Yearly Archives: 2012

Mosler And His Moslerisms

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A few readers/commenters of my blog brought attention to a video of Warren Mosler where he claims that “there is no such thing as a capital flight” – presumably for a nation with a “sovereign currency” with the implication that a Euro Area nations can simply leave the Euro and adopt their original currency without a fear of capital flight post the event.

(Why have capital controls then, if that’s the case?)

Link @22:15

This claim can be easily dismissed by simple balance of payments analysis.

For this I use the IMF’s Balance of Payments Manual (BPM6). First lets look at the format of the BPM6’s numerical example.

The example is below:

(click to enlarge)

Roughly Mosler’s argument is that if a foreigner sells assets denominated in the domestic currency, some other foreigner would need to buy it.

He gives a Bretton-Woods anti-analogy where – presumably – an official foreign creditor can demand gold for conversion and repatriate it home by ship. And that since official convertibility to gold is suspended, there is no capital flight according to this mini-story.

To see there is capital flight, one needs to look at the foreign exchange market microstructure. By the way, the Neochartalists erroneously tend to treat banks as brokers (as opposed to dealers) in the foreign exchange markets. Let us say a foreigner – perhaps a financial institution – with “portfolio investment” in the country in question liquidates assets in the domestic currency and exchanges it at a domestic bank (domestic with respect to the country we are discussing). This “order flow” leaves the bank with a short position in foreign currency which it will try to eliminate. This will lead to a cascading effect because the foreign dealer it may want to offload its position will react itself and hence a series of transactions in the fx markets – leading to a depreciation of the currency.

It may happen that the currency depreciation may bring in an order flow in the opposite direction – thereby leading to a quasi-equilibrium. However if the general expectations is such that the currency may depreciate further then it is hard. If such expectations are formed, there may be even more capital ouflow!

It is precisely here that the central bank may intervene and sell foreign reserves – thereby helping the dealers (both domestic and foreign to offload their undesired positions). So recently there was news of intervention by the Reserve Bank of India in the fx markets. (minor technicality: the reduction of domestic banks’ settlement balances due to the settlement of central bank fx sales will lead to a “fine tuning reverse operation” by the central bank)

So how does the whole thing look in the balance of payments? The answer is very simple: assuming foreigners sold 100 units of assets – minus 100 due to liquidation of domestic assets and minus 100 due to sale of reserve assets.

So that’s capital flight.

And … like that … it’s gone!

Balance Of Payments: Part 2 – Double Versus Quadruple Entry Bookkeeping

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Some time back I had started with the first part of a series of posts on this topic: see Balance Of Payments: Part 1. From the same post, here’s from the Australian Bureau of Statistics’ manual Balance of Payments and International Investment Position, Australia, Concepts, Sources and Methods, 1998

(click to enlarge)

So we have the current account, the financial and the international investment position at the beginning and end of each accounting period. In addition we have, revaluations on assets and liabilities. These arise due to change in the value of assets (such as rise in stock markets) and due to movement of the exchange rate or both.

Also, textbooks use a slightly different language than official statistics and manuals. Textbooks simply use the phrase capital account when they mean the financial account.

I aim to go into each of this and the behaviour of institutions who are involved in the whole process and how it leads to changes in assets and liabilities of all sectors and the consequences. We will see how endemic current account deficits act as a hemorrhage in the circular flow of national income as Wynne Godley would put it and decides the fate of nations as Anthony Thirlwall may have it.

To really appreciate, one needs to have a strong methodology for studying this. One way is to use G&L’s transactions flow matrix but it can get complicated in case of two nations. Needless to say, from a modeling perspective, it is more useful than the usual way of studying balance of payments. However, for appreciating G&L methodology one needs to first understand the usual way of studying this.

Double Entry Versus Quadruple Entry Bookkeeping

In contrast to national accounts, Balance of Payments is based on double entry bookkeeping. Here’s from the IMF’s Balance of Payments And International Investment Position Manual (BPM6), pg 9:

The balance of payments is a statistical statement that summarizes transactions between residents and nonresidents during a period. It consists of the goods and services account, the primary income account, the secondary income account, the capital account, and the financial account. Under the double-entry accounting system that underlies the balance of payments, each transaction is recorded as consisting of two entries and the sum of the credit entries and the sum of the debit entries is the same.

In contrast, national accounts as per SNA2008 or G&L’s way of doing it uses quadruple entry bookkeeping who point out in their book Monetary Economics that:

… Copeland pointed out that, ‘because moneyflows transactions involve two transactors, the social accounting approach to moneyflows rests not on a double-entry system but on a quadruple-entry system’. Knowing that each of the columns and each of the rows must sum to zero at all times, it follows that any alteration in one cell of the matrix must imply a modification to at least three other cells. The transactions matrix used here provides us with an exhibit which allows to report each financial flow both as an inflow to a given sector and as an outflow to the other sector involved in the transaction.

