Author Archives: V. Ramanan

Strong Assertions

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In a recent article (from last month), Warren Mosler makes strong claims. He says:

I reject the belief that economy is strong and operating anywhere near full employment. I also reject the belief that a zero-rate policy is inflationary, supports aggregate demand, or weakens the currency, or that higher rates slow the economy and reduce inflation.

…

What I am asserting is that the Fed and the mainstream have it backwards with regard to how interest rates interact with the economy. They have it backwards with regard to both the current health of the economy and inflation, and, therefore, their discussion of appropriate monetary policy is entirely confused and inapplicable.

Furthermore, while I recognize that raising rates supports both aggregate demand and inflation, I am categorically against raising rates for that purpose.

…

The problem with the mainstream credit channel is that it relies on the assumption that lower rates encourage borrowing to spend. At a micro level this seems plausible- people will borrow more to buy houses and cars, and business will borrow more to invest. But it breaks down at the macro level. For every dollar borrowed there is a dollar saved, so any reduction in interest costs for borrowers corresponds to an identical reduction for savers. The only way a rate cut would result in increased borrowing to spend would be if the propensity to spend of borrowers exceeded that of savers. The economy, however, is a large net saver, as government is an equally large net payer of interest on its outstanding debt. Therefore, rate cuts directly reduce government spending and the economy’s private sector’s net interest income.

I don’t understand why as a heteredox author, Mosler simplifies his analysis so much.

This post is not about discussion about whether it is time to raise interest rates in the United States. It’s not the time. It is about Mosler’s claim that monetary policy works opposite to what is usually assumed.

This oversimplification can easily be debunked. If the central bank raises the short term interest rate to say 15% from 0.25%, it will obviously lead to a reduction in borrowing. Firms will reduce investment and stock building as higher rates will require them to pay higher interest and the expectation that the economy will slow down will dampen production. Households may postpone plans for purchases of new houses and take out lesser loans and those with existing loans on floating interest rates are likely to reduce consumption when faced with a higher debt burden because of higher interest payments. Further, raising rates from say 0.25% to 15% may bankrupt a lot of firms because interest payments on debt may become very high. There are also feedback effects: a slowdown of output will lead to higher unemployment and less consumption and so on. It can be argued that interest payment by one economic unit is income for another so one needs a model to see how all this works: complications such as consumption propensities of interest payers and receivers.

Of course this effect may not be so strong if the short term interest rate is raised from 0.25% to say 2% but asserting that there is no effect and that the effect is exactly the opposite is too simplified a claim.

Does that mean that rising short term interest rates is always accompanied by a lower output? No. Monetary policy is only one channel. It is possible that while the central bank is raising interest rates, other things that affect aggregate demand conditions are working to raise output. For example, the government may be raising pure government expenditure while the central bank is raising rates, or exports are rising.

Now reconsider Mosler’s point quoted above:

For every dollar borrowed there is a dollar saved, so any reduction in interest costs for borrowers corresponds to an identical reduction for savers. The only way a rate cut would result in increased borrowing to spend would be if the propensity to spend of borrowers exceeded that of savers.

Not sure what that means. Dollar is not fixed in quantity. Further an economic unit may be both a net borrower and a saver. To see this think of a simple example: Your disposable income is $1mn, your consumption is $200,000 and you borrow $4.2mn to buy a house for $5mn. Your saving is $800,000 and your net borrowing is $4.2mn. You are both a saver and a borrower. Also, I am not sure how “propensity to spend of borrowers” means, as long as one is talking of borrowing to not make purchases of financial assets: all that is borrowed is spent, so this propensity is always equal to 1.

Perhaps Mosler has in mind the debt/income ratio. In the above example, your debt/income has risen but it isn’t necessarily the case with firms as investment is self-financing. Firms may borrow more in response to a fall in interest rates. But this needn’t cause a rise in debt/income as investment is also a source of income for firms as a whole. So firms’ debt/income may actually improve.

Mosler discusses the net lending of the private sector when he is talking of “net saving” (saving less investment expenditure), which is identically the net lending. Even if the private sector as a whole sees a deterioration of their net lending position it isn’t necessarily problematic in the short run. There is no reason that this is a constant relative to output or income which Mosler implicitly is assuming.

