https://criticalfinance.org/2016/09/08/consistent-modelling-and-inconsistent-terminology/
Jo Michell has a nice reply to Simon-Wren Lewis’ critique of stock-flow coherent models.
[the title of this post is the link]
Look for links to models around the world which use the SFC methodology.
This mini-post is more intended for my own reference, so that I remember this and don’t forget.
After all these years, Mario Draghi has finally said it. After repeatedly insisting Euro Area governments do “structural reforms”, Draghi has conceded that Germany should do a fiscal expansion.
Draghi: Counties that have fiscal space should use it. Germany has fiscal space
— European Central Bank (@ecb) September 8, 2016
Post-Keynesians have always maintained that “surplus” countries put a burden on “deficit” countries. Since Germany has a high positive current account balance, and sells its product abroad, it isn’t unfair to ask its government to expand domestic demand via fiscal policy and reduce imbalances.
In my opinion, what Kaldor calls the principle of circular and cumulative causation (originally ascribed to Gunnar Myrdal) is as much an important principle in economics as is the Keynesian principle of effective demand. The former is built on top of the latter and so we could just have one most important Keynesian principle.
In an article Foundations And Implications Of Free Trade Theory, written in 📚 Unemployment In Western Countries – Proceedings Of A Conference Held By The International Economics Association At Bischenberg, France, Kaldor says:
Owing to increasing returns in processing activities (in manufactures) success breeds further success and failure begets more failure. Another Swedish economist, Gunnar Myrdal called this’the principle of circular and cumulative causation’.
It is as a result of this that free trade in the field of manfactured goods led to the concentration of manufacturing production in certain areas – to a ‘polarization process’ which inhibits the growth of such activities in some areas and concentrates them on others.
In a recent paper titled The debate Over ‘Thirlwall’s Law’: Balance-Of-Payments Constrained Growth Reconsidered, Robert Blecker says:
Another key empirical question is the direction of causality between export growth and capital accumulation: does the former cause the latter (as assumed implicitly in Thirlwall’s Law), or does the latter cause the former (as in some of the newer small-country models)? Perhaps this is a case of truly ‘circular and cumulative causation’, in which investment is required to promote exports and success in exporting in turn induces further investment.
I have always thought—ever since I have read Kaldor—that this is the case. When Kaldor says success creates more success, what he is really saying is that a rise in a success of a nation makes it more competitive and increases its exports and so on.
In Kaldorian models, however, elasticity of imports/exports is taken to be constant. Rise in production leads to a rise in productivity and hence price competitiveness. But there is no way in which there is a causation to non-price competitiveness (propensity to import, or income elasticities).
A more general modeling plus empirical work should actually study the impact on non-price competitiveness. Personally, my guess is that only this will explain the vast divergence in nations’ fortunes, empirically speaking. Without it, won’t be sufficient. Interestingly, I believe the dynamics could be complex and rich and even lead to convergence in some cases, although will remain just a theoretical curiosity.
This is a continuation of my post Simon Wren-Lewis On Wynne Godley’s Models. I was comparing stock-flow coherent models to DSGE models implicitly (didn’t mention the ‘DSGE’).
One of the things I spoke of was behaviour: firms deciding how much to produce. In stock-flow consistent models, it is decided by trends in sales. So if entrepreneurs see a fall in their inventory-to-sales ratio, they’ll produce more typically. This can be made more accurate. See Wynne Godley and Marc Lavoie’s text Monetary Economics for more details.
Here I want to concentrate on models such as DSGE or any other model used by institutions such as the UK Treasury for the case of production. In these models, there is a production function describing how much firms will produce. This is incorrect to begin with. It says nothing about behaviour. If households start borrowing a lot, in DSGE models, producers are still producing the same because production is governed by the production function. In stock-flow consistent models, simple modeling assumptions about how much firms produce are far superior. So in this case, in SFC, more borrowing leads to more sales and a change in sales trends, inventory/sales ratio and hence affecting how much will be produced.
