Monthly Archives: January 2013

Trade Elasticities, Floating Exchanges And Debt Sustainability

[Although the following is a response aimed at one comment, it can be read in general]

In my post on the connection between balance of payments and debt sustainability, I got a “you are wrong” comment saying the analysis is based on the notion of trade elasticities which doesn’t exist (or is a chimerical notion) and that I ignore floating exchange rates. So a reply.

Trade Elasticities

A standard observation is that imports and exports depend on income – domestic and in the rest of the world. Exports depend on how competitive the producers are in the rest of the world and also the demand in the rest of the world. Similarly imports depend on foreign producers’ competitiveness compared to domestic producers as well as domestic demand. So in a simple Keynesian model one writes:

IM = μY

where μ is the propensity to import. It measures imports as a proportion of domestic output. Relative propensities (between nations) measure relative competitiveness of producers. This is a very quick way to build a model for how stocks and flows change over time.

There is one simplification in this. Although it rightly captures the amount of imports during a period – such as a few years, it supposes imports rise one-to-one with output – i.e.,


But in reality it could be worse – as the response of imports to a rise in domestic demand can be worse.

Also, it doesn’t capture the effect of prices. Producers across the world compete with each other on both the quality of their products and on price. So we have “non-price competitiveness” and “price competitiveness” . Now it is a Post-Keynesian observation that non-price competitiveness is much more important. So one has income elasticity of imports as well as price elasticity and the analysis can get a bit complicated. Some kinds of products have higher elasticities than others. For example manufactured products may have different elasticities as compared to raw materials, commodities etc. Also one can include nuances such as which is more important – income, expenditure, output etc.

Even more generally, the rest of the world consists of many nations and one has to be careful. So the rest of the world may be growing but it may happen that exports aren’t because exports are concentrated on one country or a group of nations which are not growing.

A good original reference is Joan Robinson’s article The Foreign Exchanges from her 1937 book Essays In The Theory Of Employment. 

Rather than going through the analysis, let me just show the plot of the United States’ imports to show that the concept of elasticity is far from chimerical as one observer claims.

The following is a scatter-plot of the logarithms of GDP and Imports for the United States since 1951 (quarterly). The data is from Federal Reserve’s Z.1 Flow of Funds Accounts.

US Imports Versus GDP

The thin grey line is the fit and in addition, there is a 45-degree line to show that the slope is different than 1.

The “elasticity” is supposed to capture the response of imports to a rise in expenditure/income/output. The above simple scatter-plot shows the relation is far from being random.

So much for the notion that trade elasticities don’t exist!

Of course, the elasticities can be improved and not god-given. A nation’s government can take some protection and/or invest in research and development because the elasticity is a supply-side concept. It can also be improved if producers learn how to improve their products and the quality of its sales force in marketing them in international markets. Still, the improvement depends on how well all these are carried out etc.

Now to floating exchanges.

Floating Exchange Rates

Now, it can be argued that a debt sustainability analysis is invalid because of floating exchange rates. If a nation’s currency floats, a depreciation of the exchange rate in the foreign exchange markets can improve the trade balance. While it is true that a depreciation can turn the balance in a nation’s favour because of price effects, it is doesn’t necessarily happen that way. Even if one assumes away J-curve effects, a nation can find itself in a balance worsening in spite of a depreciation. This is because non-price competitiveness is far more important than price-competitiveness. In fact there exists no reason how “market forces” miraculously resolve the imbalances by depreciating. In reality trade imbalances are kept from blowing up by adjustments to income.

It is one thing to say that depreciation can improve the trade balance (which has truth to it) and another to say it can do a miracle.

Now, coming to debt sustainability, one can still claim that this process can continue forever (i.e., net indebtedness to foreigners rising forever relative to gdp) without any trouble in the foreign exchange markets. That is something for another post but it is too much of a claim.

The Joan Robinson paper I quoted has the mechanism of how this ends up creating troubles in the fx markets.

