Author Archives: V. Ramanan

Krugman And Causality

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In a recent post titled Money, Inflation And Models for his NYT blog, Paul Krugman clearly states that “normal equilibrium macro models” say that the direction of causality is from money to prices. Krugman says:

Consider the relationship between the monetary base — bank reserves plus currency in circulation — and the price level. Normal equilibrium macro models say that there should be a proportional relationship — increase the monetary base by 400 percent, and the price level should also rise by 400 percent. And the historical record seems to confirm this idea.

His post is about how this fails when the economy is in a “liquidity trap”. The post hence is the clearest proof of Paul Krugman’s struggle in getting the causality right. Keynes quote from the GT is appropriate here:

The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.

Krugman presents a chart which shows the relationship between money and prices but it does not occur to him that the causality is reverse to what he is assuming, whether or not there is a liquidity trap. The simple causal story that a rise in the level of expenditure leads to a rise in the stock of money seems alien to Krugman.

It is of course also true that a rise in the stock of money such as via an asset purchase program by the central bank (“QE”) may have an effect on prices. This happens via a wealth effect: demand has an effect on prices of goods and services. This effect is likely small. The main mechanism — the reverse causality — seems to never occur in Krugman’s mental model of the way the world works.

Krugman has of course written about the “dark age of Macroeconomics”, but has shifted his position since then. Although it is not clear what exactly Krugman’s model is, one can still make an inference: normal equilibrium models work outside of liquidity traps, but in liquidity traps a lot changes. This model is chosen by Krugman so that he can confidently claim that there is hardly anything wrong in Macroeconomics.

Fiscal Conservatism, Weak International Trade Performance And Income Inequality Not Good For The U.S. Economy

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The US economy is only 8.8 percent above the pre-crisis peak.

The Levy Institute has a new Strategic Analysis publication titled Fiscal Austerity, Dollar Appreciation, And Maldistribution Will Derail The US Economy in which they identity three main structural characteristics of the economy of the United States that stand in the way of the recovery:

(1) the weak performance of net exports, (2) pervasive fiscal conservatism, and (3) high income inequality

They show that in their baseline scenario, if the projections of the Congressional Budget Office’s outlook hold, their model simulations imply that the private sector’s net lending would turn negative by the end of 2017 and hence the private sector would be in a financial deficit, which is not sustainable.

The publication has some nice charts about the US balance of payments. One is the components of the current account of balance of payments with attention on the primary income balance:

U.S. Balance Of Payments And Components

Note how the balance on primary income has grown during the recent crisis. Another chart gives a further breakdown:

Balance On Primary Income

So direct investment income is the main component.

I like the way the authors explain this: it is a symptom of the crisis. From the article:

An interesting question is whether this improvement in net primary income receipts is sustainable or just symptomatic of the crisis. In our view, it is most likely the latter.

For more details, read the article here.

Free Trade? Heterodox Dissent

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One of the most important message of this blog is that “free trade” is quite devastating to economies. In a recent article Economists Actually Agree on This: The Wisdom of Free Trade for The New York Times, Greg Mankiw once again pushes for free trade and also mentions that there is consensus in the profession.

Many of heterodox economists dissent on the issue of free trade. In this post, I will provide two examples: Joan Robinson and Wynne Godley.

Mankiw says:

Economists are famous for disagreeing with one another, and indeed, seminars in economics departments are known for their vociferous debate. But economists reach near unanimity on some topics, including international trade.

In the article, Mankiw tries to show among other things how free trade is the opposite of Mercantilism. Joan Robinson explained in her 1977 essay What Are The Questions? how foreign trade is important and that free trade is a subtle form of mercantilism.

According to Robinson:

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

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

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

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

[emphasis: mine]

According to her colleague Wynne Godley, dissenting against free trade was one of the most important reasons for his dissent against the profession. In his short autobiography written in 2001 for A Biographical Dictionary Of Dissenting Economists (Edward Elgar book site), Godley says:

There are two aspects (in particular) of the work of the CEPG [Cambridge Economic Policy Group] which put its members into a category which may he termed ‘dissenting’. The first – a matter mainly of concern to the modelling fraternity and academic econometricians – was the unconventional view we took about how to construct and use an econometric model. Thus we attached prime importance to what may be termed ‘model architecture’ by which I mean that the underlying accounting was coherent, without any ‘dustbin’ equations or sectors; everything came from somewhere and went somewhere. Our view, by which I still stand, was that model architecture in this sense takes priority over parameter estimation; I am even prepared to conjecture that a properly a ‘architected’ model will deliver much the same results over a wide range of parameter estimates, particularly if the model is used for the simulation of medium- or long-term scenarios. Furthermore our use of the model was unconventional in that we treated it, not as something which would generate accurate forecasts of what would actually happen, but as a tool that informed our minds as to a great many possible outcomes conditional on a wide range of alternative assumptions both about exogenous variables and about parameter values. In using our model in this way we were greatly assisted by Cripps’s programming expertise, which permitted us to work with a speed and flexibility not generally available at that time. I should add that econometrics, as usually defined, played (advisedly) a relatively minor role in our work.

The second, and more egregious, respect in which we became a ‘dissident’ group was that, as a result of trying to think through the possible ways in which Britain’s net export demand might be improved, we entertained the possibility that international trade should be, in some sense, ‘managed’. There might, we argued, be no way in which the adverse trends could be reversed other than some form of control of imports. Our argument (see for instance Cripps, 1978; Cripps and Godley, 1978) was never one in favour of protectionism as normally understood – that is, the selective and unilateral protection of relatively failing industries under conditions of general stagnation. On the contrary, we were most careful to lay down conditions under which the management of trade would benefit not only our own country (without making its industry less efficient) but would also increase the level of trade and output in the rest of the world. The two basic principles were, first, that trade management should reduce import propensities without ever reducing imports themselves (in total) below what they otherwise would have been; and, second, that ‘protection’ should be as minimally selective as possible (for example, through the use of market mechanisms such as auction quotas) so that industrial inefficiency would not be sponsored.

I was surprised by the hostility with which our ideas about trade were received. It seemed to me at the time, and still seems to me, that the arguments actually used against us (at their most coherent by Maurice Scott et al., 1980) did not, in practice, rest on a well-articulated theoretical position but on very special assumptions about behavioural relationships and international political responses. (I have, to the best of my ability, answered these particular points in Christodoulakis and Godley, 1987.)

…

The ‘dissident’ argument in favour of managed trade is well summarized in Kaldor (1980), where he points out that the modern theory of international trade is based on the assumption that all production takes place according to the conditions described by the neoclassical production function, with constant returns to scale. Kaldor postulated instead, and he was surely right to do so, that the principle of circular and cumulative causation leads (through dynamically increasing returns) to a process, not of convergence, but of polarization between successful and unsuccessful economies in which success in competitive performance feeds on itself and losers become immiserated by trade.

The above quote is interesting from another perspective: it explains Godley’s views about modeling, policy, “forecasting” etc.

The Illogical Golden Rule

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There’s a nice article by Wynne Godley written in 2005 for The Guardian on the fiscal policy golden rule. There are two things wrong about the golden rule. The first is to think that capital expenditure is somehow superior to current expenditure. This is the reason one frequently hears “wonks” stressing on government infrastructure spending. The other is to ignore changes in private sector behaviour and foreign trade performance.

From the article:

Criticism of the fiscal policy regime has focused too much on whether Gordon Brown will break his self-imposed Golden Rule and not enough on whether the rule is acceptable. The Golden Rule states that the balance between receipts and current expenditure should be zero over the cycle, exempting public investment, which does not ‘count’ for the purpose of making this calculation.

A relatively minor objection to this arrangement is that there exists no relevant difference between, say, capital expenditure on school building and current expenditure on teachers. Both are equally necessary for education and both absorb resources (pound for pound) to roughly the same extent.

More fundamentally, the budget balance is equal to the difference between the government’s receipts and outlays, but it is also equal, by definition, to the sum of private net saving (personal and corporate combined) plus the balance of payments deficit.

If the private sector decides to save more, the government has no choice but to allow its budget deficit to rise unless it is prepared to sacrifice full employment; the same thing applies if uncorrected trends in foreign trade cause the balance of payments deficit to increase.

A sensible target for the budget balance cannot be set unless it is integrated into a view about what will happen to autonomous trends and propensities in private net saving and foreign trade. Moreover, as those trends and propensities change, it will never be possible to determine viable targets for the deficit that are fixed through time such as, for instance, that it should never exceed some number such as 3 per cent of GDP or that it should on average be zero.

