Author Archives: V. Ramanan

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)

Anthony Thirlwall’s New Book On Keynesian And Kaldorian Economics

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During the global economic and financial crisis Keynes became popular again but Nicholas Kaldor’s ideas and the mention of the man himself didn’t take off as much. It’s unfortunate, as Kaldor played a huge role in the development of Keynesian economics itself. Kaldor’s own ideas are a subject of its own. Anthony Thirlwall is releasing a new collection of essays on Keynes and Kaldor in a book titled Essays on Keynesian and Kaldorian Economics to be published by Palgrave Macmillan.

Book website here

Anthony Thirlwall - Essays On Keynesian And Kaldorian Economics

Description:

This volume of essays contains sixteen papers that the author has written over the last forty years on various aspects of the life and work of John Maynard Keynes and Nicholas Kaldor. The essays cover both theoretical and applied topics, and highlight the continued relevance of Keynesian and Kaldorian ideas for understanding the functioning of capitalist economies. Kaldor was one of the first economists to be converted to the Keynesian revolution in the mid-1930s, and he never lost the faith, so there was a strong affinity between them. But while Keynes revolutionised employment theory, Kaldor’s major concern in the latter part of his life was with the theory and applied economics of economic growth. The papers on Keynes mainly relate to defending Keynesian economics against his classical and monetarist critics and showing how Keynesian ideas relate to developing economies and the functioning of the world economy in general. The papers on Kaldor give a sketch of his life and role as policy advisor, and outline his vision of the growth and development process within regions; within countries, and also the world economy as a whole.

Table of Contents

Introduction

  1. Keynesian Economics after Fifty Years; N. Kaldor
  2. A ‘Second Edition’ of Keynes’ General Theory (writing as John Maynard Keynes)
  3. Keynesian Employment Theory is Not Defunct
  4. The Renaissance of Keynesian Economics
  5. The Relevance of Keynes Today with Particular Reference to Unemployment in Rich and Poor Countries
  6. Keynes, Economic Development and the Developing Countries
  7. Keynes and Economic Development
  8. A Keynesian View of the Current Financial and Economic Crisis in the World Economy (an interview with John King)
  9. Nicholas Kaldor: A Biography
  10. Kaldor as a Policy Adviser
  11. Kaldor’s Vision of the Growth and Development Process
  12. A Model of Regional Growth Rate Differences on Kaldorian Lines (with R. Dixon)
  13. A General Model of Growth and Development on Kaldorian Lines
  14. A Plain Man’s Guide to Kaldor’s Growth Laws
  15. Testing Kaldor’s Growth Laws across the Countries of Africa (with Heather Wells)
  16. Talking about Kaldor (an interview with John King)

Anthony-P-ThirlwallAnthony Thirlwall

JKH On Paul De Grauwe’s Fiscal Arithmetic

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In a recent article for VOX, Paul De Grauwe and Yuemei Ji write about potential fiscal effects of a possible asset purchase program by the Eurosystem (European Central Bank and the National Central Banks in the Euro Area). In that the authors take an extreme stand suggesting that a default by a Euro Area government on bonds held by the Eurosystem doesn’t even matter.

JKH has written a fantastic critique of the VOX article by De Grauwe and Ji.

JKH says:

De Grauwe goes on to say that because bonds held by the ECB –defaulted or otherwise – are “eliminated” on consolidation, it doesn’t matter what they were valued at on the ECB balance sheet in the first place. They may as well have been valued at zero – because they have effectively been eliminated and replaced by ECB liabilities (assumed by implication to be permanently interest free).

…

Thus, the balance sheet implication of De Grauwe’s treatment is that some portion of future currency issued by the ECB will be “backed” on its own balance sheet by an asset of zero value – the defaulted Italian bond. The problem is that this currency would have been issued in any event according to the demand that will arise naturally from the growth of the European economy over time (notwithstanding current depressed conditions). And so ECB seigniorage will have been reduced from what it would have been had it included the effect of good interest on Italian bonds. That reduction in seigniorage due to default is a real fiscal cost, because it reduces the profit remittance of the ECB from what it would have been in the non-default counterfactual. And the fact that the reduced seigniorage gets distributed to the residual capital holders means that there has been a fiscal transfer to the defaulting sovereign from the remaining capital holders. So De Grauwe is simply wrong on this point.

