Yearly Archives: 2012

Nicholas Kaldor On European Political Union

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It is sometimes said that a fiscal union would be the best solution to the Euro Area crisis – perhaps it is the only solution. Indeed while the German leaders Angela Merkel and Wolfgang Schäuble have been trying to promote “more Europe” to achieve this objective, their plan is still defective since it is likely to be based on old plans of a political union.

The idea that the Euro Area needs a political union was known from before – as mentioned by the Werner Report from 1971. Nicholas Kaldor wrote an article in the same year (In The Dynamic Effects Of The Common Market first published in the New Statesman, 12 March 1971 and also reprinted (as Chapter 12, pp 187-220) in Further Essays On Applied Economics – volume 6 of the Collected Economic Essays series of Nicholas Kaldor) highlighting the serious defects in the plan.

See my post Nicholas Kaldor On The Common Market. In the post I missed out Kaldor’s important points about the plan for the fiscal union itself.

If the leaders of Europe are proposing to have a plan such as in the Werner report, then Europe is in more trouble. “What is not envisaged is that the main responsibility for public expenditure and taxation should be transferred from the national Governments to the Community.” According to Kaldor, this is bound to fail for reasons mentioned below.

This fault was also noted by Philip Arestis and Malcolm Sawyer recently in their article The Dangers Of Pseudo Fiscal Union In The EMU.

I am reproducing here the relevant section of Kaldor’s essay (pp. 202-207) for the sake of completeness:

THE CONSEQUENCES OF A FULL ECONOMIC
AND MONETARY UNION

The events of the last few years – necessitating a revaluation of the German mark and a devaluation of the French franc – have demonstrated that the Community is not viable with its present degree of economic integration. The system presupposes full currency convertibility and fixed exchange rates among the members, whilst leaving monetary and fiscal policy to the discretion of the individual member countries. Under this system, as events have shown, some countries will tend to acquire increasing (and unwanted surpluses) in their trade with other members, whist others face increasing deficits. This has two unwelcome effects. It transmits inflationary pressures emanating from some members to other members; and it causes the surplus countries to provide automatic finance on an increasing scale to the deficit countries.

Since exchange-rate adjustments or “floating rates” between members are held to be incompatible with the basic aim of economic integration (and are incompatible also with the present system of common agricultural prices fixed in international units) the governments of the Six, at their Summit meeting in The Hague in December 1969, agreed in principle to the creation of a full economic and monetary union, and appointed a high-level committee (the so-called “Werner Committee”) to work out a concrete programme of action.

The Werner Committee’s recommendations have not yet been adopted in detail, though its principal objectives have been confirmed by the Community’s Council of Ministers.

The realisation of economic and monetary union, as recommended in the Werner Report, involves three kinds of measures, each introduced in stages: monetary union, tax harmonisation, and central community control over national budgets.  It envisages a three-stage programme, with each stage lasting about three years, so that the whole plan is designed to be brought into operation by 1978-80.

In the monetary field in the first stage the interest and credit policy of each central bank is increasingly brought under common Community surveillance and permitted margins of variations between exchange rates are reduced or eliminated. In the second stage exchange rates are made immutable and “autonomous parity adjustments” are totally excluded. In the third stage the individual central banks are abolished altogether, or reduced to the status of the old colonial “Currency Boards” without any credit creating power. [footnote: Different currencies (marks, francs, etc.) might be nominally retained so long as each currency has always a 100 per cent. backing in terms of the Community’s reserve currency.]

In the field of tax harmonisation it is envisaged that each country’s system should be increasingly aligned to that of other countries, and that there should be “fiscal standardisation” to permit the complete abolition of fiscal frontiers, which means not only identical forms but also identical rates of taxation, particularly in regard to the value added tax and excise duties.

In the field of budgetary control the Werner Report says “the essential elements of the whole of the public budgets, and in particular variations in their volume, the size of balances and the methods of financing or utilizing them, will be decided at the Community level”.

What is not envisaged is that the main responsibility for public expenditure and taxation should be transferred from the national Governments to the Community. Each member will continue to be responsible for raising the revenue for its own expenditure (apart from the special taxes which are paid to finance the Community’s own budget but which will remain a relatively small proportion of total public expenditure and mainly serve the purposes of the Agriculture Fund and other development aid).

And herein lies the basic contradiction of the whole plan. For the Community also envisages that the scale of provision of public services (such as the social services) should be “harmonised” – i.e., that each country should provide such benefits on the same scale as the others and be responsible for financing them by taxation raised from its own citizens. This clearly cannot be done with equal rates of taxation unless all Community members are equally prosperous and increase their prosperity at the same rate as the other members. Otherwise the taxation of the less prosperous and/or the slower-growing countries is bound to be higher (or rise faster) than that of the more prosperous (or faster-growing) areas. [footnote: A further reason for differences in the burden of taxation necessary to provide a given level of service lies in differences in demographic structure – e.g., some countries have a larger proportion of pensioners or schoolchildren than others.]

