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Boycott The Rio Olympics To Defend Brazilian Democracy

Thomas Palley:

Terrible anti-democratic events are now unfolding in Brazil with the constitutional coup against President Dilma Rousseff, organized through a cooked-up impeachment trial.

The impeachment coup represents a naked attempt by corrupt neoliberal elements to seize power in Brazil. Make no mistake: it is a threat to democracy and social progress in Brazil, Latin America, and even the global community at large.

If Brazilian voices concur, the world should respond by boycotting the Rio Olympics scheduled for this August.

Read the rest by clicking the page title.

Output At Home And Abroad

It’s fairly common for economists to confuse accounting identities and behavioural relationships.

Question: What is the best way to find it?

Answer: The behaviour of output (at home and abroad) is not discussed in their analysis.

It’s not always the case that it’s true but a good way to find – check whether the economist is talking of the effect of changes in stocks or flows on output.

It’s also of course important to discern what someone is literally saying and what that person is trying to say. Economists aren’t the best communicators. For example, consider the sentence: “(fiscal) deficits increase growth and surplus reduces it”. This is far from accurate because the fiscal deficit is an output of a model (and everyone has a model implicitly), not an input. It’s better to state whether the fiscal policy under discussion is expansionary or contractionary. So let’s say that private expenditure rises relative to income for whatever reason, such as expectations of the future. This leads to a rise in output and hence taxes and the fiscal deficit will reduce and we have a rise in output coincident with a fall in fiscal deficit. But neither fiscal deficit or surplus caused that growth. At the same time, one should also try to check what the narrator is trying to say. So if someone says “deficit spending is needed”, he or she is actually trying to say, “an expansionary fiscal policy is needed”.

It doesn’t harm to be accurate or try to be accurate.

One of the worst mistake of this kind being discussed is using the identity (in the case of a closed economy):

G − T = S − I

where G, T, S and I are government expenditure, taxes, private saving and private investment respectively.

A careless look at this would led one to conclude that “deficits reduce investment”. What the economist who claims this is saying is that an fiscal expansion (rising government expenditure and/or reduced tax rates) decreases investment. The error in this is that, saving is thought to be constant. However, using a Keynesian stock-flow consistent model, it is not difficult to see that a fiscal expansion has an expansionary effect on output which will raise private investment and also private saving (assuming saving propensities are constant).

More generally, the equation is:

G − T + CAB = S − I

in the general case of the open economy. In the above CAB is the current account of the balance of payments. Also balance of payments accounting tells us that current account balance is equal to the net lending to the rest of the world. In the old balance of payments terminology, this is equal to the negative of the capital account balance.

So we have:

CAB + KAB = 0

Or

NL = CAB

in the modern balance of payments terminology, where NL is the net lending of resident economic units to the rest of the world.

This has led to various theories about how what causes trade imbalances. A careless conclusion which can be drawn by looking at the last equation is that an increase in private saving or a reduction in the government expenditure reduces the trade balance. Although in this case it’s true, this happens via a reduction of output.

Another strange hypothesis is to say that it’s net borrowing (the opposite of net lending) from the rest of the world which causes current account deficits. Some authors such as Michael Pettis have taken this to extreme.

Wynne Godley was one economist who made heavy use of the accounting identity.

G − T + CAB = S − I

In his view, the causal relationship linking the balances is via output at home and abroad. 

In his 1995 article, A Critical Imbalance in U.S. Trade he says:

… an accounting identity, though useful as a basis for consistent thinking about the problem can tell us nothing about why anything happens. In my view, while it is true by the laws of logic that the current balance of payments always equals the public deficit less the private financial surplus, the only causal relationship linking the balances (given trade propensities) operates through changes in the level of output at home and abroad. Thus a spontaneous increase in household saving or a spontaneous reduction in the budget deficit (say, as a result of cuts in public expenditure) would bring about an improvement in the external deficit only because either would induce a fall in total demand and output, with lower imports as a consequence.