Another way to look at it is by looking at the international investment position. A default by a nonresident on a claim on held by residents is a reduction in the net international investment position and a reduction in the wealth of the geographic region. (The wealth of a nation is the sum of the value of its non-financial assets plus the net international investment position). International investment position matters as a sounder position implies that there is higher potential to raise output.

De Grauwe has another article for The Economist from today. He writes:

Since Milton Friedman we have all become monetarists. In order to raise inflation it will be necessary to increase the growth rate of the money stock. This requires that the ECB increase the money base. And to achieve the latter there is only one practical instrument, ie, an open-market purchase of government bonds. There is no other way to raise inflation than through an increase in the money base and a bond-buying programme is the time-tested way to achieve this.

It is sad that Monetarism is still alive today, despite being repeatedly been shown to be incorrect. But more importantly for the current discussion about risks, De Grauwe repeats his stand again and states it more explicitly:

This confusion between accounting losses and real losses is unfortunate. It has led to long hesitation to act. It also leads to bad ideas and wrong proposals.

So losses do not even matter!

The problem with a Eurosystem asset purchase program of Euro Area government bonds is that it achieves little. It is not a coordinated Euro Area wide fiscal expansion which is badly needed. The ECB already has the OMT program which has helped government bond yields from rising and leading to a crisis, so a QE will hardly achieve much except having an impact on prices of financial market securities. QE just diverts attention from important challenges for a unified Europe. Challenges such as how to move toward the formation of a central government.

The Devil Is In The Detail

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There are two ways in which the terminology “net lending” is used.

In national accounts, it is the difference between saving and investment for any economic unit or a sector. “S − I”. It is the financial surplus.

Bankers and central bankers use “net lending” a bit differently. Here there is “netting” when redemptions are netted.  For example, suppose a bank lends 100 units in one period and for simplicity assume all 100 are redeemed. Also assume that it makes 110 units of loans in the next period. In this case, net lending is 10 units.

But these two shouldn’t be confused.

Steve Keen should perhaps understand that the devil is in the detail and if he is interested in making accounting models of the economy, he should improve his accounting.

In a recent Forbes piece, he says:

So if the private sector is to finance the government sector’s surplus, and if the economy is growing at the same time, then there has to be a net flow of new money created by the banking sector—part of which expands the non-banking public’s money stock, and part of which finances the government sector’s surplus. Therefore the banking sector has to “run a deficit”: new loans have to exceed loan repayments (plus interest payments on outstanding debt).

Call this net flow of new money NetLend.

[emphasis: mine]

In the scenario assumed, banks have a surplus because presumably their operations are profitable. In the absence of fixed capital formation by banks, their undistributed profits are their financial surplus. Banks are net lenders in the national accounting sense (and hence have a financial surplus not a deficit). They net lenders in bankers’ language because gross new loans exceed redemptions.

While it is not wrong redefine terminologies, Keen is doing a sectoral balance analysis where deficit/surplus has a different meaning.

In short, in a growing economy, if the government is in surplus, it is more likely that non-financial corporations and households together have a deficit or a negative financial balance. Gross new loans by banks exceeding gross redemptions does not imply banks have a deficit (i.e., a negative financial balance). It is of course not impossible for banks to have a deficit in such scenarios: consider for example, banks purchasing a lot of buildings for their offices. In that case, banks’ “S − I”  may be negative.

Keynesian Economics And Thievery

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In a WSJ opinion piece titled An Autopsy for the Keynesians, John H. Cochrane makes the following accusation on Keynesian Economics:

By Keynesian logic, fraud is good; thieves have notoriously high marginal propensities to consume.

Cochrane’s piece reads as assertions after assertions trying to prove that fiscal policy is impotent. Keynesians emphasize the role of effective demand in the determination of national income and expenditure. Hidden in Cochrane’s misprepresentation of Keynesian economics is the assumption that Keynesians think that the supply side does not matter.

