Cyprus Rescue

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Cyprus has recently received the attention of academicians and financial professionals in recent weeks. Need I say that?

So national bankruptcy is to be resolved by winding down a bank, moving guaranteed deposits (i.e., upto €100,000) to another and as per the latest Reuters article on this, big numbers (anywhere ranging from 20 to 40 per cent loss on deposits on amounts over €100,000) are quoted.

Martin Wolf has a good summary:

The current plan is closer to what one would wish to see in an orderly bank resolution. Laiki Bank is to be split into good and bad banks. Deposits of less than €100,000 in the bank and assets worth €9bn – the sum owed to the central bank as part of its liquidity support – will be transferred to Bank of Cyprus. The remainder will be wound down. Those with claims to deposits in excess of €100,000 will obtain whatever the value of the bad bank’s assets turns out to be.

Meanwhile, savers at the Bank of Cyprus with deposits of more than €100,000 will have their accounts frozen and suffer a “haircut” of still unknown size. That reduction in value is likely to be large: perhaps 40 per cent. Finally, temporary exchange controls are to be imposed.

Why are the reasons for such huge numbers?

The reason is that the nation has accumulated huge net indebtedness to foreigners over years and this has been financed by banks raising deposits from foreigners, so that if debt traps are to be avoided, foreigners are to be required to take losses.

The following is the international investment position of Cyprus at the end of Q3 2012 (source: Central Bank of Cyprus)

Cyprus - International Investment Position Q3 2012In the balance of payments literature, banks’ position is referred as Other Investment. Also, the above refers to a Financial Account but it really means net IIP. Ideally it would have been better if this data had been updated but the above information is useful nonetheless.

As a percent of gdp, the net IIP position (with the opposite convention to standard usage) was 81.1% (Source: Eurostat) which is big in itself but very much lower than the now famous banks’ liabilities to foreigners/Russians! (the second red box above).

If a nation wants to resolve bankruptcy, it is better to do it by imposing losses on foreigners – especially if an international lender of last resort is available! And if this is to done it in the optimal way, best to do it once – rather than keep doing it. The ratio of two red boxes in the table – i.e., net liability as a proportion of gross bank liabilities to foreigners is 24.56%.

So Cyprus needs to wipe out about this amount as a percent of deposits roughly. It is not necessary to reach a position of zero indebtedness but something low such as 10% of gdp is ideal. Some buffer is needed because there will be leakages in spite of capital controls – requiring fire sale of foreign assets (and subsequent losses) by banks or borrowing from the ECB which may want to ensure that banks have good collateral for the ELA. Foreign deposits below €100,000 shouldn’t be hit. So “net-net”, as a percentage, this may be higher than 24.56%. All this depends on the latest situation and the distribution of foreign deposits and also the distribution between residents and foreigners but 24.56% of deposits is a good starting point – it gives a rough estimate of the order of magnitude of the problem.

At any rate, losses imposed on foreigners have to be big for the ECB and Euro Area governments to stand behind.

The Saving = Investment Identity

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Recently I have come across many people saying S = I is not correct or that it is valid only for a purely private economy.

People who come across the sectoral balances identity

S − I = G − T + CAB

sometimes mix up with another macroeconomic identity

S = I

They are unsure of the correctness of each or the kind of setup one or the other is valid. Or – how can both be valid?

The reason both are valid is that the former is a sectoral equation and the S refers to the private sector saving and in the latter, S refers to the sum of savings of all sectors of the world*.

Remember good authors always specify the terminology used and you should too always.

But the first equation doesn’t make the second equation invalid. It is just that the contexts are slightly different.

So in the first equation, S is the private sector saving, I is private sector investment and G is the government expenditure, T is tax receipts of the government and CAB is the current account balance of payments.

So, in case you want to use the two simultaneously, use different notations.

Take an example of a closed economy.

The government’s expenditure is comprised of current and capital expenditures.

So,

G = Gcurrent + Igovt

Government’s saving is T − Gcurrent

So

Spriv − Ipriv = G − T = Igovt − (T − Gcurrent)

and hence

Spriv − Ipriv = Igovt − Sgovt

So,

Spriv + Sgovt = Ipriv + Igovt

which is written as S= I in short by authors – which is fair because they assume a context.

There is source for further confusions. This is because of mixing of the same set of symbols for planned investment and planned saving with the recorded ones. Clearly, planned investment needn’t be equal to planned saving. However, it is always good when discussing ex-ante and ex-post variables to use different symbols.

Some authors mix notation everywhere in their analysis, and call others confused!

If one doesn’t keep track of notations, a more complicated analysis will produce nonsensical results.

If someone doesn’t understand this, his confusions are his problems, not others’.

—

*Savings used as a plural of saving and as a flow instead of informal terminology referring to a stock

The Heavenly Walrasian Auctioneer

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When an economist talks of the “price mechanism”, it can be assumed that his theory is bunkum. Of course, it doesn’t mean that prices don’t play a role but the role played is entirely different than what the raw intuition of a normal person or the learned intuition for neoclassical economists says. Economists – neoclassical and their cousins – also talk of a Walrasian auctioneer whose role is to collect preliminary buy and sell orders, which he uses to find the “clearing” price. A look at the microstructure of markets reveals this is quite misleading and very incorrect inferences can be drawn from the price clearing story.