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.

Mosler gives the example of Japan to show what he says vindicates him. Low rates in Japan hasn’t helped Japan. The analysis is oversimplified because output depends on so many other things than monetary policy. There is no need to make simplistic assertions. Heteredox economists will be be seen as simpletons because of analysis such as that of Mosler. Mosler’s idea of writing was perhaps to stress the importance of fiscal policy and that mainstream economists underplay the positive role of fiscal policy and exaggerate the role of monetary policy. It can be said directly instead of claiming “the mainstream have it backwards with regard to how interest rates interact with the economy.”

IMF’s World Economic Outlook On Global Imbalances

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The IMF has released a couple of chapters from its upcoming World Economic Outlook. There is one chapter Are Global Imbalances At A Turning Point, which talks of not just “flow imbalances” (current account deficits/surpluses) but also “stock imbalances” (international investment positions).

There is a nice table with a lot of information (although it is interested in absolute indebtedness and misses out small countries with high indebtedness in the list but still good information).

IMF Largest Creditor And Debtor Economies

The article stresses that flow imbalances are not just enough to analyse the macroeconomics but stock imbalances also need to be studied. Of course, in reality deficits/surpluses are not the true measures of imbalances as Nicholas Kaldor stressed in a footnote in his 1980 article The Foundations Of Free Trade Theory And Their Implications For The Current World Recession (published in Collected Essays Vol. 9):

Morever, the actual surpluses and deficits are not a proper measure of the potential size of such imbalances (and of the deflationary force they exert) since the countries who suffer from an excessive import propensity tend, on that account, to suffer from an insufficiency of domestic demand as well so their aggregate output or income is demand-constrained; they may, in addition be forced to follow a deflationary fiscal and monetary policy, and for both of these reasons, will import less from the surplus countries than they would do under full employment conditions.

The same reasoning is valid for stock imbalances as well. The true solution to reverse the imbalances without hurting aggregate demand is to rein in free trade and expand domestic demand by fiscal policies, especially by creditor nations but with so much orthodoxy around — especially from the IMF, there still is a long way to go. The global imbalances problem itself is the result of neoliberal policies promoted by the IMF.

Credit And Economic Growth

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In a new column for Bloomberg, Noah Smith questions the intuition that credit fuels economic growth.

click to view on Twitter

He says:

It seems like the only people who don’t instinctively believe in credit-fueled growth are academic economists.

The academics have good reason for being skeptical.

His reason (in short) is the following:

It’s pretty obvious how credit drives my personal household consumption. If I borrow, I can get a nice big TV and a new car, but eventually I’ll have to skimp to pay it back. In a way, the consumption-fueled borrowing binge is an illusion of wealth — after all, borrowing doesn’t increase my salary. Pleasure today means pain tomorrow.

Notice how Smith’s argument uses a lot of national accounting and flow of funds concepts: consumption, borrowing, wealth, repayment (of loans) and so on. The interesting thing is that one can use the system of national accounts and flow of funds to create models which show precisely the opposite of what Smith is saying. The best place obviously to look out for is the book Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth by Wynne Godley and Marc Lavoie which has models called stock-flow consistent models or SFC models. It is however difficult to write down a simple SFC model in a blog post, so I will try to highlight how it works in words but refer the reader to these models.

Here’s how in a simple model:

  1. Consumers decide to borrow more and banks respond by granting them loans.
  2. Consumers spend the funds received on consumption goods.
  3. Since loans make deposits, it’s not as if someone forgoes consumption to lend as neoclassical textbooks say.
  4. Firms see their inventories go down and respond by increasing their inventories by producing more.
  5. For producing more, firms hire more labour and pay salary/compensation.
  6. People newly employed spend their income and there’s further rise in production as firms produce more when seeing a higher demand for their products.
  7. Higher production leads to a rise in productivity and wages/household incomes of the already employed rise in response (although not necessarily the case).

So we have a higher output than what we started with and higher national income.

