Monthly Archives: January 2012


In an article (obituary), Nicholas Kaldor, 12 May 1908-30 September 1986, Geoff Harcourt said:

Nicholas Kaldor’ resembled Keynes more than any other twentieth-century economist because of the breadth of his interests, his wide-ranging contributions to theory, his insistence that theory must serve policy, his periods as an adviser to governments, his fellowship at King’s and, of course, his membership of the House of Lords.

I was reading this article (for the 3rd time!) Kaldor And The Kaldorians by John E. King. It appears as a chapter in the book Handbook Of Alternative Theories Of Economic Growth edited by Mark Setterfield.

I came across this strong Kaldorian view (which I share):

How, exactly, does the constraint [balance-of-payments constraint] operate? Three mechanisms can be distinguished. First, in extreme cases like Cuba in the 1990s and Zimbabwe in the 2000s, a shortage of foreign exchange makes it impossible fully to operate the existing capital stock (since spare parts can no longer be imported), and growth declines or becomes negative. Second, during the fixed exchange rate regime imposed by the Bretton Woods system (1945–73), governments were forced to implement deflationary monetary and fiscal policies to protect the currency in face of often quite small payments deficits. This generated the “stop–go” cycle that Kaldor regarded as the principal cause of Britain’s poor growth performance in this period. Third, in a floating exchange rate regime, the principal constraint on output growth is the rate of growth of export demand. Kaldor himself came to believe that exports were the only source of autonomous aggregate demand, since all other categories of expenditure were fully determined by income: consumption directly, investment indirectly through the accelerator coefficient, and government spending indirectly through taxation receipts, themselves a function of income. This is a characteristically extreme position, which is difficult to justify. But it is not necessary to deny the existence of some autonomous consumption, investment and government spending in order to recognise the importance of export demand as a factor in economic growth. For most small countries, and for all regions within countries, exports are indeed the most important factor.

I am not sure if King’s description of Kaldor and the Kaldorians is the best but a decent one. So, as King hints, Kaldor fully understood the injection to demand due to government expenditure and private sector borrowing. In fact, one whose views closely resembled that of Kaldor was Wynne Godley.

How are exports determined?

Nicholas Kaldor, Geneva, 1948

Picture source: Economica

Kaldor had the following to say:

The growth of a country’s exports should itself be considered as the outcome of the efforts of its producers to seek out potential markets and to adapt their product structure accordingly. Basically in a growing world economy the growth of exports is mainly to be explained by the income elasticity of foreign countries for a country’s products; but it is a matter of the innovative ability and adaptative capacity of its manufacturers whether this income elasticity will tend to be relatively large or small.

in “The role of Increasing Returns, Technical Progress and Cumulative Causation in the Theory of International Trade and Economic Growth”, Economie Appliquée, 1981

This is oft-quoted by economists who are inspired by Kaldor’s work. This may look straightforward but in my opinion, it is not so in practice. There are just too many different kinds of stories one hears about the external sector from economists. In stock-flow-consistent Post Keynesian macro modelling literature, one sees equations such as

The algebra is involved and there are many more equations than the above two. To get exports and imports, one has to multiply the x£ and im£ by prices. Refer Godley&Lavoie’s text Monetary Economics, oft referred in this blog.

The above equation assumes important causalities. Exports of a nation depends on prices of exported products relative to domestic prices of products in the foreign country, for example. In addition, exports also depend on demand and income in the foreign country(y$). The parameter ε2 (and μ2 from foreigners’ viewpoint) is what Kaldor is talking of in the quote above. The more competitive producers in the £-country are, the higher ε2 will be. Of course, this is not the only important thing, and prices are also important. (For example, if the GBP starts appreciating, UK exporters will face pressures in selling their products in the US).

The above equation also shows that if there are injections to demand, such as from government expenditure or tax cuts or due to higher private expenditure (either by higher borrowing or an increased propensity to consume etc), imports will increase. Similarly, if there is a contraction, imports will decrease as was evident by the collapse of world trade due to recessions in many parts of the world during the “Great Recession”.