The Community will control each member country’s fiscal balance – i.e., it will ensure that each country will raise enough in taxation to prevent it from getting into imbalance with other members on account of its fiscal deficit. To ensure this the taxes in the slow growing areas are bound to be increased faster; this in itself will generate a vicious circle, since with rising taxation they become less competitive and fall behind even more, thereby necessitating higher social expenditures (on unemployment benefits, etc.) and more restrictive fiscal policies. [footnote: It is for this reason that in most countries it has been found necessary to transfer a rising population of social expenditure (on poor relief, education, roads etc.) from local authorities to the Central Government, and to supplement an increasing proportion of local tax revenues by grants from the Centre (such as the rate-equalisation grants in the U.K.).] A system on these lines would create rapidly growing inequalities between the different countries, and is bound to break down in a relatively short time. [footnote:  To imagine the consequences one should ask what would happen if the inhabitants of each county in the U.K. were required to finance all their social expenditure by local taxes. Living in Cumerland would be enormously penalised; living in Surrey would be a tax haven.]

This is only another way of saying that the objective of a full monetary and economic union is unattainable without a political union; and the latter pre-supposes fiscal integration, and not just fiscal harmonisation. It requires the creation of a Community Government and Parliament which takes over the responsibility for at least the major part of the expenditure now provided by national governments and finances it by taxes raised at uniform rates throughout the Community. With an integrated system of this kind, the prosperous areas automatically subside the poorer areas; and the areas whose exports are declining obtain automatic relief by paying in less, and receiving more, from the central Exchequer. The cumulative tendencies to progress and decline are thus held in check by a “built-in” fiscal stabiliser which makes the “surplus” areas provide automatic fiscal aid to the “deficit” areas.

Even so, there is need for special regional policies – such as the U.K. differential grants and subsidies to the development areas – to alleviate the problems of growing regional inequalities. The need for the latter is recognised (in a vague way) in the Werner Report, which mentioned “community measures which should primarily concern regional policy and employment policy” and whose “realization would be facilitated by an increase in financial intervention at the Community level”. What the Report fails to recognise is that the very existence of a central system of taxation and expenditure is a far more powerful instrument for dispensing “regional aid” than anything that special “financial intervention” to development areas is capable of providing.

The Community’s present plan on the other hand is like the house which “divided against itself cannot stand”. Monetary union and Community control over budgets will prevent a member country from pursuing full employment policies on its own – from taking steps to offset any sharp decline in the level of its production and employment, but without the benefit of a strong Community government which would shield its inhabitants from its worst consequences.

Some day the nations of Europe may be ready to merge their national identities and create a new European Union – the United States of Europe. If and when they do, a European Government will take over all the functions which the Federal government now provides in the U.S., or in Canada or Australia. This will involve the creation of a “full economic and monetary union”. But it is a dangerous error to believe that monetary and economic union can precede a political union or that it will act (in the words of the Werner report) “as a leaven for the evolvement of a political union which in the long run it will in any case be unable to do without”. For if the creation of a monetary union and Community control over national budgets generates pressures which lead to a breakdown of the whole system it will prevent the development of a political union, not promote it.

But it would be also dangerous to dismiss the Werner Report on the ground that it is not likely to be implemented, particularly if Britain is inside the Community and will have a voice in deciding what happens. For the problems that led to The Hague decisions and to the Werner Report are genuine enough: the framework of institutions and arrangements which make up the present European Community do not constitute a viable system. The Community must either go forward towards full integration (via a political union) or else relax the rigidity of its present arrangements, particularly in regard to agriculture and exchange rates. And it would be hopeless for Britain to join the Community not knowing whether it wishes to move in one direction or the other.

[italics in original, boldening mine]

Not A Balance-Of-Payments Crisis?

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Here’s a new piece by Randall Wray on Economonitor claiming current accounts do not matter (once again!) and didn’t have much of a role on the Euro Area crisis. Part of his arguments are the same as those who participated in public debates 1991 (most, not all) and claimed the balance-of-payments doesn’t matter.

Perhaps he should revise his study of sectoral balances.

Before I consider his analysis, let me remind you why current account deficits matter. A current account deficit is the deficit between the income and expenditure of all resident units of an economy and because it is a deficit, it needs to be financed. Cumulative current account deficits lead to a rise in the net indebtedness of a nation (i.e., consolidated net debt of all resident sectors of an economy) and cannot keep rising forever relative to output. This is because a deficit in the current account is equal to the net borrowing of the nation which has to be financed and secondly, the debt built up needs to be refinanced again and again.

Here’s via Eurostat

It is clear from the chart that nations with high negative NIIP (and hence high net indebtedness) were/are the ones in trouble.

The accounting identity which connects the NIIP to CAB is:

Δ NIIP = CAB + Revaluations

Most of the times, revaluations have less of a role in explaining the NIIP. Of course one can always come up with exceptions – such as for the United States with huge revaluations due to outward FDI and Ireland. It should however be noted that Ireland also had high current account deficits.

Here is data from the IMF on the current account balances:

From this you can see “Germany is not Greece”, “Netherlands is not Spain”, “Finland is not Cyprus” and so on and also the relation of CAB to NIIP.

