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>> Introduce Lance Taylor, the Arnhold Professor of Economics at the New School for Social Research. >> TAYLOR: Well, thank you very much. If you don't know what the title is about it refers to John Maynard Keynes, who was born in 1883, died in 1946, and was a dominant figure in economics in the 20th century, I think is a fair summary. The--unfortunately, beginning around 1970 his ideas more or less passed into oblivion, and maybe I'll talk a little bit about that. But he certainly come riding
0:59
back and forth with the crisis which began in 2007. So what I'd like to do is talk about Keynes' ideas and also try to relate into the crisis which is a fair a bid for a lecture of one hour, but I will try to be relatively coherent. So just to begin, Maynard's Macroeconomics, I'll say more about each of this topics as I go along but there are sort of a few key ideas that one has to bear in mind. One is a notion of fundamental uncertainty, you know,
1:33
I'll say something about that in a minute. The second is that Keynes' good distinction between prices of assets on the one hand, and prices of goods and services on the other and that turned out to play a pretty fundamental role in making the crisis occur. He also postulated, basically, that national output is equal to national income and the national income and property accounts or the GDP account that you read about in the newspapers are constructed
2:04
to fit that identity if you like. So the basic data that people work with was, in fact, shaped in a form that was invented by Keynes. There's an implication that investment, and by investment economist mean physical capital formation is automatically equal to saving and that is also built into the data, and I'll have something more to say about that. What that implies, in fact, is that output is determined by something called effective demand and not
2:35
aggregate supply. Now, the kind of economics that supplanted Keynes beginning around 1970, essentially postulates that GDP is determined from the supply side. That is in effect of the zooms that there is full employment of labor and capital and this full employment of labor and capital generates the level of output, that is known as Say's Law or if you're a part of my friends, Say's Law, after a French-Italian economist who sort of flourished around 1820.
3:09
And certainly the recent events have demonstrated that Say's Law is not valid and that's another point that I want to emphasize. As I've said, I'll come back to all these ideas as we go along and they all have a role to play in determining or setting up the conditions for the crisis. There's also couple of disciples that are interesting to--that are interesting to bring into the discussion. One is an American named Richard Goodwin who ended up teaching
3:42
in Cambridge because he ran into problems with McCarthy around 1940, late 1940s or early '50s and he said that there is a distribution versus demand cycle in the US economy that is over the business cycle. You'll see a clear pattern of changes in income distribution and output, and I'll have more to say about that. And then there is an Englishman named Wynne Godley, who sort of took off from the idea that it's true that income is equal to
4:15
expenditure output across the economy. But for any actor in the economy whether a person or a sector, however you choose to classify things. This actor can have income not equal to spending so that in effect if it's spending more than, if the actor is spending more than its income, then he's going to have to run up liabilities or borrow. If it's spending less in its income then it's going to have to be lending. And they're quite interesting
4:46
trends and cycles in patterns of net borrowing across the economy and big shifts as we will see around 1980. Now, I use this fancy philosophical word ontology to describe Keynes' view of how the financial world in particular operates. And there's a distinction that one can draw between fundamental uncertainty on the one hand, and what has some economist called risk on the other. And what I mean by risk is that if risk applies you can put a complete probability
5:26
distribution on all future events, and most microeconomic modeling is based on the assumption of risk. Now, Keynes and other people argued that you really can't put a complete probability distribution on future events. In part, because you can't even think of it, you can't even conceive of them and there are plenty of ecological examples of that: Easter Island, the CFCs and the ozone hole and people on Easter Island when they put up their statues just really
6:00
didn't realized that they would be denuding the forest and after a while that would become ecologically impossible. Nobody foresaw that CFCs would create the ozone hole. Back in around, up until around 1946 or 2006 rather, Ben Bernanke, Governor of the Central Bank was talking about the great moderation and he certainly did not and possibly could not have even considered the crisis that was about to break and that's the kind of thing I have
6:32
in mind about fundamental uncertainty. You really cannot know the future. Now, if that's true and in particular if you look at financial actors and this is a key theme in Keynes, that financial actors essentially based their decisions on conventions which maybe stable for a time but then can change quite rapidly. He had a metaphor about that which he called the beauty contest. Now, that's not the attempt to--that's not choosing Miss Marielle of England
7:10
of 1936 or something like that, but rather English newspapers in the '30s had contest in which they put up pretty pictures of a dozen or 15 or whatever young women and asked people to vote on not who was the prettiest but rather who the voting population would say was the prettiest. So essentially, you were trying to figure out what people--the person that people would think was the prettiest girl as opposed to just the prettiest girl
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of whose being shown. And then Keynes argued that in financial markets, then you can take this up into a number of degrees. What will the--many people think is who–-the majority of people think is the prettiest of the prettiest? And then you can get to the prettiest of the prettiest of the prettiest which is anticipating which way if you like the second derivative of opinion and Keynes went on to say that there are some people in financial markets
