Krugman, Wolf And Goodhart

Paul Krugman has a blog  post today titled Death By Accounting Identity, commenting on Martin Wolf’s FT Article Why cutting fiscal deficits is an assault on profits, where Wolf talks about the sectoral balances identity made famous by Wynne Godley. I guess the better way to put it is that Martin Wolf is trying to make the accounting identity famous.

A Damascene Moment

In his book with Marc Lavoie, Wynne Godley wrote in his part of Background memories (by W.G.)

… In 1970 I moved to Cambridge, where, with Francis Cripps, I founded the Cambridge Economic Policy Group (CEPG). I remember a damascene moment when, in early 1974 (after playing round with concepts devised in conversation with Nicky Kaldor and Robert Neild), I first apprehended the strategic importance of the accounting identity which says that, measured at current prices, the government’s budget deficit less the current account deficit is equal, by definition, to private saving net of investment. Having always thought of the balance of trade as something which could only be analysed in terms of income and price elasticities together with real output movements at home and abroad, it came as a shock to discover that if only one knows what the budget deficit and private net saving are, it follows from that information alone, without any qualification whatever, exactly what the balance of payments must be. Francis Cripps and I set out the significance of this identity as a logical framework both for modelling the economy and for the formulation of policy in the London and Cambridge Economic Bulletin in January 1974 (Godley and Cripps 1974). We correctly predicted that the Heath Barber boom would go bust later in the year at a time when the National Institute was in full support of government policy and the London Business School (i.e. Jim Ball and Terry Burns) were conditionally recommending further reflation! We also predicted that inflation could exceed 20% if the unfortunate threshold (wage indexation) scheme really got going interactively. This was important because it was later claimed that inflation (which eventually reached 26%) was the consequence of the previous rise in the ‘money supply’, while others put it down to the rising pressure of demand the previous year. …

I believe Wynne Godley discovered this identity while working for the British Treasury in the ’60s – at least the identity relating two sectors – domestic private sector and the government sector, but the damascene moment happened in 1974. The accounting identity is also used heavily in his 1983 book Macroeconomics, with Francis Cripps.

Charles Goodhart

Charles Goodhart also seems to be making use of the accounting identity (and a mental model built around this identity) in his recent Voxeu post Europe: After the Crisis. The difference is that in Charles Goodhart’s writing, fiscal policy is given less importance than monetary policy.

He talks of three implicit and incorrect assumptions:

  • The first, and most important, incorrect assumption was that a private-sector deficit in any country, matched by a capital inflow (current account deficit), should not be potentially destabilising.

The thinking was that the private sector must have worked out how to repay its debts before incurring them.

  • The second misguided assumption was that, in a single monetary system, local current account conditions not only cannot be calculated, but do not matter.
  • The third was that the public sector deficit of a member country is just as damaging when it is matched by a national private sector surplus, as by capital inflows.

I think each of these points is really insightful.

The first assumption is reminiscent of the economic agent in models who has a perfect foresight. The agent must have seen the future very well and would have calculated well in advance that things will go well. Consolidate all agents and we have the first assumption.

The second assumption is extremely well presented. People, especially economists asked – if the states in the United States used the same currency, why not Europe? The pitfall in this assumption is assuming away the U.S. Federal Government which makes fiscal transfers without anyone noticing.

The third assumption has to do with the lack of understanding the various causalities linking the three financial balances.Goodhart also goes into providing ideas for the design of “The fiscal counterpart to a monetary union”. One point I liked was on transfer dependency: 

For a stabilisa­tion instrument to be pure and effective, three principles are key (see Goodhart and Smith 1993 for details):

  • The instrument should be triggered following changes in economic activity but its intervention should be halted as soon as no further changes occur, irrespective of the level at which the economy has again become stable.

Otherwise, the instrument would perform not only a stabilisation function, but also play a redistribu­tive role. Such an ‘impurity’ is typical for traditional fiscal policy measures, but should be avoided in the Community context as it may perpetuate adjustment problems and induce transfer dependency.


Goodhart also makes a nice point on Japan – something (a part of it) you can see me writing in the Chartalists’ blogs’ comments section:

This analysis implies that the Eurozone needs a wholesale reorientation of the stability conditions. They must be refocused towards concern with external debt, and deficit, conditions and much less single-minded focus on the public sector finances.

If a member country is in a Japanese condition with a huge public-sector debt, but fully financed domestically, with a current-account surplus and large net external assets, then its debt should entirely be its own concern, and not subject to censure or control by any outside body, whether in a monetary union, or not. Of course, such greater attention to external, especially current-account, conditions needs to be more nuanced, since deficits, and external debts, incurred to finance tradeable goods production subsequently should provide the extra goods to sell to pay off such debts.

Japan’s public debt of 200% of GDP is quoted in rhetoric about public debt, but it is forgotten that Japan is a creditor nation and hence not always great to compare it with other nations.

Another recent article by Goodhart starts off well:

There are two main problems to be faced in any attempt to improve the architecture of international macro‐economic and financial oversight. The first is structural; the second is analytical. The first difficulty resides in the discord between having a system of national sovereignty at the same time as an international market economy, …

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