Coming back to the medium-term future of the British economy: if, as seems quite possible, there is now a growth recession initiated by a fall in personal expenditure, the government will have no option but to allow the deficit to rise well beyond what the Golden Rule permits. The authorities will look ridiculous if they move the goalposts again, so the rule will have to be jettisoned. I don’t think it will be long before discretionary fiscal policy, once discredited by a few serious errors in the Sixties and Seventies, has to be rehabilitated.

Interest Rate, Growth And Debt Sustainability

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Frequently, discussions about debt sustainability have discussions about the importance of the interest rate and growth in debt sustainability analysis. See for example, today’s Paul Krugman’s post on his blog. It is concluded that as long as the rate of interest is below the rate of growth, the ratio public debt/gdp doesn’t explode. Unfortunately, this result is erroneous.

John Maynard Keynes’ biggest disservice to the profession is to not start with the open economy. In my view, debt sustainability is tightly connected to balance of payments.

Imagine a nation whose exports is constant. If output rises, it will have adverse effects on the current account balance of payments because of income induced increase in imports. This will have an adverse effect on the international investment position of the nation: the net international investment position will keep deteriorating unless output is slowed down or some measure is taken to improve exports. In the case of rising exports, there is a similar constraint, except it is weaker but dependent on the rate of growth of exports.

If the ratio net international investment position/gdp keeps deteriorating, either the public debt to non-residents or private indebtedness to non-residents or both have to keep rising, all unsustainable.

There are some complications. A nation’s balance of payments also depends on how assets held abroad and liabilities to foreigners affect the primary income account of balance of payments. Also, the exchange rate can depreciate (or be devalued in fixed-exchange rate regimes) improving exports and reducing imports. However assuming that exchange rate movements do the trick is believing in the invisible hand. Foreign trade doesn’t just depend on price competitiveness but also on non-price competitiveness. These complications are highly interesting but do not affect the fundamental fact that a nation’s success is dependent on the success of corporations to compete in international markets for goods in services.

Even the conclusion that the government should contract fiscal policy and aim for a primary surplus in its budget balance or else the ratio public debt/gdp keeps rising if the rate of interest is greater than the rate of growth is erroneous. Consider a closed economy. An expansion in fiscal policy will automatically raise output and gdp and hence tax collections to prevent the ratio public debt/gdp from exploding. The public sector balance may hit primary surpluses but not due to contraction of fiscal policy or targeting a primary surplus in its budget balance.

In short, although the rate of interest and the rate of growth are important in debt sustainability analysis, it is not as easy as is usually presenting in macroeconomics textbooks and in the blogosphere. For a more detailed analysis see the reference below.

Reference

  1. Godley, W. and B. Rowthorn (1994) ‘Appendix: The Dynamics of Public Sector Deficits and Debt.’ In J. Michie and J. Grieve Smith (eds.), Unemployment in Europe (London: Academic Press), pp. 199–206

Severin Reissl’s Critique Of Steve Keen’s Black Box Economics

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Economics is a strange subject. A lot of times we learn a lot from others’ errors and even if you see the errors, there’s sometimes a lot to learn from others’ critiques of the same because sometimes it is difficult to see all the pitfalls even if one sees a few. Severin Reissl from the University of Glasgow has a fine critique of Steve Keen’s models of aggregate demand and changes in debt.

The paper titled, The return of black box economics – a critique of Keen on effective demand and changes in debt is available here.

From the paper:

The claim investigated in this article, however, has to be clearly distinguished from such arguments. The question at issue is not whether levels of (private) debt or changes therein can have an impact on effective demand and consequently national income, or on macroeconomic stability. On this proposition there appears to be universal agreement in the post-Keynesian literature. Whether such a connection exists in a given context is then an empirical question. For instance, Stockhammer and Wildauer (2015) find a positive effect of household debt on consumption, but a negative one upon investment (including residential investment). Keen’s hypothesis is more fundamental and bold, namely that capitalist economies are always and everywhere credit-driven, that there is an immutable link between changes in aggregate (i.e. all types of) debt and changes in effective demand which can be expressed in a simple relation much like the equation of exchange (M ∗ V = P ∗ Y ).

[emphasis in original]

The article also goes into Keen’s misreading of Minsky and Keynes (which Keen uses to support himself) and the notion that trading in financial assets be included in aggregate demand.

The paper has some non-standard definitions such as expenditure meaning to include other payments than just purchases of goods and services as in the System of National Accounts (SNA). For example equation (7) might better read:

Disposable Income − Expenditure = Change in Financial Assets (net)

with expenditure counting only payments for goods and services.