Let me turn now to what Wray has to say:

Yesterday one presenter at this conference provided a lot of interesting data on cross border lending by European banks, most of which consisted of lending to fellow EMU members. He showed a strong correlation between cross border lending and cross border trade. Hence, posited a link between flows of finance and flows of goods and services. So far, so good. He also accepted a comment from the audience that correlation doesn’t prove causation, and that flows of finance are orders of magnitude larger than trade in goods and services—in other words, most of the financial churning has nothing to do with “real” production.

So atleast Wray accepts there is a correlation of some kind. For causation, see the arguments presented at the beginning of this post.

I won’t rehash that argument. Balances do balance, after all. For every current account deficit there’s a capital account surplus. It seems to me that the claim that the EMU suffers from “imbalances” is on even shakier ground. After all, they all use the same currency, so there’s no chance that an “imbalance” will lead to a run on the currency and to exchange rate depreciation (a usual fear following on from a current account deficit).

This argument was made by neoclassical economists around late 80s and early 90s when Europe was planning to form a monetary union. See this post Martin Wolf Pays A Generous Tribute To Anthony Thirlwall. Wray misses the point that a balance-of-payments crisis also leads to a deflationary spiral and that even though there is no exchange rate collapse, there is deflation in the Euro Area – exactly as predicted by those economists who thought the notion “current account deficits do not matter” was precisely wrong in the early 1990s.

Then Wray goes on to suggest that banks creating a boom and bust in Germany would have looked different:

Yes. But in what sense is that an “imbalance”? Look at it this way. What if instead of running up real estate prices in the sunny south—so that Brits and northern Europeans could enjoy vacation homes—the German banks had instead fueled a real estate bubble in Berlin? What if they had eliminated all underwriting standards and lent until the cows come home on the prospect that Berlin house prices would rise at an accelerating pace? Speculators from across the world would buy a piece of the bubble on the prospect that they’d reap the gains and sell-out at the peak. Construction activity would boom, workers could demand higher wages and would increase consumption, and Germany would have experienced higher price inflation than the rest of Euroland.

In the hypothetical case of Wray where German banks lend the non-financial sectors till the “cows come home”, domestic demand would have risen sharply (which he himself suggests) and this would have had the adverse effect on the balance of payments. Germany would have started running current account deficits because imports are dependent on domestic demand. Germany would have suffered similar fate but in the end it would have depended on how fast the domestic demand rose.

Wray should be careful in doing sectoral balances.

Bad bank behavior can boom or bust an economy—with or without current account deficits. And that’s pretty much what happened in Spain and Ireland (and also in Iceland).

Wray would have sounded right if he had given examples of nations having current account surpluses but from IMF’s table above it can be seen that both Spain and Ireland had huge current account deficits.

What about Iceland?

The data is from 2004-2011 and you can see that in 2008, Iceland had a current account deficit of 28.4%.

Wray then compares the Euro Area to the United States:

In Euroland, all use the same euro currency, and clearing is accomplished among the central banks and through the ECB (that is where Target 2 comes in). It works about as smoothly as the US system. But here’s the difference: the ECB “district banks” are national central banks. It is thus easier to keep mental tabs on the “imbalances” by member states in the EMU than in the USA.

Yes keeping mental tabs on imbalances (and not “imbalances”) can have its effect, but Wray crucially misses the point that in the United States, there is an automatic mechanism of compensating for trade imbalances via fiscal transfers. This acts via lower total taxes paid by regions facing slowdown caused by trade imbalances (not to be confused with lesser taxes paid due to reduced tax rates if any). A rise in public expenditure (not necessarily discretionary but resulting from government guarantees made beforehand) also helps.

Wray however quotes Mosler but he misses the point as well since it talks of directed government spending as opposed to a built in automatic mechanism which (the latter) prevents a crisis at this scale/type from happening.

Generally speaking, Wray seems to suggest that the crisis happened because the private sector credit-led boom went bust and this has nothing to do with current account imbalances. While it is true that the private sector credit-led boom ended in a bust and caused a crisis, what Wray misses is that the current account deficits contributed to exacerbating the crisis because nations in trouble built up huge indebtedness to the rest of the world and had troubles to refinance their debts. If all sectors of an economy have a consolidated net indebtedness position to the rest of the world, they will have issues borrowing and refinancing since – as a matter of accounting – foreigners have to attracted. Foreigners were unwilling because of doubts and also because there was/is a crisis in the world economy, they changed their portfolio preferences – making the whole issue of financing even more difficult.

A Digression On TARGET2

It can be argued that since the TARGET2 mechanism has a stabilizer of some sort – that since the Eurosystem TARGET2 claims arising due to capital flight from the “periphery” is an accommodative item in the balance-of-payments, current account deficits shouldn’t have been an issue.

The error in this argument is that while it is true that capital flight is automatically financed by the resultant Eurosystem TARGET2 claims and that this is helpful, it depends on the hidden assumption that banks have unlimited/uncollaterilized overdrafts at their home central banks. We have seen in various scenarios – such as with procedures such as the Emergency Liquidity Assistance (ELA) – that banks in the “periphery” can either run out of sufficient collateral needed to borrow from their home NCB or have chances to run out of collateral. They hence need to attract funds from abroad. The nation as a whole is dependent on foreigners. Current account deficits are not self-financing.