One can take several issues with this and this is one reasons models are really helpful and pinpoint what’s going on. This is the reason I referred to the book by Godley and Lavoie above. So for example, one can ask: what if the rise in the national income and output is just a rise in the nominal value but that it’s possible that prices have changed and that the real output hasn’t changed. This of course needs a model of prices and inflation but a familiarity with stock-flow consistent models will make you realize that it is an extreme assumption to think that the real output hasn’t risen in the sequence of events highlighted above.

The second thing is the above “model” in words had just banks lending to households whereas in the real world, credit (as in any credit, such as firms borrowing) is via credit markets of which banks are only one part. This issue is not so simple to argue out, but it can be shown that it really doesn’t matter (in the first approximation). I do not know how to quickly argue it out in short here but will leave that for now.

Of course the above model can be misleading. For example, if households take a lot of debt, debt repayment burden will hit and cause a slowdown as households’ consumption will drop and this may lead to an economic slowdown. This point may look similar to what Noah Smith is saying, but that is not the case. One can imagine an economy starting with a GDP of 100 and growing to 120 in some time period and then slowing down to 118 because of the debt burden. Also the above model was implicitly a pure private sector model and in general one has both the government and the overseas sector adding more complications. Again more reasons why having a proper mathematical model for such things is important.

Another critique of Smith (in my mini-exchange of tweets with him on Twitter) was that SFC models do have behavioural assumptions. I agree, but my point was that there’s no reason to dismiss the argument “credit fuels growth” by purely theoretical arguments. If at all, the system of national income and flow of funds make it more convincing that credit is important.

Of course none of this means that policies should be promoted to ease credit conditions always and try to create a boom and what Smith says is somewhat true – there can be pain later, so it is important to consider fiscal policy, balance of payments and so on but the story told here is quite different from the one told by Noah Smith.

ROKE Issue On Steve Keen’s Notion Of Aggregate Demand

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The new issue of ROKE (Review of Keynesian Economics) is online with a few articles available free for some time. Marc Lavoie, Thomas Palley and Brett Fiebiger comment on Keen’s notion of aggregate demand.

Marc Lavoie’s article A comment on ‘Endogenous money and effective demand’: a revolution or a step backwards? is available here.

Steve Keen’s own paper Endogenous money and effective demand is available here.

From Marc Lavoie’s introduction and the ending:

Steve Keen argues that post-Keynesians have not sufficiently emphasized the revolutionary character of endogenous money for macroeconomic theory, and that this should be done by recognizing that aggregate demand is equal to current or past income plus the change in debt. This equation, attributed in particular to Hyman Minsky, is discussed and questioned, and it is recalled that a similar equation had been proposed by Alfred Eichner. The consequences of bank credit for firms or households are further analysed within the context of the national accounts, and it is shown that one does not need a redefinition of aggregate demand and aggregate supply, in contrast to what is proposed by Keen…

…

All post-Keynesians certainly concur with the idea that banks have the capacity to alter the level of aggregate demand, and hence that it would be desirable for banks, debt, and money to be included in models of macroeconomics… There are several examples of post-Keynesian macroeconomic models that incorporate banks, debt, and money – for instance, Godley and Cripps (1983) and Godley and Lavoie (2007), just to mention those that I am most familiar with… But this does not imply, as Keen claims, that we need a redefinition of aggregate demand such that the starting point of macroeconomics is that ‘effective demand is equal to income plus the turnover of new debt’ (Keen 2014a, p. 286). Nor does it mean that aggregate supply needs to be redefined ‘to incorporate the financial markets’ (ibid., p. 290). To provide new definitions of existing terms will only lead to a maze of confusions.

Keen makes the grandiose claim that his approach leads to a ‘new, monetary macroeconomics’ (Keen 2014a, p. 286). While statements of this kind may appeal to an internet audience, I doubt they will convince readers of this journal.

Marc also quotes my blog post Income ≠ Expenditure? which critiqued Keen. (Thanks!).

Tom Palley and Brett Fiebiger’s papers are not available for download by the journal. I will update the post in case ROKE decides to make it available. The permanent links are available in the left column of the papers linked in the post. Palley’s draft version is available here

Also don’t miss the paper by Anthony Thirlwall in the current issue.

