Q&A on the Financial Cycle

Question: eloquentwhimsy asked you:

What do you make of Claudio Borio’s new working paper (“The financial cycle and macroeconomics: What have we learnt?”), in particular the idea of needing to model money as an active rather than “frictional” factor and the importance of debt and credit cycles (which is similar to Hyman Minsky’s work)? In particular, the idea that private sector debt-reduction should be the most important part of any solution to the recession has long struck me as the ultimate reason to see policies like yours (Federal Lines of Credit) as the future of Government stimulus which ultimately should seek to empower households and firms to pay down their debts. There are two primary benefits to this: cutting out the middleman of stimulus projects and eliminating “multiplier” estia.

Answer: It took me a long time to think through this one. I found Claudio Borio’s paper very interesting. Here are some thoughts:

  1. A great deal of our current trouble is due to the zero lower bound on nominal interest rates. I think electronic money is the most straightforward way to get more aggregate demand and allow us to return to the natural level of output. 
  2. I am intrigued by your argument that Federal Lines of Credit, as described in my post “Getting the Biggest Bang for the Buck in Fiscal Policy” and in my short-run fiscal policy sub-blog http://blog.supplysideliberal.com/tagged/shortrunfiscal might also be helpful in balancing the economy in our current situation, even if we did have electronic money. Certainly, in the absence of electronic money, Federal Lines of Credit would help immensely, both to create additional aggregate demand and to reduce the most troublesome components of household debt. I have always thought that an important benefit of Federal Lines of Credit would be making households feel more secure so that they would spend more, even if a household does not actually need to draw on its Federal Line of Credit at all.   
  3. Claudio emphasizes the effects that the financial cycle has on the natural level of output. It occurred to me that my belief in a relatively high intertemporal elasticity of labor supply (see “What is a Supply-Side Liberal?”) indicates that the natural level of output might fluctuate quite a bit in response to financial phenomena. I am imagining, for example, a model that combines the irrational expectations of noise-trader models with the kind of machinery in models of “news shocks” such as Robert Barsky’s and Eric Sims’s “News Shocks and Business Cycles.”
  4. In relation to point 3, it is worth noting that, believing as I do that the elasticity of intertemporal substitution for consumption is below 1 and that income and substitution effects for labor supply are of roughly the same size, permanently higher rate of return expectations should lower labor supply, not raise it. To have the increase in labor supply necessary to have an irrational financial boom raise the natural level of output, either or both (a) the increased rate of return needs to be perceived as temporary–which is very interesting in this context–or (b) the increased risk could cause precautionary saving in the form of increased labor supply as well as reduced consumption.
  5. The bottom line I would emphasize is that research on financial dynamic stochastic general equilibrium models–including those that have irrational elements–needs to be brought together with research on business cycle dynamic stochastic general equilibrium models. As a step in that direction, a greater fraction of financial dynamic stochastic general equilibrium models should include elastic labor supply.