Some Aspects Of Central Bank Behaviour

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There was a discussion last week on a social network site on Basil Moore’s book Horizontalists And Verticalists. Someone mentioned he never knew anyone who owned a copy of the book! Lucky me.

I was browsing through my copy and came across this – which I thought I should quote on central bank “defensive behaviour”.

Actually, among Post-Keynesians, Alfred Eichner was the first to understand and highlight the “defensive” nature of central bank open market operations.

Outside PKE, it was a paper of Raymond E. Lombra and Raymond G. Torto titled Federal Reserve Defensive Behaviour And The Reverse Causation Argument which started analyzing the details of the Federal Reserve defensive behaviour and supported the theory of endogenous money on which economists such as James Tobin and Nicholas Kaldor were writing at the time. The term “defensive” was coined by Robert Roosa of the Federal Reserve in the book Federal Reserve Operations In The Money And Government Securities Markets originally written in 1956.

Recently central banks around the world have been doing a lot of things (“unconventional measures”) in trying to “boost” their economies – such as “large scale asset purchases” (QE). For some, recent central bank action is the natural way to start to understand monetary economics. For me, it is first important to understand what they did before the crisis to correctly understand what they have been doing and judge if their actions have any usefulness at all – on a case by case basis.

Anyways, here is from Basil Moore’s book (pages 97-99):

Open-market operations: defensive rather than dynamic?

According to the conventional story taught in most textbooks and worked through by students in countless T-account exercises, central bank open-market security purchases have expansionary effects on the money stock by raising the high-powered base. Central bank security sales conversely lower the high-powered base, and so operate to reduce the stock of money outstanding.

Table 5.2 presents the relationship between changes in total bank reserves, the monetary base, and the Federal Reserve net open-market security purchases or sales. The data are monthly time intervals for the period October 1979 to December 1983. This is the period when quantitative targeting was purportedly at last rigorously instituted. Nonborrowed reserves were avowedly the Fed’s chief operating instrument for controlling the growth rate of the monetary aggregates.

To the student of introductory economics, and even to many economists, these results will surely be startling. On a monthly basis, Federal Reserve net open-market operations fail to explain any of the actual changes in unadjusted or adjusted total reserves! They explain only 5 percent of changes in the unadjusted and only 10 percent of the changes in the high-powered base. In all cases the coefficient on net open-market purchases and sales is extremely small. It has no statistical significance in explaining observed changes in bank reserves. Although the coefficient is statistically significant in explaining the monetary base, its magnitude implies that $1000 of open-market purchases or sales were necessary to change the value of the base by $1!

The explanation for these apparently puzzling results is not far to seek (Lombra and Torto, 1973). From the central bank’s point of view a large number of stochastic nonpolicy factors operate to add or withdraw reserves from the banking system. These factors can be analyzed by an examination of the central bank’s balance sheet identity. This documents the various financial flows that accompany any change in the base: changes in float, changes in the public’s currency holding, foreign capital inflows or outflows, changes in treasury balances held with the Fed, changes in bank borrowing from the discount window. All of these flows are completely outside the control of the monetary authorities. In order to achieve a desired level of the base, these flows must be completely offset by open-market operations.

If the Fed were to take no action in the face of these large stochastic inflows and outflows of funds, the banking system would experience sharp fluctuations in its excess reserve position. Such changes would be unrelated to the Federal Reserve’s policy intentions, and would provoke continued liquidity crises and great instability in interest rates. As a result most Federal Reserve open-market operations are “defensive” and designed to offset the effects of these nonpolicy forces. Central banks operate to make reserves available to the banking system on reasonably stable terms, from day to day and week to week.

Studies of Federal Reserve open-market operations have estimated that more than 85 per cent of Federal Reserve security purchases of [sic] sales are “defensive” (Lombra and Torto, 1973, Forman, Groves and Eichner, 1984). Such flexibility is needed to deal with the very large inherent volatility of money flows. On a week-to-week basis such “noise” in the behaviour of the narrow money supply accounts for dollar changes in reserves of plus or minus $3 billion more than two-thirds of the time. This represents nearly 10 percent of total reserves, which were concurrently in the order of $40 billion (J. Pierce, 1982). On a monthly bias, such “noise” accounts for changes in the money stock or plus or minus 5 percent about two-thirds of the time.

Money And Shoes

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… Now let me give you a ridiculous example to make the point. Don’t take it too seriously. Suppose that some statistician observes that over a long period of time there is a high association, a very good fit, between gross national product and the sales of, let us say, shoes. And then suppose someone comes along and says, “That’s a very good relationship. Therefore, if we want to control GNP, we ought to control production of shoes. So, henceforth, we’ll make shoes grow in production precisely at 4 percent per year, and that will make GNP do the same.” I don’t think you would have much confidence in drawing this second conclusion and policy recommendations from the observed empirical association.