Mario Draghi – Euro Saviour?

Recently Mario Draghi, the European Central Bank President, has been going around telling everyone that “fiscal consolidation” is the absolutely essential to resolve the Euro Area crisis, given some positive developments. Although, this view of his is known and this has had a big influence on policy, he has become more and more vocal about it in recent weeks. He has also signalled a “positive contagion” – a phrase he seems to have coined.

Here is Mario Draghi talking at the recent annual conference at Davos to John Lipsky.

If Draghi is to be believed, “fiscal consolidation” is an absolute necessity for the Euro Area to come out of the crisis.

In a recent press conference from January 10, Draghi said the same:

Question: Could Outright Monetary Transactions (OMTs) lose their magical effect in the markets if no country asks for them?

Second question: Jean-Claude Juncker has said that too much fiscal consolidation could have a negative effect on countries like Spain, because unemployment is so high. What can you say about that?

Draghi: On your first question, you do not have to ask me, ask the markets.

On the second, many comments of this type have been made about several countries in the euro area. My answer to this is that so much progress has already been made, accompanied by so many enormous sacrifices. So reverting to a situation which has been found to be untenable would not be right. We should not forget that this fiscal consolidation is unavoidable, and we certainly are aware that it has short-term contractionary effects. But now that so much has been done I do not think it is right to go back.

[emphasis: mine]

Back in July 2012, when Spanish government bond prices were plunging, Mario Draghi came up with a plan to save the Euro Area by first announcing on July 26 in a conference in London that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” and after a pause, “And believe me, it will be enough.”. In the monetary policy meeting on September 6, he outlined a plan by the Eurosystem to buy government bonds without any ex-ante quantitative limits, provided the nations asking this facility agree to terms and conditions – mainly on fiscal policy.

This was greeted with great optimism and the “state of confidence” of the financial markets greatly improved in the next few months. Mario Draghi eventually became the FT Person Of The Year. The fact that nations have a backstop meant that the financial sector has been more willing to finance the governments and the nations actually haven’t felt the need to use the facility so far.

At the time, there was an urgent need to do something and the European Central Bank responded positively to prevent a financial and economic collapse.

While the condition that governments asking for the ECB’s help have to meet is unavoidable for any such plan, Mario Draghi seriously misunderstands the nature of the problem. While it is true that there needs to be structural reforms so that struggling Euro Area countries become more competitive relative to their partners and aim to improve their exports to reduce imbalances within the Euro Area, a Euro-Area wide fiscal contraction will fail to achieve this in any sustainable way. Structural reforms aka wage cuts, will further deflate demand in those nations as Michal Kalecki taught us.

Take Spain for example. Its current account is coming back to balance but this has been the result of a huge deflation of domestic demand and no wonder its unemployment rate hit 26% recently. Statements such as “fiscal consolidation is unavoidable” put all the burden on weaker nations. The Euro Area actually needs a fiscal expansion in creditor nations and although a relatively tighter fiscal policy in the debtor nations compared to creditor nations, an expansion compared to the present state nonetheless. In the long term it needs to form a political union – not like the ones floated by European leaders.

The weaknesses of the Euro Area going forward has been highlighted by Charles Goodhart in a recent appearance in the Economic and Financial affairs session of the UK Parliament. Here is the link to the video.

Also, in December 2012, Draghi and the EU leaders presented a plan Towards A Genuine Economic And Monetary Union. Again this approach has the same errors as the plans floating around since decades and debunked by Nicholas Kaldor in 1971 in one of the most prescient articles ever written.  See this post Nicholas Kaldor On European Political Union. The European leaders are seriously mistaken to think of any of their plans as “genuine”.

Somehow, the Monetarist counterrevolution of the 1970s seems to have forever distorted the vision of economists and economic advisers to politicians even if they do not think they are Monetarists.