Marc Lavoie’s New Book

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Marc Lavoie is out with his new book Post-Keynesian Economics: New Foundations. (Publisher’s site for the book)

Marc Lavoie - Post-Keynesian Economics - New FoundationsAs per the book’s website,

The book is a considerably extended and fully revamped edition of the highly successful and frequently cited Foundations of Post-Keynesian Economic Analysis, published in 1992. It provides an exhaustive account of post-Keynesian economics and of the developments that have occurred in post-Keynesian theory and in the world economy over the last twenty years. Topics covered include open-economy issues, the methodological foundations of heterodox economics, consumer theory, firms and pricing, money and credit, effective demand and employment, inflation theory, and growth theories.

Chapter 1 is available for download at the publisher’s website here

Greg Mankiw And Empirics

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Greg Mankiw wonders if teaching students empirics is feasible and answers in negative:

Noah Smith says introductory economics needs to be more empirical. I understand his argument, and have some sympathy with it, but I wonder if the substantial change he seems to be proposing is practical. Economists usually do empirical work with statistical tools that most college freshmen have not yet learned.

We teachers of introductory economics can and should explain where and why economists disagree. That is part of helping students develop their critical thinking skills. But I doubt students are in a position to try to evaluate the competing empirical work that shapes the differing views.

In the end, introductory economics is just that: an introduction to the economist’s way of thinking. That means giving students basic concepts–comparative advantage, supply and demand, market efficiency and market failure–that will make them more perceptive readers of the newspaper.

The failure to teach empirics to students and how it distorts their vision was well understood by Wynne Godley. In a 1993 article Time, Increasing Returns And Institutions In Macroeconomics, in S. Biasco, A. Roncaglia and M. Salvati (eds.), Market and Institutions in Economic Development: Essays in Honour of Paolo Sylos Labini, (New York: St. Martins Press), pp. 59-82 he wrote:

… But my objection goes beyond skepticism that the world we live in is being described realistically. My additional concern is that the NCP [neoclassical paradigm] is prejudicial with regard to the understanding of some of the most important processes going on in the world today. Thus in the ‘classical’ version of the NCP real output is determined by supply side alone; fiscal policy is entirely impotent and the government can only affect anything by changing the money supply; even then all it can do is affect the price level. The idea that fiscal policy is impotent, which seems to be based entirely on this model, has been extremely influential in contemporary political discussion; it is not just a provisional result suitable for a week or two in an elementary class.

Then the abolition of time prejudices the perception of inflation as an evolutionary process; the equilibria generate ‘explanations’ of price levels not changes, and theories of inflation cannot be convincingly coaxed forth. As if this were not enough, the whole construction leads by virtue of its axioms to the conclusion that wage and price flexibility, in combination with free trade, will generate full employment and convergence, if not equalisation, of living standards between countries and between regions within countries. In sum, while the absence of processes occurring in historical time means that the NCP does not encourage students to go and look up figures in books, if and when they are forced to do so their vision is likely to have been for ever distorted.

[emphasis added]

Steve Keen And Sectoral Balances

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Steve Keen has a new article on sectoral balances here.

First apologies in advance for sometimes criticizing heterodox economists more but needless to say, such criticisms are of a totally different nature than criticisms of mainstream economists.

Anyway, I am surprised at why Keen mixes accounting identities, especially when it involves banks in the analysis. In the new article, Keen has an equation:

 Bank lending p.a. = Nominal GDP growth / Velocity of Money + Government Deficit + Trade Surplus

I don’t get this. The correct sectoral balances equation (in a simplified three-sector setting) is:

Net Lending = Government Deficit + Current Account Balance of Payments

Here, net lending is that of the private sector. The terminology net lending is something national accountants use, while Wynne Godley used NAFA  — net accumulation of financial assets which means a slightly different thing in national accounts, but this point is irrelevant here.

