What is a Steady State?

An attempt to push a metaphor for macro models way too far....

When students first encounter the idea of a steady state in macroeconomic models, it looks pretty mystical. After many pages discussing the expectations of some variables at some time based on information available at some other time, with one stroke, all the time subscripts disappear. Who said you could do that?

The book/paper/professor says something about long run outcomes, then moves on to talk about the relationship between steady states or, even more mystically, specifies a linearized model where variables fluctuate around those steady states.

Many of the mistakes in macro come from confusion about short- vs. long-run analysis, so its important to understand steady states. The implications of the MMT policy of full monetary finance of fiscal deficits is a prominent example.

Let’s pump our intuition™ by imagining the economy as a group of people traveling down a very long valley. They’ll eventually get to the ocean when good things happen, but they have little idea how long it will take. The valley is often wide with a slow moving river going down the middle, but there are occasional waterfalls, rapids, dense jungle and all matter of obstacles in and out of the water.

Our band of merry travelers can use boats or carts or beasts of burden on their journey. Let’s keep technology constrained. Taking a jet to the ocean would ruin the story.

Their leader is a fellow named Benrone Yellspan who has guided the construction of canoes for travel down the river. They have just enough maneuverability to avoid most rocks, but occasionally the rapids are too much, and they have to carry the canoes overland. The famous ZLB falls is a prominent example.

Naturally, there are some folks in the back grumbling that Bennie is doing it all wrong, and we should go with Uncle Milton’s idea to build a big raft and go over the falls together, or build some wheeled transports and forget about the river altogether. And following even further behind are some revolutionaries that swear that just over that ridge is another river with that flows straight to the sea with fish and watermelons for everyone.

This story could go on….and maybe in will in future posts, but what about these steady states?

Steady states are the paths to the ocean shown on a satellite map that ignore the day-to-day troubles of our travelers. There may be many paths with certain advantages in terms of distances or possible speeds. The satellite map doesn’t show much about the local obstacles, but Bennie and his committee would be silly to ignore it.

The pleasant monetarist arithmetic that arises when the central bank buys a big chunk of its government’s bonds (which is related the the MMT policy) is an example where the satellite map shows a fast-moving tributary around the rapids. Not needing to pay interest on those bonds that have been issued over the the past decades certainly sounds like the easier way to go.

But the map doesn’t show exactly the width of the channel or the rock wall along one edge. Taking that tributary has risk, and some boats might not make it. Buying up those bonds all at once would flood the financial system with money with unknown effects. Whether the ZLB is binding is one of the known unknowns. We’ve just had two divergent examples: the effect of QE was remarkably limited, but the same cannot be said of the Fed’s response to COVID.

There is a long run budget benefit to monetizing government debt, but in the short run, the liquidity effects on the old money supply and demand diagrams still matter. Knowing about steady states is important, but knowing they are not the whole story is too. Let’s be careful out there.