Author Archives: V. Ramanan

Federal Government And Regional Balance Of Payments

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The Financial Times has a column titled Europe’s Fiscal Union Envy Is Misguided. The author echoes a recent article in The New York Times (referred here in my blog). According to the FT columnist, in the United States,

… The bulk of the risk-sharing happens through credit and capital markets – that is to say, private lending, borrowing and investment returns do most of the job of evening out regional shocks.

and,

… The best thing the eurozone can do to promote risk-sharing is to stop flirting with its own disintegration: as long as investors suspect politicians might let the currency unravel, they will hunker down behind national borders. Next, get cracking on developing the capital markets union – where there is much more reason to envy the Americans.

In addition, the FT author presents the following graph.

FT Image 20 July 2015Now, there are several things wrong with this. It’s true that risk-sharing happens through credit and capital markets, the argument ignores that fiscal transfers improve the net indebtedness of regions. Financial markets may improve risks by the way they work, but they cannot change net indebtedness of regions in significant ways. Borrowing is not comparable to fiscal transfers. It’s vague what “capital income and insurance flows” is.

Let’s see how a federal system works.

There are regions with local governments but there is also a federal government which raises taxes from economic units of all regions and spends on the units. Some regions will be net recipients of such flows of funds — the government expenditure toward these regions is higher than what it receives in taxes — while others will pay more taxes than what they receive from the government. These needn’t sum to zero, as the federal government may be in a deficit.

There is one peculiar thing in the way such accounting is done. The federal government is outside all regions when studying balance of payments of each region. However for the whole group, the federal government is inside. The Sixth Edition of the IMF’s Balance Of Payments And International Investment Position Manual (BPM6) does this in a similar way for monetary unions, such as for the Euro Area. In that case, the European Central Bank and the European Parliament and other such supranational institutions are considered to be outside each nation when nations’ balance of payments statistics is produced, but inside when the balance of payments of the whole region is studied.

Now, some regions may see an improvement in their balance of payments compared to the case where there is no federal government. There are four kinds of flows which are important here when thinking about the current account balance of payments of a region:

  1. Exports
  2. Imports
  3. Federal government expenditures and transfers
  4. Federal taxes and transfers.

Of course, expenditure of the federal government in the region itself may be thought of as an export, so exports in the list above is meant to exclude that and include transactions such as a private sector producer selling a car to a household in another region.

So one can roughly identify surplus regions as ones which have higher exports than imports in the definition above and others as deficit regions. These transactions of course also affect the capital and financial accounts of the balance of payments and the “regional investment position”.

Usually, one thinks of “fiscal transfers” as affecting aggregate demand. But from the above analysis, it should be clear that it also affects the regional investment position. Economic units in deficit regions also see an improvement in their net asset position. Economic units in deficit regions in aggregate will typically receive more federal government payments than what they send in taxes. The counterpart to this in the capital and financial account of the balance of payments is an improvement in their net acquisition of financial assets and net incurrence of liabilities, as compared to the case where there is no federal government. This is turn improves the regional investment position.

Of course there is still a possibility that the private sector of a union with a federal government as a whole may turn unsustainable but at least there is a regional mechanism of improvement compared to the case when there is no federal government.

To summarize, the point of the above analysis is that the financial sector as a whole cannot achieve this on its own. It takes a federal government to not only affect demand in all regions but also keep their debts in check. The workings of finances of a federal government affects the asset and liability positions of any region as a whole. The financial sector cannot take up the task of a federal government.

Ben Bernanke Embracing Heterodox Ideas

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It’s remarkable how some economists were ahead of the time, while others such as Ben Bernanke seem to just catch up. In a recent post on his blog Ben Bernanke gives out some unorthodox ideas to resolve the Euro Area crisis.

