Tag Archives: wynne godley

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).

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.

Being Keynesian In The Short Term And Classical In The Long Term

I am not. But the post is about the possibility. The title is borrowed from a paper by Gérard Duménil and Dominique Lévy. (draft here)

Steve Roth has an article titled Note To Economists: Saving Doesn’t Create Savings. If you follow his blog regularly, his pieces read

The definition of saving is wrong. Saving is equal to income minus expenditure.

That’s not an exaggeration. He actually says it:

… Since saving = income – expenditures, [aggregate] saving must equal zero.

Steve Keen on Twitter supports Steve Roth.

Steve Keen Tweet

What’s with economists’ dislike for national accounts?

Steve Roth uses the phrase “savings” as a stock. Obviously his claim is just wrong as we know from national accounts:

Change in net worth = Saving + Holding Gains.

(with netting in holding gains).

Steve Keen doesn’t use saving as a stock but as a flow and a plural of saving. But Steve Keen’s point is also wrong. National saving is equal to the sum of saving of all economic units, such as households, firms, government etc. Even the household sector’s propensity to save collectively matters. That’s what macroeconomics is all about.

Now moving the more important point: is it possible that a higher propensity to consume reduces the long run rate of accumulation?

There are several Post-Keynesian economists who have considered the possibility. Of course it should be contrasted with supply side neoclassical economics. A few are Basil Moore, Wynne Godley, Marc Lavoie, and Gérard Duménil and Dominique Lévy as mentioned at the beginning of this post.

In their paper Kaleckian Models of Growth in a Coherent Stock-Flow Monetary Framework: A Kaldorian View, Godley and Lavoie find this in their models (draft version here):

We quickly discovered that the model could be run on the basis of two stable regimes. In the first regime, the investment function reacts less to a change in the valuation ratio-Tobin’s q ratio-than it does to a change in the rate of utilization. In the second regime, the coefficient of the q ratio in the investment function is larger than that of the rate of utilization (γ3 > γ4). The two regimes yield a large number of identical results, but when these results differ, the results of the first regime seem more intuitively acceptable than those of the second regime. For this reason, we shall call the first regime a normal regime, whereas the second regime will be known as the puzzling regime. The first regime also seems to be more in line with the empirical results of Ndikumana (1999) and Semmler and Franke (1996), who find very small values for the coefficient of the q ratio in their investment functions, that is, their empirical results are more in line with the investment coefficients underlying the normal regime.

… In the puzzling regime, the paradox of savings does not hold. The faster rate of accumulation initially encountered is followed by a floundering rate, due to the strong negative effect of the falling q ratio on the investment function. The turnaround in the investment sector also leads to a turnaround in the rate of utilization of capacity. All of this leads to a new steady-state rate of accumulation, which is lower than the rate existing just before the propensity to consume was increased. Thus, in the puzzling regime, although the economy follows Keynesian or Kaleckian behavior in the short-period, long-period results are in line with those obtained in classical models or in neoclassical models of endogenous growth: the higher propensity to consume is associated with a slower rate of accumulation in the steady state. In the puzzling regime, by refusing to save, households have the ability over the long period to undo the short-period investment decisions of entrepreneurs (Moore, 1973). On the basis of the puzzling regime, it would thus be right to say, as Dumenil and Levy (1999) claim, that one can be a Keynesian in the short period, but that one must hold classical views in the long period.

So there is a possibility that a higher propensity to consume leads to a lower growth in the long run. I do not think this is generally true, but this could be possible in some economies.

Two conclusions. It’s counter-productive to mix the definition of saving and what’s called “net lending” in national accounts. It’s possible (which shouldn’t mean that it’s necessarily the case) that Keynes’ paradox of savings doesn’t hold in the long run. I don’t believe that’s the case but purely arguing using national accounts and/or changing definitions won’t do.

Helicopters

Frequently, economists start discussing helicopters. This is the most counter-productive discussion. There are two things due to which they invoke this:

  1. Confusion
  2. Intent

The confusion part is basically due to economists’ complete failure to understand what money is and how to account for it and this is due to a lack of training in national accounting/flow of funds etc.

The intent part is equally important. This is because economists are trained in thinking of fiscal policy as impotent. After the crisis, they have party understood the role of fiscal policy but the notion that fiscal policy is impotent is so deeply ingrained that it’s difficult for them to come out of it. This reason is not so obvious but can be proved as follows: If they really think that fiscal policy is not impotent, they should rather suggest a rise in government expenditure than some helicopters.

There’s a third reason.