In this post, I want to highlight how capital flows can impact trade balances using my experience with experimenting with stock flow consistent models. Before that, it’s important to note a few things which are often forgotten.

An import by a resident economic unit is a decision to purchase a good or a service produced by a non-resident producer. Similarly exports of a nation is indicative of the relative competitiveness of producers at home in international markets. It cannot be said to be caused solely by capital flows. But it’s not so simple. Imports for example depend on incomes of resident economic units and capital flows can have an impact on imports because they can affect output and income.

But it’s vacuous to say that current account imbalances are caused solely by capital flows as many economic commentators claim implicitly or explicitly.

It’s easy to commit the mistake and think that imports depend solely on prices of goods and services.  The world is not so simple. If every good or service is exactly the same, then it’s all about prices. However, producers produce thousands of different goods and services. So both price and non-price factors matter in determining imports. Even for similar goods, such as cars, consumers tend to prefer foreign produced cars over domestically produced ones even if the former is much more expensive simply because consumers are not just looking at the price but also quality, durability, looks and design and so on.

So both price competitiveness and non-price competitiveness are important. The way these things are modelled in literature is by using price and income elasticities. Imports depend on price via terms involving price and price elasticities and on income via terms involving income and income elasticities.

Where can we then look for causal connection of impact of capital flows on trade balance?

Before this it is important to keep in mind that gross capital flows can be compensated gross flows in the other direction. So to look for a causal connection in the accounting identity:

NL = CAB (or “CAB + KAB = 0″)

is silly to begin with.

So here are some ways in which capital flows can cause have an impact on trade balances.

  1. Capital flows cause exchange rates to move. With floating exchange rates, the exchange rate is the price which clears the supply and demand for assets of currencies. Note, in a correct model of exchange rates, supply and demand for all assets should be included not just “money” or “currency”. Exchange rate movement impact prices of goods and services. Since imports and exports depend on prices of goods and services (among other things), capital flows impact trade balance. It’s of course important to keep in mind producers’ own pricing behaviour: If the Japanese Yen appreciates by 30% against the US dollar, it’s not necessary that Japanese producers will raise prices of their goods in the U.S. market by 30%. They might raise the price only by 10%. But this is a digression, the important point being that capital flows cause changes in prices of imports and exports and hence the trade balance.
  2. Long term interest rates are both due to expectations of short term interest rates and portfolio preference for assets such as government bonds with long maturities. Long term Interest rates have an effect on aggregate demand which has an effect on output and income and hence imports.
  3. Capital flows can cause asset price booms, such as a stock market boom and via the wealth effect, cause changes in output and income and hence imports.
  4. There’s a further complication. Suppose there’s a large capital inflow into equities. This can cause switch of resident holders of equities (issued by resident economic units) into newly produced houses. This has an effect on aggregate demand and output and hence income and imports. This mechanism is slightly different from the wealth effect in point 3. It’s more a flow effect. Also in my opinion, it’s not easy to model this because one has to keep in mind gross capital outflows in balance of payments as well.
  5. Purchase of new houses by non-residents: Depending on regulations in the land, foreigners can directly purchase houses – such as a vacation house in Greece or to speculate on house prices such as in London. There can even be foreign investment funds which can speculate by buying houses and commercial property. This has the effect on aggregate demand and output and income and hence imports.
  6. Securitization allows banks to package loans on their balance sheet and sell it to investors. This allows banks to reduce risks and because of this they can make more loans which they may not have made without securitization. More lending means higher aggregate demand and output and income and affects imports.
  7. Direct investment: Direct investment is a more complicated example. Direct investment can raise output by various means, such as causing rising business domestically, employing people. They not only have an effect on the trade balance because of their international nature but also because their profits affect balance of payments. Also one has to be careful: sometimes direct investment is confused with the in the identity: G − T + CAB = S − I. Needless to say, this is confusing the different meanings of “investment”.
  8. Large capital outflows can cause a large depreciation of the currency and impact a nation’s fiscal policy. If there are large gross outflows, a government may be forced to deflate domestic demand and output to reduce imports. The flip-side is that large capital flows can keep a bubble from busting for long.

