Recently, The Economist had a cover story saying that surplus nations bear responsibility for global imbalances and weak economic growth. Now, the IMF is also advising surplus nations to expand domestic demand.
The IMF tweeted this, with a link to a new report (2017 External Sector Report) on global imbalances:
click to view the tweet on Twitter
As I have said before, this is the biggest concession to Keynes’ idea that surplus countries bear the responsibility.
In an article, The General Theory In An Open Economy, published in 1996, Paul Davidson says:
Keynes was well aware that the domestic employment advantage gained by export-led growth ‘is liable to involve an equal disadvantage to some other country’ (p. 338). When countries pursue an ‘immoderate policy’ (p. 338) of export-led growth (e.g., Japan, Germany and the NICs of Asia in the 1980s), this aggravates the unemployment problem for the surplus nations’ trading partners. These trading partners are then forced to engage in a ‘senseless international competition for a favorable balance which injures all alike’ (pp. 338-9). The traditional approach for improving the trade balance is to make one’s domestic industries more competitive by either forcing down nominal wages (including fringe benefits) to reduce labour production costs and/or by a devaluation of the exchange rate. Competitive gains obtained by manipulating these nominal variables can only foster further global stagnation and recession as one’s trading partners attempt to regain a competitive edge by similar policies.
Neil Irwin writing for The Upshot seems open to the idea that aggregate demand affects aggregate supply, quoting the work of J.W. Mason:
… But what if this is the wrong way of thinking about it? What if productivity growth is not so much an external force that proceeds in random fits and starts, but is rather deeply intertwined with the overall state of the economy and labor market?
It’s a chicken or egg problem: Does low productivity cause slow growth, or does slow growth cause low productivity?
Discussion of such matters was also welcomed by Narayana Kocherlakota on Twitter.
Recently, Simon Wren-Lewis also wrote recently in a post on his blog, Mainly Macro, titled, Why Recessions Followed By Austerity Can Have A Persistent Impact.
In standard economic theory, productivity rises explains the rise and fall of nations, although this shouldn’t really be happening because of the convergence promised by advocates of free trade!
In Kaldorian models, aka the principle of circular and cumulative causation, nations with higher competitiveness will see a large rise in production at the expense of other nations. Higher production leads to higher productivity, so the observed relation between success and productivity has a different story! Also, competitiveness has two aspects: price and non-price. Higher productivity does improve price-competitiveness. Further, I believe, competitiveness itself isn’t something fixed. Initial success feeds into higher competitiveness and the reverse for failure. So there’s a complicated story of causality.
The recent cover story of The Economist on Germany’s trade surpluses—titled The German Problem: Why Germany’s Current-Account Surplus Is Bad For The World Economy— is the biggest concession the magazine has made to Keynesianism. Of course, it’s not as if the publication is now a full Keynesian but still, it’s a large admission.
So it was expected that The Economist‘s story was going to be opposed by other publications pandering to the establishment. For example, FT‘s Martin Sandbu who wrote a piece, Germany Bashing Falls Flat.
That means the accusation against Germany comes about five years too late. There was indeed a strong jump in the nation’s trade surplus half a decade ago, at a time when the world was still struggling to come out of recession. But that surplus has not changed much since.
He also says:
[the] claim [that Germany’s penchant for high saving … is a drag on global growth] trips up both analytically and contextually. Analytically, because the impulse from net trade on aggregate demand is the change in the external balance, rather than its level — much like the impulse from a fiscal deficit is the change in public borrowing as a share of economic output. So long as imports, exports and other macroeconomic aggregates grow at the same rate, a stable external balance goes along with the same steady growth of aggregate demand.
This claim has a pretense to be analytical but it’s hardly the case. This can be seen in stock-flow consistent models but it’s not the easiest to show that in a blog post, so here’s an attempt:
Divide the world into Germany (and other surplus countries) and the rest of the world. The rest of the world’s current account deficit means (without minor qualifications about “revaluations”) that its net international investment position is deteriorating by the amount of its current account deficit. So it’s not the case that if some aggregates grow at some rate, everything is fine because others—such as NIIP/GDP—aren’t.
There are many debt sustainability conditions and each should be used with care. One condition is that
cad(g) < g
where the lowercase cad is the ratio CAD/GDP, CAD is the current account deficit and g is the growth rate of GDP. It’s not as simple as it looks, because growth rate of GDP also affects the current account balance or deficit. The notation cad(g) is to indicate that it is so.
For high growth rates, cad(g) is larger than g.
In other words, sustainability implies that growth is restricted to be low.
