Financial Acceleration and the Paradox of Flexibility

Macroeconomic models are rigorous, but simple. While their simplicity may lend easier interpretation to otherwise opaque economic phenomena, they often fail to capture key microfoundational realities of the economy which render it different from what the models would ascertain. And for some time, one of the features most crucially lacking from these models was any incorporation of the real-world frictions posed by financial intermediation.

Toward this end, a “financial accelerator” mechanism was adapted into the canon of modern macroeconomics, most notably by economists Ben Bernanke, Mark Gertler, and Simon Gilchrist in 1996. The financial accelerator is meant to make sense out of the recurrent observation that relatively large shocks to the economy seem to originate from proportionally smaller perturbations in the financial markets—hence the need for some sort of acceleration process which magnifies financial fluctuations into broader macroeconomic volatility.

The proposed financial accelerator model works like this: First, there is a change in asset values. This change affects borrowers’ cost of external finance, because in a world of asymmetric information, lenders are risking their money to default if loans are not fully collateralized, so a risk premium must be charged to the extent that collateral is not available. So when there is a decline in the value of assets available for collateral, it raises the cost of external financing, which depresses spending in the economy, which imparts further decline in asset values, and so on in an adverse spiral.

This concept, although not formalized until fairly recently, was not entirely unfathomed by earlier thinkers. In 1933, economist Irving Fisher articulated the related concept of “debt deflation” in order to explain the severity of the Great Depression. His idea was that in a state of over-indebtedness, distress selling leads to falling asset prices, which up against nominally-fixed debt obligations will cause declining net worth, leading to a contraction of spending as borrowing is constrained and saving is attempted to repair balance sheets, and profits fall given that price deflation presses against debt service costs, resulting in a precipitous decline in output in a vicious cycle that only makes itself worse until enough debtors default that the economy can start to recover.

To be clear, the argument is not that any increased (decreased) propensity to save (borrow) is inherently recessionary or prone to trigger such a spiral. Interest rates are the key price mechanism that can adjust up or down to equilibrate saving and borrowing; it is when interest rates are not allowed to fall enough, or they are at the zero lower bound (ZLB) and can go no lower, that an indebted, deflationary spiral can produce a recession in output. And it is this ZLB—or otherwise binding floor on interest rates—situation which has inspired a more recent assertion about the nature of aggregate demand in such a predicament.

Recall that in a New Keynesian economic framework, the aggregate demand (AD) curve represents the quantity of real output demanded at each price level. Likewise, the aggregate supply (AS) curve represents the quantity of real output supplied at each price level.


Unlike micro-level demand curves, which slope downward mainly due to micro-level substitution effects (but also income effects), the AD curve is conventionally downward sloping for three reasons: (1) the real balances effect, which is the wealth effect in cash—i.e. people spend more when they have more, as well as the inverse, and the price level determines the real value of this cash; (2) the interest rate effect, which is that a higher price level reduces the real value of savings, which raises interest rates and depresses spending (less borrowing, more saving), or the inverse; (3) the exchange rate effect, which is how a higher price level makes domestic goods more expensive and foreign goods cheaper, thus reducing exports and raising imports to decrease GDP (or the inverse).

In reality, it is the second effect—the interest rate effect—which is the most quantitatively significant for an economy like the US. And it is when interest rates get stuck at zero that New Keynesian economists Paul Krugman and Gauti Eggertsson argue that the AD curve becomes upward sloping due to the practical inability of nominal interest rates to be lowered when they are at zero, and the increasing burden of nominally-fixed debt as price deflation ensues. This is most likely the case, Krugman argues, given that the real balances effect on spending (from increased value of cash via deflation) is not very big compared to the effect of real interest rates from deflation at the ZLB.


Note that this upward sloping AD curve would not apply when recovery inflation is expected to compensate for the below-trend deflation, for that would have the effect of lowering expected real interest rates. But when lower inflation or deflation manifests as a permanent reduction in the price level, interest rates cannot go low enough to circumvent the debt deflation problem. Since the high real interest rates (i.e. lower prices in the future) encourage creditors to save the payments they receive, a spiral of self-fulfilling deflationary hoarding is the result, leading to a deep and prolonged recessionary slump.

This is the thrust of Krugman and Eggertsson’s 2010 paper titled “Debt, Deleveraging, and the Liquidity Trap.” The putatively backward-bending AD curve in the floor-bound interest rate environment leads to some counterintuitive conclusions about supply-side phenomena. This includes the “paradox of flexibility,” which suggests that removing downward nominal rigidity would actually make the recession worse because it would raise real interest rates and the real value of debt. (You thought Keynesians were all about sticky wages? Not so fast!) It also includes the “paradox of toil,” which suggests that an increased propensity to work (represented by an outward shift of AS) would actually lead to less employment for basically the same reason.