Ben Bernanke says:

… Germany’s large trade surplus puts all the burden of adjustment on countries with trade deficits, who must undergo painful deflation of wages and other costs to become more competitive. Germany could help restore balance within the euro zone and raise the currency area’s overall pace of growth by increasing spending at home, through measures like increasing investment in infrastructure, pushing for wage increases for German workers (to raise domestic consumption), and engaging in structural reforms to encourage more domestic demand. Such measures would entail little or no short-run sacrifice for Germans, and they would serve the country’s longer-term interests by reducing the risks of eventual euro breakup.

…

Second, it’s time for the leaders of the euro zone to address the problem of large and sustained trade imbalances (either surpluses or deficits), which, in a fixed-exchange-rate system like the euro zone, impose significant costs and risks. For example, the Stability and Growth Pact, which imposes rules and penalties with the goal of limiting fiscal deficits, could be extended to reference trade imbalances as well. Simply recognizing officially that creditor as well as debtor countries have an obligation to adjust over time (through fiscal and structural measures, for example) would be an important step in the right direction.

That’s in 2015.

Compare that to the conclusion from a 2007 paper titled A Simple Model Of Three Economies With Two Currencies: The Eurozone And The USA written by Wynne Godley and Marc Lavoie for Cambridge Journal Of Economics (journal link):

… it should be noted that balanced fiscal and external positions for all could as well be reached if the euro country benefiting from a (quasi) twin surplus as a result of the negative external shock on the other euro country decided to increase its government expenditures, in an effort to get rid of its budget surplus. This case, where the surplus countries rather than the deficit countries adjust, as many authors have underlined, would eliminate the current downward bias in worldwide economic activity. Now this would require an entirely new attitude towards government deficits. One would need an anti-Maastricht approach, that would run against the Stability and Growth Pact and its neoliberal obsession with fiscal balance and government debt reduction. For instance, one would need a new Pact, that would discourage fiscal surpluses. National governments that ran budget surpluses would pay large proportional automatic levies to the European Union, who would be compelled to spend the sums thus collected in the deficit countries. In this manner, the ‘weak’ and the ‘strong’ members of the eurozone could converge towards a super-stationary state, with balanced budgets and current accounts, through an increase rather than a decrease in government expenditures and economic activity.

Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries. This raises the profound question as to whether in the long term it is possible to have a community of nations which have a single currency which does not have a federal budget of substantial size, and by implication a federal government to run it—a point that was made very early on in Godley (1992).

[italics in original]

Is A Fiscal Union Expensive For Its Rich Members?

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Josh Barro writing for The New York Times claims that a fiscal union for the Euro Area will be an enourmous expense for its rich members.

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He cites the example of Connecticut:

But the American fiscal union is very expensive for rich states. According to calculations by The Economist, Connecticut paid out 5 percent of its gross domestic product in net fiscal transfers to other states between 1990 and 2009; that is, its tax payments exceeded its receipt of government services by that amount. This is typical for rich states: They pay a disproportionate share of income and payroll taxes, while government services are disproportionately collected in states where people are poor or old or infirm.

This is blatantly wrong. It assumes that output of individual regions and the whole of the the Euro Area will roughly be the same with or without a fiscal union. It ignores the notion that each region may be better off because a supranational fiscal authority will have powers to raise output via expenditure and taxes which individual regions cannot achieve.

In his 1997 article Curried EMU — The Meal That Fails To Nourish for Observer, Wynne Godley made this point well (link):

A useful comparison can be made with the US. Americans often point that if would make no sense if each US state had its own currency, so what is all the fuss about? But the question should be asked the other way round. How would the US make out with no President, no Congress, no federal budget, and no federal institutions apart from the ‘Fed’ itself, plus a powerful central bureaucracy?

The analogy is useful because the United States does so obviously need a federal budget as well as a federal bank, and the activities of the two authorities have to be co-ordinated.  If there is a recession, remedial (expansionary) fiscal policy at the federal level is the only proper response; it is inconceivable that corrective action could be left to component states, which have neither the perspective nor the co-ordinating machinery to do the job. If there is a federal budget there must obviously be a legislative and executive apparatus that executes it and is democratically accountable for it. Moreover, the need for federal institutions extends far beyond economic affairs.

