Tag Archives: balance of payments

r < g Or DEF < g ?

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It is frequently asserted by some economists and even some Post-Keynesians that as long as the effective interest rate paid on stocks of debt is less than the growth rate, stock-flow-norms do not keep rising forever. That is, ratios such as public debt/gdp, external debt/gdp do not rise forever at full employment if this condition is maintained, implying thereby that fiscal policy can be used to achieve a higher output and there is nothing one needs to do about the external sector.

It is the purpose of this post to clear such misconceptions.

Fiscal Policy

What can fiscal policy achieve and what are its limitations? In an essay from the centenary conference of 1983, Wynne Godley wrote [1]:

How did Keynes think the economy worked? Any time between 1950 and 1970 1 would have confidently attributed to Keynes, as preeminently important, the following views about economic policy:

(a)    Real demand, output and employment are determined via a multiplier process by the fiscal and   monetary operations or the government and by foreign trade performance.

(b)    Inflation, though influenced by the pressure of demand, is largely indeterminate in terms or economic variables and therefore, if it is to be controlled, requires some kind of direct political intervention.

(c)    Fiscal and monetary policies in any one country are potentially subject to important external constraints.

While there is reasonable support for these views about economic policy in Keynes’s writings, there is no warrant for them at all in the General Theory. Indeed it is strange, seeing how commonly the view is attributed to Keynes that fiscal policy is crucial to real output determination, that the General Theory is concerned with an economy in which neither a government nor for that matter a foreign sector exist at all.

Notwithstanding this I still think, not only that the propositions can be correctly attributed to Keynes, but that they are, themselves, essentially correct. I have however been forced to the conclusion that Keynes was a long way from achieving a coherent theoretical basis for maintaining them, and largely for this reason, his ideas have proved very vulnerable to the attacks from many different directions to which they have been subjected, particularly in the last fifteen years.

To points (a), (b) & (c) above, let me add

(a(i))  Higher output is also possible when the private sector expenditure is higher than private sector income.

This was highlighted by Godley himself in the late 90s, when the US economy expanded in spite of a tight fiscal stance and he was the first to write that this process is unsustainable!

Debt Convergence Analysis

Let us now turn to the question on convergence/divergence of stock-flow norms. In what follows, I simply use debt to denote the public debt or the external debt. Assuming away complications arising from revaluations, we have the identities [2]

Uppercase is for stock of debts, and lower case for debt-to-gdp ratio and g is the growth rate. Note: DEF is primary deficit and excludes interest payments. We will turn to complications added by interest payments soon. Whenever

the stock of debt keeps rising.

Note, when the debt-to-gdp ratio is less than 1 (100%), the sustainability condition is strong on the deficit. The condition DEF < g is at at a debt-to-gdp ratio is 1. Beyond 100%, the condition on the deficit is a bit weaker than DEF < g because the deficit can be between g and g·d.

This argument is sometimes presented differently by some Post Keynesians by including the effective interest rate r. The equation looks like the following when it is included:

It is argued that the third term on the right hand side can be set to be greater than the second term (which is to say that r < g is sufficient to ensure sustainability).

This argument (r < g guaranteeing problems are solved) has no substance. This is because rearranging the terms in the way done above, shows more clearly that the stock-flow ratio rises faster than the case where the analysis was done without the interest rate term!

There is one more complication. It may be argued that growth can only bring down the deficit (the deficit here being the public sector deficit). This is true for the case of a closed economy. The convergence of the public debt-to-gdp ratio is also achieved in the case of a closed economy because interest payments by the government is income for the private sector and they will consume it (although the capitalist class’s propensity to consume is less than that of the worker class). Higher consumption leads to higher national income and hence higher taxes, bringing down the deficit.

Wynne Godley and Marc Lavoie [3] showed how this happens precisely in the case of a closed economy:

This paper deploys a simple stock-flow consistent (SFC) model in order to examine various contentions regarding fiscal and monetary policy. It follows from the model that if the fiscal stance is not set in the appropriate fashion—that is, at a well-defined level and growth rate—then full employment and low inflation will not be achieved in a sustainable way. We also show that fiscal policy on its own could achieve both full employment and a target rate of inflation. Finally, we arrive at two unconventional conclusions: (1) that an economy (described within an SFC framework) with a real rate of interest net of taxes that exceeds the real growth rate will not generate explosive interest flows, even when the government is not targeting primary surpluses, and (2) that it cannot be assumed that a debtor country requires a trade surplus if interest payments on debt are not to explode.