On Twitter, T Srinivas mentioned to me that desire to accumulate reserves may cause nations to depress demand and hence lead to lower exports for other nations, citing the example of events following the Asian Crisis in the late 90s. This is partly included in 8. Although I don’t disagree, my points are more about flows caused due to changes in investor preferences themselves.

Of course it touches an important point. Low domestic demand and output in “surplus” nations leads to a positive net lending to the rest of the world. It’s more accurate to say that the current account deficit of “deficit” nations is because of low domestic demand and output than because of capital inflows to those “deficit” nations. So it’s not “saving glut” but demand shortage, beggar-my-neighbour policies.

In conclusion it is counterproductive to use the accounting identity

NL CAB

(or the same identity in the slightly misleading language CAB + KAB = 0) to claim a causation from capital flows to current account balance.

An example is this paragraph from Michael Pettis:

… This is one of the most fundamental errors that arise from a failure to understand the balance of payments mechanisms. As I explained four years ago in an article for Foreign Policy, “it may be correct to say that the role of the dollar allows Americans to consume beyond their means, but it is just as correct, and probably more so, to say that foreign accumulations of dollars force Americans to consume beyond their means.” As counter-intuitive as it may seem at first, the US does not need foreign capital because the US savings rate is low. The US savings rate is low because it must counterbalance foreign capital inflows, and this is true out of arithmetical necessity, as I showed in a May, 2014 blog entry.

It’s an extreme viewpoint. During the crisis, there was a large foreign demand for US public debt but this didn’t cause a rise in U.S. imports. Similarly, a central bank intervening in the foreign exchange market and buying U.S. dollars from U.S. resident economic units doesn’t cause U.S. imports to rise in the few seconds. (Accounting identities also hold for time periods of seconds!) It’s balanced by gross U.S. capital outflows.

Capital flows can impact trade balances but it has really nothing to do with this identity. The causal link is still output and home and abroad (and some due to price changes of goods and services due to exchange rate movements).

On The Blogs

Two things caught my attention in the last two days.

First is the claim by Roger Farmer:

The Keynesian economics of the General Theory is static.

That’s the strangest critique of the GT I have ever seen. How is the GT static? John Maynard Keynes highlighted how a fall in the propensity to consume reduces output. His mechanism was quite dynamic. He was arguing that a fall in the propensity to consume will reduce consumption and hence firms’ sales and hence production and hence employment and hence consumption and so on. Keynes did not explicitly write down a mathematical model like as done for example in the book Monetary Economics by Wynne Godley and Marc Lavoie. But his arguments were quite dynamic in nature. So was his argument about how investment creates saving. And also the Keynesian multiplier. “Stock-flow consistent” models are quite close to Keynes’ spirit.

The second is this paragraph from Michael Pettis:

… This is one of the most fundamental errors that arise from a failure to understand the balance of payments mechanisms. As I explained four years ago in an article for Foreign Policy, “it may be correct to say that the role of the dollar allows Americans to consume beyond their means, but it is just as correct, and probably more so, to say that foreign accumulations of dollars force Americans to consume beyond their means.” As counter-intuitive as it may seem at first, the US does not need foreign capital because the US savings rate is low. The US savings rate is low because it must counterbalance foreign capital inflows, and this is true out of arithmetical necessity, as I showed in a May, 2014 blog entry.

Oh boy! That’s confusing accounting identities with behaviour. A simple way to show how inaccurate this is by using standard Keynesian analysis. Assume US households reduce the propensity to consume. This leads to a fall in output and income and hence a fall in imports and an increase in the current account balance of payments (assuming exports are exogenous to the model). This can be seen more precisely in a stock-flow consistent model.

Pettis’ arguments are in response to Stephen Roach’s recent article on US balance of payments and I discussed that recently here.  Both Roach and Pettis are incorrect.

