Saturday, March 12, 2016

The Durable Goods Model and Debt

You probably have never heard of the Durable Goods Model of economic activity. That is because it is a new model proposed by Nick Rowe (without a formal name).

Introduction

The concept underlying the model is very simple: What happens if all the goods produced have some durability? What happens if some goods only have durability of days (such as a haircut) and others (such as a concrete sidewalk) have a durability of many years?

In his post, Nick's focus is on the math and he is seeking help. Reader Keshav offered a solution. Reader Roger Sparks (me) offered improvements in his initial base equality formulation. As I write, comment seems to have ended with the basic concept largely unexplored.

This post is an attempt to explore one of the nuances of a Durable Goods Model.  Nick points out that Keynesian models treat the economy using goods that are instantly consumed. If goods are  not instantly consumed, the dynamics of the model are changed in several ways, often subtle ways. The focus here will be on the effect of debt.

Debt in the Durable Goods Model

Debt in Keynesian models is treated as a simple monetary exchange. In other words, debt may-as-well-be money. Debt cannot be simply money in the Durable Goods Model. An illustration (Figure 1.) helps in understanding why not.


Figure 1. The remaining value of many items constructed in one period. A single sidewalk bought with debt demonstrates the subtlety of correct accounting in the Durable Goods Model.
Debt is a commitment to perform in a specified fashion in the future. In the Durable Goods Model, this is an important detail to remember when we measure economic activity such as GDP. GDP is a measure of economic activity within one period. As a result of measuring year-by-year, the entire activity initiated by a single durable event is captured by GDP over several years. In Figure 1, this is demonstrated with the construction of a concrete sidewalk. Built with debt, this project will show in the period of construction indirectly by counting the secondary effects of reusing the money borrowed (while the cost of the sidewalk may not be counted directly, the money used would be counted when re-spent). The sidewalk will be counted again in GDP when the owner of the sidewalk debt is repaid (because the borrower must have activity countable-by-GDP to earn the payment). The overall GDP effect in the Durable Goods Model is to count the economic activity initiated by the single debt event two times.

This double counting occurs unrecognized in standard Keynesian models as described by Nick. The Keynesian equality described by Nick only includes economic events in one time period. Unlike the Durable Goods Model, there is no carryover between measurement periods that would carry information about debt commitments. 

An intersection with macro-economics and politics

Economics is often accused as becoming politics in disguise. What does the Durable Goods Model reveal about social behavior that might affect a political view?

We can use the construction of a sidewalk as a social example. The future owner of a sidewalk may construct it himself. This would be viewed economically as a single transaction, to be recorded as an increment to GDP. This would be no different from purchasing a steak dinner or buying a pair of shoes. Two sectors have come together to make an exchange valued in money. Both sectors have performed an economic activity that ultimately resulted in the existence of a sidewalk, steak dinner, or pair of shoes.

Now consider the case of a sidewalk that was constructed using debt. The sidewalk would be built by a builder, not by the sidewalk owner. The builder would have a lien on the property for work performed, He would trade his ownership of the lien  for a promise by the property owner to repay the value of the loan, usually with interest. The builder and all of his suppliers would report this GDP countable activity the same way as if the sidewalk owner was the actual builder. 

Up to this point in the debt based analysis, there is no difference in the activity of sidewalk construction and GDP-reporting between debt and cash. The difference lays in the future. From the macro-economic view of society, the builder has improved the well being of society with the construction a sidewalk. The builder has spent his time and resources to improve the well-being of someone other than himself. He has done this in exchange for a promise to repay this generosity, presumably by performing future well-being activity for  others. This sets up the predestination of expected future economic activity.

The "predestination of expected future economic activity" can viewed as a promise by the borrower to generate (in the future) an amount of economic activity equal to the amount of money borrowed. If interest on the borrowing is promised, the future economic activity is promised to be greater than the amount borrowed. This promise could be the logical basis for using the interest rate on borrowed money as an indicator of future economic growth.

The "predestination of expected future economic activity" can be short-circuited by hints of refusal of future debt repayment. The promise of inflation (as a method of avoiding debt repayment) can have the same short-circuiting effect.

From the point-of-view of macro-economics and the broader society, the removal or decline in predestined economic commitment will have a discouraging effect on the enthusiasm of builders who build for the longer term. The removal will have little effect on those who focus their decisions on the near term with little view towards long term effects. This shift in focus from long term to short term may explain the observed mediocre effectiveness of central bank's monetary stimulation.

Conclusion

The Nick Rowe' Durable Goods Model is an attempt to model the observable fact that much of one year's production has economic impact on future years. The effects can be subtle, the mathematics more difficult, and a complete model is not yet described. The concept seems to have the potential of rich reward in terms of understanding economic systems.


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