No Keynesian would ever say that. In fact Keynesians emphasize that although the principle of effective demand is highly important, output of a nation or a geographic region is finally constrained by the capacity to produce and international competitiveness of its producers. If a nation promotes fraudsters, its capacity to produce will be lower than the case where honesty is promoted. If a nation is full of thieves, Keynes wouldn’t even take off: any attempt by the government to use Keynesian policies will fail to improve real output.

So not just morally, but even from an economic viewpoint, Keynesian economics doesn’t not promote fraud.

Cochrane’s WSJ piece just highlights the sad state of Macroeconomics.

Merry Christmas!

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

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Sergio Cesaratto has a new paper Balance Of Payments Or Monetary Sovereignty? In Search Of The EMU’s Original Sin – A Reply To Lavoie. (html link, pdf link)

I obviously agree with Sergio Cesaratto.

As long as there is no supranational fiscal authority, a Euro Area nation’s economic success is more restricted by its exports than otherwise as there is no mechanism for fiscal transfers. The European Central bank can of course backstop and to some extent it has done so, but it cannot let fiscal policy of nations become independent of balance of payments beyond a certain extent. If it does so, nations’ public debt will rise together with net indebtedness to foreigners relative to output and this will become unsustainable. The European Central Bank (the Eurosystem less the domestic National Central Bank) will become a huge creditor and this will not be acceptable to the rest of the Euro Area. (There is of course the question whether this would be morally right but I do not think it is immoral beyond a limit).

To some extent, Mario Draghi has acted the opposite and pushed austerity, but one cannot assume unlimited power for the ECB (Eurosystem to be precise).

The other way to check that it is indeed a balance-of-payments crisis is to simply see the net international investment position of nations. This chart is from 2011 (intentionally chosen to be old).

ea17-2011-niip-reused

 

The nations troubled most had huge net indebtedness to foreigners. If it is not a balance-of-payments crisis, how does one explain that countries such Germany and Luxembourg had far less troubles than Greece and Portugal?

Abstract of the paper:

In a recent paper Marc Lavoie (2014) has criticized my interpretation of the Eurozone (EZ) crisis as a balance of payments crisis (BoP view for short). He rather identified the original sin “in the setup and self-imposed constraint of the European Central Bank”. This is defined here as the monetary sovereignty view. This view belongs to a more general view that see the source of the EZ troubles in its imperfect institutional design. According to the (prevailing) BoP view, supported with different shades by a variety of economists from the conservative Sinn to the progressive Frenkel, the original sin is in the current account (CA) imbalances brought about by the abandonment of exchange rate adjustments and in the inducement to peripheral countries to get indebted with core countries. An increasing number of economists would add the German neo-mercantilist policies as an aggravating factor. While the BoP crisis appears as a fact, a better institutional design would perhaps have avoided the worse aspects of the current crisis and permitted a more effective action by the ECB. Leaving aside the political unfeasibility of a more progressive institutional set up, it is doubtful that this would fix the structural unbalances exacerbated by the euro. Be this as it may, one can, of course, blame the flawed institutional set up and the lack an ultimate action by the ECB as the culprit of the crisis, as Lavoie seems to argue. Yet, since this institutional set up is not there, the EZ crisis manifests itself as a balance of payment crisis.

Excerpt from the conclusion:

… To conclude, since the EZ is closer to a fixed exchange rate regime rather than to a viable, U.S.-style CU, the euro-crisis is akin to a classical BoP crisis. True, the existence of T2 and the possibility of some ECB backing to troubled local sovereign debts make some difference. However, the limits to an ultimate action by the ECB in connection to the absence of other institutions that compose a viable CU render its action necessarily restricted. One can, of course, blame the lack of these institutions and of an ultimate action by the ECB as the culprit of the crisis, as Lavoie and De Grauwe seem to maintain. Yet, since those institutions are not there, the EZ crisis manifests itself as a balance of payment crisis …

Finally, remember the balance-of-payments constraint manifests itself as lower domestic demand and output as much as financial crises.