Over the years, according to the monetarists, the Federal Reserve has been acting like the producers and sellers of shoes. That is, the Fed has been supplying money on demand from the economy instead of using the money supply to control the economy. The Fed has looked at the wrong targets and the wrong indicators. As a result, the Fed has allowed the supply of money to creep up when the demand for money rose as a result of expansion in business activity, and to fall when business activity has slacked off. This criticism implies that the supply of money has, in fact, not been an exogenously controlled variable over the period of observation. It has been an endogenous variable, responding to changes in economic conditions and credit market indicators via whatever response mechanism was built into the men in this room and their predecessors.

… Perhaps the monetarists will be sufficiently persuasive of the Federal Reserve and of Congressional committees to bring about, in the future, a controlled experiment in which the stock of money is actually an exogenous variable.

– James Tobin, 1969

Ref:

  1. Tobin, James, “The Role of Money In National Economic Policy – A Panel Discussion,” in Controlling Monetary Aggregates. Boston: Federal Reserve Bank of Boston, 1969, pp. 21-24 (link)

Income = Expenditure!

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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

In my previous post Income ≠ Expenditure?, I raised some accounting issues in a recent talk by Steve Keen. I found a paper European Disunion and Endogenous Money which has a background on this written with Matheus Grasselli of the Fields Institute, Toronto.

Let us look at their basic model which still has income not equal to expenditure. Now whichever way one presents it (with better defined terms using phrases “ex-ante”, “ex-post”, “planned”, “unplanned”, one cannot escape the conclusion income = expenditure).

The model is below – found on page 15.

Keen has a simple two-sector model of households and production firms and it can also be thought of as a three sector model where production firms borrow from banks to finance investments.

In the last equation, you see Keen and Grasselli’s claim that expenditure is income plus change in debt.

The trouble is with Keen’s behavioural assumption (1.4)

C = W + ΠD 

Unfortunately the rules of accounting do not allow this!

If the assumption (1.4) is relaxed, firms’ increase in debt is mirrored by households’ saving.

In a three sector model with households, firms and banks, the increase in firms’ debt is mirrored as increase in households’ deposits.

It can be generalized with firms issuing some securities purchased by households.

So equation 1.8 should read:

YE = YI 

with no need of Lebesgue Integrals to prove (1.8) is correct because it is not correct.

The Saving = Investment Identity

The Keen-Grasselli model doesn’t respect the identity

Saving = Investment

This can be easily seen. Households (in his language workers) having zero saving and zero investment. Firms have a saving of  ΠR  and investment of I.

So total saving = ΠR and total investment = I

But because these terms differ by ΔD (equation 1.5), they cannot be equal unless ΔD = 0.

So in the Keen-Grasselli model,

Saving ≠ Investment

The reason Keen and Grasselli get this inconsistency is because they assume that saving is volitional.

Basil Moore was aware of this and in his book Shaking The Invisible Hand, he wrote:

The belief that aggregate saving is the sum of volitional saving decisions by individual economic units is simply a spectacular macroeconomic illustration of the “fallacy of composition.” This fallacy has been reinforced by the unfortunate use of the colloquial verb “to save,” with its very powerful transitive volitional connotations, for an economic term which is merely an intransitive accounting definition: “income not consumed.” As economists know, it is a “fallacy of composition” that what is true for the part is necessarily also true for the whole. Total “saving” is the sum of total saving undertaken by individual “savers.” But since saving is the accounting record of investment it cannot be the sum of volitional individual saving decisions. Aggregate saving is not the sum of individual savers volitional decisions to save. It follows that in all monetary economies most “saving” is “non-volitional.”

[emphasis: mine]

Ideally (i.e., realistically) Keen’s model should sit inside a model with the government and the government would end up running surpluses. Non-volitonally 🙂 S = I would be maintained and so would YE = YI 

Some Higher Mathematics: The Dirac Delta Function

Keen and Grasselli claim that confusions around economists being not able to see things in continuous time is the source of errors by them and that the reason is that debt injections are sudden.

Now, in calculus, there is a thing called the Dirac Delta Function.

[Paul Dirac didn’t get the media attention that Einstein got but he was surely his equivalent. The Delta function is just a small contribution when compared to what he did elsewhere. He was Feynman’s hero.]

The delta function δ(x) is zero at all points except 0 where it is infinite. But the integral of δ(x) from over the range of real numbers is 1. That is difficult to digest initially when first tries to learn it.

A debt injection is a step function jump in debt. The delta function has a curious property that it is the derivative of the step function.

So income flows can be represented as sum of delta functions which different coefficients at different points in time.

So Keen’s chart (Figure 13) in his paper should have income represented as delta function spikes.

To get the flow over a period, one has to integrate and this will result in the income over the period to be the sum of the coefficients of these delta functions.

So whether in discrete formulation or continuous time formulation, YE = YI for the whole economy and the reason is not hard to guess because dD/dt cancels out with dA/dt since assets and liabilities are created equally.

For an individual sector it is true that YE = YI  + dD/dt – nobody disagrees with that but to be more accurate the right hand side should include minus dA/dt.

Also, a continuous time formulation is just taking infinitesimal intervals and then treating infinite of them together.

It makes no sense to say income before debt injection was $100 for real world transactions in a continuous time formulation. It is actually zero just before a debt injection because all income/expenditure flows are “spikey”.

