I am reading this book The Oxford Handbook of Post-Keynesian Economics, Volume 1: Theory and Origins and it has some nice chapters!
In his chapter Postkeynesian Precepts For Nonlinear, Endogenous, Nonstochastic, Business Cycle Theories, K. Vela Velupillai has some nice words on Wynne Godley and his book Monetary Economics co-authored with Marc Lavoie:
Eugene Fama was on CNBC today (US time) (video here) and he argued that QE is a non-event.
Since he was on CNBC, I presume he has prices of financial assets in mind when he says it is a “non-event” – the logic being that the Federal Reserve and the Treasury together have effectively issued short-term debt and reduced the supply of long term debt.
Of course while this it is true that there is reduction of the supply of long term debt and increase in short term debt (compared to the counter-factual), it doesn’t mean it has no effect whatsoever. Of course Fama says it may have minor effect and the description of QE as a non-event is just a quick way of communicating his point, even if he is true, it is not that simple.
But first, it is great to see Fama doesn’t say this has led to a rise in prices of goods and services!
The U.S. Federal Reserve has purchased long term bonds – such as US Treasury securities and agency mortgage-backed securities by settling the purchase by issuing settlement balances to banks’ accounts at the Federal Reserve (in either case when a bank or a non-bank is a buyer).
This is however different from any other operation changing the composition of the bonds held by the private sector because in QE, banks have been holding balances at the Federal Reserve which they may not have held otherwise. As a counterpart to this the money stock compared to the counter-factual is also higher. Because of this, the non-bank private sector will “re-balance” its portfolio and this will clear via a higher price of assets such as bonds and equities.
In general investors – both residents and nonresidents – are also interested in international assets and this will lead to a price rise of equities in other countries as well because of capital inflows (from their perspective). Of course, one may argue that a capital flow in one direction is compensated by an outflow in the other direction but this needn’t mean there is no effect because this “clearing” occurs via changes in prices – such as exchange rates and prices of assets in the resident issuer’s currency.
There are two effects here. Prices of financial assets may change purely because of rise in expectations and also due to a rise in demand for the asset when expectations are held constant. In general both will have an effect because these two cannot be cleanly separated.
There are some who try to argue that as if it is only the expectations that matter – as if the rise is purely due to a change in investor sentiment and not due to a change in asset demand. From the point of view of asset allocation theory however, both matter.
Another thing is how much effect a billion of “asset purchase” by the Federal Reserve has. That is a slightly different question. In modelspeak it is that depends on the various parameters of the portfolio preferences. However there are people who say this is difficult to measure empirically. True but exactly for the same reason, it is also difficult to empirically say what effect this will have when if the Federal Reserve “tapers” QE.
At any rate, the point is that saying that the large scale asset purchases of the Federal Reserve or QE is just like another debt management operation is not a good argument because in QE, banks hold the short term debt of the official sector which is not the case in ordinary debt management operations and the counterpart to this is the rise in the money stock than otherwise leading to portfolio re-balancing by the non-bank private sector and the overseas sector.
There are some who think that Tobin’s asset allocation ideas (which was what Ben Bernanke had in mind when he started QE) are incorrect. Recently emerging market currencies saw sharp depreciation when it was thought the Federal Reserve may taper. Whether this was due to incorrect sentiments or due to whether the asset allocation theory applies is another question – the Federal Reserve Open Market Committee (FOMC) still has to consider these things when taking a decision on tapering because even if the asset allocation theory on which it has based its LSAP is wrong, investor sentiment may itself can have negative effects on financial markets.
Looking at the matter more academically, the thinking that “there is no portfolio rebalance” is equivalent to thinking that money (as in deposits) are held non-volitionally by the non-bank sector – something which doesn’t sound right.
In the above I avoided arguing how much effect QE has had on asset prices because as I mention it is difficult to empirically conclude. In my opinion it is quite strong. But irrespective of this, the fact that it is difficult to know empirically (but with some data from depreciation of currencies of “emerging markets”) also means that it is difficult to say what happens if there is “taper”. You could argue that there was no effect to begin with and hence there is no trouble withdrawing it but there is a risk that you may be wrong!