8:15
who really proceed to the force of fifth degree of perception in this beauty contest. Now, if you think about it, if there's a little disturbance in the financial market then you have people figuring that out and then people figuring out what they are figuring out and so on. So really the beauty contest is kind of a magnification device for telling the group of financial actors as a whole which way the market is going to break. Keynes was
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actually fairly friendly with Wittgenstein and in sort of Wittgenstein's later answer for logical philosophy; he said that knowledge is based on social conventions. Keynes' view of the financial market is it also relies on social conventions with the difference from Wittgenstein that they can change rapidly and unexpectedly and that we've recently seen an example of that. Now, if you look at the housing price bubble, for example, and I'll
9:18
show you a picture of the bubble in a couple of minutes. Expectations and valuation models got built around a convention of steadily rising prices. And, in fact, housing prices had been rising fairly steadily since the late 1930s; it was greater or lesser speed. But then they stopped rising in the mid-2000s and the calculations fell apart. Simply the valuation models for both housing mortgages and the derivative security is based on housing
9:53
mortgages simply collapsed because it'd been built around on assumption of exponential growth with--which is sort of fluctuating up and down. Now there were diverse causes for the equity in housing bubbles, but certainly, the financial deregulation and the emergence of something called "finance theory" were tremendously important. Finance theory, by the way, is a discipline that emerged around 1950. Essentially saying you could put risk,
10:26
you could--it operated under conditions of risk, and in fact, it operated under conditions--under assumptions of Gaussian distribution risk. And the fact that, in fact, price fluctuations are not Gaussian is a major criticism of finance theory. But even worst you can't put a probability distribution on the future. Nobody foresaw the break in the mortgage price growth, for example, and in that sense the theory was very misleading. Now, so that's sort of one
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observation that will comeback and bring into the discussion later. The second observation is that the capitalist economy has two sets of prices, that is you got to set a prices for assets on the one hand, that is houses and shares and bonds and things like that, and then you have another set of prices for goods and services. And when people talk about inflation, they're always talking about the growth rate of an index of prices of goods
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and services. And asset prices are left out--asset price inflation is left out or has been left out until very recently of most discussions. Now there's a notion called inflation targeting which is sort of a grandson of monetarism which say's that what Central Bankers should do is raise the interest rate when the price inflation rates speeds up and reduce the interest rate when price inflation slows down. Price inflation for a variety of reason actually
12:07
slowed down beginning in the mid 1990s and that was one rationale for low interest rates or one justification for the low interest rates that were applied at that time. Even while you had asset price bubbles building up for equity and for housing. Asset price movements can be highly irregular, and let me, I'll show you in a couple of--I'll show you some slides in a minute or I can show them right now. This picture is--shows indexes
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of the nominal and real S&P 500 stock market index by real, I mean, the nominal stock market index deflated by--in this case, the GDP deflator which is the most broad price index for goods and services. Notice that you get an asset price boom getting underway, where does it start? It really takes off some time in the late 1970s or early 1980s. You see that the equity price boom peaks around 2000, then there's a break downward which was associated
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with various things, for example, line 11 and then some recovery. But even so, the real S&P that is the solid line lies considerably below the peak that it reached in the year 2000. But in any case that was just asset price excursion that lasted--this equity price excursion that lasted for about 20 years. Here, you see the GDP deflator versus housing prices. Note that housing prices more or less tracked the GDP deflator up again through
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the early 1980s. A lot of things happened in New York's economy in the early 1980s that's–-I will come back and discuss. And then you start the housing price boom, it peaks in the mid 2000s and then they you get to crash. And, again, these was unprecedented but had been built in to all the models, so housing price bubble breaks in late 1990s, housing price bubble in the mid 2000s. Now the next theme that's important to bring in, which was in
14:34
fact not emphasized by Keynes, but fits naturally into a Keynesian framework, is it basically--if you start playing, start participating in the bubble, the standard pattern are the universal pattern, is economic as economic actors increased debt to buy assets in anticipation of capital gains. Now the way that people normally thinks about this is in terms of leverage, and I'll give you a formal definition of leverage in a minute. But, basically, running up liabilities
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to buy assets in anticipation of capital gains goes back very far into financial history. The most widely--the first widely publicized example was the Dutch so called Tulip Mania which occurred in the late--in the early 16--in the early to mid 1600s, around 1620 or so. Now the records are not all that complete, but basically people were borrowing on the margin to buy up Tulip bulbs which prices were rising and after a while that crashed.