[emphasis added]

So it is incorrect to claim that a fiscal union is highly expensive for rich states. If there is a fiscal union, while rich regions will receive less from the supranational fiscal authority than what they pay in taxes, there’ll be higher output and income than otherwise simply because there is a powerful institution which raises output of each region. Rich nations will be able to net export more than otherwise, for example, compensating for transfers in absolute terms.

Analysis such as by Josh Barro are erroneous usually because of implicit assumptions made such as an aggregate production function, which implies a neutral role for fiscal policy. This can easily be verified: his assumption is that output is determined by other factors, not fiscal policy (because he doesn’t say so) and hence the role of a central government is one which just transfers from rich regions to poor, instead of having any impact on the output of the whole region. Silly.

Kaldor’s Vision Of The Growth And Development Process According To Thirlwall

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Anthony Thirlwall’s new book Essays on Keynesian and Kaldorian Economics is out. It has a nice chapter (chapter 11) originally written by Thirlwall himself from 1991 titled Kaldor’s Vision Of The Growth And Development Process. The description from introduction (pdf from Palgrave’s website) is a good summary:

Essay 11 outlines Kaldor’s vision of the growth and development process – a topic that concerned him for most of his academic life after the Second World War. The Essay covers his growth laws; his export-led growth model incorporating the notion of ‘circular and cumulative causation’, and his two-sector model of the interrelationship between the agricultural (primary product) and industrial sectors of the world economy. Central to Kaldor’s vision was the distinction to be made between increasing returns activities on the one hand (manufacturing industry) and diminishing returns activities on the other (land-based activities such as agriculture and mining). This distinction lies at the heart of his three growth laws that (i) manufacturing is the engine of growth because of (ii) static and dynamic returns to scale in industry (also known as Verdoorn’s law), and (iii) increases in productivity outside of manufacturing as resources are drawn from diminishing returns activities. The question, of course, is what determines industrial growth in the first place. Kaldor’s answer was that it is the prosperity and growth of the agricultural sector in the early stages of development, and then export growth in the later stages. In an open economy, exports are the only true [exogenous] component of aggregate demand. Consumption and investment are largely endogenous.

This view of the role of exports is the basis of his ‘regional’ export-led growth model with cumulative features which has four structural equations: (i) output growth as a function of export growth; (ii) export growth as a function of changing competitiveness and income growth outside the region; (iii) competitiveness as a function of productivity growth, and (iv) productivity growth as a function of output growth (Verdoorn’s Law). Depending on the parameters of the model, regional growth rates may diverge or converge (see Essay 12). It is also possible to introduce a balance of payments constraint into the model which, if relative prices (or real exchange rates) don’t change in the long run, leads to the result that growth will approximate to the rate of growth of exports relative to the income elasticity of demand for imports, which is the dynamic analogue of the static Harrod foreign trade multiplier, which Kaldor argued was a more important multiplier than the Keynesian closed economy multiplier for understanding the pace and rhythm of growth in open economies.

In a closed economy, however, growth by definition cannot be determined by exports. The world as a whole is a closed economy, and Kaldor lectured in Cambridge for many years on a two-sector model of world growth in which the growth of the industrial sector of the world economy is fundamentally determined by the rate of land-saving innovations in agriculture as an offset to diminishing returns in that sector. The model shows that if growth is to be maximised, there must be an equilibrium terms of trade between the two sectors, otherwise growth will be demand constrained if agricultural prices are ‘too low’, or supply constrained if agricultural prices are ‘too high’. Kaldor himself never brought the model to fruition in published form, but attempts have been made to formalise it by Targetti (1985) and myself (see Essay 13).

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On Matters Of Macroeconomics, Even A Beautiful Mind Can Go Astray

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John Nash died on Saturday in New Jersey.