Wynne Godley in his paper Money, Finance And National Income DeterminationJune 1996 had a good description of all this:

Modern textbooks on macroeconomics treat money in a remarkably uniform – and remarkably silly – way. In the primary exposition the stock of “money” is treated as exogenous in the two senses a) that it is determined outside the model and b) that it has no accounting relationship with any other variable. The reader is then invited to assume, pro tem, that the central bank controls “the money supply” so that it is constant through time. When the operations of banks are described, typically some thirty chapters later, the quantity of money is some multiple of commercial banks’ reserves as a consequence of these institutions having become “loaned up”.

Silly? The money stock, as revealed in real life financial statistics, is as volatile as Tinkerbell – for good reasons, as I shall argue below. How can it be sensible to undertake a thought experiment in which the flickering quantity called “money” is literally constant through periods at least long enough for capital equipment to be planned, built and commissioned – and for lots of other things to happen as well? And the other, “money multiplier”, story has the strange defect that, while giving some account of how credit money might be created, it completely ignores the impact on spending of the counterpart changes in bank loans which are assumed to be taking place; perhaps it is because loan expenditure would mess up the solution of the IS-LM model when alternative assumptions about “the money supply” are used, that the supposed process of money creation normally gets separated from that of income determination by so many chapters.

The bibles of the neo-classical synthesis don’t help. There is a spectacular lacuna in the constructions presented, for instance, by Patinkin, Samuelson and Modigliani with regard to the asset side of commercial banks’ balance sheets. Usually the role and
even existence of bank credit is simply ignored. Modigliani (1963) gives banks (with regard to their assets) no role other than to hold government bonds; and Milton Friedman famously used a helicopter when he wanted to get more money into the system.

There is a reason for all this. It is that mainstream macroeconomics postulates in its basic model that macroeconomic outcomes are all determined by relative prices established in Walrasian markets. Individual agents are held to engage in a market process of which the outcome is to find prices for product, labour and money which clear all three markets plus, by Walras’s law, the market for “bonds”. But as is now well known, there is no use for money in the Walrasian world even though, paradoxically, “money” is a logical necessity if the model is to be solved.

[boldening: mine]

There is no need for helicopters. All is needed is a description via social accounting (i.e. national accounting). Just say “increase government expenditure” to the government or “expand fiscal policy”.

Link

What Post-Keynesian Economics Has Brought To An Understanding Of The Global Financial Crisis

I came across a nice Marc Lavoie paper from July 2015 from which I borrowed the titled of this post. Marc Lavoie discusses the importance of PKE monetary economics, stressing flow-of-funds modelling such as as done by Wynne Godley and his prescient analysis of the fate of the US economy and the rest of the world.

(the post title is the link)

Robert Blecker has a great article from the same conference (annual conference of the Canadian Economics Association) discussing similar things: heteredox understanding of the crisis. He discusseses Wynne Godley’s Seven Unsustainable Processes. He also talks of Hyman Minsky and neo-Kaleckian models of how income distribution effects aggregate demand. His paper titled Finance Distribution And The Role Of Government: Heterodox Foundations For Understanding The Crisis is here.

Non-selective Protectionism In Wynne Godley’s 1999 Article Seven Unsustainable Processes

‘Free Trade Loses Political Favour,’ says the front-page of today’s Wall Street Journal.

Free Trade Loses Political Favour

Paul Krugman has two articles conceding that he held wrong views earlier.

Krugman says:

But it’s also true that much of the elite defense of globalization is basically dishonest: false claims of inevitability, scare tactics (protectionism causes depressions!), vastly exaggerated claims for the benefits of trade liberalization and the costs of protection, hand-waving away the large distributional effects that are what standard models actually predict.

Krugman claims that he hasn’t done any of it but a reading of his 1996 article Ricardo’s Difficult Idea says the exact opposite.

The earliest cri de cœur of the U.S. balance of payments situation came from Wynne Godley in his 1999 article Seven Unsustainable Processes. 

In his sub-heading ‘Policy Considerations,’ he says:

Policy Considerations

The main conclusion of this paper is that if, as seems likely, the United States enters an era of stagnation in the first decade of the new millennium, it will become necessary both to relax the fiscal stance and to increase exports relative to imports. According to the models deployed, there is no great technical difficulty about carrying out such a program except that it will be difficult to get the timing right. For instance, it would be quite wrong to relax fiscal policy immediately, just as the credit boom reaches its peak. As stated in the introduction, this paper does not argue in favor of fiscal fine-tuning; its central contention is rather that the whole stance of fiscal policy is wrong in that it is much too restrictive to be consistent with full employment in the long run. A more formidable obstacle to the implementation of a wholesale relaxation of fiscal policy at any stage resides in the fact that this would run slap contrary to the powerfully entrenched, political culture of the present time.