Similarly, on the creditor’s side, an economy (i.e., Germany) growing at about 2.2% (nominal) and current account balance of 8.3%, that implies that its NIIP/GDP is rising fast (and hence deteriorating the ratio of others).
So Sandbu’s claim that those asking Germany to expand domestic demand aren’t analytical itself falls flat. His analysis just does a chart eyeballing of some numbers. Just because a few things aren’t worsening, doesn’t mean things are fine. Other metrics may be worsening.
Handelsblatt‘s analysis doesn’t really say much except claiming that Germany’s trade surplus just means its expenditure is less than its income and nothing more. It also errs on endorsing the claim that, “that national economies cannot be managed like large firms.”, which the crisis taught us is highly incorrect.
I wasn’t too excited about “agent-based models” before this, but I saw this paperWhat Drives Markups? Evolutionary Pricing In An Agent-Based Stock-Flow Consistent Macroeconomic Model by Marc Lavoie (co-authored with Pascal Seppecher and Isabelle Salle) and it got me a bit interested.
From the paper:
ABMs are conceived to analyze out-of-equilibrium dynamics and adaptation processes from heterogeneous and interacting entities … On a more specific note, we use a stock-flow consistent (hereafter, SFC) framework … there has been a multiplicity of macroeconomic models that combine two important features: the principle of decentralization/disaggregation which is found in ABM and the principle of stock-flow consistency … In an ABM, macroeconomic variables are the result of a simple process of aggregation of individual data, as in the real word [sic] …, so that the accounting accuracy provided by the SFC ensures the relevance of the aggregation process …, as well as the interconnected nature of the balance sheets of all agents. Symmetrically, AB principles could provide micro-foundations to SFC macroeconomics, that is, a way to logically articulate and rigorously organize the interactions between the micro and the macro levels.
Recently, The Economist‘s cover story declared that the government of Germany ought to expand domestic demand and its refusal to do so is a threat to the world economy. It also said, “Germany’s surpluses are themselves a threat to free trade’s legitimacy.”
Post-Keynesians have long recognized this problem with the world economy. Keynes himself said in 1941:
It is characteristic of a freely convertible international standard that it throws the main burden of adjustment on the country which is in the debtor position on the international balance of payments. … The contribution in terms of the resulting social strains which the debtor country has to make to the restoration of equilibrium by changing its prices and wages is altogether out of proportion to the contribution asked of its creditors. Nor is this all. … The social strain of an adjustment downwards is much greater than that of an adjustment upwards. … The process of adjustment is compulsory for the debtor and voluntary for the creditor. If the creditor does not choose to make, or allow, his share of the adjustment, he suffers no inconvenience. For whilst a country’s reserve cannotfall below zero, there is no ceiling which sets an upper limit. The same is true if international loans are to be the means of adjustment. The debtor must borrow; the creditor is under no such compulsion
– in Collected Works, Vol. XXV, pages 27-28.
Few things:
Keynes is building a narrative to argue that creditor nations have responsibilities, although at that time (and also at present), they have no obligation. This was the motivation for his plan for Bretton-Woods, where he proposed to impose fines on creditor/surplus nations and set out some responsibilities for them.
Also, although the above was written keeping in mind a new world order (at 1941), it’s still valid for the post-Bretton-Woods era. This is because, although floating exchange rates help making adjustments, their power is completely exaggerated.
It’s also important to keep in mind, that the world is more complicated now. Creditor/suprlus nations have achieved their status by making adjustments, i.e., by keeping wages and domestic demand low. So it’s not exactly or literally like what Keynes presented. It’s not the best of worlds in Germany or China.
Still, what Keynes said was highly insightful.
It’s also interesting that for The Economist, Germany’s behaviour is a “threat to free trade’s legitimacy.” Nicholas Kaldor also said the same in 1980:
In the absence of … measures all countries may suffer a slower rate of growth and a lower level of output and employment, and not only the group of countries whose economic activity is ‘balance-of-payments constrained’. This is because the ‘surplus’ countries’ own exports will be lower with the shrinkage of world trade, and they may not offset this (or not adequately) by domestic reflationary measures so that their imports will also be lower.
For The Economist, Germany’s behaviour is a threat to free trade. For Post-Keynesians, Germany’s behaviour is expected (and ought to be different) and is a good reason to reject free trade.
But it’s not a bad thing that The Economist recognizes Keynes’ insights.
This is a continuation of a recent post at this blog, Public Debt And Current Account Deficits, in which I argued that the current account balance of payments affects the public debt.
A usual objection to the connection is that the two deficits—current account deficit and the budget deficit—although connected by an identity, don’t move together and in fact move in the opposite direction frequently. This point was raised by the blog Econbrower, yesterday.