Personally I think QE is a waste of time but for different reasons. It somehow misleads policy makers – the ones making fiscal decisions to wishfully think something good is going to happen. Financial markets however seem to be worried at the mere mention of “taper” so the best way for the Federal Reserve would be to convince that this is silly – slowing down is not to be worried about.
There is an article by Raj Chetty Yes, Economics Is A Science getting some attention – including that of Greg Mankiw who comments:
An interesting article, which raises the following questions in my mind: Is the younger generation of economists like Raj skipping some of the big questions of economics because some smaller questions are easier to answer? If so, is that optimal from the standpoint of society as a whole?
There are two things here: The question whether Economics is a science hides the fact that most economists at the most basic level are simply incompetent and struggle with basic economic concepts. This can come across as pompous but you only have to look to believe it. The Mankiw quote above is another level of shamming.
In other subjects – science or in arts – if you have the talent, there is a good chance you are successful and lead a good life. Of course one can fail or not do well for various other reasons such as having a failed love relation affecting your performance and so on, but if you are interested in economics early in life and go to a university to study, ability can make your life difficult and even miserable because your professors don’t know anything.
While it is a good debate to compare Economics to sciences such as Physics, the trouble is that almost all economists at the most elementary level fail to understand the most basic things.
Take for example the textbook on Macroeconomics by Krugman and Wells. If you are interested even partly in Macroeconomics and skim through heteredox blogs, you will find out how the concept of the “money multiplier” is erroneous to say the least. But look at what the authors say in page 399 of the 3rd edition:
And this – the money multiplier story – is just one example among numerous others. The question of whether economics is science or not is sometimes irrelevant when at the most basic level, most economists failed to understand simple things.
Paul Krugman seems to have been thinking on issues related to open economy monetary macroeconomics these days! He has recently warned his readers to not confuse accounting identities with causation but in a recent blog post he seems to be doing it himself.
So Krugman says:
So, here we go. Start from the observation that the balance of payments always balances:
Capital account + Current account = 0
where the capital account is our sales of assets to foreigners minus our purchases of assets from foreigners, and the current account is our sales of goods and services (including the services of factors of production) minus our purchases of goods and services. So in the hypothetical case in which foreigners lose confidence and stop buying our assets, they’re pushing our capital account down; as a matter of accounting, then, our current account balance must rise.
But what’s the mechanism? (Remember the fallacy of immaculate causation.) The answer is, it depends on the currency regime.
Strange. The last statement in the quote warns of potential mistake which is present in the previous statement! ie Krugman wants to have it both ways.
So “… as a matter of accounting …” ?
Let us consider a case (fixed exchange rate or floating) where there is an autonomous capital flow – such as a foreigner liquidating a bond and repatriating funds. This by itself doesn’t affect the current account. In fact it can be compensated by some accommodative flow in the capital account of the balance of payments.
There is a nice 1991 article by the BIS Capital flows in the 1980s: a survey of major trends. The author quotes James Meade who makes this distinction between autonomous flows and accommodative flows:
[accommodative capital flows] take place only because the other items in the balance of payments are such as to leave a gap of this size to be filled … [while] autonomous payments … take place regardless of other items in the balance of payments.
Of course because of flexible exchange rates, the distinction can become blurred but the same is also true in fixed exchange rates. So we have an item called Other Investment in the capital account of balance of payments – like the example in the IMF’s BPM6 (note: “financial account” in the BPM6 terminology, capital account means a different thing):
In addition Reserve Assets is also one. Again this is somewhat of a simplification and it is possible for other items to accommodate.
“Other Investment” is typically banking sector flows but refer to BPM6 for the full definition. “Reserve Assets” is things such as sale or purchases of foreign currency by the central bank or any other official institution. Sometimes a category Exceptional Financing is used – such as government borrowing in foreign currency in exceptional circumstances or official financing transactions from the IMF.