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There were major crashes in France and England in the early 1700s. And, in fact, Isaac Newton got into the South Sea Bubble in England, got out, got back and again got--lost a considerable amount of money and said after that "I can predict the motion of the planets but I cannot predict the madness of crowds." And that thought has continued until to present day. Now there's also a concept liquidity that turns out to be pretty important in this context. Keynes
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thought of liquidity as money. Now, basically, liquidity is, or money rather it is a liability of the banking system and an asset of the people who happen to hold money. And really by social convention, money is "always accepted" as a store of value and the medium for transactions. That ceases to be true in hyperinflations and--but that's something that I don't want to talk about much today. Now, what happens after a crash of--after financial crash, of
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course, is that economic actors fall back on liquidity in the form of safe assets because they're really scared. And what happens after every financial breakdown and they happened fairly frequently is a flight to liquidity in the form of assets and that has various consequences which I'll take up in a minute. Now for traders, however, on Wall Street and other such places, liquidity took the form of debt which was a liability. And in effect,
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traders ran up debt to buy assets with rising prices and, as I say, this is a very old story. It was not very much discussed by Keynes but certainly by Keynes and subsequent Keynesian economist, for example, the people named Hyman Minsky and Charles Kindleberger who died, let's see, they died and they both died in the late '90s, early 2000s. I don't have exact dates in my head. Now, so the simplest possible balance sheet, let's say, looks like that,
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the--on your assets or basically you have some kind of assets which was some kind of price, P sub A, and that is the positive side of the balance sheet. The other side of the balance sheet is either debts or equity, where equity could be interpret--also be interpreted as net worth. Now leverage or the leverage ratio, if you like, is the value of assets over equity. Now it's easy to see that--suppose you get, say, 2% increase in the price of
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the asset or–-say you're at the hundred and the price of the asset goes up by two, so there's a 2% increased there. But if you hold debt constant for the moment, then equity has to rise by the same amount. But the percentage change in assets, therefore, is a lot lower than the percentage change in equity which means that when the asset price goes up, leverage goes down. Or when the asset price goes down, leverage goes up. Now the return to an asset
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is, if you think of shares, for example, and for the moment ignored dividends although there's still somewhat important than the US economy. But if you think of shares, the return to an asset is a growth rate of its price. I guess Google hasn't got around to paying dividends yet so the return to Google share is its capital gain and that's why people buy shares in anticipation of future capital gains. Now fluctuating growth of asset prices
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was built into nearly all valuation models from finance theory that were used by traders which I mentioned before. But that turns out to be a pretty important aspect of the prices. Now, as I mentioned, with stable debt, growth in the asset price means that leverage goes down which is a clear incentive to run up more debt to buy more assets, if you can get a hold of the borrowing power and that was also built into the financial system. On the
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other hand, the decrease in–-then the asset price means that leverage goes up, and pretty soon creditors close in. That happened quite clearly after 2007, happened quite clearly after the Stock Market crashed in 1929 and it happens with some frequency in other events. So then to try to restore their positions, traders start selling assets into a falling market and so drive prices down further, so you get deleveraging and a lot of people go
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underwater. Now notice that this ties back to Keynes' view of financial markets has been driven by conventions, because if you have a convention that asset prices are going to rise, that's fine, and but on the other hand, when that convention breaks, you can have extreme disorder and a highly--again, disorderly process of deleveraging. Moreover, I didn't happen to put it into the slide but I should, the 2007 and 2008 crisis was really characterized
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by the fact that people were using the same financial models applied to the same data to price out the same derivatives. So there was an enormous amount of homogeneity in the market, probably more than had occurred in previous situations. And with all that homogeneity, the situation got noticeably worst. So the convention that asset prices keep rising falls apart, flights of liquidity, and then the crisis was exacerbated because mortgages had
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been securitized into things called derivatives which is essentially a bond based on its component mortgages and then sold on to asset holders. And these derivatives credit CDOs–-I can't remember–-had been sold, you know, the mortgages had been packaged together, sold on asset holders in very complicated patterns. People were trying to evaluate the CDOs, collateralized debt obligations using these models since they were not heavily traded and the fact
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that they were all using the same models supplied to the same data and the data changed was a major contributing factor to the crisis. But there are financial crisis all the time, I mean, just look back at recent history. You have the events of 2007 and 2008. Before that, I can't remember all the events but you had Enron, you had the Asian crisis, you had the Mexican crisis. Crisis happen every five or 10 years, it was some regularity.
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Charlie Kindleberger, whom I mentioned before, wrote a fascinating book, although a bit trying to read called "Manias, Panics and Crashes" and he has this big table showing major crashes in capitalism since around 1800 and there's an entry in that table about every 10 years for the major crisis and there are a lot of minor ones as well. So they happened all the time. Now why this latest one propagates the real side of the economy? That's the key question.