The purpose of my post was to highlight what importance economists give to price-elasticity and income-elasticity of exports/imports. Most economists worry too much about ε1 (and μ1) and Kaldorians pay much more attention to ε2 (and μ2) and what sorts of policies governments should follow based on this. For example, a nation’s government may be concentrating too much in promoting exports of goods and services where price-competitiveness plays a role. It may be beneficial if it switches to promoting exporting goods and services in which it has unique capabilities which if successful will greatly improve its external situation.

In fact, according to the work of Kaldorians such as Anthony Thirwall and John McCombie, growths of nations can be explained by the ratio of the rate of growth of exports to the income elasticity of its imports. In the stronger form, exports themselves depend on the income-elasticity of imports in the foreign nation – i.e., the “non-price competitiveness” of exporters.

The two authors wrote an excellent book in 1994: Economic Growth And The Balance-Of-Payments Constraint – considered one of the greatest books in Post-Keynesian Economics.

The (Almost) Irrelevance Of Reserve Requirements

Earlier this week, the Reserve Bank of India reduced banks’ reserve requirements by 50bps. It’s called Cash Reserve Ratio and the RBI reduced it from 6.00% to 5.50% with effect from the following week.

The Reserve Bank of India is one of the most backward central bank in liquidity management and sometimes panics and changes the reserve requirements. Typically this happens when taxes flow into the government of India’s account at the RBI and since this is not smooth, the RBI simply doesn’t know what to do.

To me this confusion was good, because three years back when someone asked me to read about this in office, I came across this Reuters article and after reading it (and slightly before when I became interested in macroeconomics after the Federal Reserve announced a Large Scale Asset Purchase Program, popularly known as “QE”) I started having suspicions on the way economists seem to describe banking and economics. This ultimately led me to some Neochartalists’ blogs and finally to Post-Keynesian Economics.

In many countries central banks have a zero-reserve requirement, such as in the UK, Canada, Sweden, Australia and New Zealand. In the United States, the Federal Reserve imposes a requirement of 10% with additional complications.

Basil Moore in his 1988 book Horizontalists and Verticalists goes into the details of central banking operating procedures and provides a fantastic account of central banking. See pages 63-65 and 95-97 for reserve requirements.

From page 63-65:

… Fed non-interest earning reserve requirements put member banks at a disadvantage relative to non-members, who were generally allowed to hold interest-earning assets as reserves and who in addition typically had lower reserve requirements. Because membership in the Federal Reserve system is voluntary under the dual banking system tradition, as interest rates rose an increasing number of banks withdrew from the system. In desperation the Federal Reserve finally proposed to pay interest on required reserve balances. Congressional reaction to this potential erosion of seigniorage from reserve earnings was loud and swift and led rapidly to the Monetary Control Act of 1980. Its solution, to make reserve requirements universal and uniform for all depository institutions, whether members of the Federal Reserve or not, was, as revealed in the 1979 hearings before the Senate Banking Committee, a compromise clearly designed to safeguard the volume of Fed-Treasury transfers and at the same time reduce membership attrition for the Fed.

Contrary to conventional wisdom, changes in reserve requirements imposed by the central bank do not directly affect the volume of bank intermediation. A change of required reserve ratios influences the volume of bank intermediation only indirectly, by affecting the required reserve markup or spread. A rise (reduction) in reserve requirements raises (lowers) the cost of obtaining funds to place in loans financed via  additional reservable deposits, in the manner of an indirect tax. The banks will therefore raise (lower) the markup of their lending rates over their borrowing rates. As a result, depending on the interest elasticity of demand for bank credit, the volume of bank intermediation will be indirectly reduced (increased).

From pages 95-97:

… In practice the Federal Reserve fully compensates for any excess reserves created by a lowering of reserve requirements by open-market sales so as to maintain free reserves at some target level. This evidence is clearly consistent with the notion that nominal money stock is demand-determined …

There are other effects. The ECB governing council decided in December to reduce reserve requirements to 1% from 2%  January 18. This “freed up” a lot of collateral banks in the Euro Area needed to pledge to the Eurosystem, thereby providing some relief to the banking system in crisis.

Chart Source: ECB

On 18 January, reserve requirement was €103.33bn as compared to €207.03bn on the previous day.

The Eurosystem And Greek Government Debt

Some bonds of the Greek government mature on March 20. The total principal amount is €14.5bn.