Also, they create some very special scenarios, where the external debt stays sustainable.

However, making the above work is difficult for the case of an open economy in general. This was what the essential argument of the New Cambridge School. 

So is there a way to achieve convergence of the stock-flow norm? To achieve that, the external sector deficit (more precisely, the primary balance in the current balance of payments) should be less than the growth rate times the external debt. This creates tensions for demand-management because if the external deficit grows higher than the growth rate, it is usually brought back to a sustainable path by deflating demand.  This is because the balance of payments deficit itself will grow if growth is high! (unless exports improve).

There are of course some scenarios which can lead to the convergence of the external debt (if the markets allow it). A more careful treatment will always lead one to studying income and price elasticities of imports, growth in the rest of the world etc.

Other scenarios which could lead to the improvement of the external sector are:  promotion of exports leading to more success abroad and luck – market forces miraculously achieving the required depreciation to improve the external sector. Since the latter is mere wishful thinking, we see nations trying to depreciate their currencies because it makes their exports more competitive.

To bring the balance of payments deficit back into balance, there is also the option of restricting imports but in the world of “free trade”, it can create tensions between nations.

There are two more options. The first is to ask your trading partners to appreciate their currencies if they have pegged them but this has to go through negotiations because they want you to do the same! The second (which includes the previous option) is what this blog is about. Since, the external sector creates problems for demand management, one can only think of coordinated efforts by institutions running the world economy, working to achieve higher world demand instead of contracting it.

References

  1. Wynne Godley, Keynes And The Management Of Real Income And Expenditure, p135, Keynes And The Modern World: Proceedings Of The Keynes Centenary Conference, ed.  David Worswick and James Trevithick, Cambridge University Press, 1983.
  2. Gennaro Zezza, Fiscal Policy And The Economics Of Financial Balances, Levy Institute Working Paper 569, 2009. Available at http://www.levyinstitute.org/publications/?docid=1161
  3. Wynne Godley and Marc Lavoie, Fiscal Policy In A Stock-Flow Consistent Model, p 79, Journal of Post Keynesian Economics / Fall 2007, Vol. 30, No. 1. Draft version available at http://www.levyinstitute.org/publications/?docid=911

Chart: Eurozone Indebtedness

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The Euro Zone is under a crisis. Is there a chart which shows what the underlying factor is which makes the difference ? Below:


You can see that the external situation is clearly the one which makes the difference as opposed to the public debt. It’s true that Belgium’s bond market is under pressure – creditors may not like high public debt but I think the graph is still useful.

Chart: U.S. Indebtedness

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The Net International Investment Position is measure of how indebted a nation is. Why is that so ? Combine all the balance sheets of the sectors of a nation. Debts between residents cancel out and one is left with assets held abroad and liabilities to non-residents. One can replace “residents” with “citizens” and define a slightly different system of accounts and hence there is more than one way of doing it. The difference between assets and liabilities is called the net international investment position or net asset position. Below you see how this has changed over the years for the United States and how it has moved from positive to negative number territory over the years.

There are many discussions we can have one this – never ending ones! This could range from sustainability of this to whether this is problematic since most of the liabilities to foreigners is in US Dollars. Also, there are many stories on the movement of this graph with puzzles such as the dark matter problem. Each is worthy of being analyzed in detail, but for now my viewpoint:

The fact that liabilities to foreigners is in US Dollars is advantageous to the United States not because of the usual reasons given but because the liabilities do not suffer from revaluation losses if the dollar depreciates. But only advantageous at best. Not more.

Enough stories over many future blogs.

bfn.

The Quick Rise And Fall Of Keynesianism

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Welcome to my blog!

This blog post is about the Great Recession, the imbalances which led to it, the use of Keynesian principles by governments of all nations to prevent a deep implosion and how and why the Keynesian mini-revolution didn’t last long. Suddenly, nobody is asking Are We Keynesians Now? and the economics profession has lost lines of communications with governments. Like a Guns ‘N Roses song that goes

What we’ve got here is failure to communicate, some men you just can’t reach.

