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Nicholas Kaldor On Floating Exchange Rates

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Martin Wolf has a nice new column on imbalances creating troubles for the UK economy in the Financial Times: What a floating currency gives and what it does not.

Why are current account deficits a haemorrhage in the flow of circular income? Weak external trade performance implies a drain in demand and hence pressure on the path to full employment and also that fiscal policy has to give in: else public debt and net indebtedness to foreigners keep rising relative to output which cannot be sustained for long. This means that if an individual nation or the world as a whole needs reflation, drastic changes need to made on how the world is run – especially using a system of regulated international trade rather than a system of free trade.

Nicholas Kaldor had a lot of change of mind about exchange rates during his lifetime. In the introduction to Volume 6 of his collected essays Further Essays On Applied Economics, he has a lot to say about his views.

Nicky Kaldor also had a paper The Relative Merits Of Fixed Exchange And Floating Rates – a memorandum as an economic adviser to the Chancellor in 1965 in which he was arguing for the merits of floating the exchange rates. In page xiii from introduction to Further Essays On Applied Economics he confesses:

The strategy advocated in my 1965 paper “The Relative Merits of Fixed and Floating Exchange Rates” thus proved in practice futile …

… So the policy which I advocated in the 1960s and developed at greater length in my 1970 Presidential Address to the British Association, of reconciling full employment growth with equilibrium in the balance of payments through adjusting the relationship between import and export propensities by a policy of continuous manipulation of the exchange rate, proved in the event a chimera. The main reason for this was that (along with most economists) I greatly overestimated the effectiveness of the price mechanism in changing the relationship of exports to imports at any given level of income. The doctrine that exports and imports are kept in balance through induced changes in their relative prices is as old and deeply ingrained as almost any proposition in economics.

So there you have it – realising his mistake earlier than anyone else.

He goes on further to drive this point:

… In other words, what the Harrod theory asserts is that trade is kept in balance by variations of production and incomes rather than by price variations: a proposition which implies that the income elasticity of demand of a country’s inhabitants for imports and those of foreigners for its exports are far more important explanatory variables than price elasticities.

which is essentially saying that it is non-price competitiveness which is far more important than price competiveness.

Further …

… If the Harrod theory provides the realistic explanation of the underlying forces which maintain the trade flows of an industrial exporter in balance (subject, of course, to the exceptions to this rule in the shape of long-term surplus and deficit countries, which must be capable of being explained in the same framework) this also carries the implication that the relationship of import propensities to exports will be relatively insensitive to such variations of relative prices as can be accomplished by monetary or exchange rate policies.

This latter implication (though discussed in the 1930s) seems to have got lost when the debate on fixed versus flexible exchange rates flared up again in the 1960s. This explains perhaps the exaggerated hopes placed on variations in exchange rates as an instrument of the “adjustment process” in international trade and payments and, for Britain in particular, on a system of “managed floating” as a means of securing higher and stable growth rates.

Again he later emphasises his learning:

… I was convinced that once exchange rates are freed from the rigidities imposed by Bretton-Woods, the forces of cumulative causation which made some countries grow fast and others slowly will no longer operate, or not in the same manner. That belief was so badly shaken by experience of subsequent years for for reasons explained in my most recent paper on the subject, which is discussed below.

James Tobin said it best once:

I believe that the basic problem today is not the exchange rate regime, whether fixed or floating. Debate on the regime evades and obscures the essential problem.

Of course that doesn’t mean one ties both shoes together and irrevocably fixes exchange rates (and give up the government powers to make drafts at the central bank) but the essential problem referred above – although gets diluted – doesn’t go away outside a monetary union.

… One Funeral At A Time?

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Eine neue wissenschaftliche Wahrheit pflegt sich nicht in der Weise durchzusetzen, daß ihre Gegner überzeugt werden und sich als belehrt erklären, sondern vielmehr dadurch, daß ihre Gegner allmählich aussterben und daß die heranwachsende Generation von vornherein mit der Wahrheit vertraut gemacht ist.

Translation: A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.

– Max Planck.

The variant of this is “Science advances one funeral at a time.”

Margaret Thatcher passed away today but Thatcherism still survives and dominates policy debates. So perhaps Max Planck doesn’t seem to apply to economics yet in a straightforward way.

