Monthly Archives: September 2015

Thomas Palley – Website 10th Anniversary: 10 Things I Got Right

by Thomas Palley

Ten years ago (September 2005) I launched my website []. To mark this anniversary, here are ten postings that I think got it right. Many of them are included in my book, The Economic Crisis: Notes From The Underground (2012).

  1. Keynesianism: what it is and why it still matters (September 18, 2005). My first post. What was intellectually unfashionable back then is now in.
  2. The Questionable Legacy of Alan Greenspan (October 16, 2005). Raining on the Maestro’s parade was not popular.
  3. Winner’s curse: The Torment of Chairman-designate Bernanke (November 4, 2005). I suspect Mrs. Bernanke wishes Mr. Bernanke read this before accepting the job.


Free Trade And Tight Fiscal Policy

Harvard economist Dani Rodrik recently responded to a question/critique on why he doesn’t believe in the faith about free trade between nations while not showing that much dissent for trade within boundaries. Among the various points in his defence are fiscal transfers and regional policies. Rodrik says:

Another thing that happens is that there is an overarching state that will engage in transfer payments and other policies that aid the lagging region. The region will have political representatives in the national government who will push for the interests of those adversely affected.

That’s a nice point. See my blog post on how fiscal transfers help in reducing regional balance-of-payments problems.

Cafe Hayek responded to Rodrik here. An important point in that argument is: why does it matter if the consumer buys from a domestic producer as opposed to a foreign producer. The Cafe Hayek author Don Boudreaux says:

Now to point (1) – the more narrowly economic point.  Sellers in foreign countries sell things to buyers in the home country only because they – the foreign sellers – wish to increase their wealth.  The motives are identical to those of sellers in the domestic economy.  What do foreign sellers do with the revenues they earn from the sale of their exports?  They spend them.  They save them.  They invest them.  Perhaps on occasion they hoard them.  These options are no different from the options confronting domestic sellers.  If the funds spent on imports return to the domestic economy as demand for exports, jobs and economic activity shift from import-competing domestic industries into exporting industries.  No problem.  If these funds instead return as investments in the domestic economy, again there’s no problem: when, for example, Ikea opens a store in New Jersey it employs workers in that store no less than would an American who opened a similar store.

Now to argue straight with the above. FDI flow is just one flow in the capital and financial account of the balance of payments. And in the stock sense, FDI is just one type of liability among many others such as government debt held by foreigners. These just pay interest to foreigners.

Apart from that, foreigners are not likely to import as much as they export. A nation can have a high amount of imports and less exports. So there’s an asymmetry here – differing level of competitiveness.

But even if competitiveness were equal, nationality of buyers and sellers still matters. This is because creditor nations’ governments may not expand fiscal policy to the extent that is needed for the benefit of the world as a whole. If the government of a nation keeps fiscal policy relatively tight, it affects domestic demand, output and incomes of economic units and hence their imports.

So to summarize, difference in competitiveness and a relatively tighter fiscal stance of creditor nations affects trade and balance-of-payments of other nations. This in turn affects output because a nation which could potentially grow fast may find itself with balance-of-payments problems. Free trade doesn’t help poor nations.

This discussion can also be used in the case of the Euro Area where trade was made more free when the Euro Area was formed. Since there is no central government for the Euro Area, free trade works against nations which have been affected by the crisis.

Sergio Cesaratto’s Debate With Marc Lavoie On Whether The Euro Area Crisis Is A Balance-Of-Payments Crisis – II

This is a continuation of the post from the end of 2014, although reading that isn’t necessary. 

In a new paper, Marc Lavoie continues his debate with Sergio Cesaratto on whether the Euro Area crisis is a balance-of-payments crisis or not. For the sake of completeness, here’s the list of papers, with references copy-pasted from Marc’s latest paper. Not all links are final versions and some may not be available to read in full).