The blogger Lord Keynes (!) has a nice post quoting Nicholas Kaldor – mainly from his 1985 book Economics Without Equilibrium – The Okun Memorial Lectures At Yale University.

The following is from pages 13-18 – which have great insights on this. It draws heavily from Kaldor’s own paper from 1939: Speculation And Economic Stability.

Perhaps for that reason general equilibrium theory retains its fascination for teachers and students of economics alike. Indeed, judging by the number of Ph.D. students working on the implications of the rational expectation hypothesis, it is gaining ground, at any rate, in America. One reason is the intuitive belief that the price mechanism is the key to everything, the key instrument in guiding the operation of an undirected, unplanned, free market economy. The Walrasian model and its most up-to-date successor may both be highly artificial abstractions from the real world but the truth that the theory conveys — that prices provide the guide to all economic action — must be fundamentally true, and its main implication that free markets secure the best results must also be true. (This second proposition was indeed demonstrated but under assumptions so restrictive that Professor Hahn turned the argument around and suggested, in his inaugural lecture, that the importance of general equilibrium theory lies precisely in showing how stringent the conditions must be for “free markets” to secure the results in terms of welfare that are naively attributed to them. This may well be true, but if so, it is truth bought at a very high cost.)

But the basic assumptions in all this — that prices are very important in the working if a market economy — is rarely, if ever questioned. Yet it is precisely this over-emphasis on the role of the price system that I regard as the major shortcoming of modern neoclassical economics, particularly the Walrasian version of it.

The Role of Dealers and Speculators

Walras knows only two categories of “agents”: producers and consumers. He makes no mention of the third category which is vital to the functioning of any market economy, namely, the “dealer” or “middleman” (or “merchant”) who is neither buyer not seller, because he is both simultaneously. It is the dealers or merchants who make a “market” which enables producers to sell and consumers to buy, and who carry stocks of commodity the deal in in large enough amounts to tide over any discrepancies between outside sellers and outside buyers over any short period of time, and in practice fulfill the role designed for the “heavenly auctioneer” since they are the people who at any moment of time quote prices for purchases or for sales. They are not required under actual rules to buy or sell only at “equilibrium” prices — whatever that is taken to mean — though there are special markets, like the London bullion market, where the actual dealing price is struck after ascertaining the demands and the offers of dealers at various prices. (This is possible when, as in the London gold market, everybody’s demand and supply can be handled through a small number of dealers.) At any given moment of time, or to be a little more realistic, at the start of business, say the first thing in the morning, all prices are given to them as a heritage of the past. The important thing is that it is the dealers who initiate the price changes necessary for aligning, or rather realigning, the demand of the consumers and the supply of producers. They make their living on the “turn” between the buying price and the selling price; and the larger the market and the greater the competition between dealers, the less this “turn” is likely to be, as a proportion of price (always provided that the “turn” must be large enough to cover interest and carrying costs on stocks plus some compensation for the risk of a fall in market prices in the future). Thus buying or selling necessarily involves transaction costs that cannot be said to fall on the seller any more than on the buyer; they are divided between them, but it is not meaningful to ask how much falls on one side rather than the other.

Any discrepancy between sales and purchases (or “outsiders,” that is, of producers and consumers) is simultaneously reflected in the stocks (or “inventories” to use the American term) carried by merchants. Experience has taught them how large their “normal” stocks need to be in relation to their turnover in order to ensure continuity of dealing, for a dealer’s reputation (or good will) depends on his ability to satisfy his customers at all times; refusal or inability to deal is likely to divert business to others. They protect their stock by varying both their buying and selling prices simultaneously, raising prices when stocks are falling and lowering them when they are rising.

The size of price variation induced by a change in the volume of stocks held by the market depends on the dealer’s expectations of how long it will take before prices return to “normal” and how firmly such expectations are held. Even before the Second World War, the short-term fluctuations in commodity market prices (i.e., the markets of the staple agricultural and industrial raw materials, including metals) were very large. According to Keynes’s calculations in 1938 (in an article in the Economic Journal)* the average annual variation in the ten previous years between the lowest and the highest prices in the same year in the case of four commodities (rubber, cotton, wheat and lead) was 67 percent. Unfortunately, the corresponding figures for the fluctuations in stocks carried that were associated with these prices variations could not have taken place unless there were frequent changes in the prevailing expectations concerning future supplies of demands.

* “ The Policy of Government Storage of Food Stuffs and Raw Materials.” Economic Journal, September 1938, pp. 449-460

Nor is it known how far the price movements were exaggerated as a result of the activities of yet another class of “agents”, the speculators. Professional dealers act under the influence of price expectations, and to that extent their market behavior can also be regarded as speculative in character. But their actions are motivated by the desire to reduce the risks facing them (which they inevitably assume as dealers) by their willingness  to reduce their stocks in times of high prices and the opposite willingness to absorb extra stocks when prices are regarded as abnormally low. In any case the risks they carry are an inevitable by-product of their function as dealers. Speculators on the other hand assume risks for the sake of a gain and thereby provide facilities for hedging by buying “futures” from those who are committed to carry stocks of a commodity, and selling “futures” from those who are committed (by their productive activities) to acquire commodities in the future for uses for which they have already entered contractual commitments.