The logic of this analysis is that, over the coming five to ten years, it will be necessary not only to bring about a substantial relaxation in the fiscal stance but also to ensure, by one means or another, that there is a structural improvement in the United States’s balance of payments. It is not legitimate to assume that the external deficit will at some stage automatically correct itself; too many countries in the past have found themselves trapped by exploding overseas indebtedness that had eventually to be corrected by force majeure for this to be tenable.

There are, in principle, four ways in which the net export demand can be increased: (1) by depreciating the currency, (2) by deflating the economy to the point at which imports are reduced to the level of exports, (3) by getting other countries to expand their economies by fiscal or other means, and (4) by adopting “Article 12 control” of imports, so called after Article 12 of the GATT (General Agreement on Tariffs and Trade), which was creatively adjusted when the World Trade Organization came into existence specifically to allow nondiscriminatory import controls to protect a country’s foreign exchange reserves. This list of remedies for the external deficit does not include protection as commonly understood, namely, the selective use of tariffs or other discriminatory measures to assist particular industries and firms that are suffering from relative decline. This kind of protectionism is not included because, apart from other fundamental objections, it would not do the trick. Of the four alternatives, we rule out the second–progressive deflation and resulting high unemployment–on moral grounds. Serious difficulties attend the adoption of any of the remaining three remedies, but none of them can be ruled out categorically.

[italics in original, underlying mine]

Stock-Flow Inconsistent?

The first rule of Post-Keynesian Economics is: You do not talk make accounting mistakes. The second rule of Post-Keynesian Economics is: You do not talk make accounting mistakes.

– Anonymous.

Jason Smith—who is a physicist—but writes a blog in Macroeconomics, wonders how equations in the simplest stock-flow consistent model given in the textbook Monetary Economics written by Wynne Godley and Marc Lavoie make any sense from a dimensional analysis viewpoint.

He says he

seem[s] to have found a major flaw.

He sees the equation:

ΔH = GT

and wonders where the time dimensions are. For, H is the stock of money and hence has no time dimension, whereas the right hand side has flows and has time dimensions of inverse of time. For example if the US government spends $4 tn in one year, is $4 tn/year.

In continuous time, the above equation is:

dH/dt = GT

So how are these two equations the same?

Perhaps, Jason is not familiar with difference equations. He instead seems to prefer:

τ·ΔH = GT

Well that’s just wrong if τ is anything different from 1, as a matter of accounting.

Now moving on to time scales, it is true that in difference equations some time scale is implicit. But it doesn’t mean the methodology itself is wrong. Many physicists for example set all constants to 1 and then talk of numbers which are dimensionless.

So if a relativist sets “c=1”, i.e, the speed of light to 1, all velocities are in relation to the speed of light. So if somebody says the speed is 0.004, he/she means the speed is 0.004 times the speed of light.

But Jason Smith says:

Where does this time scale come from over which the adjustment happens? There is some decay constant (half life). It’s never specified (more on scales here and here). If you think this unspecified time scale doesn’t matter, then we can take Δtlp and the adjustment happens instantaneously. Every model would achieve its steady state in the Planck time.

That’s not true. String theorists for example set the parameter α’ = 1. But nobody ever claims that macroscopic adjustments happen at Planckian length scales or time scales.

Coming back to economics, there’s nothing wrong in

ΔH = GT

There’s an implicit time scale yes, such as a day, or a month, or a year, or even an infinitesimal. But parameters change accordingly. So in G&L models we have the consumption function

 C = α1 ·YD + α2 ·W

where is household consumption, YD, the disposable income and W, the household wealth.

Let’s say I start with a time period of 1 year for simplicity. αmight be 0.4. But if I choose a time period of 1 quarter, αwill correspondingly change to 0.1. In English: if households consume of 4/10th  of their wealth in one year, they consume in 1/10th one quarter.

So if we were to model using a time scale of a quarter instead of a year, α2 will change accordingly.

But the equation

ΔH = GT

won’t change because it is an accounting identity!

It’s the difference equation version of the differential equation:

dH/dt = GT

Physicists can pontificate on economic matters. I myself know string theory well. But boy, they shouldn’t make mathematical errors and embarrass themselves!

In other words, accounting identities can be written as accounting identities in difference equations. What changes is values of parameters when one chooses a time scale for difference equations.

Wynne Godley’s model is touched by genius. In fact according to one of the reviewers of Monetary Economics, Lance Taylor says that it is out of choice that Wynne Godley chose a difference equation framework. They can be changed to differential equations and we’ll obtain the same underlying dynamics.