  1. Cesaratto, S. 2013. “The Implications of TARGET2 in the European Balance of payments Crisis and Beyond.” European Journal of Economics and Economic Policy: Intervention 10, no. 3: 359–382. link
  2. Lavoie, M. 2015. “The Eurozone: Similarities to and Differences from Keynes’s Plan.” International Journal of Political Economy 44, no. 1 (Spring): 3–17. link
  3. Cesaratto, S. 2015. “Balance of Payments or Monetary Sovereignty?. In Search of the EMU’s Original Sin–Comments on Marc Lavoie’s The Eurozone: Similarities to and Differences from Keynes’s Plan.” International Journal of Political Economy 44, no. 2: 142–156. link
  4. Lavoie, M. 2015. “The Eurozone Crisis: A Balance-of-Payments Problem or a Crisis Due to a Flawed Monetary Design?” International Journal of Political Economy 44, no. 2: 157-160. (abstract)

As mentioned in my part 1, referred to on top of this post, I agree with Sergio Cesaratto.

sergio-and-marcSergio Cesaratto with Marc Lavoie (picture credit: Matias Vernengo)

Marc Lavoie’s main point in the final paper seems to be that, “Eurozone countries can never run out of TARGET2 balances, which can take unlimited negative values, so that the evolution of the balance of payments cannot be the source of the crisis”.

This is not accurate in my view. Although the rules of the Eurosystem allow unlimited and uncollateralized credit facility between the Euro Area NCBs and the ECB, one has to look at the counterpart to the T2 imbalances. If an economic unit transfers funds across border from country A to country B, this first results in a reduction of balances of banks in country A at their NCB and may result in an intraday overdraft (“daylight overdraft” in U.S. language), usage of the marginal lending facility with the NCB, an MRO, or an LTRO and finally ELA in late stages of a crisis (if capital outflow is large).

Marc himself mentions this point in his latest paper:

If a Eurozone country is running a current account deficit that banks from other Eurozone members decline to finance, or if it is subjected to capital outflows, then all that happens is that the national central bank of that country will be accumulating TARGET2 debit balances at the ECB. There is no legal limit to these debit balances. The national central bank with the debit balances, which pay interest at the target interest rate, has as a counterpart in its assets the advances that it must make to its national commercial banks at that same target interest rate. And the commercial banks can obtain central bank advances as long as they show proper collateral. Why would the size of current account deficits or TARGET2 debit balances worry speculators? There might be a problem with the quality of the loans that have been granted by the banks, or with the size of the government debt, but that as such has nothing directly to do with a balance-of-payments problem.

[italics: mine]

But that is the case! It’s because of balance-of-payments. Nations who had high indebtedness to the rest of the Euro Area saw more capital flight. This is because in times of crisis, there is a home bias and international investors are likely to sell securities abroad and repatriate funds home. Large current account imbalances lead to a large negative net international investment position. (It’s of course also true that revaluations are important, and this is what happened in the case of Ireland). So when non-residents sell securities to domestic investors, banks are likely to get into a bad situation because they have to accommodate these transfer of funds and are losing central bank balances on a large scale.

It is precisely nations which had worse net international investment positions which were affected as charted in my previous post on this.

Now moving on to definitions: what is a balance-of-payments problem? The simplest definition is the problem for residents in obtaining finance from non-residents. Greece precisely has been struggling to obtain funds from non-residents.

So I do not agree with Marc’s view that:

Cesaratto, as others, is adamant that the Eurozone crisis is a balance-of-payments crisis, whereas I believe, as others do, that this is a side issue.

Marc Lavoie also says that the people arguing for this view are implicitly assuming some kind of “excess saving” view on all this:

In discussions with colleagues who support a “current account deficit” view of the Eurozone crisis, I sometimes get the impression that they are also endorsing a kind of “excess saving” view of the economy. They tell me that current accounts deficits are unsustainable within the Eurozone because the core Eurozone countries will refuse to lend to the periphery and will thus prevent these countries from financing economic activity. This seems wrong to me.

I disagree with this. It’s precisely because residents’ liabilities are large compared to their financial assets that they have to rely on non-residents/foreigners. And during the crisis a lot of capital outflow has happened and this precisely shows that non-resident private investors are unwilling to lend again on the same scale as before. This obviously means that to obtain finance, governments of nations affected have to take the help of the official sector abroad, such as from governments, the ECB and the IMF. If TARGET2 alone could do the trick, is the Greek government foolish to go abroad?

It is of course true that the design of the Euro Area was faulty. But that still leaves open the question about why Germany is not facing a crisis as severe as Greece. The design view cannot explain this. Any country (or all countries) in the Euro Area could have faced a crisis. There is a pattern here and that is where balance-of-payments comes in.