This of course doesn’t affect the conclusion about issues with Keen’s models. Overall, the paper has a nice discussion on national accounts and literature. Macroeconomics is hard but the best guide is self-consistency. It is as much important as empirical testing. Keen tries to show that his definitions are consistent with data by making various charts in his blog/papers and in articles for newspapers and magazines. These can of course be explained by models which have self-consistency unlike Keen. The paper mentions this point clearly:

Professor Keen displays a tendency to overinterpret the works he utilises as a foundation for his own argument, while these works themselves suffer from terminological imprecisions. These imprecisions can, as demonstrated above, consequently also be found in Keen’s own argument. Keen presents some empirical data to support his argument. Fiebiger (2014) provides an adequate critique of this and all that remains to note is that the evidence cannot resolve the problems raised here, since they are not foremost of an empirical nature.

The U.S. Net International Investment Position At The End Of 2014

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The U.S. Department of Commerce’s Bureau of Economic Analysis today released accounts for the United States’ international investment position. The U.S. is sometimes called the world’s biggest debtor and its net international investment position is now (at the end of 2014) minus $6.9 trillion.

Here’s the chart from the BEA’s website. U.S. Net International Investment Position 2014A few points. The importance of the U.S. balance of payments and international investment position is quite neglected in analysis of the crisis. The United States’ economy went into a crisis (and the rest of the world with it) because a huge rise in private indebtedness led to a fall in private expenditure relative to income when the burden of the debt started pinching. This caused a drop in economic activity and was saved partly due to automatic stabilizers of fiscal policy as tax payments fell due to a drop in economic activity and partly due to a relaxation of fiscal policy itself by the U.S. government and governments abroad. But the huge rise in the U.S. government debt meant that resolving the crisis by fiscal policy alone would have been difficult. This is because a huge fiscal expansion would have meant that the U.S. trade deficit would have risen much faster into an unsustainable path.

See Wynne Godley’s article The United States And Her Creditors: Can The Symbiosis Last? from 2005 here arguing such things.

Back to the international investment position. There are a lot of interesting things about it. Although the U.S. in a huge debtor to the rest of the world, the return on assets held by resident economic units of the United States earn more than paying on liabilities to nonresidents. So according to the BEA release U.S. International transactions 2014, investment income in the full year was about $813 billion while income payments was about $586 billion. (More complication arises from “secondary income”).BEA-2014-U.S.-International-Transactions

In addition, revaluations of assets and liabilities also affect the international investment position and revaluations of direct investment held abroad has acted in the United States’ favour.

Of course this cannot always be the case. Take a simple example: Suppose an economic unit’s assets is $100 and liabilities is $150 and suppose assets earn 8% every year and interest paid on liabilities is 5%. So even though the economic unit has a net indebtedness of $50, it is earning

$100 × 8% − $150 × 5% = $0.5

However, if liabilities rise to $160 and beyond the net return turns negative.

In a similar way, there is a tipping point, beyond which the net primary income of the current account of balance of payments turns negative. Because the United States has a negative current account balance and the deficit adds to the net indebtedness every year, at some point in the future, the international investment position may reach a tipping point.

All this sounds as if domestic demand and output are unrelated. This is of course not the case. Imports depend on domestic demand and exports depend on economic activity abroad. Hence the constraint on output at home because if output were to rise fast, the net indebtedness of the United States will also rise fast.

Of course the concept of a tipping point may itself be misleading. Indebtedness can keep rising even if net primary income turns negative without any trouble in financial markets because it all depends on how the financial markets see the problem. But it may be said that once a tipping point is reached, the debt will start to rise much faster than now. My article here hasn’t gone into any analysis here with numbers but I will leave it for another day.

Disappointing Start, Mr. Bernanke

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Ben Bernanke has a new blog at Brookings.

In his second post, Why are interest rates so low?, Bernanke “explains the rationale behind the Federal Reserve’s continued policies”. We should be thankful to Bernanke for his leadership qualities to have kept interest rates low to help the world economy recover from a crisis. The latest post however ends up just stating the standard neoclassical economics story: a hugely inaccurate way of looking at the world. Keynes himself debunked many such notions.

First he starts off with the notion of the Wicksellian interest rate.

To understand why this is so [“Why are interest rates so low?”], it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments.

Full employment in the United States? When did this happen? Keynes himself rejected this (see here) (quote h/t Lars Syll).