The DSGE production function is thus inconsistent with the Keynesian principle of effective demand. DSGE is not even Keynesian. It’s thus ridiculous how economists defending DSGE models and its ancestors accuse SFC modelers of not paying attention to behaviour.
There is no branch of economics in which there is a wider gap between orthodox doctrine and actual problems than in the theory of international trade.
– Joan Robinson, The Need For A Reconsideration Of The Theory Of International Trade, 1973
Orthodox trade theory tells us that the “market mechanism” should work to resolve imbalances in the current account of balance of international payments. Although, the economics profession has conceded that Keynesianism is correct, it is still far from thinking clearly about international trade.
So it is a bit surprising that The Economist would say something unorthodox about this. In a recent article it complains about Germany:
This is the Post-Keynesian idea that surplus economies put a burden on deficit economies.
A fiscal expansion by the German government has the effect of raising domestic demand and imports and reducing the German current account balance of payments. This allows the rest of the world to grow both because of German imports and also because they are less “balance-of-payments constraint”.
Second, Brad Setser has a blog post on the current account surplus of the Republic of Korea (South Korea).
It’s impressive to see Setser get the causality right:
Fiscal policy alone doesn’t determine the current account (even if tends to be the biggest factor in the IMF’s own model). A boom in domestic demand, for example, would improve the fiscal balance and lower the current account surplus, just as a fall in private demand improves the current account balance while raising the fiscal deficit.
The current account balance, government’s budget balance and the private sector financial balance are related by an identity and sum to zero. But the identity itself shouldn’t be confused with causation.
The correct causation between the balances is between domestic demand and output at home versus abroad. This causality has been highlighted by Wynne Godley in the past. See more on this blog post by me here.
New Bank Of England Paper On The Financial Balances Model For The United Kingdom
Stephen Kinsella is out with a new paper with co-authors Stephen Burgess, Oliver Burrows, Antoine Godin, and Stephen Millard published by the Bank of England.
From the paper:
Our paper makes two contributions to the literature. First, we develop, estimate, and calibrate the model itself from first principles as well as describing the stock-flow consistent database we construct to validate the model; as far as we know, we are the first to develop such a sophisticated SFC model of the UK economy in recent years.4 And second, we impose several scenarios on the model to test its usefulness as a medium-term scenario analysis tool. The approach we propose to use links decisions about real variables to credit creation in the financial sector and decisions about asset allocation among investors. It was developed in the 1980s and 1990s by James Tobin on the one hand, and Wynne Godley and co-authors on the other, and is known as the ‘stock-flow consistent’ (SFC) approach. The approach is best described in Godley and Lavoie (2012) and Caverzasi and Godin (2015) and underpins the models of Barwell and Burrows (2011), Greiff et al. (2011), and Caiani et al. (2014a,b). Dos Santos (2006) describes how SFC models incorporate detailed accounting constraints typically found in systems of national accounts. SFC models allow us to build a framework for the model where every flow comes from somewhere in the economy and goes somewhere, and sectoral savings/borrowings and capital gains/losses add or subtract from stocks of wealth/debt, following Copeland (1949). Accounting constraints allow us to identify relationships between sectoral transactions in the short and long run. The addition of accounting constraints is crucial, as one aspect of the economy we would like to model is the way it might react differently when policies such as fiscal consolidations are imposed slowly or quickly
4 Such models were popular in the past; for example Davis (1987a, 1987b) developed a rudimentary stock flow consistent model of the UK economy.
[The title of this page is the link]
Simon Wren-Lewis has an article on his blog on stock-flow consistent/coherent models by Wynne Godley. Unlike other articles, this has a more engaging tone and isn’t dismissive.