The best opposition to Thatcherism came from Cambridge. In a small book based on speeches in the House of Lords (1979-1982) The Economic Consequences Of Mrs Thatcher and devoted entirely to pin-pointing the fundamental errors of Thatcherism, Nicholas Kaldor wrote in this in a chapter titled The Economics of the Primitive (18.3.81), page 83:

The belief that public expenditure must be cut in order to balance the budget, which is clearly held passionately by Mrs Thatcher and her immediate associates, derives from an anthropomorphic conception of economics. Primitive religions are anthropomorphic. They believe in gods which resemble human beings in physical shape and character. Mrs Thatcher’s economics is anthropomorphic, in that she believes in applying to the national economy the same principles and rules of conduct as have been found appropriate to a single individual or a family – paying your way, trimming your expenditure to fit your earnings, avoiding living beyond your means and avoiding getting into debt. These are well-worn principles of prudent conduct for an individual  but when applied to policy prescriptions to a national economy they lead to absurdities.

If an individual cuts his expenditure he will not thereby reduce his income. However, if  a Government cut their public expenditure programme in relation to tax rates and charges, they will reduce the total spending in the economy and hence the total production and income. It will reduce the revenue yielded by existing taxes and it will cause public expenditure on unemployment benefits and on the support of firms in trouble, and other similar items, to rise. It is a policy that is appropriate only in times of excess demand and over-full employment, as was the case with Crippsian austerity after the war. At a time like now, with 2½ million unemployed, far from being a recipe for prudent housekeeping and future prosperity it is a recipe for ruin. To keep tightening the budget in the hope of  ‘balancing the books’ is to keep reducing the output and income of the nation and hence to fail to balance the books as tax yields shrink and expenditures to support the disintegrating economy increase.

The word “prudent” still survives to this day and perhaps heard more often, in politicians’ and central bankers’ speeches, research reports of financial markets’ “experts” and in the media and in rating agencies pressuring government to tighten fiscal policy.

Update: Here is John Boehner repeating Thatcherism on Twitter:

click to view on Twitter

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

Mario Draghi – Euro Saviour?

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Recently Mario Draghi, the European Central Bank President, has been going around telling everyone that “fiscal consolidation” is the absolutely essential to resolve the Euro Area crisis, given some positive developments. Although, this view of his is known and this has had a big influence on policy, he has become more and more vocal about it in recent weeks. He has also signalled a “positive contagion” – a phrase he seems to have coined.

Here is Mario Draghi talking at the recent annual conference at Davos to John Lipsky. (Link no longer works)

If Draghi is to be believed, “fiscal consolidation” is an absolute necessity for the Euro Area to come out of the crisis.

In a recent press conference from January 10, Draghi said the same:

Question: Could Outright Monetary Transactions (OMTs) lose their magical effect in the markets if no country asks for them?

Second question: Jean-Claude Juncker has said that too much fiscal consolidation could have a negative effect on countries like Spain, because unemployment is so high. What can you say about that?

Draghi: On your first question, you do not have to ask me, ask the markets.

On the second, many comments of this type have been made about several countries in the euro area. My answer to this is that so much progress has already been made, accompanied by so many enormous sacrifices. So reverting to a situation which has been found to be untenable would not be right. We should not forget that this fiscal consolidation is unavoidable, and we certainly are aware that it has short-term contractionary effects. But now that so much has been done I do not think it is right to go back.

[emphasis: mine]

Back in July 2012, when Spanish government bond prices were plunging, Mario Draghi came up with a plan to save the Euro Area by first announcing on July 26 in a conference in London that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” and after a pause, “And believe me, it will be enough.”. In the monetary policy meeting on September 6, he outlined a plan by the Eurosystem to buy government bonds without any ex-ante quantitative limits, provided the nations asking this facility agree to terms and conditions – mainly on fiscal policy.

This was greeted with great optimism and the “state of confidence” of the financial markets greatly improved in the next few months. Mario Draghi eventually became the FT Person Of The Year. The fact that nations have a backstop meant that the financial sector has been more willing to finance the governments and the nations actually haven’t felt the need to use the facility so far.