Will it take another crisis to revive Keynesianism? While, the author is a die-hard Keynesian, he believes that fiscal policy alone cannot resolve the crisis. Governments are aware of this but government officials give only vague replies when taken to task.

The blog in general is/will be about an approach which has roots in the New Cambridge approach to studying economies and how it can be applied to find political economic solutions to put the world in a sustainable path of growth and achieve full employment. It is also about about the Post-Keynesian theory of Endogenous Money and the Stock Flow Coherent Approach. Using the blogosphere as a medium to satiate my crave to put forth my understanding of how economies work, I aim to make a difference. Post-Keynesians emphasize that monetary economies function differently from the chimerical neoclassical story and money cannot but be endogenous. I plan to take the reader into how the monetary and financial system works, the role of various sectors (individuals and institutions) in a demand-led process, their behaviour and what can be done to reverse sectoral imbalances that have built up. 

Why Keynesianism was short-lived in the Great Recession is a difficult question to tackle in a single post. Before the 1970s, for many years, the world was run using Keynesian principles and suddenly it fell apart. To me, the situation right now is very reminiscent of what went on during the 70s and the 80s (I am not that old!).

Francis Cripps wrote this brilliantly in a 1983 article What Is Wrong With Monetarism [1]

The conclusion which has to be drawn is that, if a modern economic system is to function properly, a mechanism is required for the management of aggregate demand. Now it happens that the need for management of aggregate demand within a closed national economy can be met rather easily. It is easily met because national economies have an institution called the state which is unique in that it has virtually unlimited powers of credit creation or borrowing (or would have within a closed national economy). Keynesians gave up at this point, thinking that once the need for demand management had been pointed out, and the possibility for demand management by a national government had been understood, the problem of demand management was solved once and for all. Unfortunately, there is no such thing as the state in the contemporary international economy at the international level and the absence of the state as such at the international level is, I believe, a sufficient explanation of why the world economy has run into serious problems of recession …

… The important point is rather that in an international economy the possibilities of national demand management are strictly limited. They are limited by problems of balance of payments adjustment and international finance. Governments that wish to regulate national demand so as to sustain full employment run into problems of increasing trade deficits and, in economics with liberal exchange regimes, loss or confidence and outflows of capital. It is actual or potential balance of payments crises which have been decisive in breaking the habit or Keynesian demand management at the national level. Many national governments are still trying but they are trying under difficulties and they are frightened of balance of payments problems that would result if they tried too hard.

Further, as Francis Cripps concluded, in that brilliant article,

… [U]ntil the economists in our society get around to tackling this problem, we risk being stuck with periods of long recession, even if we are occasionally and accidentally favoured with periods of world boom.

In the book From Keynesianism To Monetarism: The Evolution Of UK Macroeconometric Models [2], Peter Kenway writes:

… There is, however, a greater sense in which the development of the Cambridge Group in that period is more important than the model that came to represent them. That sense stems from the historical significance of those ideas…. the ideas were therefore more ‘anti-Keynesian’ than ‘Keynesian’… what makes the anti-Keynesian views of the 1970s Cambridge Economic Policy Group so significant is that they grew out of the very heart of Keynesianism itself …

… On the one hand, as far as the goals it espoused are concerned, of full employment, of steady growth and of government’s responsibility to pursue these ends, the Group’s commitment to Keynesianism never wavered. But on the other hand, as far as the practice of Keynesianism was concerned, and especially the conceptualization of the reasons for the increasing and evident failure of that practice, the Policy Group not only was part of, but in some respects actually led the revolution against Keynesianism in the UK …

(No) Conclusion

Think my blog posts should be short, but this being the introduction needed to longer. Come back for some Kaldorian Monetary Economics!

References

  1. Francis Cripps, What Is Wrong With Monetarism, pp 55-68, Monetarism Economic Crisis And The Third World, ed. Karel Jansen, Frank Cass, 1983.
  2. Peter Kenway, p 92, From Keynesianism To Monetarism: The Evolution Of UK Macroeconometric Models, Routledge, 1994 (2011 reprint).