The activities of both dealers and speculators are supposed to smooth out both fluctuations in prices and variations in the size of inventories. Price rises should be moderated by the reduction of inventories held by dealers; similarly, a price fall should be moderated by a consequential increase in inventories. As Arthur Okun pointed out in one of his papers, * as a matter of “stylized fact” this is the very opposite of what actually happens.

The hallmark of U.S. postwar recessions has been inventory liquidation, following a major buildup of inventories at the peak of the expansion. Standard models that assume price-taking and continuous market clearing do not suggest that a disappointment about relative prices will lead to liquidate inventories. For example, a sudden drop in the demand for, and hence the price of wheat that leads farmers to decrease production in the future will generally lead traders to increase stocks initially. (The price tends to fall enough currently relative to its new future expected value to provide traders with that incentive.) Why then, in the business cycle, is an aggregate cut back in production accompanied by a cutback in stocks?

*Rational Expectations with Misperceptions As a Theory of the Business Cycle, proceedings of a seminar held in February 1980 and printed in the Journal of Money, Credit and Banking, November 1980, Part 2]

This was mentioned as the first of eight “stylized cyclical facts” that Okun regarded as inconsistent with the rational expectations hypothesis; it related to the behavior of a special class of “agents” whose main business it is to be rational in their expectations.

All this related mainly to the behavior of commodity markets which come nearer to the “auction markets” of general equilibrium theory than all the other “markets” in the economy. Yet they fail to satisfy the theoretical requirements from more than one point of view. First, they are not “market clearing” in the sense of equating demand and supply on the strict criterion that the maximum amount sellers desire to sell at the ruling price is equal to the maximum buyers desire to buy. There is a change in inventories from period to period, held by insiders in the market, that is quite un-Walrasian – it means that demand was either in excess of, or short of supply-the market has not “cleared” and the transactions, even in the shortest of periods, such as a day or even an hour, did not take place at a uniform price but at prices that varied sometimes minute by minute.

Nicholas Kaldor - Economics Without Equilibrium

Nicky Kaldor from the back cover of Economics Without Equilibrium

A Dubious FT Critique Of The UK ONS

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On 28 Feb, FT’s columnist Chris Giles attacked the United Kingdom Office of National Statistics in his article titled UK’s official statistics cannot be trusted.

As his title suggests, Giles argues that the ONS is helping the UK government hide some public finances statistics and is losing its independence. His article is misleading to say the least.

Also see Jil Matheson’s reply to FT.

To see this one needs to understand some national accounts concepts. Usually economists and journalists err on simple concepts and Chris Giles does the same – leading him to his strange conclusions.

The government’s deficit is the difference between its expenditures and income (mainly taxes). The difference is financed by borrowing from the markets. This used to be called the PSBR – Public Sector Borrowing Requirement. The government also earns from the central bank’s profits. During any period of measurement however, the government also rolls over its maturing debt and the nomenclature changed to PSNB – public sector net borrowing.

So we had

G – (T + Fcb) = PSNB

where G is the government expenditure including interest payments (and including interest payments to the central bank), T is tax receipts and is the Fcb profits of the central bank (assumed to be remitted in full to the Treasury for simplicity). However, during the financial crisis, the UK government needed to bailout banks and to finance its purchases of newly issued equities, it needed to borrow more. Hence the above relation was no longer valid.

So

G – (T + Fcb) ≠ PSNB

However, the deficit is fundamentally the left hand side. The purchase of equities cannot be thought of as adding to the government’s deficit because the government acquires financial assets in return. Of course this adds to PSNB and hence also to the public debt. So to measure the real effects, the UK ONS proposed a measure PSNBex.

G – (T + Fcb) = PSNBex

This is as it should be – the bailout of banks by purchases of its newly issued equities cannot be said to be equivalent to an expenditure by the government which has a direct effect on aggregate demand. The bailout of banks although has its benefits – in the sense that they will be less constrained in lending – has an indirect effect and it will be captured when banks lend for a house purchases and this will reflect in investment expenditures. Of course the bank bailout has to appear somewhere in the accounts and it does and the UK ONS has been careful in doing it the right way.

In the Euro Area however, this is captured differently in national accounts and this is not the best way in the spirit of the accounts. So when the Irish government bailed out banks, it was measured as a huge rise in the deficit.

So here is from the Eurostat for the year 2010 and you can see Ireland visibly:

Eurostat_Graph_teina200

(Source: Eurostat. Click to enlarge)

Back to UK national accounts.