Just after the debt injection it is zero again because nobody spends the instant a loan is given. The debt injection increases assets and liabilities by the amount of the loan if the borrowing is from a bank.

So after the loan is given at the next infinitesimal, change in debt is zero and income/expenditure is also zero.

Then income/expenditure flow spikes at the moment the transaction happens – like a delta function.

But that is income for someone and for an economy as a whole Income = Expenditure.

Anyway, nothing of the analysis justifies the definition of “aggregate demand” (now renamed by Keen to “effective demand”).

20 Years Of Maastricht And All That

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I recite all this to suggest, not that sovereignty should not be given up in the noble cause of European integration, but that if all these functions are renounced by individual governments they simply have to be taken on by some other authority. The incredible lacuna in the Maastricht programme is that, while it contains a blueprint for the establishment and modus operandi of an independent central bank, there is no blueprint whatever of the analogue, in Community terms, of a central government. Yet there would simply have to be a system of institutions which fulfils all those functions at a Community level which are at present exercised by the central governments of individual member countries.

The counterpart of giving up sovereignty should be that the component nations are constituted into a federation to whom their sovereignty is entrusted. And the federal system, or government, as it had better be called, would have to exercise all those functions in relation to its members and to the outside world which I have briefly outlined above.

That was published 8th October 1992 – exactly 20 years back!

Worth your time if you haven’t read it yet. Even if you have, worth reading it again!

Here’s the link to the full article Maastricht And All That by Wynne Godley.

Wynne Godley

(photo credit: King’s College, Cambridge)

Also check out John Cassidy’s post The Man Who Saw Through The Euro written for The New Yorker last year.

Income ≠ Expenditure?

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I like Steve Keen. He is terrific in debunking economics! In a recent debate with Paul Krugman, Keen put Krugman on the defensive and exposed his weaknesses. Krugman obviously didn’t want to accept defeat and tried to escape with the help of comments in the comments section of Nick Rowe’s blog (that DSGE is not neoclassical – whatever!).

There are however some issues with Keen’s own methodologies. In a recent talk (video here), he claims that income is not equal to expenditure due to debt creation. Keen also claims in the video that Schumpeter and Minsky claimed that is the case.

Keen is right about an individual sector but not an economy as a whole when it is closed.

In the following I assume a closed economy – as does Keen. At least he doesn’t make any distinction and thereby his claim is a claim for a closed economy as well. So here is Keen’s claim:

Further he attributes this difference to discontinuities due to debt injections.

In the above Keen forgets that expenditure creates income.

There is no need for a claim that income is not equal to expenditure. In fact it is convenient to have them equal.

Wynne Godley and Francis Cripps wrote a nice book in 1983 named Macroeconomics. Here is from just the second page of Chapter 1: National Accounts:

It is extremely useful to choose definitions such that total income and expenditure in any year, month, day or second are identically equal to one another; they will be – because we choose to define them so that they are – two different ways of looking at the same process. We are only going to admit into the category of flows called income things which have an exact counterpart in the category of flows called expenditure. [footnote]

(with a footnote on qualifications for the case of an open economy).

Further in pages 27-29:

Although the definitions so far imply that the income of all individuals and institutions taken together equals their total expenditure on goods and services in each and every period, this need not be true of any particular person or institution …

… It is easy to understand that any one individual who does not spend all his or her income in a period will have more money left over at the end of the period. But we have chosen a system of definitions which ensures that total income in each period when summed across the whole economy equals total expenditure in the same period. It must therefore be the case that if some people or institutions are accumulating money or other financial assets, others are incurring debts on an exactly equal scale. In the economy as a whole the total increase in financial assets must always be equal in each period to the total increase in debt (financial liabilities).

But since the possibility of borrowing is included as a source of funds for spending, our formal representation of the budget constraint for any individual or institution including the government, is

Equation 1.4 simply says that any excess of income over spending must equal the acquisition of financial assets less the acquisition of debts. As this is true for all individuals it must also be true for the economy as a whole.

But since total national income equals total national expenditure (i.e., Y ≡ E) it must follow for the economy as a whole the change in financial assets must be equal to the aggregate change in debt, i.e.,

ΔFA ≡  ΔD

Back to Keen. He has this slide in this talk:

In the above, households consume by getting wages and going into debt. Hence households have their expenditure higher than income. Similar story for firms.

However, Keen forgets that consumption is income for firms and his accounting has black holes. The whole thing can be done right by creating a Transactions Flow Matrix, so that one is sure that nothing is missed out.

The reason Keen gets into paradoxes can be seen by looking at the following slide where he changes the definition of expenditure.

The right definition of expenditure does not include purchases of financial assets. For Keen if  a household purchases financial assets, it will be counted as “expenditure”. From the above slide, it can be seen that Keen’s definition of expenditure itself is different to begin with from standard ones and obviously he gets the paradoxical claim that Income ≠ Expenditure!

If Keen wants to do an empirical study of the rise in gross assets and liabilities, there is a systematic way to do this: for example see this Bank of England paper Growing Fragilities – Balance Sheets In The Great Moderation.