G&L point out that even Hyman Minsky was aware of this. Here’s from the article The Essential Characteristics of Post-Keynesian Economics (page 20):

The structure of an economic model that is relevant for a capitalist economy needs to include the interrelated balance sheets and income statements of the units of the economy. The principle of double entry book keeping, where financial assets are liabilities on another balance sheet and where every entry on   balance sheet has a dual in another entry on the same balance sheet, means that every transaction in assets requires four entries.

The System of National Accounts 2008 (2008 SNA) says (page 21):

In principle, the recording of the consequences of an action as it affects all units and all sectors is based on a principle of quadruple entry accounting, because most transactions involve two institutional units. Each transaction of this type must be recorded twice by each of the two transactors involved. For example, a social benefit in cash paid by a government unit to a household is recorded in the accounts of government as a use under the relevant type of transfers and a negative acquisition of assets under currency and deposits; in the accounts of the household sector, it is recorded as a resource under transfers and an acquisition of assets under currency and deposits. The principle of quadruple entry accounting applies even when the detailed from-whom-to-whom relations between sectors are not shown in the accounts. Correctly recording the four transactions involved ensures full consistency in the accounts.

Simple example: your and my favourite: loans make deposits. The following is a transaction where a household has borrowed some funds from the banking sector:

 

Introduction To Current Transactions

I mentioned that in recording transactions between residents and nonresidents and presenting it as balance of payments, national accountants use double entry bookkeeping (as opposed to quadruple), so any transaction in the current account necessarily involves another entry in the financial account (ignoring barter and accidental cancellations). However, the opposite is not the case: a transaction on the financial account will lead to another entry in the financial account and not directly in the current account. A purchase of US equities by a UK resident cannot be said to cause or increase the US current account deficit.

One example: if you are are US citizen travelling to the UK and have pay for coffee at the London airport by paying in Federal Reserve notes, it will give rise to an entry in the current account (credit from the perspective of the UK balance of payments) and a debit (increase in assets of UK residents: change in currency notes). This is just transaction among thousands and the question is how is all this to be recorded and more importantly (later) what does it tell us.

Here’s how a standard balance of payments table looks like (note: this does not include international investment position)

(source: UK Pink Book 2011; click to enlarge)

We will go over details in the next post in this series. For now let us see how this looks for the example presented earlier: A US traveller pays $10 for coffee at the London Heathrow airport with Federal Reserve currency notes. Assuming the current exchange rate, the following (double) entries need to be included in the UK balance of payments:

 

£ CreditsDebits
Current Account
Goods and Services6.328
Financial Account
Bank Deposits, Foreign Currency Assets6.328

 

 

This is a simple example – hardly needing so much background and information but in the next post in this series, we will look at complicated examples where intuitions can easily go wrong. If the above were the only transaction between UK and US residents in the accounting period (quarter/year), this will also change the US indebtedness to the UK by £6.328 or $10 and this will be shown in the international investment positions of the UK and the US. If the exchange rate had moved from the start of the period, revaluations would need to be done to record the closing stocks of assets and liabilities.

Sovereignty In The Euro Area

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Nouriel Roubini tweets about Trichet’s plan to save the Euro Zone and wonders about sovereignty:

click to view the tweet on Twitter

Two things:

My guess is Trichet’s plan involves a Euro Area institution setting fiscal policy. Trichet’s plan seems to involve some set of technocrats taking control of fiscal policy of a weak nation and then deflating domestic demand and hence not solving anything at all or making it worse. Here it is – clear from the following:

For the European Union, a fully fledged United States of Europe where nation states cede a large chunk of fiscal authority to the federal government appears politically unpalatable, Trichet said.

An alternative is to activate the EU federal powers only in exceptional circumstances when a country’s budgetary policies threaten the broader monetary union, he said.

Secondly, Nouriel Roubini thinks it “undermines national sovereignty” but the Euro Area nations had given this up long back! So while Euro Area nations surrendered sovereignty long back,  Trichet’s plan involves removing more powers from governments without the possibility of those nations receiving fiscal equalization in return!

Trichet’s plan hence has a “central government” with no fiscal authority! There was no sovereignty to begin with and no institution taking up the sovereignty either.

The Man Who Saw Through The Euro had a profound way of looking at how economies function. Wynne Godley already understood in 1992 that by joining the Euro Area, nations surrender their sovereignty. In his article 20 years back Maastricht And All That, Godley said:

But there is much more to it all. It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues.

and that:

… 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.

and also that:

If a country or region has no power to devalue, and if it is not the beneficiary of a system of fiscal equalisation, then there is nothing to stop it suffering a process of cumulative and terminal decline leading, in the end, to emigration as the only alternative to poverty or starvation.