The identity in question is:
NL = DEF + CAB
where, NL is the private sector net lending, DEF is the government’s deficit and CAB is the current account balance of payments (and is to a zeroth order approximation, exports less imports).
This is not a behavioural hypothesis but still a useful tool to build a narrative. Also, the causality connecting the identities is domestic demand and output at home and abroad.
Imagine, initially that NL is a small positive relative to GDP (for example, NL/GDP = 2%), Also remember that,
NL = Private Income − Private Expenditure
Now assume that private expenditure rises relative to private income. This will lead to higher GDP, a higher national income and a rise in imports because of income effects and hence a lower CAB. It will also lead to higher taxes because of higher income and hence will reduce the budget deficit, DEF, ceteris paribus.
So if the current account balance is in deficit, it would mean that the budget deficit and the current account deficit move in opposite directions.
That’s the theoretical basis for the empirical relationship. But that in itself isn’t the whole story. This is because the other balance—net lending, NL—has a life of its own. As is the case in the United States and several western countries, it turned negative once or twice in the 1990s the 2000s, and when the private sector’s debt rose, it made a sharp U-turn into the positive territory. The blue line in this graph:
Click the graph to see it on FRED.
So, if net lending reverts to its mean of staying positive, one can then conclude that the cumulative budget deficit, or the public debt is affected by cumulative current account deficits.
At any rate, the public debt shouldn’t be the main object of study. What’s more important is the international investment position. And it’s an identity that:
NIIP = cumulative CAB + Revaluations
where, NIIP, is the net international investment position.
A nation which runs current account deficits can become indebted to the rest of the world. IIP is the position of assets and liabilities of resident sectors of a nation. So, the net debt (the negative of NIIP) is the nation’s debt.
The above linked Econbrowser post brings in the complication of revaluations to deny the relationship between CAB and NIIP. But revaluations can’t save you for long.
In short, both public debt and NIIP depend on current account deficits.
Finally a weak analogy: if you play in the rain, you might enjoy it as well. But then if you get sick, you can’t say, “I felt so good playing in rains, so playing in the rain didn’t make me sick”. Saying the two deficits (current account and budget) move in opposite directions is an argument like that.
Recently, a U.S. politician Rick Perry cited Say’s Law:
Here’s a little economics lesson: supply and demand. You put the supply out there and the demand will follow.
Just saying that implicitly rejects the Keynesian principle of effective demand.
But it’s interesting to see that according to Nicholas Kaldor, the principle of effective demand is not a rejection of Say’s Law.
What is Say’s Law. Usually this paragraph—from Jean Baptiste Say’s book, A Treatise On Political Economy; Or The Production, Distribution, And Consumption Of Wealth, published in 1821,page 38—is referred:
It is worth while to remark, that a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus, the mere circumstance of the creation of one product immediately opens a vent foi other products.
In Keynesian Economics After Fifty Years, in the book, Keynes And The Modern World, ed. George David Norman Worswick and James Anthony Trevithick, Cambridge University Press, 1983, page 5, Kaldor says:
The Principle Of Effective Demand
The core of Keynes’s theory is the principle of effective demand which is best analysed as a development or refinement of Say’s law, rather than a complete rejection of the ideas behind that law.
Further, on page 6:
The originality in Keynes’s conception of effective demand lies in the division of demand into two components, an endogenous component and an exogenous component. It is the endogenous component which reflects (i.e., is automatically generated by) production, for much the same reasons as those given by Ricardo, Mill or Say — the difference is only that in a money economy (i.e. in an economy where things are not directly exchanged, but only through the intermediation of money) aggregate demand can be a function of aggregate supply (both measured in money terms) without being equal to it — the one can be some fraction of the other. To make the two equal requires the addition of the exogenous component (which could be one of a number of things, of which capital expenditure – ‘investment’ – is only one) the value of which is extraneously determined. Given the relationship between aggregate output and the endogenous demand generated by it (where the latter can be assumed to be a monotonic function of the former), there is only one level of output at which output (or employment) is in ‘equilibrium’ – that particular level at which the amount of exogenous demand is just equal to the difference between the value of output and the value of the endogenous demand generated by it. If the relationship between output and endogenous demand (which Keynes called ‘the propensity to consume’) is taken as given, it is the value of exogenous demand which determines what total production and employment will be. A rise in exogenous demand, for whatever reasons, will cause an increase in production which will be some multiple of the former, since the increase in production thus caused will cause a consequential increase in endogenous demand, by a ‘multiplier’ process.