The focus in the financial markets is what will happen to these securities and everyday we read about negotiations with the creditors on “private sector involvement (PSI)”. For the latest see this WSJ article Greece Private-Sector Creditors Meet in Paris.

According to The New York Times DealBook

Brokers estimate that of the 14.5 billion euros of these bonds outstanding, the largest holder is the European Central Bank, which bought these securities in 2010 at a price of around 70 cents in an early, ultimately futile attempt to boost Greece’s failing bond market. The brokers say that 4 billion to 5 billion euros of bonds are owned by hedge funds at an average cost of around 40 cents to 45 cents, with some of the larger positions being held by funds based in the United States that have large London offices.

Let us look at what may happen as far as the Eurosystem is concerned on March 20. Let’s assume that the Eurosystem holds €10bn of the maturing issue – €3bn each by De Nederlandsche Bank and the Bank of Greece and €4bn by the European Central Bank. And that the remaining €4.5bn are held by hedge funds.

Let’s assume that the hedge funds will be paid 15 cents for every € of bond held and are issued new restructured debt securities – i.e., €675m (Plus what about the final coupon payment?)

Question:  Where does Greece get the €10.675bn from?

The ECB is opposed to losses on the Eurosystem’s holdings as per this Bloomberg report from today so it may get a preferred creditor status.

The Eurosystem and the Greek government cannot roll the debt as it will violate the Treaty. So some official creditor or a group of creditors (EFSF?) will have to purchase €10bn+ of bonds from the Greek government before March 20 who will then pay €3bn each to the De Nederlandsche Bank and the Bank of Greece and €4bn the European Central Bank (plus coupons) on March 20 who will then later purchase the bonds from the group of official creditors!

The same holds even if the Eurosystem takes some loss.

Some GIMP Fun With Spain’s Sectoral Balances

… but not fun for the Spanish people.

In yesterday’s post Spain’s Sectoral Balances, I briefly discussed the sectoral balances of Spain and its connection with demand, income and output. Here’s the original graph from the Banco de España again with my viewpoints in the previous post.

I learned some GIMP from a friend some time ago and thought I’ll use it for some fun.

I consider two scenarios:

Suppose the Spanish government relaxes its fiscal policy (independent of other Euro Area governments’ policies) or does not tighten it. How do the sectoral balances look? Here’s a likely scenario:

(may not sum to zero because of drawing discrepancies)

The “projection” – not to scale since I had limited availability for space – implies the government deficit keeps rising and this is the result of the rising current account deficit. A higher fiscal stance leads to a slightly higher income and employment but the flip side of this is a rising indebtedness to the rest of the world caused due to the current account deficits. The public sector is incurring almost all the change in net indebtedness – i.e., its contribution to net borrowing from the rest of the world is the highest.

Of course, this process cannot go on forever as a rising indebtedness implies foreigners have to be attracted by hook or crook and interest rate paid on government debt and consequently all private sector debts will also keep rising leading to a deflationary bust at some stage.

Also note, the causality here is a bit opposite of what was described in the previous post! The causalities between the balances of the “three sectors” is complex and not so straightforward. Here a higher fiscal stance leads to a higher income and expenditure and a widening of the current account deficit which in turn widens the budget deficit.

To prevent such possible instabilities – at least their smell of such instabilities – the European leaders have imposed the “fiscal compact” on nations.

What do they aim to achieve? The following “projection” is a possible answer:

The above describes the possible outcome of a tight fiscal stance of the Spanish government. A tight fiscal policy leads to lower income and hence a lower current account deficit – because of lower expenditure on foreign products – but it is achieved via lower output and employment.

The above projections are not based on a specific model for the Spanish economy but some analysis based on familiarity with SFC modelling.

Macroeconomics is not so easy – there are so many constraints – and governments have to strive to achieve the best optimal outcome. “Market forces” do not do that.

The second scenario can also be achieved by a coordinated fiscal expansion by the Euro Area nations. The sectoral balances may behave similar to the second scenario but in the expansionary scenario, output and hence employment is higher. Unfortunately there is no mechanism or institutional means by which fiscal policies are coordinated within the Euro Area (the exception is the recent “fiscal compact” which unfortunately misses the point). Even if there is an agreement on fiscal expansion, there is nothing to make sure that there is a constant management of the whole process – i.e., there are chances of failure.