In an article Commonsense Route To A Common Europe in 1991 in The Observer, Godley said:

If we are to proceed creatively towards EMU, it is essential to break out of the vicious circle of ‘negative integration’— the process by which power is progressively removed from individual governments without there being any positive, organic, all-European alternative to transcend it. The nightmare is that the whole country, not just the countryside becomes at best a prairie, at worst a derelict area.

Spanish Banks, Banco de España & TARGET2

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In two big operations in December and February, the Eurosystem lent around €1tn to banks in the Euro Area:

(click to expand, source: ECB)

Spanish banks it seems borrowed around €315bn (gross) as per the recently the Banco de España released statistic Financing In The Eurosystem (April 2012):

(click to expand)

Due to the continuing capital flight out of Spain, the TARGET2 liabilities of Banco de España increased in April and averaged €284.5bn in the month. The flow equivalent in the balance-of-payments language may be called the accommodating item.

Born In The U.S.A. – MMT And Monetary Sovereignty

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In my previous post on government defaults and its connection to open economies, I had a comment from Sergio Cesaratto (who is full professor of Economics at the University of Siena (Italy)) which I liked. Since I don’t publish comments, I asked him if I could promote it to a post and he sent me an updated version which looks more like a post.

Sergio Cesaratto*

sergio.cesaratto@unisi.it
http://www.econ-pol.unisi.it/cesaratto/
http://politicaeconomiablog.blogspot.com/

The absence of a truly European central bank to guarantee the liquidity of the European sovereign debts aggravated (although it not originated) the crisis by letting the sovereign spreads to spiralling upward. As  consequence of the ECB deficient conduct, according to De Grauwe (2011: 8-10) the periphery’s public debts (PD) moved from a low risk to a high risk equilibrium, in his view from a liquidity to a solvability crisis.  This is not totally correct since the original troubles with the European periphery seem solvability, not of just of liquidity, and indeed it emerged when liquidity was abundant and the sovereign spreads low. According to Wray and his MMT fellows this abundance just delayed the redde rationem of the deficient Eurozone (EZ) monetary constitution, so that they attribute an almost exclusive relevance to the renunciation to national sovereign central bank (SCB) as the explanation of the European financial crisis.

In short Wray argues that as long as a country retains a sovereign currency, that is it retain the privilege to make payments by issuing its own currency and does not promise to redeem the debt at any fixed exchange rate or worse in a foreign currency, then it cannot default and the nationality of the debt holders is irrelevant:

The important variable for them [Reinhart and Rogoff 2009] is who holds the government’s debt—internal or external creditors—and the relative power of these constituencies is supposed to be an important factor in government’s decision to default (…). This would also correlate to whether the nation was a net importer or exporter. We believe that it is more useful to categorize government debt according to the currency in which it is denominated and according to the exchange rate regime adopted. … we believe that the “sovereign debt” issued by a country that adopts its own floating rate, nonconvertible (no promise to convert to metal or foreign currency at a pegged rate) currency does not face default risk. Again, we call this a sovereign currency, issued by a sovereign government. …A sovereign government services its debt—whether held by foreigners or domestically—in exactly one way: by crediting bank accounts. … [it is indeed]  irrelevant for matters of solvency and interest rates whether there are takers for government bonds and whether the bonds are owned by domestic citizens or foreigners. (Nersisyan and Wray 2010: 12-14).

While it is certainly right that if a fixed exchange rate leads to a current account (CA) deficit, a country is exposed to “sudden stops” in capital flows and the higher interest rate necessary to avoid the capital flights and to keep the parity will worsen the external and domestic imbalances Wray seems to hold a different view: for him the CA imbalances are irrelevant:

a country can run a current account deficit so long as the rest of the world wants to accumulate its IOUs. The country’s capital account surplus “balances” its current account deficit…. We can even view the current account deficit as resulting from a rest of world desire to accumulate net savings in the form of claims on the country.

That is, any country with a fully sovereign currency and no promise of convertibility at a given exchange rate can confide on an unlimited foreign credit. But for most of the countries countries, the no-promise of convertibility at a given exchange rate is precisely the case in which they will not get (cheap) foreign credit. Indeed, it is by promising at-pair convertibility that periphery countries can finance in a cheap way their CA deficits.  This will, of course, often create future problems, but certainly a floating exchange rate would discourage cheap foreign lending. One may also say that a competitive (real) exchange rate policy is what periphery countries need, a position largely shared by development economists nowadays, not least because it is not conducive to a fictitious foreign-borrowing-led growth.

Wray (2001)  elsewhere admits that the irrelevance proposition that any State

can run budget deficits that help to fuel current account deficits without worry about government or national insolvency

applies indeed only to the US: precisely because the rest of the world wants Dollars. But surely that cannot be true of any other nation. Today, the US Dollar is the international reserve currency—making the US special. … the two main reasons why the US can run persistent current account deficits are: a) virtually all its foreign-held debt is in Dollars; and b) external demand for Dollar-denominated assets is high—for a variety of reasons.