A capitalist economy (for reasons explained below) is not ‘self-adjusting’ in the sense that an increase in potential output will automatically induce a correspond¬ing growth of actual output. This will only be the case if exogenous demand expands at the same time to the required degree: and as this cannot be taken for granted, the maintenance of full employment in a growing economy requires a deliberate policy of demand management … the mere existence of competition between sellers (‘firms’) will not in itself ensure the full utilization of resources unless all firms expand in concert. Any one firm, acting in isolation, may find that the market for its own products is limited, and will therefore refrain from expanding its production even when its marginal costs are well below the ruling price. Under these conditions involuntary unemployment could only be avoided if something – the growth of some extraneous component of demand – drives the economy forward.
So Say’s law is not wrong, it’s incomplete. Nonetheless, it’s not surprising that politicians like Rick Perry are going to use it, mislead and reject the Keynesian principle of effective demand.
tl;dr
Say’s law: supply creates demand.
Principle of effective demand: demand also creates its own supply. supply creating demand doesn’t mean the economy is running at full capacity.
The Economist‘s latest cover is about the German balance of payments. The subheading of its editorial says, that it “[t]he country saves too much and spends too little”.
That’s welcome, although the article claims that the German government’s policy is not mercantilist, while at the same time saying that wages have been held down to achieve more competitiveness in exports.
🤦🏻♂️
Anyway, it’s good that it has recognized that this is a problem for the world economy. Funnily, the editorial is still defending free trade, without realizing that the ideology is based on the assumption that market forces will resolve imbalances. If the magic of the price mechanism works, why do you need active policy?
It’s important to remember that John Maynard Keynes recognized that active policy measures are needed to resolve global imbalances. He proposed to impose a penalty on creditor nations in his plan for Bretton-Woods and also require them to take measures such as:
(a) Measures for the expansion of domestic credit and domestic demand. (b) The appreciation of its local currency in terms of bancor, or, alternatively, the encouragement of an increase in money rates of earnings; (c) The reduction of tariffs and other discouragements against imports. (d) International development loans.
– page 24 of The Keynes Plan
A lot of times, people argue that the moral stand that Germany reduce its surpluses is vacuous. Germany is independent and responsible for its own decision. Who are others asking German politicians to raise domestic demand?
The answer to that is Germany makes huge gains out of its success in international trade. What if deficit nations form a union and impose high tariffs and quotas on their imports? International trade runs under a set of rules (the “rules of the game”) and other nations have a right to demand this from Germany and ask for fairer rules.
Anyway, The Economist has finally accepted what Keynes was saying 80 years ago!
Yesterday, there was an article at Vox which takes issue with a statement from Donald Trump which connects the US public debt with current account deficits.
Trump ran his campaign on dividing people, is out to destroy health care and wants a regressive system of taxation and so should be resisted. At the same time, a blanket opposition is counterproductive, especially when it is an important matter.
Vox quotes Trump:
For many, many years the United States has suffered through massive trade deficits; that’s why we have $20 trillion in debt.
In response, Vox claims:
The US trade deficit refers to the fact that the US imports more from the world than it exports. The national debt is the result of the fact that the US government spends more revenue than it collects. There’s no direct relationship between the two.
The whole article is written to claim that there is no connection. But anyone who knows the sectoral balances identity will recognize that there is a connection.
So the sectoral balances identity is:
NL = DEF + CAB
where, NL is the private sector net lending, DEF is the government’s deficit and CAB is the current account balance of payments (and is to a zeroth order approximation, exports less imports).
Of course, this is an identity and shouldn’t be confused for any behavioural hypothesis but it’s still useful in creating a narrative around a model (such as an SFC model) with behaviour for households, firms, the financial system, the government and the rest of the world.
On an average the private sector net lending is a small positive number relative to GDP (such as 2%), although it can fluctuate a lot. So for the U.S. economy, we saw that it was negative a lot in the 2000s and then reverted to a large positive just before and during the crisis.
One should of course keep in mind the correct causality connecting the three terms. What connects them is demand and output at home and abroad.
So the government’s deficit is affected by exports and imports. If there’s a large current account deficit, there’s a fall in demand and hence output and hence income and hence taxes leading to a higher government deficit than otherwise. Deficits in turn affects the public debt.
In other words, the U.S. public debt would have been lower, ceteris paribus, had the problem of the U.S. trade imbalance would have been addressed. This would have happened because of higher national income and higher taxes.
People don’t see the connection because they are comparing different nations. So for example, Japan has been successful in international trade and yet has a high public debt. In the other extreme, Australia has had large current account deficits over the years and public debt much lower than Japan (relative to GDP). But one should do a ceteris paribus comparison.