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And, again, one can fall back on Keynes and his followers to try to construct some kind of a model. Now as I mentioned, Keynes postulated that output which I will call X is equal to income which I will call Y automatically. And he was willing to be flexible about how this happened and it sort of drove a lot of people crazy by so doing. But the output equals income identity is built in, as I mentioned, the GDP accounts. And, so it was in--and these
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accounts were invented by Keynes around 1940, and they're basically the input into almost all macroeconomic discussion these days. And so he's still hovering over us in that sense by setting up the accounts and then which, by which we all think. The simplest example if output is equal to investment plus consumption, and if income is equal to saving plus consumption, then investment has to be equal saving automatically and that's–-those are the basic identities
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so to speak. Now consumption depends on income which also means that saving has to depend on income. Then you just do the algebra and you'll see that investment is going to determine the level of output. And this is the principle of effective demand that is demand is driven by a certain injections. The other major injections would be exports and government purchases. And there are also leakages to savings in imports and taxes and the calculus of injections
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and leakages is what underlies the principle of effective demand which is all quite simple and straightforward. There is something called the paradox of thrift, if you think about that arises in this particular context that is if people try to save more then in effect they'll be consuming less and reducing excess demands so that everybody who are trying to save more is in fact self-defeating. This paradox of thrift is an example of something
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that's called the fallacy of composition which also enters rather strongly into Keynes in economics, so that's effective demand. Now let me say something about distribution and demand which begins to cut into the knob of the transmission of the financial crisis to the real side of the economy. In macroeconomics, the easiest metrics for income distribution are the shares of wages and profits and income and that's a terrible metric in many ways.
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But it's about the best that we can get our hands on for doing macro. You'd be much better if you could map the whole size distribution of income into some two or three simple categories and some people have tried to do that. But let me stick with wages and profits for the moment. Wage and profit shares and those shares have to add up to one subject to a number of assumptions which I could go into if you want to hear about it. Now suppose we start
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with labor productivity; and productivity is measured very crudely in all economics or in all macroeconomics as output over employment, or output per person hour, or some such measure. And economists like to babble about technological change and how it's going on in this sector or that sector. And when they do that they basically just talking about output over employment which is a pretty stupid measure but it's what--it's the one that we deal with. Now
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as it turns out, productivity tends to rise when output swings up at the end of a recession. So this diagram, the recessions in the US economy as monitored by something called the National Bureau of Economic Research are shaded in. And as you can see recessions don't last very long. The present one which I supposed ended in the last quarter of 2009 was actually a fairly lengthy recession in terms of output. Employment is a lot worst. It's a lagging
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indicator and that's one reason why employment is still–-unemployment is still so high. But if you look at output as the measure this is the kind of picture you get. As you can see productivity is tradition–-this is log deviation of productivity from trend. And as you can see productivity tends to swing up rather sharply after--as economy emerges from a recession. The general idea is that firms are unwilling to hire on more people
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until they're pretty sure that the output is seriously going to go up so that they keep their same labor force in the beginning of the upswing while output is rising and, therefore, productivity is conventionally measured, it tends to go up fairly rapidly and then as you can see it tends to drop off. Now, if you work through the algebra which is not terribly difficult, you can see that the wage share is equal to the real wage divided by
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productivity. And there are productivity in wage share versus output cycles. The wage share tends to fall, coming out of recession because labor doesn't have much bargaining power. The real wage doesn't go up while productivity is rising and therefore, the wage share tends to fall. After a while, labor gets itself into a better bargaining position and the real wage tends to rise. So that the falling wage share basically leads rising capacity
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utilization. And, again, economists were always borrowing models from everybody else in the world. This can be rationalized in terms of a simple predator-prey model from mathematical ecology. The wage share is the predator and capacity utilization is the prey. This idea, as I mentioned, was sort of formalized by Richard Goodwin, if you go read volume one of Capital, you can see a pretty clear statement in Marx. Now the interesting thing, if you
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look at the data, is that--so in this particular diagram you see that the wage share is the solid line, capacity utilization is the dotted line. The wage, if you look across cycles, the wage share tends to fall as capacity utilization tends to rise. Then the wage share builds up as the predator and the capacity utilization peaks and then you go into another cycle. Yes. >> How do you define capacity utilization?