The main reason seems that the U.S. issues the main reserve currency and you issue a liability (so to speak, it’s fiat money) internationally fully accepted even without a commitment to convert it in something else.  So, what Wray say, with a sovereign currency PD and CA debts are not a problem only apply to the U.S.

With fixed exchange rates, it is not so much the promise to redeem the debt at a fixed exchange rate or in a foreign currency that creates problems. It would not be a problem in CA surplus countries, for instance. The problem is that fixed exchange rates lead periphery countries to a CA deficit, to the fear of devaluation, unsustainable interest rates, “sudden capital stops” etc. Recall that the European unbalances initially grew with a ECB pursuing very low interest rates that with financial liberalization and the end of a devaluation risk led to the bubbles in the periphery and eventually to the unbalances. This is not to say that the role of a SCB is not relevant: quite the opposite.  Lately, the ECB should and could have operated to avoid the increase in the sovereign spread, but it could not have avoided the preceding sequence of events.

It may be added that with the right institutional setting, the EZ could be a perfect U.S.-MMT style country. With the full backing of the ECB the infra-European financial imbalances would be perfectly sustainable for a region with external balanced accounts that, what’s more, issues an international currency. The institutional change required for the EZ to resemble the U.S. includes the transfer of the conspicuous part of existing PDs along with many government budget functions to a federal government (to avoid moral hazard),[1] while national States would work as the American local States. Monetary policy should cooperate with fiscal policy to pursue full employment and, subordinated to this, price stability. Federal transfers from dynamic to troubled areas should dramatically increase while minimum standard welfare rights should be universally recognised to all European citizens. Labour mobility and infra-EZ direct investment should be incentivised. Actually, fiscal pacts were already includes in the Maastricht (1992) and Amsterdam (1997) treaties, in which the European periphery exchanged budget discipline with German inflation ‘credibility’ and low interest rates. As the subsequent experience has shown, the troubles have not derived from fiscal indiscipline. Part of the problems certainly derived from a deregulated finance. At the European and national level, financial resources should therefore be re-regulated to sustain public, social and environmental investment rather than construction or consumption bubbles. Public or semi-public investment banks should be used at both levels to this purpose. Be as it may, at the time of writing this project appear still too challenging for real Europe, a club of independent states. Short of this full institutional unification, a pro-active monetary and budget policies at the European level, particularly in the surplus countries, would of course also go into the direction of a solution.

References

De Grauwe Paul  (2011) Managing a fragile Eurozone, Vox

Nersisyan Y., Wray R.L. (2010), Does Excessive Sovereign Debt Really Hurt Growth? A Critique of This Time Is Different, by Reinhart and Rogoff, Working Paper No. 603, Levy Institute June 2010

Wray L.R.  (2011), Currency Solvency and the Special Case of the US Dollar

(this post is a section of a longer essay on the European crisis; I originally sent a summary to Concerted action as a comment to his latest post. I thank Ramanan for promoting it to a post and, without implications, Eladio Febrero for comments).

* Sergio Cesaratto is full professor of Economics at the University of Siena (Italy).

[1] As Nersisyan and Wray 2010: 16 argue:

With a sovereign currency, the need to balance the budget over some time period determined by the movements of celestial objects or over the course of a business cycle is a myth, an old-fashioned religion. When a country operates on a fiat monetary regime, debt and deficit limits and even bond issues for that matter are self-imposed, i.e., there are no financial constraints inherent in the fiat system that exist under a gold standard or fixed exchange rate regime. But that superstition is seen as necessary because if everyone realizes that government is not actually constrained by the necessity of balanced budgets, then it might spend ‘out of control,’ taking too large a percent of the nation’s resources.

The Monetary Economics Of Sovereign Government Rating

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If a government (outside monetary unions) can make a draft at the central bank, why do rating agencies rate governments’ creditworthiness?

In this post, I will attempt to describe the dynamics of defaults and restructurings by going through some monetary economics of open economies.

Carmen Reinhart and Kenneth Rogoff wrote a book in 2009 titled This Time Is Different: Eight Centuries Of Financial Folly or simply This Time Is Different arguing that governments do indeed default – both in debt denominated in the domestic and foreign currencies. They blame the public debt and the government for the public debt – hence giving the innuendo that governments across the planet should attempt to cut public debt by tight fiscal policies. This is an illegitimate conclusion – on which I will say more below.

At another extreme are the Chartalists who argue that the government cannot “run out of money” and hence fiscal policy has no monetary constraints. Sometimes they qualify this statement by saying that the currency they are discussing are “sovereign currencies”. Now, there are various definitions of what a sovereign currency is but it is frequently pointed out by them that nations who have seen restructuring of government debt did not have a “sovereign currency” – because the currency is either pegged or fixed or it is the case that the government had a lot of debt in foreign currency which presumably allows defaults/restructuring of government debt in the domestic currency as well. The motivation behind this is Milton Friedman’s idea that nations should freely float their currencies in international markets and that markets will clear and that the State intervention in the currency markets can only make things worse. Hence Reinhart/Rogoff don’t prove them wrong – according to them – since the situations are supposedly different.

