a thing is currently possible, which I do) or expansionary fiscal policy, without leading to an appreciable increase in inflation.