This debate is an interesting one. Both Sergio Cesaratto and Marc Lavoie agree on almost everything, except this BIG thing.

Of course this also spills over to policy proposals. Marc Lavoie believes that the European Central Bank can guarantee that all nations can have independent fiscal policies (by promising to buy all government debt which the financial markets isn’t interested in purchasing). Sergio Cesaratto is clear on this (and I agree very much) – in another paper Alternative Interpretation of a Stateless Currency Crisis:

A more resolute role of the ECB as lender of last resort accompanied by fine-tuned expansionary fiscal policies can only be imagined in a different political and institutional framework, quite close to that of a political union.

Let’s consider what happens if there is no federal government and if the ECB is the main supranational authority (ignoring other supranational institutions which have limited powers). Suppose the ECB were to guarantee the debt of governments of all Euro Area nations. There’s nothing to prevent, say, the government of Finland to increase the compensation of its employees every year by a huge percentage and thereby affecting Finnish corporations’ compensation of its employees. This will result in a reduction of competitiveness of Finnish producers and Finnish resident economic units will rely more on goods and services produced abroad. This will raise Finland’s net indebtedness to the rest of the Euro Area and the world. If someone believes that this debt is not a problem, how about the inflationary impact of this rise in demand on the rest of the Euro Area?

So the solution lies in bringing down the balance-of-payments imbalances (both negative and positive ones such as that of Germany). This requires a supranational institution, which is a central government. National governments would have rules on their budgets but the central government — since its goals and objectives are different — wouldn’t be bound by any rules. Wage rises would need to be coordinated. And as I argue in this post, fiscal transfers also plays a role of keeping imbalances in check.

Of course there are many other economists who also argue that the Euro Area problem is a balance-of-payments problem, but with a different motive. Their argument is to blame the nations in crisis instead of taking a humanist approach.

To summarize, the Euro Area problem wouldn’t have been a balance-of-payments problem had the official sector promised to act as a lender of the last resort to national Euro Area governments without any condition. As long as there are conditions, it is a balance-of-payments problem. One cannot pretend that the European Central Bank has or can be given such powers to lend without any condition. And hence the Euro Area crisis is a balance-of-payments problem.

Casual Monetarism

In an Op-Ed for The New York Times, Japan’s Economy, Crippled by Caution, Paul Krugman is seen using a highly Monetarist language:

As I said, you might think that ending deflation is easy. Can’t you just print money? But the question is what do you do with the newly printed money (or, more usually, the bank reserves you’ve just conjured into existence, but let’s call that money-printing for convenience). And that’s where respectability becomes such a problem.

When central banks like the Federal Reserve or the Bank of Japan print money, they generally use it to buy government debt. In normal times this starts a chain reaction in the financial system: The sellers of that government debt don’t want to sit on idle cash, so they lend it out, stimulating spending and boosting the real economy. And as the economy heats up, wages and prices should eventually start to rise, solving the problem of deflation.

… When you print money, don’t use it to buy assets; use it to buy stuff. That is, run budget deficits paid for with the printing press.

Now, there are several things wrong about this. The most important one is the implicit assumption in the “model” that fiscal expansion via increased government expenditure is about neutral and that domestic demand is boosted only because of the way in which the government debt is financed – i.e., central bank purchases of government debt. In other words, Krugman is saying that if there is deflation and if there is an expansion of fiscal policy via a rise in say government expenditures, it will have little effect when the central bank doesn’t purchase government debt. Put it in another way, it is saying that the government expenditure multiplier effect acts mainly because of central bank purchase of government debt and not because of the increase in government expenditure per se.

This is silly intuition and the cause of this is the notion that fiscal policy is more or less neutral except in special circumstances.

In reality, it is the other way round. If the government expenditure rises, and if the central bank purchases government debt, the rise in output is mainly attributable to the former. This can of course be seen in a stock-flow consistent model but can also be seen by simple accounting and flow of funds. A rise in government expenditure on goods and services raises output directly and also via the multiplier effect. The central bank has a huge control over interest rates and the additional debt is simply absorbed by the bond markets easily. There’s no competition with other borrowers as the wealth of the private sector rises. In addition, if the central bank purchases government debt, it is hardly clear if households know if inflation is going to rise and increase their consumption because of “inflation expectations”. Even if they think that if inflation is set to rise, they might reduce consumption as inflation might reduce their real wealth.