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>> TAYLOR: The question is how do you define capacity utilization? And this is another economist slide offhand. You essentially fit the trends to output. See what's going up and down. We pretend to be serious but we're really aren't. Now, the other thing you see here is that the wage share fluctuations across the cycle take a big change after around 1980. That is the reductions are much deeper and the recoveries are weaker, then they were
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prior to about 1980. So there was a fairly significant change in behavior of the distribution versus demand cycle. Again, beginning 30 years ago and we'll see other example of that sort of pattern in a minute. The other side of the following--the side of falling wage share was arising. Profit rate, the dark line is the profit rate which is not that easy to estimate either, but notice that it begins to again rise sometime in the 1980s. And then
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let's see, the solid line is a real short term interest rate. The dash line is a real short term interest rate and the solid line is a real five year interest rate. And, basically, the story there is that in response to the decade of stagflation between 1970 and 1980, the Federal Reserve had a shock increase in the interest rates, they all jumped up in and then gradually tended downward with some fluctuations. Part of the reduction beginning
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in the late 1990s was due to inflation targeting that I mentioned that is a rate of inflation drop off and given their peculiar mindset the Central Bank, Alan Greenspan had no particular reason to try to increase interest rates. Now the low interest rates–-yes. >> Why [INDISTINCT]? >> TAYLOR: Let's start over. Shift it to the right, yes, they are. Okay. Just shift them back. Sorry. I'll have to take that up with
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my RA who does this kind of stuff much better than I do. Okay, now the interest rate reductions, there was a guy named--an Austrian economist named Hayek, Friedrich Von Hayek was actually pretty close social friend of Keynes although they disagreed about many things. And Hayek emphasized that low interest rates could feed into asset price bubble so that was one of one of his major ideas which is I would say was not something that Keynes thought about
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very much. But I think it's fair to say that low interest rates certainly were contributing factor to the bubbles but, I think financial deregulation was probably more important. And here you have an experiment if you like, in the sense that Canada have the same low interest rates as the US but did not relax regulation, and they avoided the worse aspects of the prices and that's about this close to an experiment that we're actually going
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to get in Macroeconomics. Now, as I mentioned, for any individual or collective economic actor, net borrowing is equal to expenditure minus income, which in most cases is equal to investment minus saving, which is in most cases equal to a demand injection minus the demand in leakages. At the same time, the sum of net borrowing flows across all actors must be zero, so that the accounting built into the national income and product accounts
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can be satisfied. Now if you take a look at the data. So what we did was put together data on net borrowing for US households, business government and net borrowing from the rest of the world which, of course, is as same as net lending to the United States. And, first, if you look at the first graph, first graph on the upper left you see that household net borrowing was in fact negative until around 1980 which means that households were basically
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lending to government and to business which is a fairly traditional pattern. Then if, again, around 1980, it's started to trend very rapidly upward with some fluctuations, and then, of course, with the onset of the crisis broke downward as households got wiped out basically and had to try to reconstruct their balance sheets. In the upper trend beginning around 1980, underlying the upper trend was a share--the share of consumption and income
37:30
rose by about 10 percentage points which is a lot and that is it when the share of total consumption income is at--if I remember the numbers correctly, it went from something like 80% to 90%. And most of that if you decompose it was due to rising healthcare cost which in that sense had a major impact on the system. The counterpart then that shows up in the lower right, and that's not very clear, I hope you can see it, was falling net borrowing
38:03
by the rest of the world or rising net lending to the US economy. Now people talk about twin deficits, and during the Reagan period there was a lot of discussion about how the, about how the federal deficit was driving the external deficit and all you had to do to get rid of the external deficit was to reduce the government deficit. The president of my university happened to be a senator at that time and he sort of talks about how--they told us all--all we
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had to do to reduce the external deficit was cut the budget deficit and we did then nothing happened, so that was, that shows you what economist advice is worth. The real twins in this data, at least, were the private household consumption deficit and the foreign deficit to a degree that pattern reversed after the crisis as I mentioned that household borrowing dropped off. And also net lending to the US declined if you turn the diagram into lower
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right upside down. Another observation that comes out in the data is that government net borrowing tends to be counter-cyclical that is during the recession tax collections go down; unemployment, insurance goes up, et cetera, et cetera, so that makes--forces government to borrow more. So the government in fact stabilizes the economy which is an old idea, which is about been around for a long time. This diagram shows, if you want to spend a
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few hours looking at it, it shows all the patterns superimposed, and I think I'll just skip over it. Now, so what you see then so far is a changed and distributed patterns beginning in 1980 and the change in net borrowing patterns at about that same time. Now, the next thing is a lead in to trying to make a bridge between the financial and real side--the next thing is to bring it a little bit of historical background. Going back really to