At the time, there was an urgent need to do something and the European Central Bank responded positively to prevent a financial and economic collapse.

While the condition that governments asking for the ECB’s help have to meet is unavoidable for any such plan, Mario Draghi seriously misunderstands the nature of the problem. While it is true that there needs to be structural reforms so that struggling Euro Area countries become more competitive relative to their partners and aim to improve their exports to reduce imbalances within the Euro Area, a Euro-Area wide fiscal contraction will fail to achieve this in any sustainable way. Structural reforms aka wage cuts, will further deflate demand in those nations as Michal Kalecki taught us.

Take Spain for example. Its current account is coming back to balance but this has been the result of a huge deflation of domestic demand and no wonder its unemployment rate hit 26% recently. Statements such as “fiscal consolidation is unavoidable” put all the burden on weaker nations. The Euro Area actually needs a fiscal expansion in creditor nations and although a relatively tighter fiscal policy in the debtor nations compared to creditor nations, an expansion compared to the present state nonetheless. In the long term it needs to form a political union – not like the ones floated by European leaders.

The weaknesses of the Euro Area going forward has been highlighted by Charles Goodhart in a recent appearance in the Economic and Financial affairs session of the UK Parliament. Here is the link to the video.

Also, in December 2012, Draghi and the EU leaders presented a plan Towards A Genuine Economic And Monetary Union. Again this approach has the same errors as the plans floating around since decades and debunked by Nicholas Kaldor in 1971 in one of the most prescient articles ever written.  See this post Nicholas Kaldor On European Political Union. The European leaders are seriously mistaken to think of any of their plans as “genuine”.

Somehow, the Monetarist counterrevolution of the 1970s seems to have forever distorted the vision of economists and economic advisers to politicians even if they do not think they are Monetarists.

Origins Of The Sectoral Balances Identity

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I thought I should share what I found recently about who was to state the sectoral balances identity first – since it comes across as enlightening to say the least. I found the identity in Nicholas Kaldor’s 1944 article Quantitative Aspects Of The Full Employment Problem In Britain. It was published as Appendix C to Full Employment In A Free Society by William Beveridge.

(If you find the mention of this identity anywhere before, please let me know!)

Here’s a Google Books screenshot of the page:

The article also appears in Kaldor’s Collected Essays, Vol 3 (Chapter 2, pp. 23-82).

The ‘net’ is net of consumption of fixed capital. Also ‘balance of payments’ is used for the current balance (footnote 1, page 28). (In The Scourge Of Monetarism, Kaldor used ‘net saving’ as saving net of investment).

Anthony Thirlwall wrote a biography of Kaldor in 1987 and he mentions that Kaldor kept pushing the implications of the identity in the 1960s (page 251). He managed to convinced some of his colleagues such as Wynne Godley and Francis Cripps and pick up public fights with others such as Richard Kahn.

Wynne Godley recalled how he came to appreciate this identity in his book Monetary Economics with Marc Lavoie. In Background Memories (W.G.) he wrote:

… In 1970 I moved to Cambridge, where, with Francis Cripps, I founded the Cambridge Economic Policy Group (CEPG). I remember a damascene moment when, in early 1974 (after playing round with concepts devised in conversation with Nicky Kaldor and Robert Neild), I first apprehended the strategic importance of the accounting identity which says that, measured at current prices, the government’s budget deficit less the current account deficit is equal, by definition, to private saving net of investment. Having always thought of the balance of trade as something which could only be analysed in terms of income and price elasticities together with real output movements at home and abroad, it came as a shock to discover that if only one knows what the budget deficit and private net saving are, it follows from that information alone, without any qualification whatever, exactly what the balance of payments must be. Francis Cripps and I set out the significance of this identity as a logical framework both for modelling the economy and for the formulation of policy in the London and Cambridge Economic Bulletin in January 1974 (Godley and Cripps 1974). We correctly predicted that the Heath Barber boom would go bust later in the year at a time when the National Institute was in full support of government policy and the London Business School (i.e. Jim Ball and Terry Burns) were conditionally recommending further reflation! We also predicted that inflation could exceed 20% if the unfortunate threshold (wage indexation) scheme really got going interactively. This was important because it was later claimed that inflation (which eventually reached 26%) was the consequence of the previous rise in the ‘money supply’, while others put it down to the rising pressure of demand the previous year …

Joe Stiglitz’s Presentation On Global Imbalances

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I came across this presentation of Joe Stiglitz (from INET earlier this year) today as someone referred to it on Facebook. I think I may have referred to it earlier. Stiglitz is certainly one of the better economists in mainstream. The presentation is at Business Insider with the title Joe Stiglitz’s Presentation On Why The Entire Global Economic System Is Doomed To Fail – which I think was a nice heading!