Keen’s equation seems to mix many things and it has a term for GDP growth which actually needs a model and is not something that can be derived from an accounting identity. Morever, Keen seems to forever blur bank lending and lending in general and hopefully he gets these things right in the future. The hidden assumption in Keen’s models —something which has been pointed out by Nick Edmonds — is that non-bank lending has no effect on aggregate demand which (the assumption) doesn’t make sense.

The original sectoral balances identity was used by Wynne Godley with a behavioural model around it, although he started building his models when he realized in the 70s that the accounting identity itself is a great revelation. And a narrative around the three balances makes a good story especially for telling a story about future scenarios and so on.

Keen, on the other hand has a relation which is not really an identity but a behavioural equation. By itself there’s nothing wrong but given his mixing things up, it really ends up adding confusions. Keen’s blog title uses the phrase “arithmetic” which simply means a manipulation of numbers but has an equation which is more than arithmetic. Reading his article suggests that he has improved the sectoral balances to take into account bank lending. But the sectoral balances equation is an identity even if banks exists. And Keen seems to derive his equation as if it were an accounting identity.

Again goes on to show, it is highly important in macroeconomics to know flow of funds properly.

Paul Krugman, Gattopardo Economist, Part 2

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As mentioned in my previous blog, Paul Krugman tries his best to put down heterodoxy. His claims that nobody predicted the crisis is deeply unintellectual when someone such as Wynne Godley and other heterodox economists had warned about it. Moreover, Jan Hatzius who uses Wynne Godley’s approach also had made a case for a severe deflation around 2007. There’s a reason I bring in Hatzius because sometime ago, Paul Krugman mentioned Jan Hatzius:

Now, it’s interesting to note that the really smart Wall Street money doesn’t buy into this canon. Jan Hatzius and the rest of the economics group at Goldman have an underlying macroeconomic framework pretty much indistinguishable from mine, and have consistently talked down the risks from easy money and deficits.

[emphasis: mine]

There are two things dishonest about this. First, Jan Hatzius pays tribute to Wynne Godley when he writes for Goldman Sachs about the sectoral balances approach and obviously doesn’t mention Krugman. Second Wynne Godley was a heterodox economist and strongly against orthodoxy. Jan Hatzius uses Wynne Godley’s approach and Krugman claims it is indistinguishable from his and sidelines heterodoxy.

What’s going on here?

Paul Krugman, Gattopardo Economist

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In response to Thomas Palley’s op-ed, Paul Krugman has written a couple of pieces on his New York Times blog (here and here)

I have seen many heteredox economists defending Krugman but these pieces should now make it crystal clear that Paul Krugman himself is the head of Gattopardo Economics. Consciously or subconsciously, Krugman’s strategy has been to sideline heteredox, in the hope that pages of history sing praises of him. Unfortunately for him, whenever he gets into a technical argument with heteredox economists on money, he makes the silliest mistakes.

Rather than giving many examples of why Krugman is the part of the problem, let me illustrate one example where he pushed very hard on the issue of free trade. It is a lecture paper for Manchester conference on free trade, March 1996 titled Ricardo’s Difficult Idea.

The following quote is clearly a strategy for propaganda:

5. What can be done?

I cannot offer any grand strategy for dealing with the aversion of intellectuals to Ricardo’s difficult idea. No matter what economists do, we can be sure that ten years from now the talk shows and the op-ed pages will still be full of men and women who regard themselves as experts on the global economy, but do not know or want to know about comparative advantage. Still, the diagnosis I have offered here provides some tactical hints:

(i) Take ignorance seriously: I am convinced that many economists, when they try to argue in favor of free trade, make the mistake of overestimating both their opponents and their audience. They cannot believe that famous intellectuals who write and speak often about world trade could be entirely ignorant of the most basic ideas. But they are — and so are their readers. This makes the task of explaining the benefits of trade harder — but it also means that it is remarkably easy to make fools of your opponents, catching them in elementary errors of logic and fact. This is playing dirty, and I advocate it strongly.

(ii) Adopt the stance of rebel: There is nothing that plays worse in our culture than seeming to be the stodgy defender of old ideas, no matter how true those ideas may be. Luckily, at this point the orthodoxy of the academic economists is very much a minority position among intellectuals in general; one can seem to be a courageous maverick, boldly challenging the powers that be, by reciting the contents of a standard textbook. It has worked for me!