There are various ideas one sees on proposing a solution to end the Euro crisis but almost none appreciate the real problems. In my opinion, there is no alternative to moving ahead with a European integration and granting more fiscal powers to the European powers – making it a central government – which is involved in fiscal transfers and a mandate to achieve full employment.

Spain’s Sectoral Balances

The Banco de España released its Quarterly Economic Bulletin today and it had an interesting chart on the sectoral balances of the Spanish economy.

With a net indebtedness of €994.5bn – i.e., close to €1 trillion – as compared to the gross domestic product of €1.06tn (2010 figure) Spain has limited choices. Except via the possibility of expanding by another private sector led credit expansion which is highly unlikely, the Spanish economy faces the prospects of low output and demand. Increasing exports is another option but with all Euro Area nations’ governments being forced by a “fiscal compact” to contract, this is unlikely because of low demand in the rest of Europe.

The chart is really interesting as it illustrates some of the many causalities associated with the financial balances identity


where NAFA is the Net Accumulation of Financial Assets of the domestic private sector, PSBR is the Public Sector Borrowing Requirement or the deficit and BP is the current balance of payments.

When the domestic private sector tries to increase its saving, there is a contraction of demand, income and output (unless exports increase). As a result imports too reduce (because income is lower). The higher propensity to save also leads to an increase in the government’s budget balance.

So in the chart you see a dramatic fall in the current account deficit and a huge increase in the government’s budget deficit. (The term “Nation” is used in the chart because the current balance of payments is the difference between the incomes and expenditures of all domestic sectors of a nation).

The situation is not atypical of recent (post crisis) behaviour of other nations’ sectoral balances but the fall in the external sector balance in this case is striking, though the same could be said for various deficit nations in the Euro Area.

The Banco de España – whose short-term projections are usually accurate – also said today that unemployment will hit 23.4% in 2012!

By The Theory’s Originators, At Any Rate

While most people – including most economists – treat money as a commodity, there are some who understand the endogeneity of money. However, there is a degree of endogeneity assigned to the nature of money with some thinking money was a commodity in some periods in history. So one sees claims that what is written in economics textbooks works only in “gold standard” or worse – fixed exchange rate regimes. Fixed or floating is not the focus of this post, but I’d like to quote James Tobin who once said:

I believe that the basic problem today is not the exchange rate regime, whether fixed or floating. Debate on the regime evades and obscures the essential problem.

… The man and his wisdom 🙂

Nicholas Kaldor wrote a major article in 1985 titled How Monetarism Failed (Challenge, Vol. 28, No. 2, link). The article goes into the heart of confusions in economists’ minds on the nature of money.

Kaldor talks about the Monetarists’ false intuition:

Given the fact that the demand for money represents a stable function of incomes (or expenditures), Friedman and his associates conclude that any increase in the supply of money, however brought about (for ex- ample, through open-market operations that lead to the substitution of cash for short-term government debt in the hands of discount houses or other financial institutions), will imply that the supply of money will exceed the demand at the prevailing level of incomes (people will “find themselves” with more money than they wish to hold). This defect, in their view, will be remedied, and can only be remedied, by an increase in expenditures that will raise incomes sufficiently to eliminate the excess of supply over the demand for money.

As a description of what happens in a modern economy, and as a piece of reasoning applied to situations where money consists of “credit money” brought about by the creation of public or private debt, this is a fallacious piece of reasoning. It is an illegitimate application of the original propositions of the quantity theory of money, which (by the theory’s originators at any rate) were applied to situations in which money consisted of commodities, such as gold or silver, where the total quantity in existence could be regarded as exogenously given at any one time as a heritage of the past; and where sudden and unexpected increases in supply could occur (such as those following the Spanish conquest of Mexico), the absorption of which necessitated a fall in the value of the money commodity relative to other commodities. Until that happened, someone was always holding more gold (or silver) than he desired, and since all the gold (and silver) that is anywhere must be somewhere, the total quantity of precious metals to be held by all money-users was independent of the demand for it. The only way supply could be brought into conformity, and kept in conformity, with demand was through changes in the value of the commodity used as money.