Here’s Lance Taylor in A foxy hedgehog: Wynne Godley and macroeconomic modelling

Godley has always preferred to work in discrete time, responding to the way the data are presented.

Question: is the equation ΔH = Gconsistent with dimensional analysis?

Answer: Yes. H is the stock of money at the end of previous period. Δis the change in stock of money in a period. and are the government expenditure and tax revenues in that period. So H, ΔH, G and T have no times dimensions in difference equations. All are in the unit of account. Such as $10tn, $400bn, $4 tn, $3.6tn. Time dynamics is captured by model parameters.

In G&L’s book Monetary Economics, in Appendix 3 of Chapter 3, there’s a mean-lag theorem, which tells you the mean lag between two equilibrium (defined as a state where stock/flow ratios have stabilized):

it is:

[(1 − α1)/α2 ]· [(1 – θ)/θ]

where θ is the tax rate.

So, in the model, assuming a value of 0.6 for α1, 0.4 for α2, and 0.2 for θ we have the mean-lag equal to 4.

Let’s assume that time period is yearly. This means the mean lag is 4 years.

If instead, we were to use quarterly time periods, α2 would be 0.1 and the mean lag evaluates to 16, i.e., sixteen quarters, which is 4 years, same as before.

So there is really no inconsistency in stock-flow consistent models.

tl;dr summary: In difference equations, there’s nothing wrong with equations such as ΔH = GT. It is an accounting identity. By a choice of a time scale, one implicity chooses a time scale for parameter values. What’s wrong? Jason Smith would obtain the same results as the simplest Godley/Lavoie model if he were to work in continuous time and write equations such as dH/dt = GT. I will leave it to him as an exercise!

Last updated 4 Mar 2016, 1:17pm UTC. 

Occult Or Investment Banky?

Noah Smith has a blog post calling heteredox economics occult. Rather than write a long post which nobody will read, let me point out that Goldman Sachs’ chief economist Jan Hatzius uses Wynne Godley’s model. He frequently cites Wynne Godley (and only him!) for his model as well.

Noah Smith is a fan of investment banks and Goldman Sachs being the top firm should make him realize the importance of heterodox modelling.

Not only does heterodox economics have a framework, it is used by the top investment banking firm!

Here’s are two screen snips of GS’ paper written by their chief economist Jan Hatzius and describing their model in detail.

Jan Hatzius Paper Using Wynne Godley's Work

Jan Hatzius’ paper dated September 18, 2003

Jan Hatzius Paper Using Wynne Godley's Work - 2

Jan Hatzius acknowledging Wynne Godley for his model of the US economy 

U.S. Manufacturing Deficit

The latest U.S. trade report is out and has data for the whole year 2015. Manufacturing deficit is something worth noting.

The U.S. manufacturing deficit is $831 bn.

U.S. Manufacturing Deficit

U.S. Manufacturing Exports/Imports

It is sometimes said that manufacturing has lost its importance and that countries in balance of payments difficulties should look to trade in services to put things right. However, while it is still true that manufacturing output has declined substantially as a share of GDP, the figures quoted above show that the share of manufacturing imports has risen substantially. The importance of manufacturing does not reside in the quantity of domestic output and employment it generates, still less in any intrinsic superiority that production of goods has over provision of services; it resides, rather, in the potential that manufactures have for expansion in international trade.

– Wynne Godley, A Critical Imbalance In U.S. Trade, The U.S. Balance Of Payments, International Indebtedness, And Economic PolicySeptember 1995.

Anwar Shaikh’s New Book

Anwar Shaikh is one of the few economists who had warned about cracks in the foundations of growth of the US economy and the world economy as a whole and that it will lead to a crisis in the 2000s. He has a new book titled Capitalism: Competition, Conflict, Crises. It will be published around February next year.

Capitalism - Competition, Conflict And Crises

The book and 1024 pages and looks like a huge analysis of all ideas in economics. You can preview the table of contents at amazon.com here. The book is published by Oxford University Press and the book’s page at OUP is here.

Anwar Shaikh is a very knowledgeable economist. In an interview to Ian Macfarlane, Wynne Godley says how much he learned about neoclassical economics from Anwar Shaikh. They then put up a paper titled An Important Inconsistency at the Heart of the Standard Macroeconomic Model. Wynne Godley considered it one of his most important papers. I like the paper and want to sometime rework it in a slightly different way to show that neoclassical economics makes no sense at all.

Anwar Shaikh

Anwar Shaikh, Levy Institute, May 2011, Photograph by me.