We will see that while there is some truth to it, the notion of a “sovereign currency” is highly misleading. Such intuitions are coincident with the incorrect notion that indebtedness to foreigners (in domestic currency) is just a technical liability and there’s nothing more to that!

Here’s S&P’s article on the methodology it uses to assign ratings on governments: Standard & Poor’s – Sovereign Government Rating And Methodology. One can see the importance it gives to the external sector. However, S&P does not provide a mechanism on how a government will finally end up defaulting. The purpose of this post is to look into this.

Before this let us make a connection between the public debt and the net indebtedness of a nation. Most people in the planet confuse the two. The former is the debt of the government whereas the latter is the (net) indebtedness of the nation as a whole. This is the net international investment position (adjusting for traditional settlement assets such as gold) with the sign reversed. This can be obtained by consolidating all the sectors of an economy and the consolidation involves (for example) netting of the assets of the domestic private sector held abroad and also its gross indebtedness to the rest of the world.

So one can think of two extremes:

  1. Japan – with a high public debt of about 195% of gdp (includes just the central government debt),  while being a net creditor of the world. It’s NIIP is about 50% of gdp (data source: MoF, Japan)
  2. Australia – with a low public debt of 18% of gdp and NIIP of minus 59% of gdp.

So in the case of Japan, while the government is a huge debtor, the nation as a whole is a creditor, whereas in the case of Australia, it is the opposite. So the rating agencies get it wrong or opposite!

Let us first assume a closed economy. The greatest starting point in analyzing economies is the sectoral balances approach. For a closed economy it is:

NAFA = DEF

where NAFA is the Net Accumulation of Financial Assets of the private sector and DEF is the government’s budget deficit. If the private sector wants to accumulate a lot of financial assets, and the government wants to run the economy near full employment, the public debt will be higher, the higher the propensity to save, for example. (This is not as straightforward as presented here but can be shown in a simple stock-flow consistent model). So unlike what neoclassical economists think, the level of public debt is somewhat irrelevant. Neither does the government has too much trouble in financing its debt because the public debt is the mirror image of the private sector net financial asset position.

Now let us take the case of an open economy. The sectoral balances identity now is

NAFA = DEF + CAB

A deficit in the current account implies an increase in the net indebtedness to foreigners. Unless the markets miraculously clear with the exchange rate adjusting to bring the CAB in balance, a deficit in the current account implies the nation as a whole has to attract foreigners to finance this deficit i.e., via a lower NAFA or higher DEF. In the long run, the private sector is accumulating financial assets (or has small positive NAFA) and the whole of the current account balance is reflected in the public sector balance.

So the debate fixed vs floating doesn’t help too much. A relaxation of fiscal policy may spill over into higher imports with the public debt and the net indebtedness to foreigners keeps rising forever to gdp. Hence nations typically have to curb growth to bring the current account into balance.

An excellent reference for this is New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, 1978, by Martin Fetherston and Wynne Godley.

This is theory. So let’s look at an open economy mechanism of an event of default by the government as a story.

In the following, I will use the phrase “pure float” instead of the dubious terminology “sovereign currency”.

Here’s the simplest model:

In the above, a nation with its currency on a pure float and with zero official sector liabilities in foreign currencies has a somewhat weak external position in 2012. Now, according to some of the Neochartalist arguments this nation can’t default on its government debt. However this is a wrong conclusion as the scenario above hightlights. In the scenario constructed, the balance of payments position weakens over the years (and I have mentioned that roughly in 2020 it weakens). In 2022, foreigners are no longer willing to finance the debt. This may be due to a capital flight or due to the inability of the banking system to maintain a low net open position in foreign currency. The depreciation of the domestic currency isn’t sufficient to clear the fx markets and the official sector (either the central bank or the government’s treasury) necessarily has to intervene in the foreign exchange markets by issuing debt denominated in foreign currency. The government is then acting as the borrower of the last resort and the objective is to use the proceeds to partially have more foreign exchange reserves and/or to sell the foreign currency proceeds from the debt issuance to clear the fx markets. The government is then left with a net liability position in the foreign currency. Soon the external situation worsens to the point requiring official foreign help – such as from the IMF – which promises to help and requires a restructuring of the debt both in domestic and foreign currencies.

Free marketers have a blind belief in the markets and the theories are built on the assumption that markets always clear. The recent crisis has highlighted that this isn’t the case. Even for the case of Australia – whose currency can be considered closed to being pure float – has had issues in the external sector and the Reserve Bank of Australia had to borrow in US dollars from the Federal Reserve (via swap lines) to help Australian banks meet their foreign currency funding needs during the crisis.

