Economic Outlook: An Analysis of Two Shocks

There are two shocks supposedly hitting the non-financial sector (which is most of our economy) as a result of the banking crisis. One of them is an adverse saver-investor intermediation shock. That is, the return to saving is low even while the cost of borrowing is high. The second shock is one of "confidence" (and also recognition that the stock market has crashed) -- an adverse wealth effect on consumption and leisure. These two shocks have exactly the opposite effects, which is why I am much less confident than the rest of America that GDP will fall as a result of the last month's events.

Intermediation Shock

I have argued that the intermediation shock is not that large, and at worst short-lived, because the entry motive pushes toward reducing that shock. Nevertheless, I will analyze it as if it were quantitatively important. By itself, this shock INCREASES consumption, because the alternative (saving) does not look as attractive. It decreases investment and raises the marginal product of capital because the cost of capital is temporarily high.

Capital is fixed in the short run, so any effect on GDP has to come from labor supply or productivity. Labor supply should fall due to an intertemporal substitution effect (i.e., working hard is one way to save, but now is, according to the theory, not a good time to save). This effect may not be large, because there are other intertemporal substitution effects to worry about (e.g., Obama's winning the election and eventually hiking tax rates). Productivity will be down somewhat, only because the banking sector is terribly unproductive and the banking sector is part of the aggregate. So the intermediation effect will reduce output in the short term, but increase output post-crisis above what it would have been absent the crisis.

Wealth Effect

Owners of equities are undoubtably poorer now than they were a year ago. Even persons who do not own equities may fear an eventual reduction in their labor income. This INCREASES labor supply, DECREASES consumption, and increases investment (with an ambiguous effect on the marginal product of capital). For example, baby boomers may delay their retirement because their 401k values no longer afford them as comfortable a retirement. This increases output now, and post-crisis compared to what it had been absent the crisis.

You may have read in the newspaper that consumption is 2/3 of GDP, so that a reduction in consumer confidence reduces GDP by reducing consumption. But, not surprisingly, that analysis ignores supply (that's why I call this blog "Supply and Demand (IN THAT ORDER)"). Baby-boomers are productive, knowledgeable people. If they stay in the workforce rather than retiring, that will result in more output, not less.

Combined Effect

These two shocks have exactly the opposite effects. The intermediation shock favors current activity (consumption and leisure) over the future. The confidence shock does the opposite. The lesson here: this is yet another reason why the intermediation shock's effect will be muted. I have already explained why I don't think the intermediation shock is very big. But even if it were, it has the wealth effects pushing in the opposite direction. These are two reasons why I am much less confident than the rest of America that GDP will fall as a result of the last month's events. [but note that the effect on efficiency and welfare is clear: the economy is less efficient and people are worse off -- ie, they'd rather live in a world without these shocks. But that doesn't mean less GDP]