Balance of payments is important and in my opinion, the most important thing in Economics. Michael Pettis gets the attention because he realizes the importance of balance of payments in the economic dynamics of the world. However looked more closely, many of his arguments appear vacuous.

Kalecki And Keynes, Part 2

Continuing from the previous post, Kalecki And Keynes …

The General Theory of Employment, Interest and Money was published in January, 1936.

Meanwhile, … , Michal Kalecki had found the same solution.

His book, Essays in the Theory of Business Cycles, published in Polish in 1933, clearly states the principle of effective demand in mathematical form. At the same time he was already exploring the implications of the analysis for the problem of a country’s balance of trade, along the same lines that I followed in drawing riders from the General Theory in essays published in 1937.

The version of his theory set out in prose (published in ‘Polska Gospodarcza’ No. 43, X, 1935) could very well be used today as an introduction to the theory of employment.

He opens by attacking the orthodox theory at the most vital point – the view that unemployment could be reduced  by cutting money wage rates. And he shows (a point that Keynesians came to much later, and under his influence) that , of monopolistic influences prevent prices from falling when wage costs are lowered, the situation is still worse, because reduced purchasing power causes a fall in sales on consumption goods …

Michal Kalecki’s claim to priority of publication is indisputable.

– Joan Robinson, Kalecki And Keynes in Essays In Honour Of Michal Kalecki, 1964. 

Kalecki And Keynes

Michal Kalecki swam into my ken just after the publication of the General Theory of Employment, Interest and Money, in 1936. The small group who had been working with Maynard Keynes during the gestation of the book understood what it was about, but amongst the public as a whole it was still a mystery. Kalecki, however, knew it all. He had taken a year’s leave from the institute where he was working in Warsaw to write the theory of employment but Keynes’ book came out, and got all the glory. Michal never made any claim for himself and I made it my business to blow his trumpet for him, but most of the profession (including Keynes) just thought that I was being kind to a lame duck. Only since the publication of his essays written in Polish from 1933 to 1935 has it been generally recognized that he had already worked out all the essentials of what became known as Keynes’ theory (Selected Essays on the Dynamics of the Capitalist Economy, Cambridge University Press, 1971). He showed that it is investment, not private saving, that brings about capital accumulation; that a government deficit, in a slump, will increase employment; that cutting wages only makes the slump worse; that the rate of interest depends upon supply and demand of the stock of money, not on the flow of saving, and that it is the forward-looking expectation of profits that induces firms to accumulate.

The question of glory did not seem to me to be important. As Michal was the first to admit, his ideas would have taken a long time to establish while with Keynes they burst upon the world as a revolution. But I was deeply impressed by the fact that two thinkers of such different background and habits of thought could arrive at the same diagnosis of the economic situation. Logic is the same for everybody; the same logical structure, if it is not fudged, can support quite different ideologies, but for most social scientists ideology leaks into the logic and corrupts it.

In the natural sciences, it is common enough for the same discovery to come almost simultaneously from two independent sources. The general development of a subject throws up a new problem and two equally original minds find the same answer, which turns out to be validated by further work. In the history of economic thought, the case of the discovery of the theory of employment by Keynes and Kalecki is unique.

– Joan Robinson in PORTRAIT: Michal Kalecki, Challenge, Vol. 20, No. 5, November/December, 1977, pp. 67-69, http://www.jstor.org/stable/40719591

Abraham Ptachya Lerner, An Inconsistent Fellow

This quote of Abba Lerner from his article “The Burden of the National Debt,” in Lloyd A. Metzler et al.,Income, Employment and Public Policy (New York, 1948), p. 256 is frequently quoted in the Post-Keynesian blogosphere:

One of the most effective ways of clearing up this most serious of all semantic confusions is to point out that private debt differs from national debt in being external. It is owed by one person to others. That is what makes it burdensome. Because it is interpersonal the proper analogy is not to national debt but to international debt…. There is no external creditor. “We owe it to ourselves.”