Assuming bailouts are in the past, i.e., not in the period of recording and also assuming no sale of equities by the government,

G – (T + Fcb) = PSNBex = PSNB

Now, the Bank of England has been has been purchasing government bonds in open markets as part of its Asset Purchase Facility program (strange word “facility”). It established a fund (or a financial vehicle) called Bank of England Asset Purchase Facility Fund Ltd which funded its purchases of UK government bonds by borrowing from the Bank of England. Over time, the BEAPFF has made profits on its operations and this is reflected in its cash balances at the Bank of England. The UK Treasury recently decided to transfer the cash to its own account (“raid” in the words of Chris Giles).

The cash transfer is an income flow from the Bank of England to the Treasury and hence reduces the PSNBex.

The ONS came with a technical note on how to measure this and Giles decided saw it as a proof that the ONS is not independent!

Although these effects seem intra-government, national accounts (SNA) treats the central bank as part of the financial sector and hence the transfer of the cash from BEAPFF reduces the PSNBex. Hence according to the ONS:

Following recommendations from the National Accounts Classification Committee (NACC), The Public Sector Finances Technical Advisory Group (PSFTAG) and Eurostat, it has been decided that:

  • The Asset Purchase Facility will continue to be treated as part of the Bank of England in National Accounts and Public Sector Finance statistics.

  • The flows of cash from the BEAPFF to HM Treasury, up to the level of the combined Bank of England’s ‘Entrepreneurial Income’ from the previous year, are treated as final dividends and therefore reduce the level of General Government Net Borrowing by that amount. However, anything above this level will be treated as a special transaction in equity, known as a super-dividend, which will not impact on the level of General Government Net Borrowing. (This calculation is known as the super-dividend test.) Whatever the impact on General Government Net Borrowing, the full value of the payments will impact on the General Government Net Cash Requirement.

  • Any flows of cash from HM Treasury to the Bank of England in the future to cover losses made by the BEAPFF will be treated as Capital Transfers and so will impact (in the opposite direction) on measures of General Government Net Borrowing and General Government Net Cash Requirement.

  • The BEAPFF as a whole should remain classified as a temporary effect of financial interventions as the end state of the BEAPFF remains unknown.

  • The payments between the Bank of England and Treasury should be treated as permanent effects and therefore impact on the headline measures of Public Sector Net Borrowing (PSNB ex) and Public Sector Net Debt (PSND ex), which exclude temporary effects of financial interventions.

All this is consistent with the principles of national accounts – how the central bank is treated and how various flows are measured and recorded etc. The government interest payment to the BEAPFF increases PSNBex and the cash transfer reduces it.

The ONS says clearly that in case the BEAPFF suffers a loss, there will be a capitalization by the government and this will be treated as a capital transfer and will impact government’s accounts – but in the future.

Yet in spite of very clear thinking and action by the ONS, Chris Giles erroneously concludes that “official statistics cannot be trusted”. His critique is vacuous.

So The Bank Of England And The UK Government Cannot Default On Its Bonds – Is It?

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Always start macroeconomics with balance of payments 🙂

Recently,

Moody’s Investors Service has today downgraded the domestic- and foreign-currency government bond ratings of the United Kingdom by one notch to Aa1 from Aaa.

It also downgraded the Bank of England:

In a related rating action, Moody’s has today also downgraded the ratings of the Bank of England to Aa1 from Aaa.

This has seen a lot of reactions – such as quoted here in an FT Alphaville blog post ‘This downgrade is nonsense!’

So let us get straight to scenarios which lead to defaults – in addition to ones purely voluntary.

Scenario 1.

The easiest is to think of a scenario where the Euro Area forms a political union and the UK is invited to join it and it joins it – such as in 2027. The UK government then gives up the power to make drafts on its central bank and becomes a state level government. UK government bonds will be redenominated in Euro and hence a possibility of default exists – including on debts in existence in 2013.

Scenario 2.

Suppose the UK pegs GBP to some currency such as the Euro or the dollar in 2024. Then surely the government and the central bank can default on debts in existence in 2013 and denominated in GBP in say 2037 isn’t it (like Russia in 1998)?

Now you may complain that it was the government’s mistake to have pegged its exchange rate – but whatever said, an investor holding a bond in 2013 would have been hurt in 2037.

Scenario 3.

Suppose the UK has a balance of payments crisis in 2030. It needs foreign exchanges and needs an international lender such as the IMF. Now suppose the IMF insists that the UK government and the Bank of England default on foreigners holding GBP denominated bonds including those in existence in 2013. Voluntary default?

Conclusion

Moody’s can be criticized for playing political games but a good critique cannot be that default is not possible.

You can come up qualifiers but won’t prove Moody’s rating change wrong.

Don’t get me wrong. I am trying to convince to come up with stronger arguments for critiquing the rating agencies instead of simple ridiculing. Usually the rating actions are defended by people arguing for fiscal contraction. Paradoxically the recovery of the world economy cannot come about easily with without at least a worldwide fiscal expansion.