The world is severely imbalanced as a result of the promotion of free trade and this has led to debtor exhaustion (borrowing words from Stiglitz). Deficit nations are in a position where they cannot expand domestic demand unilaterally because sooner or later they will run into a balance-of-payments crisis. Surplus nations on the other hand are showing no inclination to do fiscal expansion. Till now the United States was acting as an “importer of the last resort” or a “demander of the last resort” and this allowed the world to grow. But faced with its own balance of payments problems, it is not easy for the United States to grow. The rising public debt (as a counterpart of the rising net indebtedness of the United States to the rest of the world caused due to the United States’ balance of payments) will not be promoted by the Federal Reserve – the exorbitant privilege of the United States has become a burden. This is not to say that fiscal policy will not help the United States but it cannot alone bring the nation back to full employment.

I absolutely love Nicholas Kaldor and I saw some nice things in the presentation (emphasized by Kaldor such as “learning by doing”), promoting industrial policy in the developing world and modifying the rules of the game for the world trade to allow nations to take unilateral action to prevent imbalances from getting out of hand (last slide in the presentation). Kaldor himself (and his “New Cambridge” group) had advocated import controls for the United Kingdom in the late 70s/early 80s.

Kaldor had an articulate way to put his ideas across. Here’s from his 1981 article The Role Of Increasing Returns, Technical Progress And Cumulative Causation In The Theory Of International Trade And Economic Growth (from his Collected Papers, Vol 9):

Traditional theory, both classical and neoclassical, asserts that free trade in goods between different regions is always to the advantage of each trading country, and is therefore the best arrangement from the point of view of the welfare of the trading world as a whole, as well as of each part of the world taken separately. [footnote: The latter part of this proposition abstracts from the possibility that a particular country possesses some degree of monopoly power and thereby can turn the terms of trade in its favour by means of a tariff even after retaliation by other countries is taken into account.] However, these propositions are only true under specific abstract assumptions which do not correspond to reality. Under more realistic assumptions unrestricted trade is likely to lead to a loss of welfare to particular regions or countries and even to the world as a whole – that is to say that the world will be worse off under free trade than it could be under some system of regulated trade …

… Owing to increasing returns in processing activities (in manufactures) success breeds further success and failure begets more failure. Another Swedish economist, Gunnar Myrdal, called this ‘the principle of circular and cumulative causation’.

[italics in original]

Although there are some right things Stiglitz says about international imbalances, he emphasizes monetary policy more than fiscal policy (something all mainstream economists do) and also suggests a global reserve system (the kind proposed by Keynes with a World Central Bank and all that). Economists have to wake up to the fact that monetary policy has a limited role to play and it is fiscal policy which matters. The idea of a world central bank won’t work – as emphasized by Kaldor (in the 60s!) because it would necessarily involve surrendering political sovereignty – governments won’t give each other unlimited credit lines to each other in such a system. (More on Kaldor and the world central bank some other time).

I have some commenters contacting me on the “About” and “Aspiration” pages on this blog recently and I thought this blog post should make my position clear that free trade makes everyone worse off. A closely related claim here (which will be defended again and again) is that over the long run, exports are the only source of autonomous demand. Because some nations get ahead of the others, this puts a severe handicap on others and new rules of the game is the only way out to prevent the general state of stagnation in the world economy (in between occasional periods of booms). Hence the title of the blog “Concerted Action”!

Happy Diwali!

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Happy Diwali to my Indian (and also non-Indian) readers!

Diwali is a celebration of the triumph of good over evil.