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the end of the First World War--by the way, Keynes first made his reputation by right, he was a delegate to the Versailles Conference for awhile and then went home and wrote a book called the "Economic Consequences of the Peace" which was a devastating critique of the reparations it had been imposed on Germany and that became an international bestseller and made him famous and he didn't look back after that. It's still worth reading these
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days particularly for the nasty comments about the leaders of the discussion at the Versailles negotiations. In any case, beginning around 1928, you had rising in an income and equality in the US and throughout the world. In the European sense of the word, there was a liberal period and that ended up in the Great Crash which is based on the run up of leverage particularly after around 1927 in the stock market in New York. 1929 to 1950, you get a whole series
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of event, The Great Depression, the New Deal which imposed very heavy financial regulation, World War II, and recovery. 1950 to 1970, in retrospect to sometimes called the Golden Age because it was really the best 20 to 25 years of economic performance worldwide both in the advance economies and in the rich countries and then the poor. It was characterized by the creation of the welfare state the Keynesian consensus and as I say fairly good economic
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performance. 1970 to 1980, you get stagflation, oil shocks, loss of post World War II US hegemony. 1980 to 2007, you get another liberal resurgence, heavy financial deregulation, emergence of finance theory and big changes in inequality over these periods that is the numbers here come from income tax data which has been compiled by a couple of guys--put together by a couple of guys up at Berkley. In 1929, if income includes realized capital gains, then in 1929,
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22 or 22.5% of income was in the hands of 1% of the households that fell to 9% in 1979, and was back up to 22.5% in 2006 which is, you know, a very major shift in terms of distribution and is reflected in the wage share and profit rate data that I presented earlier. Now, you then get various trends going together. We know that the trend decreased in the wage share that's the solid black line across cycles and it pretty clearly goes down. There was
43:45
a big increase in the consumption share of income which is the dotted line and that's what underlies the patterns of net borrowing that I was discussing above. And then you get a big increase in household real debt, which sort of it goes--begins to go down with the beginning of the recession. Again, these are major breaks that occur mostly after 1980, at the same time as liberal political economy resurgence got underway. And you got some
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pretty strong trends here and the only--one of the few things that you've known economics is that trends can't go on forever, something has to break. It's fairly clear that they broke around 2007 and 2008. Now the collateral for the debt, of course, was rising equity and housing prices. And household borrowing was eased by falling real interest rates. So you see the real medium term--let's see, what do I have here--we have real debt which
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is the dotted line that the one that's rising, the one that rises the highest, which was accompanied by real housing prices by rise in real housing prices. Note that there was over shooting which often happens in financial crisis that is the real housing prices broke down or before real debt began to break downward. So somehow people hang in there for a little while after the asset price booms--after the asset price booms stops. And, of course, this
45:54
was accompanied by steady decreases in the real rate of interest, again, trends which could not persist. Interestingly enough, households were rational in the sense that their debt in that worth ratio which is the dotted line stated fairly stable until, of course, the denominator net worth went down because asset prices went down. And household expenditures and net worth actually declined. So if you like households were being somewhat rational
46:28
behaving rationally, Ninja mortgages and all, perhaps thinking that household prices would tend to trend up forever but in fact, they did not. So those are factors that help contribute to the crisis. Finally, after World War II the US had a very strong external surplus of the trade in the rising surplus and interest in dividends from abroad or factor income. The trade surplus disappeared around 1980, and Japan, Germany, China, and OPEC essentially
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picked up the surplus position. So global economic flows became highly unbalanced and I have some tables here which illustrate that, but I think I'll skip over them since you probably can't read them anyway. If there's someone curious we can talk about them later on. So just to try to sum up, you get nine interacting sets of events. One, being the major shift in political economy after 1980; the second is that the real interest rate
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in wage share trended downward after 1980 across business cycles, the profit rate in household borrowing trended up; these trends cannot continue forever. The ratio of household debt income doubled which, again, is a really major change. There was an equity price boom for the early '80s to the late '90s. Thereafter returns to equity where flat or negative. The housing price boomed, peaked around 2006. Asset price bubbles allowed households to
48:15
maintain consumption even with rising in equality that is the way that most people essentially paid to keep their level of spending up was to borrow. And again, the borrowing was made possible by the asset price increases. The twin to the rising household borrowing was foreign trade surpluses, and you can see that clearly in the data although I tipped all over it. Falling real interest rates probably supported the bubbles, but light touch regulation
48:48