A New Handbook Of Post-Keynesian Economics

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This looks nice but will be released only in May 🙁

The Oxford Handbook Of Post-Keynesian Economics - Volume I - Theory And Origins

Link: OUP, Amazon

Table of Contents

Preface and acknowledgements

Introduction – G.C. Harcourt and Peter Kriesler

1. A personal view of the origins of post-Keynesian ideas in the history of economics – Jan Kregel

2. Sraffa, Keynes and post-Keynesianism – Heinz Kurz

3. Sraffa, Keynes and post-Keynesians: Suggestions for a synthesis in the making – Richard Arena and Stephanie Blankenburg

4. On the notion of equilibrium or the centre of gravitation in economic theory – Ajit Sinha

5. Keynesian foundations of post-Keynesian economics – Paul Davidson

6. Money – Randall Wray

7. Post-Keynesian theories of money and credit: conflict and (some) resolutions – Victoria Chick and Sheila Dow

8. The scientific illusion of New Keynesian monetary theory – Colin Rogers

9. Single period analysis and continuation analysis of endogenous money: a revisitation of the debate between horizontalists and structuralists – Giuseppe Fontana

10. Post-Keynesian monetary economics Godley-like – Marc Lavoie

11. Hyman Minsky and the financial instability hypothesis – John King

12. Endogenous growth: A Kaldorian approach – Mark Setterfield

13. Structural economic dynamics and the Cambridge tradition – Prue Kerr and Robert Scazzieri

14. The Cambridge post-Keynesian school of income and wealth distribution – Mauro Baranzini and Amalia Mirante

15. Reinventing macroeconomics – Edward Nell

16. Long-run growth in open economies: export-led cumulative causation or a balance-of-payments constraint? – Robert Blecker

17. Post-Keynesian precepts for nonlinear, endogenous, nonstochastic, business cycle theories – K. Vela Velupillai

18. Post-Keynesian approaches to industrial pricing: a survey and critique – Ken Coutts and Neville Norman

19. Post-Keynesian price theory: from pricing to market governance to the economy as a whole – Frederic S. Lee

20. Kaleckian economics – Robert Dixon and Jan Toporowski

21. Wages policy – John King

22. Discrimination in the labour markets – Peter Riach and Judith Rich

23. Post-Keynesian perspectives on economic development and growth – Peter Kriesler

24. Keynes and economic development – Tony Thirlwall

25. Post-Keynesian economics and the role of aggregate demand in less-developed economies – Amitava Krishna Dutt

—

Volume 2 website here

Table of Contents

Preface and acknowledgements

Introduction (from volume 1) – G.C. Harcourt and Peter Kriesler

1. On microfoundations of macroeconomics – Abu Rizvi

2. Post-Keynesian economics, rationality and conventions – Tom Boylan and Paschal O’Gorman

3. Methodology and post-Keynesian economics. – Sheila Dow

4. Critiques, methodology and the relationship of post-Keynesianism to other heterodox approaches – Gay Meeks

5. Two post-Keynesian approaches to uncertainty and irreducible uncertainty – Rod O’Donnell

6. The interdisciplinary applications of post-Keynesian economics – Wylie Bradford

7. Post-Keynesian economics, critical realism and social ontology – Stephen Pratten

8. The traverse, equilibrium analysis and post-Keynesian economics – Joseph Halevi, Neil Hart and Peter Kriesler

9. A personal view of post-Keynesian elements in the development of economic complexity theory and its application to policy – Barclay Rosser Jr.

10. How sound are the foundations of the aggregate production function? – Jesus Felipe and John McCombie

11. Marx and post-Keynesians – Claudio Sardoni

12. The L-shaped aggregate supply curve, the Phillips curve, and the future of macroeconomics – James Forder

13. A post-Keynesian critique of independent central banking – Joerg Bibow

14. The post-Keynesian critique of the mainstream theory of the state and the post-Keynesian approaches to economic policy – Richard Holt

15. A modern Kaleckian-Keynesian framework for economic theory and policy – Philip Arestis and Malcolm Sawyer

16. Classical-Keynesian political economy: genesis, present state and implications for political philosophy and economic policy – Heinrich Bortis

17. Post-Keynesian distribution of personal income and policy – James K. Galbraith

18. Environmental economics – Neil Perry

19. Theorising about post-Keynesian economics in Australasia: aggregate demand, economic growth and income distribution policy – Paul Dalziel and J. W. Nevile

20. The heterodox spiral and the neoclassical sink: reclaiming economic theory after neo-liberalism – Gary Dymski

21. Keynesianism and the crisis – Lance Taylor

Fake Trade-Offs

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Elasticities for one last time for now.

Recently Tom Palley wrote a fine critique of the Neochartalist approach to solve the world problems with oversimplistic solutions. Among other things, Palley challenges the simplistic Chartalist solutions due to dilemmas posed by the external sector.

Bill Mitchell of Australia wrote a reply in which he states the following:

It is easy to see that a Job Guarantee model requires a flexible exchange rate to be effective. We can identify two external effects. First, given the higher disposable incomes that the Job Guarantee workers would have compared to if they were unemployed imports would likely rise.

With a flexible exchange rate, the increase in imports would promote depreciation in the exchange rate. We should expect the current account to improve and net exports increase their contribution to local employment. The result depends on the estimates of the export and import price elasticities. The body of evidence available suggests that import elasticities are small (around –0.5).