Via the blog Econospeak, I came across a 2005 talk titled Ideal Money and Asymptotically Ideal Money by John Nash about money and macroeconomics. pdf here and a news report here. Nash starts his lecture straightaway by dismissing Keynesian economics:

The special commodity or medium that we call money has a long and interesting history. And since we are so dependent on our use of it and so much controlled and motivated by the wish to have more of it or not to lose what we have we may become irrational in thinking about it and fail to be able to reason about it like about a technology, such as radio, to be used more or less efficiently.

So I wish to present the argument that various interests and groups, notably including “Keynesian” economists, have sold to the public a “quasi-doctrine” which teaches, in effect, that “less is more” or that (in other words) “bad money is better than good money”. Here we can remember the classic ancient economics saying called “Gresham’s law” which was “The bad money drives out the good”. The saying of Gresham’s is mostly of interest here because it illustrates the “old” or “classical” concept of “bad money” and this can be contrasted with more recent attitudes which have been very much influenced by the Keynesians and by the results of their influence on government policies since the 30s.

This is beyond belief. My post will not defend Keynesianism here because it requires a separate defense and there is a lot of literature on it. My only purpose is to quote how wrong a renowned economist can be on matters of money and macroeconomics. Further in the essay, there’s also a defense of a common currency for various nations, such as the Euro (without any political union) and a proposal for other nations:

In the near future there may be a smaller number of major currencies used in the world and these may stand in competitive relations among themselves. There is now the “euro” and the old inflationary history of the Italian lira is past history now. And there COULD be introduced, for example, a similar international currency for the Islamic world or for South Asia, or for South America, or here or there.

All this is just the orthodox belief that governments are incompetent to have any influence on output, employment and so on or that any attempt is just counterproductive. We all know what has become of the Euro Area and many (Post-)Keynesians predicted the problem of forming a currency union without a political union. It sometimes surprises me that even brilliant minds are unable to accept the notion that governments around the world drive their economies via fiscal and monetary policies. Some concede that governments can and should get their economies out of depression if it happens but then assume that outside of recessions or depressions, fiscal policy becomes unimportant and only monetary policy has some role to play. The recent crisis has changed opinions of many but there is still a long way to go.

Krugman And Causality

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In a recent post titled Money, Inflation And Models for his NYT blog, Paul Krugman clearly states that “normal equilibrium macro models” say that the direction of causality is from money to prices. Krugman says:

Consider the relationship between the monetary base — bank reserves plus currency in circulation — and the price level. Normal equilibrium macro models say that there should be a proportional relationship — increase the monetary base by 400 percent, and the price level should also rise by 400 percent. And the historical record seems to confirm this idea.

His post is about how this fails when the economy is in a “liquidity trap”. The post hence is the clearest proof of Paul Krugman’s struggle in getting the causality right. Keynes quote from the GT is appropriate here:

The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.

Krugman presents a chart which shows the relationship between money and prices but it does not occur to him that the causality is reverse to what he is assuming, whether or not there is a liquidity trap. The simple causal story that a rise in the level of expenditure leads to a rise in the stock of money seems alien to Krugman.

It is of course also true that a rise in the stock of money such as via an asset purchase program by the central bank (“QE”) may have an effect on prices. This happens via a wealth effect: demand has an effect on prices of goods and services. This effect is likely small. The main mechanism — the reverse causality — seems to never occur in Krugman’s mental model of the way the world works.

Krugman has of course written about the “dark age of Macroeconomics”, but has shifted his position since then. Although it is not clear what exactly Krugman’s model is, one can still make an inference: normal equilibrium models work outside of liquidity traps, but in liquidity traps a lot changes. This model is chosen by Krugman so that he can confidently claim that there is hardly anything wrong in Macroeconomics.

Fiscal Conservatism, Weak International Trade Performance And Income Inequality Not Good For The U.S. Economy

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The US economy is only 8.8 percent above the pre-crisis peak.