The Beggar-My-Neighbour Game

How did Keynes and the Cambridge Keynesians (such as Joan Robinson, Richard Kahn, Nicholas Kaldor and Wynne Godley) think the world economy works?

A few important principles relevant here and of course not exhaustive:

First, real demand, output and employment is determined by the fiscal and monetary policies of the government with the former having a more solid impact on demand. Second, fiscal policy has constraints due to the capacity to produce, and inflation. High inflation – although also influenced by demand – needs to to tackled by direct political means as it is also (highly) dependent on costs. Third, economies have a balance-of-payments constraint and a nation’s success depends crucially on how its producers perform in international markets.

For neoclassical economists and their cousins, world demand and output is determined by the supply-side. It is fantasized that with economic scarcity (as if!) utility and profit maximising behaviour of economic agents will lead to the most efficient allocation of resources and attempts to regulate trade will only make everyone worse-off. The amount of resources is “given” and interference with markets only leads to a lower output for that “given” amount of resources. Fiscal policy is neutral – although it is conceded by them that it can have positive short-term effect. Over the long run, fiscal policy is strictly neutral in this view. The prescription is for the government to balance the budget – sooner the better, and for monetary policy to either “control” the stock of monetary aggregates and/or for interest rate to return to some vaguely defined normal. Further, at an international level, the free trade ideology is imposed on nations because it is thought that it will lead to a convergence of incomes and living standards and full employment.

For example the WTO page on tariffs says:

Customs duties on merchandise imports are called tariffs. Tariffs give a price advantage to locally-produced goods over similar goods which are imported, and they raise revenues for governments. One result of the Uruguay Round was countries’ commitments to cut tariffs and to “bind” their customs duty rates to levels which are difficult to raise. The current negotiations under the Doha Agenda continue efforts in that direction in agriculture and non-agricultural market access.

Unfortunately, free trade, has the opposite effect. Rather than leading to any convergence, it leads to some nations gaining more success and others failing. As Nicholas Kaldor said, “success breeds further success and failure begets more failure.”

How does this operate? A government which wishes its nation to grow faster can put up fiscal policy but sooner or later will be faced with a balance of payments because of the adverse effect on trade and rising indebtedness to foreigners. This constraint shows up as troubles in the foreign exchange markets. This constraint is strongest for a nation whose currency is fixed irrevocably (such as the Euro Area nations) but also is also strong for nations whose currencies are pegged and freely floating.

Now, a nation which has good exports sees good economic expansion via the “export multiplier”. Imports on the other hand are “leakages”. Let us think of a Nation X with a higher propensity to import. Faced with higher imports, X may try to use fiscal contraction to further contract demand and hence imports. This has negative ripples throughout the world as a whole. Exporters to X will see a lower demand for their products – even if they maintain market shares. Via lower multiplier than otherwise, this leads to a lower demand than otherwise in the rest of the world. This again has a contractionary effect on X because of lower exports again leading to a lower demand in the rest of the world than otherwise and so on. So fiscal expansion and investment are good for the world as a whole but free trade is damaging. This is not to deny the benefits of globalization but a world with free trade will be worse-off than with a system of regulated trade which will have higher output, income and world trade since allows more space for fiscal policy and via an accelerator process, allows investment to expand faster.

Now, till recently the United States was acting as the “demander of the last resort” because of its huge imports. Faced with a high balance of payments deficit (in the current account), the United States neither wants to be in this position nor is going to expand domestic demand. It is as if the engine of growth has been cut off.