This is a typical oversimplistic and incorrect approach.

First, Mitchell incorrectly claims that import elasticities are low for Australia citing a “body of evidence”. The number he quotes is price elasticity. He hides away from income elasticity. I suppose he thinks that the numbers estimated are “low” enough not worthy of mention. Unfortunately it is not.

Second, he claims that as a result of running an employer of the last resort by the government, the Australian exchange rate would fall and this would actually lead to an improvement of the current account.

This is a primitive neoclassical argument. While it is true that a depreciation of the Australian dollar would act to reduce imports due to price effects, it is no guarantee to reduce the trade imbalance. This is because if incomes rise faster, the trade imbalance may be rising (i.e., imports are rising) even if the Australian dollar is depreciating. Note that is different from the J-curve effect. Exports on the other hand depend on the competitiveness of Australian producers and demand conditions in the rest of the world and hence improvement of exports is dependent on how the rest of the world grows which cannot be assumed arbitrarily.

[Incidentally, producers in other nations may be even less competitive than Australian producers – thereby implying a stronger constraint on those nations because exports may not be rising as fast]

Funnily, the blog posts claims in one place that imports reduce and later that it increases. In that discussion, Mitchell seems to be addressing imported inflation – a somewhat less important detail here in this post.

Third and the most important point is since the exchange rate is not under official control, there is no guarantee that the exchange rate will depreciate. It may appreciate and stay at appreciated levels for an uncertain period till the net indebtedness of Australia rises to alarming levels.

I suppose Mitchell believes there cannot be a crisis because according to a 2008 paper coauthored by him, There is no financial crisis so deep that cannot be dealt with by public spending. Ironically during the global financial crisis which started in 2007-8, Australian banks went into a heavy US dollar funding problem which had to be resolved by the Reserve Bank of Australia using its credit lines at the Federal Reserve (via swap lines). This puts his huge claim that crises can simply be solved by public spending into pieces.

Now, if incomes rise in Australia, this has the adverse effect of deteriorating the balance of payments which Mitchell denies reguarly. Of course in real life, Australian authorities won’t like a deterioration. Here is where the fake trade-off of the employer of the last resort proposal comes in.

If incomes are to not rise because imports have to be kept under check, then the ELR is simply a redistribution to the ELR employee out of taxes. This is because more people receive the disposable income due to production and if output is constrained from the external sector, so are incomes – thereby implying lower disposable incomes for others already employed and not in the ELR.

Incidentally I mention in the passing that Australian banks are subject to vulnerabilities due to funding from foreigners – something Chartalists (who are also Minskyians) would deny. The huge amount of external funding needs of Australian banks – both in domestic and foreign currencies is a direct result of the current account imbalances accumulated over the past.

Somehow a group of Keynesians think that simply deficit spending solves all our problems.

A Nation’s Net Indebtedness: An Example

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Over this thread at Matias Vernengo’s blog Naked Keynesianism, I got into an exchange about current account deficits and sustainability with an anonymous commenter – a topic I had blogged on recently in 2-3 posts.

The commenter seems to not understand how this works or seems to believe that net indebtedness cannot keep rising relative to GDP in scenarios. I will present some scenarios below. The scenario presented below is not what literally happens but rather shows the absurdity of some types of growth.

Before this, let me give the expression for net indebtedness to foreigners. Ignoring revaluations, only current account transactions change claims on foreigners or claims by foreigners on residents. So

Change in Net Indebtedness to Foreigners = Current Account Deficit.

For simplicity, I will ignore other items in the current account – such as interest and dividend payments between residents and non-residents etc.

So start with GDP of £100, imports of £20 and exports of £15 and net indebtedness to foreigners of 20% of GDP.

Assume GDP grows at 5% annually. Imports as a percent of GDP is 20% and exports do not grow.

(In real life imports can be even worse when output changes but let’s just keep things simpler).

The numbers are nominal values.

So here is how it looks in Excel:

Net Indebtedness To Foreigners - Example

Now one can argue about the simplicity in the assumption that export was held constant. So here it is at 4% export growth.

To make it more realistic, I also use import elasticity of 1.5 – which means that for a 1% rise in GDP, imports rise by 1.5%.

Net Indebtedness To Foreigners - Example 2

Deteriorating in either case. If you were to extend the scenario to more rows in Excel, you can see how it rises forever.

It illustrates one thing: At sufficiently low growth of exports or a high propensity to import, a faster rate of growth of output comes with net indebtedness to foreigners rising relative to GDP which cannot be sustained for long.

Also if one assumes (although not always the case) that the private sector net accumulation of financial assets (NAFA) is a small positive number (such as 2% of GDP), then the current account reflects directly on the fiscal deficit because of the sectoral balances identity.

You can do this on your own sheet and see how these numbers change for different scenarios assumed.

The reason I have a numerical example is that it is easier to see how fast these stocks and flows change.