I won’t pursue this further except saying a few things.

I think Keen’s intuition is that households and firms incurred liabilities at an increasing scale before the financial crisis for both expenditures and purchases of financial assets and this led to increases in asset prices and hence capital gains and hence a feedback loop leading to debt-fuelled growth. Etc etc etc. There is a way to do this but changing definitions is not the right way.

Keen’s model will look accounting consistent (highly important) and more realistic (with no need to define aggregate demand = gdp + change in debt) if he uses some sort of econometric modeling in which Private Expenditure PX is dependent on many things – for example PX-1 so that income need not be equal to expenditure for the economy as a whole (as the time periods for which they are recorded are different) and there is some sort of econometric relation with change in debt.

Else one gets hodgepodge and/or endless redefinitions.

I think his “model” mixes identities, behaviour and plausible econometric relationships.

Below are some “endnotes”

Change in Inventories

“Change in Inventories” create some issues for “Y ≡ E”.  The right way is to have Expenditure equal Final Purchases plus change in inventories. As per Godley & Cripps (p 33):

Y ≡ E = FE + ΔI

Open Economies

Funnily, it is in the case of an open economy that for an economy as a whole, Income ≠ Expenditure! The difference between expenditure and income is equal to the increase in net indebtedness to foreigners.

GDP by Expenditure

Expenditure (of a resident sectors) used here shouldn’t be confused with the expenditure in “gdp by expenditure”. In the former, we include expenditures of residents while in the latter, the export component refers to expenditure of the rest of the world sector of goods and services produced by resident sectors.

Why Paul De Grauwe Is Wrong About TARGET2

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The financial and non-financial resources at the disposal of an institutional unit or sector shown in the balance sheet provide an indicator of economic status. These resources are summarized in the balancing item, net worth. Net worth is defined as the value of all the assets owned by an institutional unit or sector less the value of all its outstanding liabilities. For the economy as a whole, the balance sheet shows the sum of non-financial assets and net claims on the rest of the world. This sum is often referred to as national wealth.

– 13.4, System of National Accounts 2008 (pdf)

Recently, Paul De Grauwe joined the long debate on TARGET2 with a paper What Germany Should Fear Most Is Its Own Fear: An Analysis Of Target2 And Current Account Imbalances. He is supposed to be the top economist in both public and academic debates about the Euro Area but unfortunately, there are glaring errors in his paper.

This paper was aimed at Hans-Werner Sinn who started ringing alarm bells on the huge TARGET2 claims of the Deutsche Bundesbank. The claim of this post (and some more in the past in this blog) is that while Prof Sinn may be wrong on many issues in the debate, he is right about a few important issues. Needless to say, his prescriptions are not defended by me. I am a fan of Nicholas Kaldor’s ideas as quoted in my post Nicholas Kaldor On The Common Market.

De Grauwe’s argument is slightly more nuanced that others such as Karl Whelan. While Whelan dismisses any argument that a loss of creditor nations’ TARGET2 claims on the periphery Euro Area nations is a loss, De Grauwe modifies this to say that the repatriation of funds by Germans (individual investors and institutions) does not increase Germany’s risks.

So we have this claim in his paper:

Thus the increase in the Target2 claims of the Bundesbank should not be interpreted as an increase of foreign claims of Germany, and thus as an increase of risk from higher foreign exposure. Using the Target claims as a measure of risk incurred by the German population is therefore erroneous. As we have seen earlier, after 2010, the Target claims of Germany (and other Northern countries) increased dramatically and much more than the current account surpluses during this period. This increase in Target2 claims cannot be interpreted as an increase in the foreign exposure (net foreign claims) of Germany, except to the extent that they were the result of current account surpluses. What changed dramatically is the nature of these claims. Prior to 2010, these claims were mainly claims held by private German agents (mainly financial institutions). Similarly the liabilities of the peripheral countries were held by private agents (financial institutions). The eurozone crisis led to a dramatic shift. As a result of the breakdown of the interbank market, a large part of these private claims and liabilities were transformed into (public) Target claims and liabilities (Buiter et al., 2011), without however changing the total net foreign claims and liabilities of these countries. Thus, the explosion of the Target claims of Germany since 2010 cannot be interpreted as an explosion of the risk of foreign exposure for Germany.

Ignoring the fact that the repatriation of funds by German residents back to Germany puts the risks on the public sector’s books and awards the (ex-) German lender, there is some element of truth to the above claim. The repatriation of funds does not increase Germany’s gross international investment position (assets and liabilities) but just changes the composition. It however ignores the fact that nonresidents also reallocate their portfolios in German assets and this increases Germany’s gross foreign assets and liabilities and in case there is a default by the periphery on the TARGET2 liabilities (in case they leave the Euro Area), Germany suffers a loss. We will see this with an example below. Before that let me highlight one misleading claim in the paper:

The value of the money base is exclusively determined by its purchasing power in terms of goods and services. This value is independent of the value of the assets held by the central bank. In fact in the fiat money system we live in, the central bank could literally destroy the assets without any effect on the value of the money base. In order to stabilize the value of the money base, the central bank should keep the right supply of money base, i.e. a supply that will maintain price stability.