This is a good thing but it has the tone “Oh, there’s hardly anything new” about stock-flow consistent modeling and the sectoral balances approach. 🤦. To me this is highly inaccurate, to say the least. None of the models outside SFC models —with one exception—come anywhere close to the important question about what money is and how money is created. Even in the Post-Keynesian literature, while there are various non-mathematical approaches, there’s hardly anything that comes close. That important exception is the work of James Tobin as is summarized in his Nobel Prize lecture Money and Finance in the Macroeconomic Process. Except that Wynne Godley’s model greatly improve upon the deficiencies of Tobin’s approach.
The sectoral balances approach is a mini-version of stock-flow coherent modeling. Wren-Lewis seems to say there’s hardly anything great and don’t tell much. First, almost nobody was making a cri de coeur as much as Wynne Godley. Second, the approach makes it clear why a huge recession was coming. This is because US private expenditure was rising faster than private income and the US private sector was in deficit for long and the private sector was accumulating debt on a huge scale relative to income. It’s difficult to say when this would have reversed pre-2007, but had to reverse. Once this is reversed, i.e., when private expenditure slows relative to private income, so that the private sector goes into a surplus, output will fall as a result of a slowdown of private expenditure.
Moreover, the US economy had a critical imbalance in its trade with its current account balance of payments touching almost 6.5% at the end of 2005, hemorrhaging the circular flow of national income at a massive scale.
Wynne Godley’s argument was that because of the external imbalance, the US fiscal policy will be unable to expand output to full employment easily, once the US enters a recession. Hence, he proposed import controls for the United States.
None of anybody outside Wynne Godley’s circle came anywhere close to saying anything of this sort.
But these empirical analysis is a much more complicated discussion. At a simpler level, nobody has come closer to what stock-flow coherent models achieve. All we see is economists struggling with basic questions on how money is created, what role it plays and so on.
Wren-Lewis also criticises SFC models saying they have minimal behavioural hypothesis. Now, this is far from the truth. If you write stock-flow consistent models, which are more realistic, you’ll end up with having a lot of equations and parameters. Behaviour of each “sector” is articulated in these models. How money is created by the act of loan making by banks, to how households and firms accumulate assets and liabilities, to how firms making pricing decisions and how much they produce and how much households consume. In addition, the importance of fiscal policy is articulated: how governments make spending decisions, whether government expenditure can be thought of as exogenous and how in normal times—when politicians pay attention to how much the government’s deficit and debt it has—governement’s fiscal policy can be thought of as endogenous. And crucially, the supreme importance of the government’s finance in the financial assets/liabities creation process. While most economists stop at one time-step for the expenditure process, using stock-flow consistent models, you can see the full process. Moreover, the analysis highlights the correct direction of causalities. A good example is the direction of causation from prices to money.
I want to however highlight another important point. A lot about how the economy works can be understood without going too much into behaviour. Just national accounts, flow of funds and a minimal set of behavioural assumptions would be a great progress. The rest of the profession however struggles to even understand basic flow of funds. A lot can be understood because most of the times, economists are erring on basic accounting. Hence their story doesn’t add up and produces something completely unrelated to the real world. If only economists understood this, that’ll be a lot of progress. Stock-flow consistent models are rich in behavioral analysis but even without it, understanding flow of funds with a minimal set of assumptions is the right direction.
Joseph Stiglitz has written an article Seven Changes Needed To Save The Euro And The EU for The Guardian (also publish in Project Syndicate). None of the seven points say anything about a Euro Area central government. His point number 3 proposes “Eurobonds”, but this is not the same as having a federal government like the federal government of the United States.
Guess since nobody has said it, so I will: a Euro Area central government is the only way to save the Euro Area. Some patches can be done here and there such as the rescues done by the European Central Bank but this just helps remove some financial instability and doesn’t address the problem of economic stagnation. There is also a possibility of exiting the Euro Area but at this point in time, this is highly dangerous because debt levels are high and can cause a systemic crisis in not just the nation leaving but also the rest of the Euro Area and the rest of the world.