Reminds of this:

I think I had best begin by making my own position clear – I regard ‘monetarism’ as a terrible curse, a visitation of evil spirits, with particularly unfortunate, one could say devastating, effects on our country, Britain. The biological process of natural selection should make for the development of favourable traits in human character – and that includes the acceptance of ideas and beliefs that promote progress and the rejection of ideas that have the opposite effect. As we all know this is not, unfortunately, either a smooth or a continuous process – it proceeds by fits and starts. The religion of most societies contains the basic dualism between god and evil spirits, between angels and devils, between the purveyors of good advice and the purveyors of bad advice. The choice between them is often represented as a moral issue whereas it is more truly a matter of flair and intuition which sometimes works and sometimes does not. Decadence, according to Nietzsche, is a state in which the individual intuitively goes for the bad solutions for getting out of difficulties, and fails to pick out good ones.

The alarming thing is not that some people should hold crackpot ideas. The alarming thing is when crackpot ideas sweep the board – when they capture the minds of a wide selection of important and influential people. This has been the case with the rapid spread of monetarism among academics, journalists, bankers and politicians in the last five to ten years. It has also been the case with the rapid spread of racialism, the mass conversions of Fascist or Nazi ideas and ideals in the 1920s and 30s; and no doubt many other examples could be given. Ultimately the devil fails – at least this has been the case hitherto, otherwise we should not be here. But the cost is sometimes horrendous – whether through wars, revolutions or the misery and agony inflicted by mass unemployment, loss of opportunities, loss of skills or even loss of knowledge and know-how.

– Nicholas Kaldor, Origins Of The New Monetarism, 1981

Nicholas Kaldor On European Political Union

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It is sometimes said that a fiscal union would be the best solution to the Euro Area crisis – perhaps it is the only solution. Indeed while the German leaders Angela Merkel and Wolfgang Schäuble have been trying to promote “more Europe” to achieve this objective, their plan is still defective since it is likely to be based on old plans of a political union.

The idea that the Euro Area needs a political union was known from before – as mentioned by the Werner Report from 1971. Nicholas Kaldor wrote an article in the same year (In The Dynamic Effects Of The Common Market first published in the New Statesman, 12 March 1971 and also reprinted (as Chapter 12, pp 187-220) in Further Essays On Applied Economics – volume 6 of the Collected Economic Essays series of Nicholas Kaldor) highlighting the serious defects in the plan.

See my post Nicholas Kaldor On The Common Market. In the post I missed out Kaldor’s important points about the plan for the fiscal union itself.

If the leaders of Europe are proposing to have a plan such as in the Werner report, then Europe is in more trouble. “What is not envisaged is that the main responsibility for public expenditure and taxation should be transferred from the national Governments to the Community.” According to Kaldor, this is bound to fail for reasons mentioned below.

This fault was also noted by Philip Arestis and Malcolm Sawyer recently in their article The Dangers Of Pseudo Fiscal Union In The EMU.

I am reproducing here the relevant section of Kaldor’s essay (pp. 202-207) for the sake of completeness:

THE CONSEQUENCES OF A FULL ECONOMIC
AND MONETARY UNION

The events of the last few years – necessitating a revaluation of the German mark and a devaluation of the French franc – have demonstrated that the Community is not viable with its present degree of economic integration. The system presupposes full currency convertibility and fixed exchange rates among the members, whilst leaving monetary and fiscal policy to the discretion of the individual member countries. Under this system, as events have shown, some countries will tend to acquire increasing (and unwanted surpluses) in their trade with other members, whist others face increasing deficits. This has two unwelcome effects. It transmits inflationary pressures emanating from some members to other members; and it causes the surplus countries to provide automatic finance on an increasing scale to the deficit countries.

Since exchange-rate adjustments or “floating rates” between members are held to be incompatible with the basic aim of economic integration (and are incompatible also with the present system of common agricultural prices fixed in international units) the governments of the Six, at their Summit meeting in The Hague in December 1969, agreed in principle to the creation of a full economic and monetary union, and appointed a high-level committee (the so-called “Werner Committee”) to work out a concrete programme of action.

The Werner Committee’s recommendations have not yet been adopted in detail, though its principal objectives have been confirmed by the Community’s Council of Ministers.

The realisation of economic and monetary union, as recommended in the Werner Report, involves three kinds of measures, each introduced in stages: monetary union, tax harmonisation, and central community control over national budgets.  It envisages a three-stage programme, with each stage lasting about three years, so that the whole plan is designed to be brought into operation by 1978-80.