The Levy Institute has a new Strategic Analysis publication titled Fiscal Austerity, Dollar Appreciation, And Maldistribution Will Derail The US Economy in which they identity three main structural characteristics of the economy of the United States that stand in the way of the recovery:

(1) the weak performance of net exports, (2) pervasive fiscal conservatism, and (3) high income inequality

They show that in their baseline scenario, if the projections of the Congressional Budget Office’s outlook hold, their model simulations imply that the private sector’s net lending would turn negative by the end of 2017 and hence the private sector would be in a financial deficit, which is not sustainable.

The publication has some nice charts about the US balance of payments. One is the components of the current account of balance of payments with attention on the primary income balance:

U.S. Balance Of Payments And Components

Note how the balance on primary income has grown during the recent crisis. Another chart gives a further breakdown:

Balance On Primary Income

So direct investment income is the main component.

I like the way the authors explain this: it is a symptom of the crisis. From the article:

An interesting question is whether this improvement in net primary income receipts is sustainable or just symptomatic of the crisis. In our view, it is most likely the latter.

For more details, read the article here.

Free Trade? Heterodox Dissent

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One of the most important message of this blog is that “free trade” is quite devastating to economies. In a recent article Economists Actually Agree on This: The Wisdom of Free Trade for The New York Times, Greg Mankiw once again pushes for free trade and also mentions that there is consensus in the profession.

Many of heterodox economists dissent on the issue of free trade. In this post, I will provide two examples: Joan Robinson and Wynne Godley.

Mankiw says:

Economists are famous for disagreeing with one another, and indeed, seminars in economics departments are known for their vociferous debate. But economists reach near unanimity on some topics, including international trade.

In the article, Mankiw tries to show among other things how free trade is the opposite of Mercantilism. Joan Robinson explained in her 1977 essay What Are The Questions? how foreign trade is important and that free trade is a subtle form of mercantilism.

According to Robinson:

A surplus of exports is advantageous, first of all, in connection with the short-period problem of effective demand. A surplus of value of exports over value of imports represents “foreign investment.” An increase in it has an employment and multiplier effect. Any increase in activity at home is liable to increase imports so that a boost to income and employment from an increase in the flow of home investment is partly offset by a reduction in foreign investment. A boost due to increasing exports or production of home substitutes for imports (when there is sufficient slack in the economy) does not reduce home investment, but creates conditions favorable to raising it. Thus, an export surplus is a more powerful stimulus to income than home investment.

In the beggar-my-neighbor scramble for trade during the great slump, every country was desparately trying to export its own unemployment. Every country had to join in, for any one that attempted to maintain employment without protecting its balance of trade (through tariffs, subsidies, depreciation, etc.) would have been beggared by the others.

From a long-run point of view, export-led growth is the basis of success. A country that has a competitive advantage in industrial production can maintain a high level of home investment, without fear of being checked by a balance-of-payments crisis. Capital accumulation and technical improvements then progressively enhance its competitive advantage. Employment is high and real-wage rates rising so that “labor trouble” is kept at bay. Its financial position is strong. If it prefers an extra rise of home consumption to acquiring foreign assets, it can allow its exchange rate to appreciate and turn the terms of trade in its own favor. In all these respects, a country in a weak competitive position suffers the corresponding disadvantages.

When Ricardo set out the case against protection, he was supporting British economic interests. Free trade ruined Portuguese industry. Free trade for others is in the interests of the strongest competitor in world markets, and a sufficiently strong competitor has no need for protection at home. Free trade doctrine, in practice, is a more subtle form of Mercantilism. When Britain was the workshop of the world, universal free trade suited her interests. When (with the aid of protection) rival industries developed in Germany and the United States, she was still able to preserve free trade for her own exports in the Empire. The historical tradition of attachment to free trade doctrine is so strong in England that even now, in her weakness, the idea of protectionism is considered shocking.