[boldening: mine]

Notice the wording “by the theory’s originators at any rate”.

And what about mining or the lack of mining?

… the value of the money commodity depended, in the longer run at least, on its costs of production, in the same way as the demand for other commodities. With the expansion of the general level of production, the value of monetary transactions through the purchases and sales of goods and services expanded pari passu, which made it profitable to expand the production of the money commodity in line with commodities in general. From the very beginning, therefore, the increase in the supply of money in circulation was a response to increased demand and not an autonomous event, though occasionally the supply of the money commodity ran ahead of the increase in the supply of other commodities, as with the gold and silver discovered in the new Spanish colonies of the sixteenth century; at such times, money could be said to have exerted an autonomous influence on the demand for goods and services. It did so because those who first came into the possession of the new gold or silver were thereby personally enriched, and thus became the source of additional demand for goods and services. But the converse of this proposition was equally true: where the increase in the supply of the money commodity lagged behind, this placed obstacles on economic expansion that historically were gradually overcome with the successive introduction of money substitutes.

Kaldor then goes into the development of the banking system:

This latter development was closely associated with the development of banking. Originally, goldsmiths (who possessed strong rooms for holding gold and other valuables) developed the facility of accepting gold for safekeeping, and issued deposit certificates to the owners. The latter found it convenient to make payments by means of these certificates, thereby saving the time and trouble of taking gold coins out of the strong room only to have them re-deposited by the recipient of the payment, who was likely to have much the same incentive of keeping valuables deposited for safekeeping. The next step in the evolution toward a credit-money system was when the goldsmiths found it convenient to lend money as well as to accept it on deposit for safekeeping. For the purpose of lending they had to issue their own promissory notes to pay cash to the bearer (as distinct from a named depositor) on demand; with this latter development the goldsmiths became bankers, i.e., financial intermediaries between lenders and borrowers. Since real money (gold) was only required on specific occasions (when payments had to be made abroad or when the contract specifically provided for payment in cash), the banks found that the amount of such notes issued to borrowers came to exceed by many times the amount of gold deposited in their vaults by the lenders- though the total amount they owed to the lenders was always larger than the total amount lent to the borrowers. The apparent contradiction between the formal solvency of the banks when the volume of credits granted to borrowers was compared with their total obligation to their depositors, and their palpable insolvency when the value of the promissory notes issued was compared with the amount of gold held for their encashment, was not properly understood for a surprisingly long period. It gave rise to prolonged controversies between those (like Edwin Cannan) who firmly believed in “cloakroom banking” and those who believed that, by issuing pieces of paper that came to serve as a circulating medium, the banks were “creating credit,” which meant an effective enlargement of the money supply.

Did central banks “control” the money stock during gold exchange standards? Kaldor says:

Traditionally, the core of central-banking policy consisted of protecting the reserves (in gold or reserve currencies) through the instrument of changes in the bank rate. Ostensibly, such changes served the purpose of keeping the balance of payments with foreign countries on an even keel – a loss of reserves was taken as evidence of an unfavorable balance, and vice versa. The policy worked in the sense that even moderate changes in short-term interest rates (relative to other financial centers) sufficed to reverse the trend in the movement in reserves. But until the new monetarism came into fashion, stabilizing the quantity of money in circulation, as distinct from stabilizing the volume of international reserves, was not regarded as a primary objective.

One more thing. There is a very interesting point that Kaldor makes at the beginning of the article – the ending of the following is the point of the greatest interest to me.

