Looking for AD in all the wrong places
By Scott Sumner
Here’s a typical story about the economy, this one from the Washington Post:
When oil prices began to dive in October, analysts and investors spoke of an economy poised for a higher gear: Cheaper prices at the pump amounted to a massive tax cut for the middle class that would stimulate discretionary spending and create more jobs.
But that hasn’t happened. Personal spending was up a tepid 1.8 percent in the first quarter, well off the pace from last year. Meanwhile, Americans are dumping more money into their savings accounts. If their habits between January and March keep up, consumers this year will save an extra $800, according to government data.
The change in behavior appears to be at least partly psychological. The recession coincided with a wave of busted home loans, premature retirements, long unemployment lines and depleted retirement savings. Americans have since worked to rebuild their financial security. Millennials, according to researchers, are perhaps the most surprising conservative spenders, shaped by recent years in which they incurred student debt, fought for jobs and were forced to take lower-paying positions.
“Now, more are getting jobs, more moving out of their parents’ home,” said Warren Solochek, vice president of client development at NPD Group, a market research company. “But that group is much more cautious because they’ve lived through this crappy time.”
According to Bankrate.com, a financial services company, only one in seven Americans have spent their gasoline savings on discretionary items such as travel and dining out. Separate government data showed that spending is flat on electronics, groceries and furniture.
For Richard Knipp, 57, a member of Teamsters Local Union No. 142 in Gary, Ind., cheaper gasoline prices have allowed him to maintain his daily spending while also contributing 3 percent more to his retirement fund. He recently began doling out $200 monthly to each of his three grandchildren for their long-term savings accounts.
“I opened those accounts even before the recession,” Knipp said, “but some years I didn’t put in anything. Now I’m putting in more.”
Economists are uncertain how long the new prudence will last and say the question marks a major fork in the road for U.S. growth.
Historically, spikes in the savings rate have proven temporary, Jason Furman, chairman of the White House Council of Economic Advisers, said in a statement Friday. If the savings rate snaps back to its previous level for the rest of 2015, consumption will grow at a brisk 4 percent rate — enough to drive faster economic growth.
For the well-educated readers of the WaPo, this all sounds sensible. They took basic macro in college, with the Keynesian cross model. Savings is a “leakage” that reduces growth. Unfortunately this sort of speculation about future growth is about as fruitful as reading tea leaves or tracing the lines in someone’s hand.
The truth is much simpler. Both the Fed and private forecasters expect NGDP to be about 2% higher 6 months from now, give or take a few tenths of a percent. The Fed wants NGDP at that level; otherwise they would not be telling us that they expect to raise interest rates later this year. And since current AD is strongly influenced by expected future AD, it’s reasonable to assume that the current level of spending is also about where the Fed wants it.
By indicating that they will raise rates later in the year, the Fed has been modestly tightening policy, as compared to an alternative path where they promised to hold rates at zero until the economy was stronger. These statements have affected current AD in all sorts of ways, but the easiest mechanism to visualize is that the dollar is a bit stronger than if the Fed had promised a lower interest rate path.
Back when interest rates were above zero, Paul Krugman used to say that the unemployment rate can be modeled quite simply; in the short run it’s roughly where Alan Greenspan wants it to be. Even I wouldn’t go quite that far; unemployment is a real variable. But we are now back in a world where there is no doubt that the Fed is steering NGDP. Unfortunately most people never got the message, not even in the 1990s when elite economists like Paul Krugman told us that this was how the world worked. Most people rely on the outdated macro they learned in college, and common sense, which are equally useless.
So let’s not hear any more talk about savings leakages or the paradox of thrift. Unlike Paul Krugman, I don’t think we ever left the world where the Fed drives AD. But even if I’m wrong about the past 6 years, we are certainly back in that world today.
Pick almost any economic issue; inflation, recession, trade deficits, minimum wages, tax incidence, interest rates, exchange rates, etc., etc. The news media discussion of the issue usually bears about as much resemblance to cutting edge economic theory as an alchemy book does to modern chemistry.