was probably more important and again the US versus Canada comparison is quite interesting. And the light tech--light touch regulation was again rationalized by the emergence of high tech finance theory. Keynesian Macroeconomics is part of the liberal resurgence had been supplanted by Say's Law in the eyes of the profession and so people just didn't really think anymore about professional economist particularly, so to speak, up the road little
49:24
base, if that's up the road and the other major universities simply forgot everything the Keynesians had to say and that was more or less a conscious process. I could go into history but that that would be another whole lecture and so I'll spare you. Now the factors that I mentioned seven through nine, essentially, the ones on the finance side supported the "Mania, Panic and Crash" and, again, this is nothing new in historical terms, we get
49:54
a crash every few years. Why it propagated to the real side of the economy, it had to do, I think mainly it was shifts in household behavior aided by the asset price bubbles. When the crisis hits, aggregate demand collapsed, household net borrowing collapsed. Since output is determined by demand, you got a major recession and evidently Say's Law was not enforced. Global trade and financial flows have adjusted to an extent to be consistent with the crisis
50:31
in the US, they basically had to because accounting across the world has to add up and the changing political economy environment made the whole thing possible. Now, I don't think Keynes or anyone else could have foreseen all the complexities of the crisis that would emerge, but I would argue that the only way you can really think about the crisis, historically, and economic really is a historical science. We can try to unravel things after they occur
51:04
and maybe say a little bit about what's going to happen in the future, but not very much. And the framework, intellectual framework provided by Keynes, I think, is the only one that allows us to try to figure it out in the consistent body of theory. And that, of course, is the source of his revenge after being forgotten for all of these many years, he turns out to have been correct in much of what he said, not all and other people
51:33
said things as I've emphasized which what goes into the story. But they were all Keynesians, and I think in that sense, Keynes is innocent, Keynes has been vindicated. Well, that's all I have to say. Questions? Are you convinced? Yes. Do you want to use the mic or--oh, it's too much work. >> [INDISTINCT] the things like, what is the next [INDISTINCT] me to happen in all the [INDISTINCT] like what is [INDISTINCT]?
52:31
>> TAYLOR: Okay, the question is, what is the next good thing and the next bad thing that might happen? Let me, I'll try--I can try to answer, but let me just preface the answer by saying that Donald Rumsfeld was a Keynesian... >> Okay. >> TAYLOR: ...in the sense that, you know, he talked about the no knowns and the unknown knowns; the know and the unknowns; and the unknown unknowns which is very close to fundamental uncertainty and there's really a lot we don't
52:59
know particularly right now because the unknown unknowns, the things we can't conceive of or likely to determine the outcome. Now that being said, the positive development, so to speak, would be, if I can get back to the net borrowing picture which is always back. Notice that how household net borrowing breaks downward with the onset of the crisis and in fact, it's getting down towards the levels of, it's not there yet, but it's towards the
53:35
levels of--that were prior to 1980. So if households managed to swing themselves back, and they may or may not, but if they managed to swing themselves into a position of actually being negative net borrowers or net lenders to the rest of the economy that could provide a mechanism to bring the extra note account back into balance. If the government, which the government eventually will have to do, also manages to get its physical situation
54:04
back in balance, so the positive outcome could arise from essentially rebalancing the US economy internally. Now that will have to be accompanied by rebalancing of the global economy externally and if you like a major negative, a major bad possibility is that it's not going to happen that is that, Germany and China, in particular, as the major exporters will not find it feasible or convenient to swing their economies in the direction of
54:40
generating more internal demand and in that sense bringing the world back into balance. So, I mean, most of the discussion these days centers around the international situation that you pick up any newspaper in the US any day and somebody is going to be berating China for its exchange rate policy. But, I think, if the US is still has enough hegemonic power to affect the world if, in fact, to get its internal situation in order that, I guess,
55:09
that would be the answer. Yes. >> Hi, there. And so, I guess my question was related to the mooring of households which should start up to answer. I was wondering if there's a waiting like sort of soft lend [INDISTINCT] trend. And I am wondering what's the relation of the households' debt so to speak to the assets they're holding, you know, like 401(k)s and, you know, like other types of investments which are not counted I guess
55:38
today as savings. I mean as typical savings like, you know, like a money market account in the bank or something like that? >> TAYLOR: Well, I mean your contribution to 401(k) certainly is saving that in national accounts terms. The US, the ratio of US debt and net worth--I could probably, no. I can't pull it out here. Maybe I can. Is that the diagram here? US debt to net worth is the dash line on the left scale and as you can
56:22
see it as a number it's not all that high because the US prior--the US household sector actually has a lot of net worth in the form roughly off the top of my head--roughly 30%, 40% in terms of housing and the rest in terms of financial assets. So in that sense, households are not highly leveraged but on the other hand leverage went up quite strongly with the fall in asset prices beginning in--beginning with the stock market and then with the housing
57:03
bubble. Now, the decline in net borrowing or negative net borrowing means that households would gradually be building up their net worth's. But the real cause of the swings in net worth is the asset price bubbles, and it takes a lot of net borrowing to offset the fall of an asset price, I guess. So I expect that households will be in bad budgetary situation for quite a while which in a way is not a bad thing. I mean, the US really should be saving a lot more than it is. >> Thank you.