In the light of the above, the main contention – and indeed, the sine qua non – of monetarism, that the money supply of each “economy” is exogenously determined by the monetary authority of the “economy” concerned, may be questioned from the start. Monetarists, following Milton Friedman, assume that the monetary authority determines the so-called “monetary base” (or “high-powered money,” to use Friedman’s expression), which is nothing else but the amount of bank notes issued which at any one time are partly in the hands of the public and partly in the hands of the banks, whether in the form of vault-cash or of deposits with the central bank; either legally enforceable rules or conventions determine an established ratio between this “base money” and all other forms of money. Hence the “monetary authority” ultimately determines the supply of money in all forms. It does so partly by active measures such as “open-market operations,” by which the central bank buys or sells government securities in exchange for its own notes, and partly by passive measures, the re-discounting of short-term paper consisting of public or private debt, in which it seeks to achieve its objective as regards the money supply by varying its own rate of re-discount. The further assumption that the (inverted) pyramid of bank money bears a stable relationship to the monetary base is supposed to be ensured by the banks’ rationing credit so as to prevent their liabilities from becoming larger (or rising faster) than the legal or prudential reserve ratio permitted. It is admitted, however, that each “economy” characterized by the possession of a separate currency must be wholly autonomous, which means that the central bank is not under any obligation to maintain its exchange rate at a predetermined relationship with other currencies (as was the case under the pre-1914 gold standard or the Bretton Woods system); rather, it allows its exchange rate to fluctuate freely so as to achieve a balance in the foreign-exchange market without central-bank intervention. (The possibility that payments, whether among the same nationals or between different nationals, are effected in other currencies or through transfers between extraterritorial bank accounts has not, to my knowledge, been explicitly considered.)

[last emphasis: mine]

I will have a post in the future on international flow of money, correspondent banking, foreign exchange market microstructure, fx settlements and balance of payments to argue Tobin’s wisecrack that the fixed versus floating debate obscures the problems facing the world today.

Hopefully my post (which was mainly quotes from Kaldor) may force the reader to think about the Horizontalist claim that money is endogenous and it cannot be otherwise.

Bidding Behaviour In The Eurosystem’s December 3-Year LTRO

On 28 December 2011, the Eurosystem conducted a large 3-year LTRO (Longer-Term Refinancing Operation) in which banks in the Euro Area bid about €489bn. I covered this in my post Today’s Eurosystem LTRO and I wrote that the LTRO was to help banks meet their funding needs and that they participated in it to roll over existing debt to the financial system excluding the Eurosystem.

My post had some responses having some issues with this but today the ECB released its January Monthly Bulletin which has a section on the bidding behaviour (page 30 of the pub, 31 of the pdf) confirming this:

(click to enlarge)

Some remarks can be made regarding the bidding behaviour in the three-year LTRO. First, the large amount of liquidity obtained by euro area banks in this operation can be viewed as a reflection of their refinancing needs over the coming three years, as shown in Chart A. Measuring the rollover needs over a shorter horizon, for instance over the next six months, even though it captures the large amount of refinancing needed in the first half of 2012, does not fully explain the bidding behaviour. This suggests that medium-term funding considerations may have had a significant influence on the bidding behaviour. Indeed, in addition to assessing the rollover risk faced by banks, it is useful to consider the residual maturity of banks’ outstanding debt. The longer the residual maturity, the lower the risk that banks will need to seek market funding under unfavourable conditions. Chart B illustrates a clear negative relationship between the size of the bids and the residual maturity of the bidders’ debt. This also suggests that funding considerations may have played a major role in determining the bidding behaviour. Second, banks may have placed relatively high bids in the first three-year LTRO as they viewed the operation as attractively priced compared with the prices that could be inferred from the EURIBOR swap curves or the spreads required by the market for bond issuance in 2011.

Overall, the analysis suggests that funding considerations played a major role in the bidding behaviour of banks in this first three-year LTRO, supporting the Governing Council’s view that the announced measures will help to remove impediments to access to finance in the economy, stemming notably from spillovers from the sovereign debt crisis to banks’ funding markets.

In the press conference following the ECB Governing Council decision on monetary policy (to keep the short-term rate targets unchanged), Mario Draghi mentioned that

Let us not forget that in the first quarter of this year, more than €200 billion of bank bonds fall due. So this decision certainly prevented a potentially major funding constraint for our banking system, with all the negative consequences this might have had on the credit side.

He also repeated this and gave out interesting details in Q&A session of the Hearing on the ESRB before the Committee on Economic and Monetary Affairs of the European Parliament. I will update the post when the transcripts of the Q&A session become available.

Without the LTRO, banks would have faced pressures to redeem maturing obligations by asset sales which could have led to a fall in asset prices, and if the assets were government bonds, it would have increased risks of a self-fullfilling prophecy.

Of course, all this just buys more time!