Of course the above is not typical but to prevent the external vulnerability to go out of control, governments keep domestic demand low and a lot of times, they over-do this.

The point of the exercise is to prove that it is not meaningless to think of nations becoming bankrupt in whichever situation one can think of and it doesn’t help to laugh at the rating agencies and make fun of them – possibly with the exception for the case of Japan. Statements such as “government with a sovereign currency cannot become bankrupt” are simply misleading. In the above, the Chartalists would argue that the currency was not sovereign and they were not wrong about the default but the currency was sovereign in their own definition in 2012!

Here are some comments on some nations.

Japan: As mentioned above, Japan is a net creditor of the rest of the world and partially as a consequence of that, most of the Japanese government’s debt is held internally. The rating agencies are aware of this but in spite of this continue to make comments on the creditworthiness of the Japanese government. It is possible that residents may transfer funds abroad for unknown reasons (which the raters for some reason suspect) but it may require just a minor interest rate hike to prevent this from happening. Japan has a relatively strong external situation and hence has no issues in financing its government debt.

Canada: Nick Rowe of WCI mentioned to me on his blog that worrying about the balance of payments constraint is like “beating a dead horse” – citing the example of Canada which has floated its currency and it seems has no trouble with its external sector. But this ignores other things in the formulation of the problem. Canada is an advanced nation and an external situation which is not weak. However, a growth of the nation much faster than the rest of the world will lead to a worsening of the external situation. To some extent the nation’s external situation has been the result of its relatively better competitiveness of exporters compared to its propensity to import and a demand situation which either as a conscious attempt of demand management of the government or by pure fluke has helped its external situation remain non-vulnerable.

United States: The US dollar is the reserve currency of the world and slowly over time, the United States has turned from being a creditor of the rest of the world to becoming the world’s largest debtor nation. (Again not due to its public debt but because of its net indebtedness to foreigners). The US external sector is a great imbalance and any attempt to get out of the recession by fiscal policy alone will worsen its external situation leading to a crash at some point. S&P is right! So to come out of the depressed state, the nation has to complement fiscal expansion with improvement of the external situation such as by (and not restricted to) asking trading partners to not revalue their currencies. Still for some reasons bloggers at the “New Economic Perspectives” think that

… Bernanke also knows that the US has infinite ability to finance these fiscal components, that there is no solvency issue and that the policy rate and both ends of the yield curve are under the direct control of the Fed.

Back to This Time Is Different. While Reinhart and Rogoff’s analysis of government debt may be useful, their conclusions can be destructive for the world as a whole. The domestic private sector of a nation needs continuous injection from outside so that it can run surpluses in general and tightening of fiscal policies will lead to a depression. Global imbalances is crucial in understanding the nature of this crisis (and not public debt alone) and even coordinated attempts to reflate economies may provide only a temporary relief. Since failure in international trade restricts the growth of nations and their attempts to reach full employment, what the world needs is an entirely different way to run the economies under managed trade with fiscal expansion. Ideas of “free trade” such as that outlined here by Alan Blinder simply help some classes of society at the expense of others because it relies on the “market mechanism” which has failed over and over again.

This brings me to “sovereignty”. As argued, the concept “sovereign currency” is almost vacuous (except highlighting the problems of the Euro Area) but sovereignty as argued by Wynne Godley in his great 1992 article Maastricht And All That and by Anthony Thirlwall in the same year on FT (my post on it here Martin Wolf Pays A Generous Tribute To Anthony Thirlwall) definitely have great importance. Some of Thirwall’s concepts of economic sovereignty in the article were: the ability to protect and encourage strategic industries, the possibility of designing systems of managed trade to even out payments imbalances, the ability to protect against certain countries with persistent surpluses, differential taxes which discriminate in favour of the tradeable goods sector.

Private Indebtedness In CBO’s Forecasts

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Michael Stephens of the Levy Institute highlights the recent Levy Institute Strategic Analysis: Back To Business As Usual? Or A Fiscal Boost? in a post Where Will US Growth Come From If Austerity Reigns on the Institute’s blog Multiplier Effect. 

According to the authors Dimitri Papadimitriou, Gennaro Zezza and Greg Hannsgen,

The results of our simulation are reported in Figure 4. The government deficit falls rapidly, but if we want to achieve the CBO’s projected growth path, the private sector has to start borrowing again, switching to a deficit position. Under this scenario, we would return to a situation not so different from the one we had before the 2007–09 recession.

In Figure 5 we report the path of household and non-financial business debt, relative to GDP. Both of these sectors must become more indebted, given our scenario 1 assumptions. If this is the path the US economy takes, it will not be long before another crisis hits, if only because of heavy private sector indebtedness.