In general — in other institutional setups, the importance of the government’s power to make drafts at its central bank is exaggerated. It is highly important of course, but problems of balance-of-payments restrain the power of governments in having a fiscal policy independent of what is happening in international trade. In the Euro Area, the lack of critique of the “Common Market” is striking. One can however see these discussions in the works of Nicholas Kaldor.

Unlimited TARGET2 power?

An important point in the current discussion is around the issue of limits of TARGET2. It is true that the TARGET2 system has large powers to absorb imbalances. The intra-Eurosystem debts need not be collateralized. However, when there is capital flight from a nation, banks become more indebted to their NCB. This process can go on for a long time but ultimately it is restricted by collateral banks can provide to their NCB for replenishing lost settlement balances. There is of course the ELA, Emergency Loan Assistance, but this too is limited beyond a point. There is a lot of politics involved here with some nations complaining unfairly on debtor nations’ use of the ELA, but beyond a certain point, their complaints may be fair.

To summarize, TARGET2 is a big shock absorber: beyond what any economist may have expected, but it cannot absorb shocks beyond a limit.

John McCombie Reviews Marc Lavoie’s Post-Keynesian Economics: New Foundations

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John McCombie is one of my favourite economists. He is the co-author of the book Economic Growth And The Balance-Of-Payments Constraint, one of the most supremely insightful books.

McCombie has written a review of Marc Lavoie’s book Post-Keynesian Economics: New Foundations, which is the second edition of his book titled Foundations of Post-Keynesian Economic Analysis.

He says:

… the greatest significance of this work is that it clearly demonstrates that there is a coherent and interrelated body of economic theory that stands in marked contrast to the neoclassical framework. Indeed, with the deficiencies of the prevailing orthodoxy exposed by the subprime crisis the publication of this book could not have come at a more propitious time. Some post-Keynesians have concentrated on attacking the foundations of the neoclassical paradigm … to such an extent that it could (and has been) unfairly accused of nihilism.

But as Kuhn has pointed out, a paradigm can only be overthrown by the development of a  new paradigm and Marc‘s book shows that there is a substantial corpus of Post Keynesian that meets this criterion. Criticisms of a paradigm is not enough to cause a change in the world view of the practioners …

… It is worth re-emphasizing that one of the great successes of this book is that it takes many important contributions of the Post Keynesians which may otherwise have been lost buried in the journals and integrates them into a coherent story; in a very real sense the sum of this work is greater than the parts.

Marc Lavoie - Post-Keynesian Economics - New Foundations

Read the full review here.

Strong Assertions: Reply To A Comment [Update 2]

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I don’t generally publish comments and reply offline via email but this one needed one on the blog.

Winterspeak commented on my previous post Strong Assertions:

Deliberate obtuseness ramanan?

A 15% interest rate will certainly reduce borrowing as a first order effect, but it will also have another first order effect which will move AD in another direction. You know what this is, why not address it directly? And then why not respond to Mosler’s primary point directly as well?

I don’t think warren’s problem is that his writing is too simple.

My response below:

Deliberate obtuseness? My post was clear that the assertion that economists have it backward is quite wrong and misleading. I do in fact mention the effect of higher interest rates because of interest payment on government debt. In my post, I said

Finally the point about interest income on government bonds: it is true that if interest rates are higher, the private sector is receiving more income from the government and this is one factor to consider among all factors which affect aggregate demand. But there is no reason to assume that this effect is always higher.

In stock-flow consistent models, one sees the long run output depend positively on interest rates. But short term, this effect isn’t always positive except in simple pedagogic models.

My example of 15% was not really purely academic. Such an experiment happened in the UK in the 70s where interest rates were raised sharply and it led to a contraction of output. Several firms had to close down because of a rise in debt burden. The full story is in Nicholas Kaldor’s book The Scourge of Monetarism. I suppose Winterspeak thinks Monetarism cannot be a scourge. There were additional effects as well. The exchange rate appreciated  and led to a rise in imports contracting domestic demand even more than via other factors.