Keynes said:

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest—namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s ‘natural rate of interest’, which was, according to him, the rate which would preserve the stability of some, not quite clearly specified, price-level.

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the ‘natural’ rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.

I am now no longer of the opinion that the [Wicksellian] concept of a ‘natural’ rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.

Ben Bernanke then says:

Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.

This again confuses the direction of causality from saving to investment among other things. Bernanke himself is a witness to the fact that large US government deficits didn’t have such effects. Economists such as Paul Krugman have an explanation for this, claiming this is untrue when the economy is in a “liquidity trap” but think this is the case. A large deficit has the private sector net lending as the mirror image and there’s no reason for interest rates to necessarily rise because of large deficits. Ben Bernanke is simply repeating economists’ favourite “crowding out” argument.

Ben Shalom Bernanke. Huge disappointment.

Respect For Identities

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The accounting identities equating aggregate expenditures to production and of both to incomes at market prices are inescapable, no matter which variety of Keynesian or classical economics you espouse. I tell students that respect for identities is the first piece of wisdom that distinguishes economists from others who expiate on economics. The second? … Identities say nothing about causation.

– James Tobin, 1997, p. 300, ‘Comment’, in B.D. Bernheim and J.B. Shoven (eds), National Saving and Economic Performance, Chicago: University of Chicago Press.

This is such a nice quote by James Tobin. Almost all economists, orthodox or heterodox would agree with it I believe.

In practice, however, economists confuse identities for behaviour and causation no end. They even confuse identities themselves. But it now seems that some think that usage of national accounting identities produces erroneous conclusions.

In a series of posts, (here and few posts before), David Glasner, the author of the blog Uneasy Money — Commentary on monetary policy in the spirit of R. G. Hawtrey, seems to be suggesting that letting identities go is the way forward for macroeconomic modeling.

Glasner says:

There are two reasons why defining savings and investment to be identically equal in all states of the world is not useful in a macroeconomic theory of income. First, if we define savings and investment (or income and expenditure) to be identically equal, we can’t solve, either algebraically or graphically, the system of equations describing the model for a unique equilibrium.

[boldening and emphasis added]

So it seems that using accounting identities in your model would lead to inconsistencies. I and a few other commenters have tried to convince Glasner of his errors in series of posts.

Some people seem to think that identities do not tell anything. The truth is not so straightforward. Identities constrain outcomes. Any macroeconomic model which does not use identities as constraints may produce non-possible states of the world.

Brad deLong confronted Glasner on Twitter with this point:

click to view on Twitter

If you have time, interest and energy, please convince Glasner that accounting identities cause no issues in macroeconomic modeling.

Derailed: Wynne Godley On The Euro Area

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I am in favour of Britain having much closer ties with other European countries, provided that appropriate institutions are created and the whole thing is brought under effective political control. But I have never been able to understand what it is that those who support the Maastricht Treaty think they are going to get out of it. Maastricht supporters are keen on ‘not being left out’. But left out of what exactly?

…

It seems clear that the Maastricht criteria for the establishment of ‘convergence’ were far too narrowly conceived. To fulfil the conditions necessary for a successful currency union it is not nearly enough that member countries agree to follow simple rules on budgetary policy and achieve some minimum period of low inflation and currency stability. They need to reach a degree of structural homogeneity such that shocks to the system as a whole do not normally affect component regions in drastically different ways. Moreover, arrangements should be made which ensure that when substantial changes of a structural kind do turn up the federal authority is equipped to share out any burden which ensues. It would be wrong to suppose that there exist well-defined ‘fault lines’ which can be cured once and for all. Structural changes are always going to be taking place as a consequence of political earthquakes, or for other reasons, and the Community must have some way of dealing with them.

– Wynne Godley, Derailed, 1993

A list of articles by Wynne Godley on the Euro Area:

  1. ‘Commonsense Route To A Common Europe’, Observer,  6 January 1991, page 28 (scan)
  2. ‘Maastricht And All That’, London Review of Books, Vol. 14 No. 19, 8 October 1992, pages 3-4 (link)
  3. ‘Derailed’, London Review of Books, Vol. 15 No. 16, 19 August 1993, page 9 (link, more here)
  4. ‘Curried EMU – The Meal That Fails To Nourish’, Observer, 31 August 1997, page 24 (scan)

Wynne-Godley-July-1981Wynne Godley, July 1981
(picture source)