Faced with so many constraints, nations try to play the beggar-my-neighbour game. Unfortunately this game is also played by the creditor nations. The phrase was first introduced by Joan Robinson in a 1937 article titled Beggar-My-Neighbour Remedies For Unemployment. This excerpt is from beginning of the article:

For any one country an increase in the balance of trade is equivalent to an increase in investment and normally leads (given the level of home investment) to an increase in employment.An expansion of export industries, or of home industries rival to imports, causes a primary increase in employment, while the expenditure of additional incomes earned in these industries leads, in so far as it falls upon home-produced goods, to a secondary increase in employment. But an increase in employment brought about in this way is of a totally different nature from an increase due to home investment. For an increase in home investment brings about a net increase in employment for the world as a whole, while an increase in the balance of trade of one country at best leaves the level of employment for the world as a whole unaffected.A decline in the imports of one country is a decline in the exports or other countries, and the balance of trade for the world as a whole is always equal to zero.3

In times of general unemployment a game of beggar-my-neighbour is played between the nations, each one endeavouring to throw a larger share of the burden upon the others. As soon as one succeeds in increasing its trade balance at the expense of the rest, others retaliate, and the total volume of international trade sinks continuously, relatively to the total volume of world activity. Political, strategic and sentimental considerations add fuel to the fire, and the flames of economic nationalism blaze ever higher and higher.

In the process not only is the efficiency of world production impaired by the sacrifice of international division of labour, but the total of world activity is also likely to be reduced. For while an increase in the balance of trade of one country creates a situation in which its home rate of interest tends to fall, the corresponding reduction in the balances of the rest tends to raise their rates of interest, and owing to the apprehensive and cautious tradition which dominates the policy or monetary authorities, they are chronically more inclined to foster a rise in the rate of interest when the balance of trade is reduced than to permit a fall when it is increased. The beggar-my-neighbour game is therefore likely to be accompanied by a rise in the rate of interest for the world as a whole and consequently by a decline in world activity.

The principal devices by which the balance of trade can be increased are (1) exchange depreciation, (2) reductions in wages (which may take the form of increasing hours ot work at the same weekly wage), (3) subsidies to exports and (4) restriction of imports by means of tariffs and quotas. To borrow a trope from Mr. D. H. Robertson, there are four suits in the pack, and a trick can be taken by playing a higher card out of any suit.

1 See below, p. 159, note, for an exceptional case. [Note on p. 159: When the foreign demand is inelastic a tax on exports (as in Germany in 1922) or restriction of output (as in many raw-material-producing countries in recent years) will increase the balance of trade, while at the same time reducing the amount of employment in the export industries, and increasing the ratio of profits to wages in them. In these circumstances, therefore, an induced increase in the balance of trade may be accomoanied bv no increase, or even a decrease, in the level of employment.]

2 Unless it happens that the Multiplier is higher than the average for the world in the country whose balance increases.

3 The visible balances of all countries normally add up to a negative figure, since exports are reckoned f.o.b. and imports c.i.f. But this is compensated by a corresponding item in the invisible account, representing shipping and handling costs.

Claims Economists Make

Economists struggle with simple things. Two examples.

National Saving, Trade Deficits etc.

In a blog article Has Anyone Heard of the Trade Deficit?, Dean Baker uses the sectoral balances identity to make a claim which is presented like a no-go theorem.

Baker says:

Fans of arithmetic (a tiny minority among DC policy types) like to point out that a large trade deficit implies negative national savings. In other words, if we have a trade deficit then by definition the United States as a whole has a negative saving rate.

This means that we either must have budget deficits (negative public savings) or negative private savings, or both. There is no way around this fact.

Baker confuses saving with saving net of investment – just like the Neochartalists. (Confuses S with S minus I)

Without proof, the sum of saving of a whole economy is given by

S = I + BP

where (here) S is the sum of the savings of all resident sectors of the economy – the “national saving”, I is the total investment expenditure of the resident sectors of the economy (i.e., both private and public) and BP is the current account balance of international payments.

So it is possible for an economy to have a trade deficit and hence a negative BP (although it’s not always the case that the trade deficit translates into a current account deficit) and still have I + BP positive if investment is sufficiently high. So an economy can have positive national saving with a trade deficit.