One cannot simply say that a rise in interest rates will lead to a rise in interest payments on government debt and that hence domestic demand and output will rise because of this. Suppose the government debt is 60% and let us say the average interest rate on government debt rises by 2% initially. This will lead to an additional interest payment of 1.2% to the private sector. This does not increase output by 1.2% automatically. It depends on the interest receivers’ propensity to consume. If this is say 0.2, the first order effect is a rise in output by 0.24% only. (Higher order effects are via income/expenditure multiplier process). However, borrowing also depends on the interest rate. Suppose fixed capital formation by firms and households reduces by more than 0.24%, the latter has had a bigger negative effect than the positive effect of the former.

So the effect depends on interest elasticity for borrowing and propensity to consume from interest income. But that is not all. A rise in interest rates may also lead to a fall in asset prices and which has wealth effects on economic activity. There are other complications as well which I do not need to go into in detail because my point is made. In many countries, a lot of households took various kinds of mortgages which have amortization schedule highly sensitive on interest rates. If interest rates are raised, their monthly payments will increase leading to a lower consumption. Of course, it can be argued that the interest paid is income to some other economic unit, but one needs to look into who the interest receiver is, how their behaviour and so on.

Update

After I posted this, I received a comment again from Winterspeak:

Please.

A 15% FFR will impact more than income from the Government. And the only people assuming that a “rise in interest rates will only have one effect” are you and Monetarists. Talk about being overly simplistic.

I recommend leaving strawmen out of it and focusing on the meat of the argument.

Puhleeze!

Winterspeak tells me of being overly simplistic and attacking a strawman.

But look who is overly simplistic here. Winterspeak simply announces that a 15% rise in interest rates will have more impact than the income from the government. Clearly he has not understood much. My post talked of the propensity to consume of the interest earners and also the mutliplier effects of this. There is no reason that the effect of this (including multiplier effects) is greater than 1.

Plus Winterspeak seems to completely  ignore the negative effects on borrowing: proving my point. Ignoring intermediate consumption, the gross domestic product is the same as output which is (in a simple closed economy model):

C + I + G

where C is household consumption, I is private fixed capital formation and G is “pure” government expenditure (which doesn’t include interest payments on government debt) i.e., government consumption and fixed capital formation.

While C may rise because of higher interest earned by households because of higher interest income. I can fall more because of high interest rates. It is also not clear if C will necessarily rise. This is because if households have large liabilities (such as mortgages), their disposable income will fall due to a rise in interest rates (and hence interest payments) and hence consumption as well.

Update 2

After I wrote the above, I received a patronizing comment by Winterspeak:

Great — you’re slowly getting closer.

So what did Warren actually say and why? Or, in other words, what is the logical next step from your (third) post?

Let me argue again. Let us use subscripts 1 and 2 for time periods.

Initially the GDP is

C1 + I1 + G1

Now interest rates are raised to 15%. The GDP is

C2 + I2 + G2

With pure government expenditure remaining the same,

G2 = G1

Interest expenditure of the government is not counted in production. G stands for government consumption expenditure and expenditure on fixed capital formation, not total government expenditure. (Ignoring changes in inventories for simplicity, both for firms and the government). Of course, the interest income should appear somewhere, and it will make an appearance in the consumption function.

Fixed capital formation is assumed to depend on interest rates, so

I2 < I1

Consumption depends on income, holding gains and previously accumulated wealth and propensities to consume. Propensities can depend on the type of income (compensation of employees, interest income, income via dividends) and so on.

Less fixed capital formation implies firms hire less. This means compensation paid to employees is lesser than before and also since fixed capital formation of firms is also an income flow for firms as a whole, a reduction implies less profits and dividends paid to households.

Hence, despite households receiving higher interest income on government debt, their total income is likely less than before with interest rate at 15% and hence,

C2 < C1

This implies:

C2 + I2 + G2 < C1 + I1 + G1

Which was I intended to show.

Funnily, Winterspeak puts me in the same position of Monetarists but it is him who is being a Neo-Fisherite here. (Referring to Krugman’s terminology is not an endorsement to his monetary economics.)