There is of course supranational institutions but these are not powerful enough. What one needs is a central government which has huge fiscal powers for making expenditures and receiving taxes from Euro Area economic units, just like federal taxes in the United States.
The most important economic reason is that the federal government will engage in automatic fiscal transfers which will stabilize output and debts of each Euro Area nation. Imagine if a nation such as Greece is allowed to expand output by fiscal policy or by private expenditure. Without a central government, a rise in output at say x% will require domestic demand to grow much faster and run into an unsustainable territory – mainly because of deterioration in the current account balance of payments.
Imagine Greece’s current account deficit hits 15% of GDP. This is not an exaggeration. At the peak of the crisis, Portugal’s current account deficit hit 12.6%. Because of the sectoral financial balance identity
NL = Govt DEF + CAB
where NL is the private sector net lending, Govt DEF is the government’s deficit and CAB is the current account balance of international payments, a 15% current account deficit would imply atleast 15% government deficit. This is assuming private sector net lending is positive. Otherwise private sector net lending would turn negative, or it would have to become a net borrower.
But it’s not the case that there is an upper limit to the process. A steady rate of output would require an ever increasing rise in current account deficit, and an ever increasing debt/gdp which would stop eventually because foreign investors and institutions will not like it at some point. At that point, output will collapse and unemployment will rise.
By having a central government, such processes are prevented from becoming unsustainable. The difference between private receipts on exports less expenditure on imports will be compensated by the central government expenditure and tax receipts. So output is more stable and so is indebtedness to non-resident economic units.
So a Euro Area central government can raise output of the whole Euro Area and also keep indebtedness of Euro Area nations in check. Without a central government one is at the expense of the other. Right now, there is a deflationary bias to keep debts in check. Proposers such as Joseph Stiglitz want output to rise but do not realize that without a Euro Area central government, it comes at the expense of unsustainable debt.
Steve Keen was recently on BBC HARDtalk, interviewed by Steven Sackur. It’s a nice interview. Sackur asks Keen whether he’s contrarian just for the sake for it and Keen comes up with good answers and why economic “experts” cannot be trusted.
At around 11:00, Keen also quotes Wynne Godley and his article Maastricht And All That and calls it the most prescient article ever written.
click the picture to watch the video on YouTube.
Recently, Noah Smith wrote an article for Bloomberg View, titled Economics Without Math Is Trendy, But It Doesn’t Add Up.
Smith’s attitude is the following:
How about something opposite? That stock flow consistent/coherent models come close to describing the real world and neoclassical models don’t even start in the right foot? The usage of mathematics in neoclassical economics looks silly to me to say the least. Heterodox authors on the other hand have made important breakthroughs with stock-flow consistent models. In these models, the description of how stocks and flows affect each other leading to macrodynamics describing the real world is obtained.
Neoclassical models (which the phrase I use for the “new consensus”) not only doesn’t have anything as mathematical as this but it fails in the first place to identify the correct tools to describe economic behaviour.
Morris Copeland writing in Social Accounting For Moneyflows in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949] said:
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’s work is what led the U.S. flow of funds which is published by the Federal Reserve every quarter. National accounts have also improved since their first version to incorporate Copeland’s ideas. See the 2008 SNA and the Balance of Payments And International Investment Position Manual, Sixth Edition for example.
Apart from stock-flow consistent/coherent models, models of the economy don’t even come close to describing the economy, because they miss the most important aspect: flow of funds.
So Goldman Sachs’ chief economist, Jan Hatzius for example uses this approach. See his paper The Private Sector Deficit Meets The GSFCI : A Financial Balances Model Of The US Economy, Global Economics Paper No. 98, Goldman Sachs, Sep 18, 2003.
So it is not that neoclassical economists have great mathematical tools. It’s that by failing to incorporate the framework of flow of funds, they are showing their incompetence in mathematical reasoning.