Of course it must be said that the persons he is attacking are wrong. The claim (of the persons he is criticizing)* is that the United States should save more (by a reduction in budget deficits brought about by a tightening of fiscal policy and/or higher propensity to save of the private sector achieved in some way). This is illegitimate as such a policy will induce a recession in the United States. Via the paradox of thrift, an increase in the private sector propensity to save can lead to lower saving of the private sector. Investment will fall because of lower sales expectations and the recession in the United States caused by the fiscal tightening will most likely lead to a recession in the rest of the world reducing its exports so that the only thing achieved is higher world unemployment.

Debt/GDP Ratio

In a series of posts aimed at showing something, Randall Wray claims the following:

… To simplify, if the interest rate is higher than the economy’s growth rate, then the debt ratio rises continuously…

Of course he also claims that if g>r, the debt ratio stabilizes.

Now, the debt sustainability conditions relating the interest rate and the growth rate of output are misleading. I showed this two posts back, where I showed that the claim that the condition that g>r ensures stabilization of the public debt/gdp ratio is incorrect. The above quote claims the opposite and is equally erroneous and misleading.

An economy can have the growth rate lower than the interest rate and still not have an exploding debt ratio.

A standard error in such analysis is to treat the budget deficit as exogenous. 

Consider an economy without a strong balance of payments constraint and with inflation less of a trouble. A fiscal expansion brings about an increase in output and this has the effect of stabilizing the debt ratio in two ways: the higher output itself and an increase in tax revenues of the government due to higher output. The budget balance may go into primary surplus automatically even though the government may not be targeting this.

In other words, if r>g, the sequence dgiven by the relation

dt – dt-1 = λdt-1 – pbt

(where λ is equal to (r-g)/(1+g) and  dt is the debt/gdp ratio at the end of time period t and pbt is the primary budget balance of the government in the period) would seem to explode because of the first time on the right hand side. But higher output will automatically lead to a dynamics for pbensuring sustainability.

How this works was shown by Wynne Godley in an article The Dynamics Of Public Sector Deficits And Debts written in 1994 written by his co-author Bob Rowthorn in J. Michie and J. Grieve Smith (eds), Unemployment in Europe (London: Academic Press), 1994 pp. 199-206 and which was originally a paper to the UK Treasury around ’92-’93.

For a demand constrained economy:

… Note that the primary budget balance adjusts automatically so as the stabilise the debt to GDP ratio. This spontaneous adjustment occurs through induced variations in GDP. The government cannot directly determine the primary balance. It can only control r, θ and G, and once the time path of these is fixed as above, the variable Y will evolve so as to stabilise the ratio B/Y. If this ratio is too large, Y will grow rapidly and generate sufficient tax revenue to bring this ratio down.

There is a standard proposition that the government cannot permanently maintain a primary deficit if the interest rate is greater than the growth rate (r>g) … even if true, the statement can be misleading. In a demand-constrained economy, the level of Y relative to G will automatically adjust so as to produce a primary balance (deficit or surplus) to stabilise the ratio B/Y …

[Emphasis mine]

(θ is the tax rate in the model in above paper). Also see this post Wynne Godley And The Dynamics Of Deficits And Debts

It is counterproductive to go around making statements about the conditions on interest rate and the growth rate without qualifications and care and considering a situation/history and future scenarios.

There is one place where this condition is useful. Consider a balance of payments constrained economy. In studying the sustainability of the external debt of a country, one can conclude that if r>g (where r is the effective interest rate paid on foreign liabilities), then the debt dynamics will lead to an exploding debt even if the trade balance is held constant. Of course that doesn’t mean if r<g alone ensures sustainability.

*Updated 1650 GMT 17 Jan 2013 to make it clear.


I was very happy to have found a small mention in a recent Wired article on the “one trillion coin” – till the idea was killed by the U.S. Treasury and the Federal Reserve.

You may have certainly heard of the proposed $1T platinum coin even if you are not from the United States.