Here’s private indebtedness in the assumed CBO scenario of growth and lower budget deficits.

So this implies that the United States still has cracks in the foundations of growth (as per a title of the Institute’s Strategic Analysis piece before the crisis) and policy needs to change.

The Institute’s Strategic Analysis articles have always pointed out logical inconsistencies in the CBO’s projections (from mid 1995 onward) and presented more realistic scenarios on growth with solid suggestions on how to run the economy. Here’s from April 2007 in a report titled The U.S. Economy – What’s Next:

The authors said:

In Figure 3, we translate the debt-to-GDP ratios in Figure 2 into flows of lending relative to GDP simply by subtracting from each quarter’s debt the previous quarter’s debt. One striking feature of Figure 3, not at all obvious from inspection of Figure 2, is that net lending was already falling rapidly from the beginning of 2006. The lower line for the post-2006 period shows what would happen to the net lending flow if the debt-to-income ratio were to level off: net lending would continue to fall rapidly, though not so far or fast as happened in 1980. The projections in the figure also show the enormous gap between the leveling-off scenario, in which we are inclined to believe, and the (implied) CBO scenario, in which we don’t believe at all.

In reaching provisional conclusions about the future growth rate of output and the future configuration of the three financial balances, we have used revised assumptions about output in the rest of the world because of lower U.S. growth than in the CBO scenario (based on the solution of a world model) and the performance of the stock market. The major conclusion is that output growth slows down almost to zero sometime between now and 2008 and then recovers toward 3 percent or thereabouts in 2009–10. However, by the end of the period, the level of output is still far (about 3 percent) below that in the CBO’s projection, which implies that unemployment starts to rise significantly and does not come down again.

(emphasis: mine)

Of course every situation is different, so to see/make some scenarios and projections, do look at Back To Business As Usual? Or A Fiscal Boost?

Debt Monetization

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Let us take the public sector budget equation:

G – T = ΔH + ΔB

Inspired by Milton Friedman’s popularity in the 1970s and the 80s, most textbooks and journal articles incorrectly claim that the central bank “controls” the money stock (such as M0, M1, M2 etc). Simultaneously they also claim – rightly – that the central bank targets the short term interest rates.

Recently, Alan Blinder – formerly Vice Chairman of the Federal Reserve Board – said this in New York Times’ Room For Debate (h/t wh10):

Remember “conventional” monetary policy? The Federal Reserve shortens recessions by creating more bank reserves (“printing money”), which fuels a multiple expansion of the money supply and credit because banks don’t want to hold excess reserves. So they get rid of them making more loans and deposits, which also lowers short-term interest rates. Compare that to current reality: Banks are content to hold over $1.6 trillion in excess reserves, short-term interest rates are stuck near zero, and Fed policy often works on long-term interest rates instead. No, this is not your father’s monetary policy, and the old ways of teaching about it simply won’t do.

Einstein declared that everything should be made as simple as possible, but not more so. The crisis has made the “but not more so” part more important.

Alan Blinder is a good economist, but I guess the best way to put it is that the usual story is pure fantasy.

(To be a bit technical, let us assume – in what follows – till the next section that the central bank is targeting overnight interest rates using a corridor system)

Apart from the chimerical money multiplier story, neoclassical economists also bring in the government’s budget into the story. So the story goes that if the government wants to increase its expenditures, it will sooner or later ask the central bank to “monetize” its deficit. So the government’s Treasury and the central bank can decide the proportion of the deficit which is financed by issuing H (high-powered-money or currency notes and reserves/bank settlement balances) and B (government bills and bonds). This – higher issuance of H will cause a sequence of events involving higher private expenditure inevitably resulting in price rise and higher inflation in this story.

In my post Open Mouth Operations, I discussed two kinds of open market operations – temporary and permanent. As we saw, when the private sector needs more currency notes, the central bank must neutralize this outflow by engaging in permanent open market operations. The central bank just targets/sets the short term interest rates and simply cannot be anything but defensive.

Neoclassical economists however, think of this as purely being decided by the central bank (or the central bank acting under pressure by the government) and the process is called debt monetization. Since this involves purchases of government bonds, debt monetization is a process of purchases of government bonds by the central bank (directly from the government or in open markets) in order to increase the stock of money.

We however saw that this decision of the central bank is based purely on the private sector’s needs for currency or banks’  need for higher reserves/settlement balances and the central bank must act defensively.

This was understood well by members of the “New Cambridge” School and some of their critics. In an article attempting to show the full working of their model, New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, 1978, Martin Fetherston and Wynne Godley say:

… It will further be assumed that domestic monetary policy involves supplying cash and bonds in whatever amounts necessary to maintain private (and overseas) portfolio equilibrium at given (i.e., baseline) rates of interest…

This was from a conference Public Policy In Open Economies and Alan Blinder understood this – in a reply to the New Cambridge model, Whats New And Whats Keynesian In The New Cambridge Keynesianism (same link as above) he said:

Fiscal policy can, therefore, have no immediate effect on these asset demands. (It has a longer-run effect through raising net wealth.) The central bank monetizes just enough government debt to keep interest rates from rising, so there can be no “crowding out.”

on the New Cambridge model. i.e., as we move forward in time, because the private sector has higher wealth, the Bank of England will purchase government debt depending on how much of this wealth the private sector wants in the form of money.