So changes in some items in the capital account can be balanced by changes in some other account in the capital account and not the current account. Of course this doesn’t mean that there is no causality from the capital account to the current account and I will come to it in a moment but what Krugman says is silly.
Let’s take a few examples starting with the simplest – and you guessed it right – the Euro Area 😉
Suppose there is a capital flow where a German financial firm liquidates Spanish government bonds and transfers funds back home.
As I have explained in posts long back, this will lead to a TARGET2 imbalance in which the Spanish NCB will have a rise in indebtedness to the ECB (which is considered to be a Spanish non-resident). Either it ends here or the Spanish banking system will try to attract funds from abroad. In either case there is an accommodative flow in the balance of payments – balancing the initial outflow and without affecting the current account.
Now take the example of a nation with its currency pegged to another anchor currency. Suppose a nonresident economic unit sells sells securities and transfers funds outside the country. Since banks acts as dealers in the foreign exchange markets, this leaves the banking system with a short position in foreign currency. It may try to close it by borrowing in foreign currency or try to attract funds from outside. In the latter case that is all there is to it (in the short term) and this flow is accommodating and will appear in Other Investment. In the former case, the banking system is left with an open position in foreign currency. As long as the bank’s own risk management or the central bank (with the confident knowledge that it has sufficient foreign exchange in case it has) thinks this it is alright, this is what there is for the short term. Else banks may need to attract funds from abroad. However if there is a depreciation outside the tolerable band (fixed doesn’t mean god has fixed it) in response to a huge amount of capital outflow, the central bank may sell foreign currency. It may also try to hike interest rates to get attract foreigners.
Again no change in the current account. One item in the capital account cancels another to preserve the accounting identity Krugman quotes.
In floating exchange regimes this is more complicated but the story is not too different from the BoP viewpoint. An outflow of funds will be accommodated by banks’ open position (or inventories). Banks will typically try to offload the inventories depending on market conditions and opportunities and it is sometimes said in the fx microstructure theory that the inventory half-life is around 15 minutes. The currency will depreciate to the point where expectations of the market participants reverse in the direction of appreciation bringing in flows in the opposite direction to the initial capital outflow. How this works precisely is a very challenging open question. Of course looked at from a medium term perspective, in general, it is not immediately obvious why the current account balance and capital account sum to zero since the magnitude of “Portfolio Investment” and “Direct Investment” may be quite different from the current account balance. But the sum of balances is zero as a matter of accounting. In such cases, banks may try to attract funds from abroad themselves by marketing bonds offshore – i.e., they may try to find offshore funding. More complications arise from derivative contracts with nonresidents which is not easy to go into in this post.
Of course this not guaranteed to work – pure float is the luxury of a few nations – and sometimes the central bank may need to intervene in the foreign exchange markets and in the extremis, undertake exceptional financing transactions such as borrowing from the IMF.
In recent times, the Reserve Bank of India had an interesting swap scheme with the banking system who would attract funds from abroad.
Of course, none of this means there is no causality from the capital account to the current account. A nation may face troubles financing its balance of payments and it may try to deflate domestic demand by fiscal and monetary policy to keep its current account imbalance from getting out of hand. It is important to note here this is not a straightforward result of the identity but there is a more complicated story and that output suffers because of this. Krugman makes it sound as if nothing happens to output.
Question: Are flexible exchange rates better than fixed exchange rates?
Answer: Silly oversimplified question.
In a blog post today, Paul Krugman asks Do Currency Regimes Matter? – in the context of the Euro Area. My answer to that would be James Tobin’s wisecrack:
I believe that the basic problem today is not the exchange rate regime, whether fixed or floating. Debate on the regime evades and obscures the essential problem.