The United States government has hit the debt-ceiling, and will soon run out of other financial resources (asset-sales) to finance its expenditure and this may result in a default on its debt or almost complete freeze on expenditure (except interest payments on debt being financed out of taxes). Of course the simplest solution is to increase the ceiling or to completely do away with this. But it is not so easy.

Here’s Krugman aptly describing the situation in his New York Times Op-Ed piece Coins Against Crazies:

… Republicans go wild at this analogy, but it’s unavoidable. This is exactly like someone walking into a crowded room, announcing that he has a bomb strapped to his chest, and threatening to set that bomb off unless his demands are met.

So there’s an idea originally from Carlos Mucha, a lawyer from Georgia which became viral. The idea is for the U.S. Treasury to mint a $1T platinum coin and deposit it at the Federal Reserve. This sidesteps the debt ceiling because the coin doesn’t count in public debt!

Here is an article from the magazine Wired on him: Meet the Genius Behind the Trillion-Dollar Coin and the Plot to Breach the Debt Ceiling. The article mentions my name as the first to have understood Carlos’ idea and spread it :-) :-)

Ezra Klein of the Washington Post first reported two days back that the coin idea was killed by the US Treasury and the Federal Reserve.

What is it that gives the Treasury Secretary the power to mint a platinum coin of $1T?

According to § 5112 (k) of Chapter 51 of Title 31, Subtitle IV of the U.S. Code:

Platinum Coin Law

Now this alone was strong to make it go viral – thanks to the initiative of Joe Weisenthel of Business Insider who picked up the idea from Cullen Roche of Pragmatic Capitalism and Monetary Realism. Also Neochartalist bloggers were spreading the idea.

The trick was that the coin – although a liability of the government – doesn’t count in what the U.S. government calls the “public debt”.

Now there are several things. Since there are other laws to prevent the Federal Reserve from directly lending to the US Treasury, this raises the question of whether the Federal Reserve can accept the coin. Also, the U.S. Mint which is a part of the U.S. Treasury (as opposed to the Bureau of Engraving and Printing – which prints currency notes for the Federal Reserve) sells “circulating” coins directly to the Federal Reserve – depending on the demand for it from households, businesses and foreigners. There are however some types of coins such as numismatic coins (which coin collectors love) which are directly marketed by the Mint without the Federal Reserve entering the picture. So there are legalities around whether the Fed can directly buy the $1T coin from the U.S. Treasury. To avoid this, some people have proposed that the U.S. Treasury directly sell platinum coins of smaller denominations to the public to get funds in its account in order to make payments.

Another obstacle is that the U.S. Code isn’t straightforward on the “price theory” of the coin. For other coins there are some codes in the U.S. Code but apparently not for the platinum coin.

The coin was introduced in a bill H.R. 2018 (104th): United States Platinum and Gold Bullion Coin Act of 1995 which has the price theory (below) for the coin but the whole thing didn’t make it to the final law.

Platinum Coin Price Theory

I think this may have had a role in the Federal Reserve and the U.S. Treasury refusing it.

But it is a genie out of the bottle and won’t go back so easily!

Finally the ultimate authority on the platinum coin:

Carlos Mucha

(click to go to the New York Times’ Room For Debate)

“Free Trade Doctrine, In Practice, Is A More Subtle Form Of Mercantilism”

Dani Rodrik has written a very interesting article The New Mercantilist Challenge for Project Syndicate. 

Perhaps it is the main aim of this blog to argue how the sacred tenet of free trade is devastating to the world as a whole and why a sustainable resolution of a crisis can only be achieved by new international agreements on how to trade with one another combined with coordinated demand management policies with an expansionary bias.