(iii) Don’t take simple things for granted: It is crucial, when trying to communicate Ricardo’s idea to a broader audience, to stop and try to put yourself in the position of someone who does not know economics. Arguments must be built from the ground up — don’t assume that people understand why it is reasonable to assume constant employment, or a self-correcting trade balance, or even that similar workers tend to be paid similar wages in different industries.

(iv) Justify modeling: Do not presume, as I did, that people accept and understand the idea that models facilitate understanding. Most intellectuals don’t accept that idea, and must be persuaded or at least put on notice that it is an issue. It is particularly useful to have some clear examples of how “common sense” can be misleading, and a simple model can clarify matters immensely. (My recent favorite involves the “dollarization” of Russia. It is not easy to convince a non-economist that when gangsters hoard $100 bills in Vladivostock, this is a capital outflow from Russia’s point of view — and that it has the same effects on the US economy as if that money was put in a New York bank. But if you can get the point across, you have also taught an object lesson in why economists who think in terms of models have an advantage over people who do economics by catch-phrase). None of this is going to be easy. Ricardo’s idea is truly, madly, deeply difficult. But it is also utterly true, immensely sophisticated — and extremely relevant to the modern world.

[Highlighting: mine]

Keen’s Reply To Palley

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Steve Keen has replied to Thomas Palley’s critique of him with an article How not to win an economic argument.

All models are incomplete because they ignore many complications in order to highlight a few key concepts. In other times, a simple model is a starting point with the aim that the modeler adds more complications to make it more realistic. So it is sometimes not a good critique to point out what the models misses. But Steve Keen is making it look as if Palley’s critique is of what his models do not have.

This is diverting attention. For about two years or more, Keen has given all sorts of definitions of aggregate demand. The reason Palley’s critique is so solid is that it again points out that Keen’s definitions are wrong. Keen has repeated statements on aggregate demand and “change in debt” many times, making it sound like a universal law. Palley has shown via very straightforward arguments as quoted in my previous post Thomas Palley’s Nice Critique Of Steve Keen’s Models that the definition is incorrect. Moreover, Keen has changed his definitions as highlighted by a nice blog article by JKH. In my opinion Keen himself is confused on which definition is right and uses all of them together many times without realizing that they are different. His earlier definitions were simply incorrect on basic flow of funds accounting.

In short, there is no simple expression for changes in aggregate demand with changes in debt, a point mentioned by Nick Edmonds on his blog. Even if not, one could argue that it is useful but that is not the case because even at the theoretical level, there are conceptual issues, a lot because Keen doesn’t do his accounting right. Such things are not mere technicalities but the concepts of flow of funds is highly important to make some progress in analytic modeling.

Keen says:

My approach was to take the other side’s model, and show that if their assumptions were correct, they were right: banks could be ignored in macroeconomics, and changes in private debt had only a miniscule effect on demand.

Then I made one realistic small change, and hey presto — banks were essential to macroeconomics, and changes in private debt were the main game (but not the only one) in changing aggregate demand.

True neoclassical economists do not incorporate money and debt in their analysis but Keen has all this while given hints that Post-Keynesians themselves have not if you see his videos. Even the above quotes suggests as if nobody has done this before Keen. That coupled with the fact that Keen considers anyone having issues his models to be sinful of the loanable funds model. There is an irony here because Keen himself makes errors of the loanable funds approach when distinguishing bank debt and non-bank debt.

In my opinion Keen should completely get rid of this aggregate demand/change in debt slogan. Rejection of this does not mean debt is unimportant and all that. There are nice and realistic models such as that of Wynne Godley and Marc Lavoie (G&L) in which money and credit are central to the analysis and with no need at all for Keen’s fondness of aggregate demand/change in debt. These models have a very important role for aggregate demand and credit and feedback effects and so on but there is no need for inventing new definitions.

Neither is there any need for Lebesgue integrals. If one repeats Keen’s analysis where an economic unit pays for a good with a debit card or cash instead of a credit card, then it violates his own aggregate demand/change in debt definitions.