Of course that doesn’t mean one ties both shoes together and irrevocably fixes exchange rates (and give up the government powers to make drafts at the central bank) but the essential problem referred above – although gets diluted – doesn’t go away outside a monetary union. Also, a crucial element often missed in the discussion is the existence of the “common market” which acted as (and still acts as) a constraint on Euro Area economies to expand domestic demand.
Sadly by blurring issues such as this and oversimplifying the macroeconomics behind all this, the Euro Area was formed with the incredible lacuna.
One of economists’ fantasy is assuming the existence of a floating exchange rate regime without any need of official intervention. Although it is true for some nations, it doesn’t mean any nation can simply “truly float” and stop worrying.
In the same article A Proposal For International Monetary Reform, Tobin also points out:
Clearly flexible rates have not been the panacea which their more extravagant advocates had hoped …
although also pointing out that:
… I still think that floating rates are an improvement on the Bretton Woods system. I do contend that the major problems we are now experiencing will continue unless something else is done too.
Incidentally, I do not think Tobin tax in the foreign exchange markets is the way to go as has been pointed out by economists working in fx microstructure theory. Nonetheless Tobin’s highly important insights remain.
John Maynard Keynes’ biggest disservice to the economics profession is to not start with an open economy. In a world of free trade and free movement of capital, a nation’s biggest constraint on raising output is the “balance-of-payments constraint”. It is sad that in spite of the crisis the economic profession has not even started debating on the constraints imposed on nations due to free trade (and the whole world as a consequence).
The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.
I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.
– Morris Copeland, inventor of the Flow Of Funds Accounts of the United States, in Social Accounting For Moneyflows, in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949]
So the news is that Eugene Fama shares this year’s Economics Nobel with Robert Shiller and Lars Hansen.
Instead of going into Fama’s main work, I thought I will point out Fama’s quackery on national accounts and flow of funds – which economists are supposed to know but is rarely the case.
In an article from 2009, Bailouts and Stimulus Plans, Fama again puts down fiscal policy in a rather comical way. Fama starts with the sectoral balances identity:
There is an identity in macroeconomics. It says that in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit),
PI = PS + CS + GS (1)
In a global economy the quantities in the equation are global. This means the equation need not hold in a particular country, but it must hold in the world as a whole.
There is so much muddle to start the analysis. The above is incorrect to start with because “private savings” automatically includes corporate savings. Perhaps this error is a typo but going through his analysis doesn’t support the hypothesis that he even knows the equation right. Incidentally government saving is not government surplus in standard terminology. He seems to think these are equal.
Another error in the above equation is that the left hand side should include government investment as well.
Anyway …
Fama continues:
Government bailouts and stimulus plans seem attractive when there are idle resources – unemployment. Unfortunately, bailouts and stimulus plans are not a cure. The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment.
There are so many incorrect things with this. First, there is a reverse causality in the saving/investment identity. Investment creates saving. Second, Fama seems to think that government deficit reduces private saving but the identity itself is suggestive of another interpretation. If I write it as (in the context of a closed economy):
S = I + G – T
where S is the private saving, I is private investment and G and T are government expenditure and tax receipts, respectively. It then becomes clear that government deficit – instead of reducing private saving, creates private saving.
Even more worrisome is his statement “the money must be somewhere” – as if the stock of money is an exogenously fixed quantity. A fiscal expansion (meaning higher governmen expenditure and/or decrease of tax rate) can increase the stock of money in two ways. First is direct – if there is a government deficit with the fiscal expansion and banks purchase a fraction of government debt, the stock of money increases. The second is via a rise in domestic demand which will lead to higher borrowing by the private sector from banks thereby increasing the money stock. Of course there are other effects too via the non-bank private sector asset allocation decisions etc.
Not going in much details for now as I write a lot about it and in any case there is Post-Keynesian monetary economics on this. My aim was to show how an economics Nobel Prize winner is clueless about basic economics! The prize is to be awarded to people who have made great contributions to society but we have an example of someone – Fama – who pushes fiscal contraction with clueless analysis of national accounts.