Joan Robinson was one of the fiercest critics of free trade. A good appreciation of her work is by Robert Blecker in the book Joan Robinson’s Economics (2005)

Joan Robinson's Economics

Blecker says:

Robinson’s critique of free trade had several dimensions, including her opposition to the comparative static methodology usually employed to “prove” the existence of gains from trade, as well as her scathing criticism of the actual practice of trade policy by nations proclaiming their fealty to free trade while seeking mercantilist advantages over their neighbors. Robinson also thought that international trade relations were far more conflictive than they were usually portrayed by free traders

[emphasis: mine]

In her 1977 essay What Are The Questions? (which is full of quotable quotes) Robinson says:

A surplus of exports is advantageous, first of all, in connection with the short-period problem of effective demand. A surplus of value of exports over value of imports represents “foreign investment.” An increase in it has an employment and multiplier effect. Any increase in activity at home is liable to increase imports so that a boost to income and employment from an increase in the flow of home investment is partly offset by a reduction in foreign investment. A boost due to increasing exports or production of home substitutes for imports (when there is sufficient slack in the economy) does not reduce home investment, but creates conditions favorable to raising it. Thus, an export surplus is a more powerful stimulus to income than home investment.

In the beggar-my-neighbor scramble for trade during the great slump, every country was desparately trying to export its own unemployment. Every country had to join in, for any one that attempted to maintain employment without protecting its balance of trade (through tariffs, subsidies, depreciation, etc.) would have been beggared by the others.

From a long-run point of view, export-led growth is the basis of success. A country that has a competitive advantage in industrial production can maintain a high level of home investment, without fear of being checked by a balance-of-payments crisis. Capital accumulation and technical improvements then progressively enhance its competitive advantage. Employment is high and real-wage rates rising so that “labor trouble” is kept at bay. Its financial position is strong. If it prefers an extra rise of home consumption to acquiring foreign assets, it can allow its exchange rate to appreciate and turn the terms of trade in its own favor. In all these respects, a country in a weak competitive position suffers the corresponding disadvantages.

When Ricardo set out the case against protection, he was supporting British economic interests. Free trade ruined Portuguese industry. Free trade for others is in the interests of the strongest competitor in world markets, and a sufficiently strong competitor has no need for protection at home. Free trade doctrine, in practice, is a more subtle form of Mercantilism. When Britain was the workshop of the world, universal free trade suited her interests. When (with the aid of protection) rival industries developed in Germany and the United States, she was still able to preserve free trade for her own exports in the Empire. The historical tradition of attachment to free trade doctrine is so strong in England that even now, in her weakness, the idea of protectionism is considered shocking.

[emphasis: mine]

Joan Robinson - What Are The Questions

Joan Robinson (1981)
What Are The Questions? And Other Essays

Wynne Godley And The Dynamics Of Deficits And Debts

In a five-part series in his blog, Functional Finance and the Debt Ratio Scott Fullwiler claims that if the interest rate is held below the growth rate of output, sustainability of the public debt/gdp ratio is guaranteed in the sense that the ratio converges and does not keep increasing forever. This is erroneous and his conclusions are misleading.

Wolfgang Schäuble understands the connection between public finances and international competitiveness, although his solutions are all wrong. Heteredox economists should understand this connection as well!

Rather than write a detailed essay, I thought I should directly get to the point and pinpoint his errors. Of course, several Post Keynesians even before Fullwiler wrote his 2006 paper Interest Rates And Fiscal Sustainability (referred in his posts) have made this claim and this criticism applies to them as well.

While there are future scenarios, where growth improves the public debt/gdp ratio, it does not mean that all scenarios lead to a convergence. Fullwiler has examples in his posts where he shows how the convergence happens. But it doesn’t prove much.

Fullwiler’s error is a simple mathematical one. He sums the series for debt-sustainability equation and shows the the public debt/gdp ratio converges to

– pb/(g – r)

where pb is the primary balance/gdp ratio, g is the growth rate of output and r the interest rate. [notations are changed somewhat without any effect on conclusions]

This is a wrong result because it assumes that the primary balance is constant as a percentage of gdp. The series he sums need not converge if the primary balance in each period is different. One such scenario is when the deficit in each period is bigger than the deficit of the previous period. Fullwiler claims:

… in terms of convergence or unbounded growth of the debt ratio, as Jamie Galbraith put it, “it’s the interest rate, stupid!” since any level of primary deficit can converge if the interest rate is below the growth rate.