This example is an illustration of the balance-of-payments constraint nations face. Faced with rising current account imbalances, nations may be faced with little optimism – such as the ability to use of fiscal policy to improve demand and output. In a world of free trade, there is less one can do such as raising tariffs, import controls and so on. The trend in international political economy is actually tending toward reducing tariffs which makes the problem even worse. Subsidies to exporters can be provided but these lead to cries of foul at WTO. Even if subsidies are given to exporters, they are limited by how well they can compete with big firms in international markets. When this happens for everyone – such as at present – an international political economy game happens where muddled policy makers try to discuss something but in the end vow to continue free trade policies. Or they play games such as beggar-my-neighbour. Whatever said, a nation’s success crucially depends on how their producers do in international markets.

Back to stocks and flows. In real life things get more complicated and interesting. A nation may receive a lot of payments from abroad – even if its trade balance is worsening because of direct investments made in the past etc. Residents hold stock market securities abroad and these may make a killing – so analysing this becomes even more interesting! So high holding gains of assets held abroad may be sufficient to prevent net indebtedness from rising even if the current account balance is high. So there is an interesting dynamics here but finally, the current account balance wins over revaluations.

The example is motivated by one given in Wynne Godley and Francis Cripps’ book Macroeconomics.

The Production Function View Of The World

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Recently FT published an interview with Adair Turner, chairman of the UK Financial Services Authority- who supposedly thinks of himself as heterodox!

Here is from the interview:

Lord Turner: Well, I think there is a challenge of macroeconomic policy which, for the last 30 years, we have largely, appropriately, located in central banks, which is the management of the pace of increase of aggregate nominal demand.

And we have had a philosophy, which I think is a right philosophy, that there is a macro challenge of making sure that aggregate nominal demand is growing at an appropriate pace, but all that can do is ensure price stability. And, within the constraint of price stability, the return of an economy to a full, or close to capacity level, and that there is no ability of those set of levers to change the trend growth rate of real output. And I think that was the shift in the orthodoxy, but this bit of the shift in the orthodoxy was absolutely right, I think, during the 1960s where there had been a previous tendency on the part of some economists to believe that you could call macro levers, fiscal and monetary levers, in a way that would increase the trend real growth rate of the economy.

So I think I’m clearly in the camp who believe the trend real growth rate of the economy is driven by a set of supply factors, the exogenous rate of technological growth, the growth of the labour market, the pace of capital formation, etc, and that the rejection in the 1960s of the idea that we could stimulate that by running large fiscal deficits or by monetary policy was quite correct.

Which is entirely inaccurate and super-neoclassical.

In the interview Turner also talks of “money-financed” stimulus – a crude and entirely misleading way of looking at fiscal policy. His interview summarized in another article Print money to fund spending – Turner seems to have irritated mainstream analysts as well 🙂

In Monetarism, fiscal policy is financed by the government and the central bank by issuing bonds and cash and this is decided by the two authorities by deciding on the proportions (as if the preference of the private sector’s portfolio allocation does not matter). A high proportion of issuance of cash leads to price rise with no increase in real output and the opposite case leads to a rise in interest rates. So fiscal policy is not only impotent but also has negative effects according to Monetarism.

Now mainstream economists have conceded that fiscal policy can have positive effects but tend to argue that it works in exceptional circumstances only and Turner’s view of the world is around that theme.

The notion of the production function seems to be the main point in Turner’s view of how the world works. In the interview he talks of “poison” when discussing fiscal expansion. Why do economists think of  the use of fiscal policy as immoral? One example below:

Production Function

In neoclassical theory, output is determined by a production function. Supply creates its own demand.

So one writes

GDP = C + I + G

assuming a closed economy and symbols with their meanings.

Now, in neoclassical theory, output [or GDP – although not the same thing because the latter excludes intermediate consumption for example] is determined by a production function. Unless you don’t understand Keynes, this seems to be a reasonable assumption but remember what Joan Robinson said – “The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists”.

Unfortunately it does not work that way and in (post-) Keynesian economics, demand creates its own supply. It has been difficult for economists to appreciate this because they would have to give up the concept of the production function. The aggregate production function is crucial to neoclassical economics. Without it, neoclassical economics cannot live.

Post-Keynesians have written the most devastating critiques of this fantastical object. In this post – humble compared to the critiques – I will just consider one aspect.

So the production function is

Q(t) = F(L(t), K(t); t)

This is a relationship which says that output is determined by factors of production. To simplify, only land, labour and capital are taken as inputs. To make it slightly more general, it is also assumed that the function is dependent on time – in order to allow technical change.

Since output and hence GDP is determined by this in this way of thinking, the left hand side of “GDP = C + I + G” is determined by the production function. It is then argued that since the left hand side is fixed, higher government expenditure can only work to reduce investment and consumption. Hence government should reduce its expenditure!

Also, since it supposed to hold inflation-adjusted as well, expenditures by the government can only increase prices – together with the earlier result of “crowding out”. Also further arguments – in discussions about interest rates etc. – this argument is further supported by the authors – with results such as increased government expenditures invariably leading to higher interest rates etc in the absence of “monetary financing”. So allegedly independent central bank does not “money finance” the deficit and the opposite case – central bank losing some independence leads invariably to higher inflation. This is connected with the notion of an exogenous stock of money and the standard neoclassical description is such that increased government expenditure leads to shortage of funds available for investment.