This is unfortunately inconsistent with his “functional finance”. Abba Lerner clearly says that external debt can be problematic. However he probably never realized that if his advise is followed in running fiscal policy, a nation’s balance of payments will deteriorate and its international debt will increase (because current account balance adds to the net international investment position).

Public debt is not the same the negative of the net international investment position but it’s related as the external debt is directly or indirectly picked up by the public sector.

Sound finance is all junk science but Abba Lerner is not your friend to learn about money, debts, deficits and all that.

International Effects On The Distribution Of Income

I came across this PKSG (Post-Keynesian Study Group) reading list 2016 which “provides introductory and advanced readings for those interested in post-Keynesian economics.”

(h/t Severin Reissl on Facebook)

A recommended reading is Robert Blecker’s international economics written for The Elgar Companion to Post Keynesian Economics edited by John E. King. The chapter can be previewed from Amazon.

One interesting aspect is the distribution of income between profits and wages. Blecker says:

Post Keynesian in the Kaleckian tradition emphasize the feedback effects of international competition onto domestic profit mark-up rates and hence on the distribution of income between profits and wages. When a currency appreciates (or domestic costs rise relative to foreign), oligopolistic firms squeeze price-cost margins in order to ‘price-to-market’, which in turn leads to a fall in the profit share with possible negative repercussions for investment and growth (although this may be offset by boost to domestic consumption arising from higher real wages and labour income). When a currency depreciates (or domestic costs fall relative to foreign), the opposite happens as domestic oligopolies are able to raise their price-cost margins without losing market share, income is distributed from wages to profits, and the potential repercussions for investment and growth and consumption are all reversed. Outcomes in which a redistribution of income towards wages is expansionary are known as ‘wage-led’ regimes, while outcomes in which a redistribution towards profits is expansionary are ‘profit-led’. Mainstream economists have recognized the flexibility of profit margins in response to exchange-rate fluctuations – what they call ‘partial pass-through’ – but they have not analysed the feedback effect onto income distribution, aggregate demand and economic growth.

Stephen Roach, Accounting Identities And Behavioural Relationships

A well known economic identity states:

Snational = Inational + CAB

where Snational and Inational are national saving and national investment and CAB is the current account balance of international payments. In calculating national saving and investment, one adds saving and investment, respectively, of all resident sectors of the economy.

However, an accounting identity shouldn’t be confused with behavioural relationships.

Steven Roach is a good economist and it’s sad to see him confusing this. In a recent article for Project Syndicate titled America’s Trade Deficit Begins at Home, he uses this identity to conclude that if America wants to reduce her trade deficit, the solution is more saving.

Roach says:

What the candidates won’t tell the American people is that the trade deficit and the pressures it places on hard-pressed middle-class workers stem from problems made at home. In fact, the real reason the US has such a massive multilateral trade deficit is that Americans don’t save.

Total US saving – the sum total of the saving of families, businesses, and the government sector – amounted to just 2.6% of national income in the fourth quarter of 2015. That is a 0.6-percentage-point drop from a year earlier and less than half the 6.3% average that prevailed during the final three decades of the twentieth century.

Any basic economics course stresses the ironclad accounting identity that saving must equal investment at each and every point in time. Without saving, investing in the future is all but impossible.

A little thought on behavioural relationships tell a different story. The main causality connecting accounting identities is behaviour of demand and output at home and abroad. While it is true that by accounting identity, the U.S. current account balance will improve by more saving (such as households saving more, firms retaining higher earnings and government (both at the federal and state level) attempting to increase its saving tighten fiscal policy, it happens via a contraction of output.