Broadly interpreted, the unconventional, upward sloping AD curve implies that positive supply shocks reduce output and negative supply shocks raise output. Both of these paradoxes are supplements to the already well-known “paradox of thrift,” which suggests that attempts to save in a ZLB environment (or alternatively, a “liquidity trap“) depress income and actually lead to less saving in the aggregate.

Krugman and Eggertsson’s model has led them to suggest that wage cuts, oil shocks, and the like may not have the effect that they are usually believed to have in liquidity trap conditions. This is a modern formulation—one that Keynes did not apparently believe when he insisted that FDR’s fixing of prices and wages under NIRA “probably impedes Recovery.” (However, Keynes had also argued that aggregate wage cuts would not help.) The backward AD curve would imply that adverse restrictions on supply—downward nominal wage rigidity, higher commodity prices, etc.—are abnormally promotional of output under these special economic circumstances.

So, are Krugman and Eggertsson right? Is aggregate demand upward sloping under debt deflation and floor-bound interest rates, with all its implications for the supply side? I am doubtful. This may be one of those cases, as in the 1970s with inflation expectations, in which a Keynesian model comes up short for an inadequate account of microfoundations. Several factors come to mind that contravene their conclusion:

1) Wage cuts could serve as an alternative to unemployment. Obviously this could do more to preserve output on the micro level, but on the macro level? Assuming firms’ labor demand schedules are sufficiently elastic, it could also help preserve output on the macro level insofar as it improves total labor income through less unemployment, which would promote consumer spending.

2) Debt is burdensome in proportion to income, not prices. And if wage flexibility promotes income, it would effectively ease the aggregate debt burden. Sure, there may be fewer defaults to discharge debt with shared cuts instead of acute unemployment, but to the extent that households are risk-averse, they would feel less pressure to deleverage, and lenders would have less need to assign a higher risk premium associated with potential default if wage cuts mitigate unemployment.

(In addition to high oil prices and interest rates, an unemployment shock could help explain that “Minsky moment” which effectively lowered the ceiling on acceptable leverage.)

3) Krugman and Eggertsson do not effectively model investment or its returns. Wage flexibility could raise the marginal efficiency of capital, to the extent that a higher payroll keeps capital producing output, and wage flexibility improves employers’ (~capital owners’) profit margins on output. Because asset prices are derived from discounted returns to capital, this could mitigate asset price deflation and actually dampen the financial accelerator mechanism.

Of course, it’s possible that the effect of higher real interest rates from deflation amidst debt overhang could be greater than the effects I suggest. It could be the case that firm-level labor demand is not elastic enough in partial equilibrium, that household balance sheet behavior is not that risk-averse, that profit margins are not much improved by flexibility, and higher real interest rates are the bigger factor. But the a priori reasoning here only suggests ambiguity, and the positive economic reality can only be ascertained through empirical evidence. We do not know that AD is upward sloping just because interest rates are stuck, real balance effects are small, and debt burdens abound.

What would answer the question is evidence on the impact of supply-side phenomena during periods when interest rates are floor-bound (i.e. supply shocks in a liquidity trap). To that end, here is the historical data showing inverted real wages and output during the Great Depression:


As Scott Sumner explains, a huge part of the variation in output during the Great Depression is explained by real wages. When wages were hiked, economic growth stalled—especially in 1937-38 after the Wagner Act had granted significant power for unions to coerce wage hikes. Assuming the Great Depression qualifies as having liquidity trap conditions that could alter the slope of AD (which some may dispute, but Krugman would think so), this is powerful evidence against the view that negative supply shocks are expansionary, and so maybe AD does not readily become upward sloping after all.

So until Krugman, Eggertsson, or anyone can provide a survey of historical evidence to suggest that their upward sloping AD model comes true in practice, it should be safe to assume it does not. And in the meantime, positive supply shocks and wage/price flexibility should be welcomed. It’s true that downward rigidity is, to a great extent, an inexorable reality of the market; moreover, price stickiness in moderation may have some secular benefits. Notwithstanding that, price flexibility is a lubricant necessary to make markets function well, and public policy should not adversely encourage more rigidity through suboptimal safety net and minimum wage policies, and the like.

But one thing is made clearer by this framework: While debt deflation may not invert the AD curve, it plausibly steepens it, and thus flexibility in wages is somewhat less helpful than it otherwise would be. (It follows from Bayesian reasoning.) This raises the relative importance of having a demand-side price level reversion rule in monetary policy. I prefer nominal GDP level targeting, for the way it responds to supply shocks compared to pure price level targeting. (Unlike Krugman, I think it’s ultimately about income rather than inflation, as this post should have made clear.)

Indeed, nominal reversion after a recessionary shock may be the single most important reform that could prevent severe demand-side recessions from ever taking place again. Regardless, we should still seek to enable more flexibility in these situations, because history suggests it would serve to attenuate economic shocks in the most unparadoxical way.

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