Such is the crude world of neoclassical economics. The concept of the chimerical production function goes hand-in-hand with the widely held damaging view that fiscal policy is not only neutral but also “poisonous”!

This is also presented another way. GDP is also equal to the sum of disposable incomes of all sectors of an economy. Since GDP is given by the supply side (the production function), a higher tax revenue for the government implies lower disposable incomes for the private sector. So the government should reduce taxes – by reducing the tax rates. In a demand-side description, although there is some truth to this – it is due to different reasons. A decrease in the tax rate leads to an increase in demand – as people will be left with more disposable incomes and will spend more and this acts to increase output but also brings in more tax receipts for the government because of the increase in total taxes due to higher economic activity.

Of course, supply-siders are misled by demand-side theories because they incorrectly tend to view them as if the theories assume that there is no supply-constraint at all. That takes one to “endogenous growth theory” but understanding the basic demand-led growth story is a Herculean task for most economists that such discussions rarely happen.

Trade Elasticities, Floating Exchanges And Debt Sustainability

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[Although the following is a response aimed at one comment, it can be read in general]

In my post on the connection between balance of payments and debt sustainability, I got a “you are wrong” comment saying the analysis is based on the notion of trade elasticities which doesn’t exist (or is a chimerical notion) and that I ignore floating exchange rates. So a reply.

Trade Elasticities

A standard observation is that imports and exports depend on income – domestic and in the rest of the world. Exports depend on how competitive the producers are in the rest of the world and also the demand in the rest of the world. Similarly imports depend on foreign producers’ competitiveness compared to domestic producers as well as domestic demand. So in a simple Keynesian model one writes:

IM = μY

where μ is the propensity to import. It measures imports as a proportion of domestic output. Relative propensities (between nations) measure relative competitiveness of producers. This is a very quick way to build a model for how stocks and flows change over time.

There is one simplification in this. Although it rightly captures the amount of imports during a period – such as a few years, it supposes imports rise one-to-one with output – i.e.,

ΔIM/IM = ΔY/Y

But in reality it could be worse – as the response of imports to a rise in domestic demand can be worse.

Also, it doesn’t capture the effect of prices. Producers across the world compete with each other on both the quality of their products and on price. So we have “non-price competitiveness” and “price competitiveness” . Now it is a Post-Keynesian observation that non-price competitiveness is much more important. So one has income elasticity of imports as well as price elasticity and the analysis can get a bit complicated. Some kinds of products have higher elasticities than others. For example manufactured products may have different elasticities as compared to raw materials, commodities etc. Also one can include nuances such as which is more important – income, expenditure, output etc.

Even more generally, the rest of the world consists of many nations and one has to be careful. So the rest of the world may be growing but it may happen that exports aren’t because exports are concentrated on one country or a group of nations which are not growing.

A good original reference is Joan Robinson’s article The Foreign Exchanges from her 1937 book Essays In The Theory Of Employment. 

Rather than going through the analysis, let me just show the plot of the United States’ imports to show that the concept of elasticity is far from chimerical as one observer claims.

The following is a scatter-plot of the logarithms of GDP and Imports for the United States since 1951 (quarterly). The data is from Federal Reserve’s Z.1 Flow of Funds Accounts.

US Imports Versus GDP

The thin grey line is the fit and in addition, there is a 45-degree line to show that the slope is different than 1.

The “elasticity” is supposed to capture the response of imports to a rise in expenditure/income/output. The above simple scatter-plot shows the relation is far from being random.

So much for the notion that trade elasticities don’t exist!

Of course, the elasticities can be improved and not god-given. A nation’s government can take some protection and/or invest in research and development because the elasticity is a supply-side concept. It can also be improved if producers learn how to improve their products and the quality of its sales force in marketing them in international markets. Still, the improvement depends on how well all these are carried out etc.

Now to floating exchanges.

Floating Exchange Rates

Now, it can be argued that a debt sustainability analysis is invalid because of floating exchange rates. If a nation’s currency floats, a depreciation of the exchange rate in the foreign exchange markets can improve the trade balance. While it is true that a depreciation can turn the balance in a nation’s favour because of price effects, it is doesn’t necessarily happen that way. Even if one assumes away J-curve effects, a nation can find itself in a balance worsening in spite of a depreciation. This is because non-price competitiveness is far more important than price-competitiveness. In fact there exists no reason how “market forces” miraculously resolve the imbalances by depreciating. In reality trade imbalances are kept from blowing up by adjustments to income.

It is one thing to say that depreciation can improve the trade balance (which has truth to it) and another to say it can do a miracle.

Now, coming to debt sustainability, one can still claim that this process can continue forever (i.e., net indebtedness to foreigners rising forever relative to gdp) without any trouble in the foreign exchange markets. That is something for another post but it is too much of a claim.

The Joan Robinson paper I quoted has the mechanism of how this ends up creating troubles in the fx markets.