That is Monetarist handwaving. Won’t say anything further!

When the central bank acquires assets, mainly government bonds, it issues new liabilities. The latter take the place of the government bonds in the portfolios of private agents. It is as if the government debt has disappeared. It has been replaced by central bank debt. The central bank could literally put the government bonds in the shredding machine. This would not affect the value of the central bank debt as the central bank has made no promise to redeem its debt (money base) into government bonds. And as long as the central bank maintains price stability, agents will willingly hold the new debt (money base) issued by the central bank.

That is incorrect. The People’s Bank of China cannot shred US Treasuries into a dustbin and claim it does not matter to the Chinese people.

Now to the main point about this post: foreigners shifting funds into assets issued by German residents.

Here is from the Bundebank’s statistical supplement for Germany’s international investment position:

Aktiva is Assets, Passiva is Liabilities and Saldo is Net.

Germany’s assets and liabilities can increase as a result of a nonresident (such as from Spain) buying German Bunds (government bonds). If an institution in Spain liquidates its position in Spanish assets and transfers the funds to purchase  Bunds, Bundebank’s TARGET2 claims will increase (in the current scenario).

Let us use these numbers to see how Germany’s IIP changes if there is a purchase of €100bn of German assets by German nonresidents (but residents in Euro Area for simplicity).

Initially,

Germany’s Assets = €6,843bn

(of which TARGET2 claims = €727bn)

Germany’s Liabilities = €5,829bn

NIIP = €1,014bn

Now assuming a nonresident purchases €100bn of German government bonds from a German resident,

Germany’s Assets = €6,943bn

(of which TARGET2 claims = €827bn)

Germany’s Liabilities = €5,929bn

NIIP = €1,014bn

So while Germany’s gross assets and liabilities have increased by €100bn, its net position is the same.

However this is not the end of the story. When nonresidents purchase €100bn worth of German securities, the TARGET2 claims of the Bundesbank (or more generally creditor nation’s TARGET2 claims) increases by €100bn. If there is breakup of the Euro Area position at this point in time, this will leave the creditor EA nations with an additional liability of €100bn (incurred just before the breakup) while at the same time losing the €100bn of assets (TARGET2) acquired (in addition to other assets) and hence an NIIP worse than the case if the transaction had not occurred.

This number can be much higher because when there are tensions building up in the financial markets, foreigners may shift funds into Germany and if a breakup really is forced upon the Euro Area, it will leave Germany with additional liabilities and a lower NIIP than before and a huge loss of wealth.

At any rate, a non-negligible part of the German international investment position can be due to foreigners already having shifted funds in German assets (as the gross assets and liabilities position indicates).

But De Grauwe claims (thanks to JKH for pointing):

It is surprising that these simple principles are not widely understood.

!

Recently, the ECB announced a plan which substantially reduces the risks of a breakup of the Euro Area. In the absence of a breakup, discussions such as these are purely academic. However, the story has new twists and turns, and one can never be sure what is going to happen. It is however counterproductive to claim there is no risk/loss (in select scenarios) when there is indeed one.

Needless to say this analysis is not a defense of the German position either. Free trade has helped them a lot and it is time they increase domestic demand and help reduce global imbalances.

OMT! Enter The Draghi

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As leaked earlier by Bloomberg, Mario Draghi in a press conference today, presented his big plan to save the world.

This will involve OMTs (Outright Monetary Transactions) – in which a Euro Area nation central government requesting aid from the EFSF/ESM will also be provided help by the ECB. Under this plan, when a nation’s government asks for financial aid (and a big if), the ECB/Eurosystem may buy government bonds in the open markets to bring the yields down.

The Eurosystem will buy bonds with maturities between one and three years and will accept credit risk on these bonds and will not ask for a seniority status in case of default. Of course, this will come with strict conditions – the government asking for aid would need to commit to a tighter fiscal policy and promise supply side reforms. There will be no upper limit to the  amount of bonds purchased by the Eurosystem.

The full details are here: Introductory statement to the press conference, 6 September 2012 – Technical features of Outright Monetary Transactions.

During the press conference (actually a bit before as well – after Bloomberg leaked a part of the plan), government bond yields had huge moves (e.g, Spanish ten year yields decreased 39bp). Now, if the yields do not reverse and deteriorate again soon, governments requiring help may just delay asking for aid. However, sooner or later bond yields may rise again – especially if foreigners holding the bonds start to get nervous.

My own view is that this plan significantly reduces the risk of an exit by a Euro Area member. Unlike previous plans (SMP, EFSF, ESM) this has no limit on the amount of funds needed. There is no need to wait for parliaments and courts to approve any transaction or aid.

Of course this is not a happy set of affairs. Forcing governments into retrenchment will lead to economic conditions deteriorating further. One however needs to realize that an independent fiscal policy for the troubled nations – while it (an expansion) increases national income and output – will have the adverse effect of deteriorating the balance of payments – resulting in the public debt and the nation’s net indebtedness to foreigners (and the latter is already high for troubled nations) rising without limit relative to output. The plan will look good in retrospect if it is supposed to be a bridge toward a political union with a central government.