[emphasis: mine]

According to her colleague Wynne Godley, dissenting against free trade was one of the most important reasons for his dissent against the profession. In his short autobiography written in 2001 for A Biographical Dictionary Of Dissenting Economists (Edward Elgar book site), Godley says:

There are two aspects (in particular) of the work of the CEPG [Cambridge Economic Policy Group] which put its members into a category which may he termed ‘dissenting’. The first – a matter mainly of concern to the modelling fraternity and academic econometricians – was the unconventional view we took about how to construct and use an econometric model. Thus we attached prime importance to what may be termed ‘model architecture’ by which I mean that the underlying accounting was coherent, without any ‘dustbin’ equations or sectors; everything came from somewhere and went somewhere. Our view, by which I still stand, was that model architecture in this sense takes priority over parameter estimation; I am even prepared to conjecture that a properly a ‘architected’ model will deliver much the same results over a wide range of parameter estimates, particularly if the model is used for the simulation of medium- or long-term scenarios. Furthermore our use of the model was unconventional in that we treated it, not as something which would generate accurate forecasts of what would actually happen, but as a tool that informed our minds as to a great many possible outcomes conditional on a wide range of alternative assumptions both about exogenous variables and about parameter values. In using our model in this way we were greatly assisted by Cripps’s programming expertise, which permitted us to work with a speed and flexibility not generally available at that time. I should add that econometrics, as usually defined, played (advisedly) a relatively minor role in our work.

The second, and more egregious, respect in which we became a ‘dissident’ group was that, as a result of trying to think through the possible ways in which Britain’s net export demand might be improved, we entertained the possibility that international trade should be, in some sense, ‘managed’. There might, we argued, be no way in which the adverse trends could be reversed other than some form of control of imports. Our argument (see for instance Cripps, 1978; Cripps and Godley, 1978) was never one in favour of protectionism as normally understood – that is, the selective and unilateral protection of relatively failing industries under conditions of general stagnation. On the contrary, we were most careful to lay down conditions under which the management of trade would benefit not only our own country (without making its industry less efficient) but would also increase the level of trade and output in the rest of the world. The two basic principles were, first, that trade management should reduce import propensities without ever reducing imports themselves (in total) below what they otherwise would have been; and, second, that ‘protection’ should be as minimally selective as possible (for example, through the use of market mechanisms such as auction quotas) so that industrial inefficiency would not be sponsored.

I was surprised by the hostility with which our ideas about trade were received. It seemed to me at the time, and still seems to me, that the arguments actually used against us (at their most coherent by Maurice Scott et al., 1980) did not, in practice, rest on a well-articulated theoretical position but on very special assumptions about behavioural relationships and international political responses. (I have, to the best of my ability, answered these particular points in Christodoulakis and Godley, 1987.)

…

The ‘dissident’ argument in favour of managed trade is well summarized in Kaldor (1980), where he points out that the modern theory of international trade is based on the assumption that all production takes place according to the conditions described by the neoclassical production function, with constant returns to scale. Kaldor postulated instead, and he was surely right to do so, that the principle of circular and cumulative causation leads (through dynamically increasing returns) to a process, not of convergence, but of polarization between successful and unsuccessful economies in which success in competitive performance feeds on itself and losers become immiserated by trade.

The above quote is interesting from another perspective: it explains Godley’s views about modeling, policy, “forecasting” etc.

The Illogical Golden Rule

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There’s a nice article by Wynne Godley written in 2005 for The Guardian on the fiscal policy golden rule. There are two things wrong about the golden rule. The first is to think that capital expenditure is somehow superior to current expenditure. This is the reason one frequently hears “wonks” stressing on government infrastructure spending. The other is to ignore changes in private sector behaviour and foreign trade performance.

From the article:

Criticism of the fiscal policy regime has focused too much on whether Gordon Brown will break his self-imposed Golden Rule and not enough on whether the rule is acceptable. The Golden Rule states that the balance between receipts and current expenditure should be zero over the cycle, exempting public investment, which does not ‘count’ for the purpose of making this calculation.