Hence we can say that monetization is endogenous. So if the central bank purchases more government bonds than it is supposed to, banks will have more settlement balances and the central bank’s target will fall to the lower end of the corridor and will be forced to sell bonds in equal quantities. The description of the corridor and floor systems can be found in the post Open Mouth Operations.

The Floor System And Central Bank Large Scale Asset Purchases

In recent times (since the last three years), central banks especially the Federal Reserve – who have adopted a floor system – have been purchasing a lot of domestic government bonds in the open markets (and also other securities such as “agency debt” and “agency MBS”). This is also called “QE”, and it’s a bad phrase. However does this mean the private sector has “excess money”? The private sector’s wealth allocation decision depends on its portfolio preferences between various forms of wealth and since purchases also lead to a reduction of long term government bond yields (as compared to the case when the asset purchase program hadn’t been carried out) and hence the private sector wishes to hold less of its wealth in the form of government bonds and more in the form of money – hence sold the bonds the Federal Reserve intends to buy!

Of course the result is that banks have more central bank reserves than they wish to hold, but as a whole the banking system won’t convert these settlement balances into currency notes unless the non-bank private sector wishes to hold them. If the non-bank private sector needs more currency notes, banks will easily accommodate this need and so will the central bank and this need is not a function of how much settlement balances the banking system holds. And it won’t cause price rises either because “money” doesn’t lead to inflation. The strategy of the central banks in reducing long term bonds comes with asking the banks to hold the settlement balances for some time (and keeping them happy by paying interest on the reserves) and the Federal Reserve may sometime phase out the program by an “exit strategy”. However this has nothing to do with “inflation expecations” or some chimerical story about runaway inflation waiting to happen.

The Federal Reserve’s strategy has been to create more demand by reducing long term rates so that depending on the interest elasticity (as opposed to income elasticity) of investment by the private sector and/or its animal spirits, there may be higher activity. But since income elasticity effects are stronger, the LSAP hasn’t really worked as desired.

Private expenditure depends mainly on private income and LSAPs do not directly affect private expenditure. There can be indirect effects due to portfolio preferences – because LSAPs may induce the private sector to purchase other asset classes such as corporate equities leading to a rise in stock prices, leading to wealth effects via capital gains. Hence we see a lot of references to James Tobin’s work in central bank papers on this.

There were other effects which didn’t work as desired – such as refinancing of existing mortgages due to lower interest rates and this leading to extra demand because it was thought that households will be able to refinance in huge numbers and this will lead to higher consumption because they will spend the difference they gain due to lower monthly outflows to the banking system.

Of course, none of this has anything to do with the fantasy story that there is an excess of money appearing out of nowhere and which will be eliminated via higher expenditures resulting in a permanent price rise and fantasy stories such as that.

To summarize, stories around money leading to inflation, excess money due to central bank government debt purchases etc have all led to tragic debates around macroeconomic issues.

Here’s from Marc Lavoie’s Changes In Central Bank Procedures During The Subprime Crisis And Their Repercussions On Monetary Theory (working paper here):

The financial crisis has made these features of the real world even more obvious and it should make clear that nearly all of mainstream monetary theory as applied to central banking is nearly worthless, as is for instance the infamous money multiplier fable and the presumed causal relationship running from bank reserves at the central bank to price inflation.

Also, while central bankers simply did not know that a crisis was going to hit but did good work (in my opinion) in preventing an implosion of the financial system, there is simply no need to congratulate them for having purchased government debt such as as done by Paul McCulley here and as done by Adair Turner here at the recent INET conference. Their arguments sound something like: central banks prevented a deflation of prices by purchasing government debt!

SMP

A qualification needs to be made in the above analysis on the purchases of Euro Area governments’ debt by the Eurosystem under the ECB’s Securities Markets Progam (SMP). Here some government debt markets have/had the potential to become “dysfunctional” (ECB’s phrase) and NCBs purchase(d) government bonds in the secondary markets to prevent government bond yields from rising forever as a result of a self-fulfilling prophecy of financial markets and its inability to absorb government debt because of suspicions that some governments could become insolvent in the long run. This is useful because it just postpones the day of reckoning or buys some time to reach an economic state of lower activity to keep some Euro Area nations’ net foreign indebtedness in check.

The ECB website and communications stress that these operations are being “sterilized” and hence keeps price stability in check but the explanation is right if there is a Monetarist causality from money to prices!