Wynne Godley was one who stressed this before the crisis. In his paper The United States And Her Creditors: Can The Symbiosis Last? written with Dimitri Papadimitrou, Claudio Dos Santos and Gennaro Zezza, this is made clear:

A well-known accounting identity says that the current account balance is equal, by definition, to the gap between national saving and investment. (The current account balance is exports minus imports, plus net flows of certain types of cross-border income.) All too often, the conclusion is drawn that a current account deficit can be cured by raising national saving—and therefore that the government should cut its budget deficit. This conclusion is illegitimate, because any improvement in the current account balance would only come about if the fiscal restriction caused a recession. But in any case, the balance between saving and investment in the economy as a whole is not a satisfactory operational concept because it aggregates two sectors (government and private) that are separately motivated and behave in entirely different ways. We prefer to use the accounting identity (tautology) that divides the economy into three sectors rather than two—the current account balance, the general government’s budget deficit, and the private sector’s surplus of disposable income over expenditure (net saving)—as a tool to bring coherence to the discussion of strategic issues. It is hardly necessary to add that little or nothing can be learned from these financial balances measured ex post until we know a great deal more about what else has happened in the economy—in particular, how the level of output has changed

[boldening: mine]

This was pre-crisis from a few who were avowed Keynesians all their life! It’s unfortunate to see Steve Roach make an error even after so many years into the global economic and financial crisis. One should study Keynes seriously. While I am sure Roach appreciates the paradox of thrift, he forgets applying it to the analysis of United States of America’s trade deficits.

Nicholas Kaldor On The Foreign Trade Multiplier

This is the basis of the doctrine of the ‘foreign trade multiplier’, according to which the production of a country will be determined by the external demand for its products and will tend to be that multiple of such demand which is represented by the reciprocal of the proportion of internal incomes spent on imports. This doctrine asserts the very opposite of Say’s Law: the level of production will not be confined by the availability of capital and labour; on the contrary, the amount of capital accumulated, and the amount of labour effectively employed at any one time, will be the result of the growth of external demand over a long series of past periods, which permitted the capital accumulation to take place that was required to enable the amount of labour to be employed and the level of output to be reached which were (or could be) attained in the current period.

Keynes, writing in the middle of the Great Depression of the 1930s, focused his attention on the consequences of the failure to invest (due to unfavourable business expectations) in limiting industrial employment below industry’s attained capacity to provide such employment; and he attributed this failure to excessive saving (or an insufficient propensity to consume) relative to the opportunities for profitable investment. Hence his concentration on liquidity preference and the rate of interest, as the basic cause for the failure of Say’s Law to operate under conditions of low investment opportunities and/or excessive savings, and the importance he attached to the savings/investment multiplier as a short-period determinant of the level of production and employment.

On retrospect I believe it to have been unfortunate that the very success of Keynes’s ideas in connection with the savings/investment multiplier diverted attention from the ‘foreign trade multiplier’, which, over longer periods, is a far more important and basic factor in explaining the growth and rhythm of industrial development. For over longer periods Ricardo’s presumption that capitalists only save in order to invest, and that hence the proportion of profits saved would adapt to changes in the profitability of investment, seems to me more relevant; the limitation of effective demand due to oversaving is a short-run (or cyclical) phenomenon, whereas the rate of growth of’external’ demand is a more basic long-run determinant of both the rate of accumulation and the growth of output and employment in the ‘capitalist’ or ‘industrial’ sectors of the world economy.

– Nicholas Kaldor, Capitalism and industrial development: some lessons from Britain’s experience, Camb. J. Econ. (1977) 1 (2): 193204, link

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Year Of The Outsider: Why Bernie Sanders’ Democratic Rebellion Is So Significant

Thomas Palley:

2016 was supposed to have been the year of Jeb Bush versus Hillary Clinton: the year when the established Bush dynasty confronted the upstart rival Clinton Dynasty. But the year of the insider has turned into the year of the outsider. On both sides, voters have unexpectedly given vent to thirty years of accumulated anger with neoliberalism which has downsized their incomes and hopes.

Though the Republican rebellion has been more clear-cut in its dismissal of insider candidates, it is Bernie Sanders’ Democratic rebellion that is of potentially far greater historic significance.

Read the rest by clicking the page title.