James Tobin On Public Debt

James Tobin was one of the greatest economists. He had stock-flow consistency, understood how the monetary and financial system worked and had great ideas on open economy macroeconomics. However, he struggled to express his ideas at a more formal level, especially since he used some neoclassical formalism.

This post may be of interest to Neochartalists. It seems there was a Committee on Public Debt in 1949 and they released a report Our National Debt (Sage Journals link). James Tobin reviewed the report.

Tobin begins by saying:

The peace of mind of a conscientious American must be disturbed every time he is reminded that his government is 250 billion dollars in debt. He must be shocked by the frequent announcement that every newborn baby is burdened, not with a silver spoon, but with a debt of $1700. The citizen depressed by these somber calculations will find no solace in the book under review. The Committee on Public Debt Policy and its advisors are leaders in the worlds of banking, insurance, business, economics, and education. Experts in finance, they have undertaken to enlarge public understanding of the debt. The Committee believes that the challenge can be met, the difficulties overcome, the crisis surmounted. But these hopeful prophecies are voiced in the tone of a leader summoning his people to an uphill struggle which will demand all their courage, wisdom, and devotion. The world is too full of such struggles, and the Committee does the public it wishes to enlighten no service by elevating to epic status the management of the national debt.

The book permits lay readers to retain misconceptions of the nature of public debt and exaggerated impressions of its present size. The amateur is bound to project to a national scale his own experience of private debt. To him “debt” is a frightening word, and counting debt in billions staggers his imagination. But a national debt is a burden on the nation analogous to the burden of a private debt on an individual only if the nation is in debt abroad. If the United States owed 250 billion dollars to foreign creditors, our real national income would be reduced by the five billion dollars of our annual production exported to pay the interest. As the debt became due, we would face additional sacrifices to repay it, or we could extend it only on terms allowed by foreign lenders. Happily the 250 billion dollars are owed by the Government to its own citizens. Indeed, about one quarter of the present debt is not even an obligation of the Government to its citizens; it is essentially a debt of the federal government to itself or to state and local governments. Payments of interest are not an external drain on our production, and, thanks to the lending power of the Federal Reserve System, the Government need never encounter difficulty in refinancing existing debt or in borrowing more money.

The Committee’s report seemed to have been insistent on retiring the public debt on which Tobin says:

… Deficit spending in times of high demand and full employment is certainly inflationary. This does not prove that old public debt, merely by its continued existence, is inflationary and should be retired.

The present debt represents almost entirely the wartime savings of Americans, who earned record incomes in war production and could not find consumers’ goods to buy. Had the war been financed wholly by taxation, the public could not have acquired these savings …

And on interest payments:

The second possible danger in the public debt is the burden of interest charges. Transfer of interest from taxpayers to bondholders is a nuisance. Committing a large share of the national income in advance as interest on the debt weakens incentives for effort and risk-taking. Interest transfers may promote income inequality. These evils are scarcely serious enough to justify sacrificing other objectives of current public policy to a commitment for debt retirement. Interest payments now amount to only two per cent of the national income; the percentage should decrease with economic progress provided full employment and low interest rates are maintained.

And finally:

… Decisions concerning current taxes and appropriations should be geared to the current economic situation; they should not be influenced by irrational fear of the national debt. But the debt will undoubtedly continue to be an ideological symbol invoked in every public debate. The purpose of this book, the advancement of popular understanding of the debt, remains unfulfilled.

Post Keynesian Markup Pricing

I was collecting some articles by Basil Moore and I found this table from an article In Praise Of Markets – Wage Imitation And Price Stability (unsure as to why the article is titled “praise of markets”). The article appeared in Challenge in 1982.

Post Keynesians adopt Kaleckian theory of pricing. There are two sectors – fix price and flex price.

(The following table is for the fix-price sector).

Of course, this is just a quick and dirty way of getting into Post Keynesian pricing theory which has a rich literature and has obsessed all the leading PKEists for years.