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>> So, a few slides ago you asserted that Say's Law had been determined to hold. >> TAYLOR: Has been determined or not determined? >> Well, you said that it'd been not determined in your post mortem analysis. >> TAYLOR: Yeah. >> But in your causal factors you listed that as one of them. >> TAYLOR: Yeah. >> I was kind of--I don't understand where you say that Say's Law was determined to hold or to be thought to upheld?
58:16
>> TAYLOR: Well, I mean--well, a short answer I guess comes from Candide that is "Economist like to believe that we're living in the best of all possible worlds." And most of the trust of conventional macroeconomics essentially says that the economy is going to tend toward a "efficient position" where all resources are utilized definitely in that kind of thing. And, evidently, you can't have a lot of unemployment of all resources being used optimally. So,
58:54
economists are really brainwashed into thinking these kinds of thing in their graduate education. You should ask your chief economist to give you a lecture about why that's not true? Yeah. >> Hey. So it seems to me that one of the major confusions about Keynesian economics is that once one accepts that premise that one is to intervene in the economy, then naturally the next question is just how much intervention is the right amount? So without getting too
59:29
much into policy prescriptions, it seems--depending on how you measure it the balance sheet of the Fed has been increased by somewhat 33% or so. >> TAYLOR: More than that. >> Let's try to be conservative. So let's say we buy into the notion that all the right things are being done then what can we expect? China maybe growing at like 9% or so annually, so let's say something on that order of magnitude still results in an excess in the monetary base on the order 25% year over year. What
1:00:06
is your comment on that? Is that too much? Is that healthy? What made of that number? >> TAYLOR: Well, let me answer in the following way. I think, basically, if you want to avoid a major recession or avoid a depression given the reduction in investment and the increase in saving that followed the financial crisis, basically, the only way you can maintain aggregate demand at some level is between--is by using some combination of fiscal expansion which
1:00:55
the Obama package did. I would argue it wasn't too small living when they did what they did. And monetary expansion, that's aggregate demand. At the same time, if you like Wall Street manage to shoot itself in the foot so dramatically that the--basically, the financial system was in grave peril of collapsing. And the only way that you can avoid that is by throwing a lot of money at Wall Street, which they did very enthusiastically. The expansion of
1:01:28
the Fed balance sheets which before the crisis was running, what, on the order of 600 billion or something like that and it's now something like to a trillion. That was a consequence of expansionary, monetary policy to try to bail out Wall Street. Sooner or later, they're going to have to mop that up, and there are various ways that one can--various technical ways that one can think about doing that which they're beginning to dabble with at the moment.
1:01:59
But, I mean, the Fed ultimately is going to have to shrink its balance sheet and that's also going to--but that would create problems with the availability of credits of the real economy. So it is whole can of work, and I think if those interventions have not happened, we would now be in a depression. There's no question in my mind about that. And then the real issue was how to gradually unwind the interventions, get the fiscal deficit down
1:02:32
to, say, I could go back, I can't remember the exact number. We'd go back to look at it, you know, shrink the physical deficit by something like 6% of GDP, and hope the household borrowing stays negative, so lending is positive and there is some possibility of a soft lending, but I wouldn't count on. Is that the...? >> So it seems that you're saying what has been done was the least of all evils, but my question still is, so let's take this pair of numbers you go from 600 billion to 2 trillion
1:03:10
over more than a year, but whatever, how do you know where to stop? I mean, if that's been such a good thing in the sense that it's been the least of all evils, why not continues doing it? >> TAYLOR: Well, it hasn't erased all evils. I mean, I'm not going to defend Goldman Sachs, for example, and the Goldman Sachs and Citibank, for god sake, were--and the other banks were major beneficiaries of these intervention.
1:03:36
They're so interconnected with the rest of the economy that had the monetary intervention not happened, then we would be in the real mess. If you look, by the way, at when--look at experience in developing economies who specialize in this kind of event, when their banking systems falls apart, you find that to rebuild the banking system takes a pretty significant chunk of GDP like 20%. And the US is getting up in that range, we're in the
1:04:09
same ballpark. As I said, I don't think we have any choice but to do it but that doesn't mean that's a happy process and stopping were we have stopped, if we are indeed stopping as I guess is probably a good thing. >> Thanks. >> So I pulled on my investments into cash back in 2004. >> TAYLOR: I don't give financial advice, although I did more or less the same thing. >> Yes. Well, that was back in 2004 but it took four years for the crash to occur and
1:04:42
I was this close to doing something very bad investing into the stock market. So, for the current sucker rally, any idea how long it will take before it crashes? >> TAYLOR: I think I'll pass. Regrettably, I honestly, don't know. Well, thank you very much.
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