[italics and link in original]

This is repeated:

… More importantly, given an interest rate lower than GDP growth, any primary budget deficit will eventually converge …

Now this doesn’t make sense. The claim that “any” level of primary deficit can converge if the interest rate is below the growth rate is incorrect. For example, if we have primary balances pb0, pb1, pb2 and so on and each of them is growing sufficiently faster, the debt/gdp ratio is explosive even if interest rate is less than the growth rate of output. His result is valid if each of the balances pb0, pb1, pb2 … are equal to each other and not in general.

In other words, if g>r, the sequence dn given by the relation

dt – dt-1 = λdt-1 – pbt

where λ is equal to (r-g)/(1+g) need not converge for general values of pband only converges in special circumstances (if suppose the pbn are all equal or more realistic if there is a mechanism to bring the primary deficit into a surplus which may or may not be a discretionary attempt by the government.)


Nothing of the above is purely academic. So in what situation can the public debt explode?

Let us assume an open economy. Let us assume that a country’s exports is X0 and not growing because of its inability to increase its market share or because of limited demand in world markets due to deflationary policies adopted by the rest of the world. Or both.

If one imagines a scenario in which there is growth in output and hence income, imports rise as well in a world of free trade.  This implies the current account deficit explodes. While growth may work to improve the debt/gdp ratio, the current account deficits work to worsen the debt ratio. The net effect is that “growth” instead of improving the debt/ratio worsens it.

This can be seen if one remembers that the sectoral balances identity connects the public sector deficit and the current balance of payments. We have


where NAFA is the private sector net accumulation of financial assets, PSBR is the public sector borrowing requirement (the deficit) and BP is the current account balance of international payments.

Since the private sector typically wishes to have a positive NAFA (else there is another unsustainable process!), an exploding BP leads to an exploding PSBR if output grows much faster than exports. This implies the public debt/gdp grows forever and growth is not sustainable.

Now Fullwiler can potentially claim that the government can “simply credit bank accounts” and public debt/gdp and external debt/gdp rising forever is no cause for trouble but then why write a post claiming convergence of the ratios!

There is a diagram in the post which I modified below with a red line for a path for the sectoral balances. Is the claim that this line extrapolated leads to a stabilizing debt ratio?

[image updated]sf-p4-fig9-modified-corrected

Wynne Godley And Debt Dynamics

The above was pointed out by Wynne Godley in the 1970s. The following brings it out clearly. It is from an appendix to an article written by his co-author Bob Rowthorn in J. Michie and J. Grieve Smith (eds), Unemployment in Europe (London: Academic Press), 1994 pp. 199-206 and was originally a paper to the UK Treasury around ’92-’93

The main conclusions are as follows. Consider an economy in which neither inflation nor the balance of payments is a constraint on output, so that any permanent increase in demand leads to an equal and permanent rise in output. In such an economy, tax cuts or additional government expenditure are eventually self-financing. They lead to some increase in government debt, but not to an explosion, since this debt will ultimately stabilise. The factor stabilising the debt is the behaviour of output. Following a fiscal stimulus, output will rise and tax revenue will automatically increase. Moreover, the expansion will continue to the point where additional tax revenue is sufficient to halt government borrowing and stabilise the debt. In an inflation-constrained economy, the expansionary process will lead to an unsustainable inflation and the government will be compelled to half the expansion before tax revenue has increased sufficiently to stabilise the government debt. In a balance of payments constrained economy, the government debt will grow without limit because the output multiplier will be too small to generate the tax revenue required to stabilise government debt. The counterpart to expanding government debt will be an expanding national debt to foreigners.


Now this may sound as a pessimistic view for any individual nation or the world as a whole. The real problem is free trade – the most sacred tenet of the economics profession.

Updated 28 January 2013 8:40PM GMT