During the 1970s, wages in advanced economies rose due to the rise in the bargaining power of labour unions and this led to a wage-price spiral. As wages increased, firms increased prices in response. This led workers to demand higher wages so as to be compensated for inflation – leading to further price rises. The pricing was also complicated by increase in other costs such as energy prices which led to an increase in markup as well. When firms faced more wage costs, they borrowed more from banks and this led to a huge increase in the money stock. (I am resisting the usage of the  word “supply” for money, as it is misleading). Monetarism came to popularity as the Monetarists led by Milton Friedman were making a lot of noises and saw the relationship and used their political powers to ask central banks to “control” the money stock. When central banks responded saying they do not and cannot control the money stock, Milton Friedman declared them “incompetent”!

Some central banks were forced to bow into political pressures and had to raise short term interest rates (i.e, they still weren’t controlling the money stock, because it cannot be controlled). This had the additional complication that firms’ interest costs (on borrowings) increased and they were forced to increase prices more. In the end, interest rates was raised to such a high level that it led to a huge fall in demand and employment, even though Monetarists’ theories continued claiming that wages will fall and “free markets” will lead to full employment!

During the period (70s/80s), there were also debates about the “velocity of money” – the supposed stability of the relationship of money stock and money income. Some Keynesians try to argue that the relationship is not stable etc. However Marc Lavoie, in an article in response to a comment to his earlier article on endogenous money pointed out:

… The second point I want to raise is the question of the stability of the velocity of money. Gedeon says that an unstable velocity is the typical post Keynesian argument and she goes into a detailed  analysis of a demand for money function that would exhibit this characteristic … I do not think that the stability or instability of the velocity of money is a fundamental question since it ignores the more vital issue of causation. Provided it is recognized that money does not determine income, post Keynesians can feel comfortable  with either stable or unstable velocity.

Monetarism is no longer as popular now as it used to be, but traces can easily be found in most theories of economics such as the “New Consensus”.

S&P’s FAQs On EA Rating Actions

S&P released another document yesterday in connection with the rating action of Eurozone governments yesterday which you can get via it’s Tweet:

click to view the tweet on Twitter

On the political agreements, the release says:

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called “periphery”. As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.

Two points.

First – yes, fiscal profligacy is not the only source of the crisis. It is typical to give the example of Spain and Ireland – and done by S&P itself – to justify this:

This to us is supported by the examples of Spain and Ireland, which ran an average fiscal deficit of 0.4% of GDP and a surplus of 1.6% of GDP, respectively, during the period 1999-2007 (versus a deficit of 2.3% of GDP in the case of Germany), while reducing significantly their public debt ratio during that period.

There is a risk in making such an argument and even progressives sometimes do so. The error is assuming that the public sector deficit is a proxy for the fiscal stance of the government! Macroeconomists using stock flow coherent macro modeling have shown that the budget balance is just an endogenous outcome and the more appropriate proxy for the fiscal stance is G/θ, where G is the government expenditure and θ is the average tax rate.

To me it seems both Spain and Ireland governments (and local governments) were actually lavish in their spending. The private sector was even more lavish in its expenditure and rising incomes led to higher tax revenues which improved the government’s budget balance before the crisis. The whole process was allowed to continue by market forces, domestic and foreign lenders who (not surprisingly) underpriced risk. Needless to say the lack of a central government overseeing demand management and the ignorance of Keynesian principles contributed to the haphazardness.

Second, most commentators – including the S&P – pay too much attention to price competitiveness. So typically one sees a graph of unit labour costs of individual nations in almost all analysis. One even does not need to take innovations in the export sector to explain the crisis.

The EA17 nations had different levels of non-price competitiveness to begin with and faster growth of income/expenditure in the “periphery” as a result of the boom as compared to slower growth in the “core” nations led to exploding current account deficits. Here’s the data from the IMF’s latest World Economic Outlook published in September 2011 on the current account balances:

With different non-price competitiveness (or income elasticity of imports) (to begin with at the formation of the monetary union rather than innovations during the last ten years) combined with fast rising income/expenditure in the periphery, this led to a dramatic increase in net indebtedness of the periphery as a straightforward consequence. To emphasize the point, even if non-price competitiveness was similar between the core and the periphery, this would have resulted in rising net indebtedness.

It is surprising how international finance contributes to unsustainable processes from continuing as if they can continue forever!


Paul Krugman has a new post on his NY Times Blog on the same comment from S&P from its FAQs but with a different viewpoint.