A relatively minor objection to this arrangement is that there exists no relevant difference between, say, capital expenditure on school building and current expenditure on teachers. Both are equally necessary for education and both absorb resources (pound for pound) to roughly the same extent.

More fundamentally, the budget balance is equal to the difference between the government’s receipts and outlays, but it is also equal, by definition, to the sum of private net saving (personal and corporate combined) plus the balance of payments deficit.

If the private sector decides to save more, the government has no choice but to allow its budget deficit to rise unless it is prepared to sacrifice full employment; the same thing applies if uncorrected trends in foreign trade cause the balance of payments deficit to increase.

A sensible target for the budget balance cannot be set unless it is integrated into a view about what will happen to autonomous trends and propensities in private net saving and foreign trade. Moreover, as those trends and propensities change, it will never be possible to determine viable targets for the deficit that are fixed through time such as, for instance, that it should never exceed some number such as 3 per cent of GDP or that it should on average be zero.

Coming back to the medium-term future of the British economy: if, as seems quite possible, there is now a growth recession initiated by a fall in personal expenditure, the government will have no option but to allow the deficit to rise well beyond what the Golden Rule permits. The authorities will look ridiculous if they move the goalposts again, so the rule will have to be jettisoned. I don’t think it will be long before discretionary fiscal policy, once discredited by a few serious errors in the Sixties and Seventies, has to be rehabilitated.

Interest Rate, Growth And Debt Sustainability

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Frequently, discussions about debt sustainability have discussions about the importance of the interest rate and growth in debt sustainability analysis. See for example, today’s Paul Krugman’s post on his blog. It is concluded that as long as the rate of interest is below the rate of growth, the ratio public debt/gdp doesn’t explode. Unfortunately, this result is erroneous.

John Maynard Keynes’ biggest disservice to the profession is to not start with the open economy. In my view, debt sustainability is tightly connected to balance of payments.

Imagine a nation whose exports is constant. If output rises, it will have adverse effects on the current account balance of payments because of income induced increase in imports. This will have an adverse effect on the international investment position of the nation: the net international investment position will keep deteriorating unless output is slowed down or some measure is taken to improve exports. In the case of rising exports, there is a similar constraint, except it is weaker but dependent on the rate of growth of exports.

If the ratio net international investment position/gdp keeps deteriorating, either the public debt to non-residents or private indebtedness to non-residents or both have to keep rising, all unsustainable.

There are some complications. A nation’s balance of payments also depends on how assets held abroad and liabilities to foreigners affect the primary income account of balance of payments. Also, the exchange rate can depreciate (or be devalued in fixed-exchange rate regimes) improving exports and reducing imports. However assuming that exchange rate movements do the trick is believing in the invisible hand. Foreign trade doesn’t just depend on price competitiveness but also on non-price competitiveness. These complications are highly interesting but do not affect the fundamental fact that a nation’s success is dependent on the success of corporations to compete in international markets for goods in services.

Even the conclusion that the government should contract fiscal policy and aim for a primary surplus in its budget balance or else the ratio public debt/gdp keeps rising if the rate of interest is greater than the rate of growth is erroneous. Consider a closed economy. An expansion in fiscal policy will automatically raise output and gdp and hence tax collections to prevent the ratio public debt/gdp from exploding. The public sector balance may hit primary surpluses but not due to contraction of fiscal policy or targeting a primary surplus in its budget balance.

In short, although the rate of interest and the rate of growth are important in debt sustainability analysis, it is not as easy as is usually presenting in macroeconomics textbooks and in the blogosphere. For a more detailed analysis see the reference below.

Reference

  1. Godley, W. and B. Rowthorn (1994) ‘Appendix: The Dynamics of Public Sector Deficits and Debt.’ In J. Michie and J. Grieve Smith (eds.), Unemployment in Europe (London: Academic Press), pp. 199–206