Which is not to say that asset purchase programs of the central bank or “quantitative easing” has no effect on demand and output. It works via capital gains in wealth leading to higher consumption and the feedback effects of this. It also works if economic units shift their portfolios to buying non-financial assets. The effect of all this is unclear. In addition, as mentioned earlier, casual Monetarism like the language used by Paul Krugman mixes up correct attributions of government expenditure and central bank government debt purchases on output, misleading everyone.

Simply say “raise government expenditures”. Why all this casual Monetarism with “printing presses”?

Do Keynesians Ought To Love Tax Cuts?

Cullen Roche – in response to Paul Krugman – says Keynesians should learn to love tax cuts. His argument is that since Keynesians believe in the principle of effective demand and that since tax rate cuts boosts domestic demand and hence output, it is surprising to find Paul Krugman not favouring tax cuts.

Tax cuts raise output by increasing disposable incomes of economic units who will raise their expenditures in response. This via a multiplier effect will raise output. But it’s not as if tax rate cuts is the only tool available to the government.

Let’s see 4 different ways the government can boost domestic demand:

  1. Raise government expenditures,
  2. Decrease tax rates,
  3. Raise government expenditures and decrease tax rates, and,
  4. Increase government expenditures and raise tax rates.

The expansionary nature of the first three ways above is obvious. For the fourth, it depends on the numbers. So if the government raises tax rates from say 25% to 30% and increases government expenditure by 1%, it is likely contractionary. Instead, if the government increases its expenditure by 25%, it is expansionary.

These are not the only ways available for demand management. The government by coordinating with  the central bank can reduce interest rates. It can make lending/borrowing easier by other ways. It can give guarantees to bonds issued by corporations, thus giving an incentive for corporations to increase expenditures. It can raise tariffs on imports. There are several ways but here those things are less relevant for now.

Each of the four ways above has a different effect on output and the distribution of income. Tax cuts usually favour economic units who earn more. Richer economic units such as rich households have a lower propensity to consume and hence this will have a smaller multiplier effect. If Keynesians favour tax cuts, they’d favour it for low earning households than for corporations.

Of course, the multiplier effect is not a complete argument in itself as the opponents might argue “So cut taxes even more according to your logic”. But at any rate, let’s see how it works.

In stock-flow-consistent models, there’s the concept of a fiscal stance toward which GDP converges for a given government expenditure and a tax rate θ. So we have

GDP = G/θ

With that,

dGDP/GDP = dG/G − dθ/θ

So a percentage rise in government expenditure will have the same multiplier effect as a percentage fall in tax rate.

This of course is the long-run output. For the short run, the expression in the simplest Keynesian model:

GDPG/(1 − α1·(1 − θ))

α< 1

The parameter αis the propensity to consume.

In this case, i.e., for the short run,

dGDP/GDP = dG/G − [α1·θ/(1 − α1·(1 − θ))2dθ/θ

By taking some values such as 0.6 for αand 25% for θ, you can convince yourself that a proportional rise in government expenditure is more effective than a proportional fall in tax rates. Of course, this is not a complete argument but illustrative. If a tax rate cut of x% doesn’t achieve a $1 rise in government expenditure, one can make the case for a higher tax rate cut to achieve a similar result.

Apart from that there are other implicit assumptions of the model: there is no income inequality in the simplest Keynesian models. So rich economic units will have a lower propensity to spend: households working as employees of firms with higher compensation will have lower propensity to consume. Households may have an even lesser propensity to consume out of other incomes such as interest and dividends.

So the multiplier analysis illustrates that a tax cut for richer economic units is not the same as the poorer units because the multiplier in the short run depends on the propensities to spend.

The correct stand hence is about the distributional effects of fiscal policy and the effect on output. So the correct stand is to argue for a rise in government expenditure and fair rates of taxes for economic units. Many economic units will have to pay higher taxes in this view. What’s fair of course is debatable but at least in this line of argument, souls believing in the principle of effective demand needn’t love “tax cuts”.

There is another argument for not promoting lower tax rates. This is because once tax rates are reduced, it is politically difficult to raise it if needed.