In the monetary field in the first stage the interest and credit policy of each central bank is increasingly brought under common Community surveillance and permitted margins of variations between exchange rates are reduced or eliminated. In the second stage exchange rates are made immutable and “autonomous parity adjustments” are totally excluded. In the third stage the individual central banks are abolished altogether, or reduced to the status of the old colonial “Currency Boards” without any credit creating power. [footnote: Different currencies (marks, francs, etc.) might be nominally retained so long as each currency has always a 100 per cent. backing in terms of the Community’s reserve currency.]

In the field of tax harmonisation it is envisaged that each country’s system should be increasingly aligned to that of other countries, and that there should be “fiscal standardisation” to permit the complete abolition of fiscal frontiers, which means not only identical forms but also identical rates of taxation, particularly in regard to the value added tax and excise duties.

In the field of budgetary control the Werner Report says “the essential elements of the whole of the public budgets, and in particular variations in their volume, the size of balances and the methods of financing or utilizing them, will be decided at the Community level”.

What is not envisaged is that the main responsibility for public expenditure and taxation should be transferred from the national Governments to the Community. Each member will continue to be responsible for raising the revenue for its own expenditure (apart from the special taxes which are paid to finance the Community’s own budget but which will remain a relatively small proportion of total public expenditure and mainly serve the purposes of the Agriculture Fund and other development aid).

And herein lies the basic contradiction of the whole plan. For the Community also envisages that the scale of provision of public services (such as the social services) should be “harmonised” – i.e., that each country should provide such benefits on the same scale as the others and be responsible for financing them by taxation raised from its own citizens. This clearly cannot be done with equal rates of taxation unless all Community members are equally prosperous and increase their prosperity at the same rate as the other members. Otherwise the taxation of the less prosperous and/or the slower-growing countries is bound to be higher (or rise faster) than that of the more prosperous (or faster-growing) areas. [footnote: A further reason for differences in the burden of taxation necessary to provide a given level of service lies in differences in demographic structure – e.g., some countries have a larger proportion of pensioners or schoolchildren than others.]

The Community will control each member country’s fiscal balance – i.e., it will ensure that each country will raise enough in taxation to prevent it from getting into imbalance with other members on account of its fiscal deficit. To ensure this the taxes in the slow growing areas are bound to be increased faster; this in itself will generate a vicious circle, since with rising taxation they become less competitive and fall behind even more, thereby necessitating higher social expenditures (on unemployment benefits, etc.) and more restrictive fiscal policies. [footnote: It is for this reason that in most countries it has been found necessary to transfer a rising population of social expenditure (on poor relief, education, roads etc.) from local authorities to the Central Government, and to supplement an increasing proportion of local tax revenues by grants from the Centre (such as the rate-equalisation grants in the U.K.).] A system on these lines would create rapidly growing inequalities between the different countries, and is bound to break down in a relatively short time. [footnote:  To imagine the consequences one should ask what would happen if the inhabitants of each county in the U.K. were required to finance all their social expenditure by local taxes. Living in Cumerland would be enormously penalised; living in Surrey would be a tax haven.]

This is only another way of saying that the objective of a full monetary and economic union is unattainable without a political union; and the latter pre-supposes fiscal integration, and not just fiscal harmonisation. It requires the creation of a Community Government and Parliament which takes over the responsibility for at least the major part of the expenditure now provided by national governments and finances it by taxes raised at uniform rates throughout the Community. With an integrated system of this kind, the prosperous areas automatically subside the poorer areas; and the areas whose exports are declining obtain automatic relief by paying in less, and receiving more, from the central Exchequer. The cumulative tendencies to progress and decline are thus held in check by a “built-in” fiscal stabiliser which makes the “surplus” areas provide automatic fiscal aid to the “deficit” areas.

Even so, there is need for special regional policies – such as the U.K. differential grants and subsidies to the development areas – to alleviate the problems of growing regional inequalities. The need for the latter is recognised (in a vague way) in the Werner Report, which mentioned “community measures which should primarily concern regional policy and employment policy” and whose “realization would be facilitated by an increase in financial intervention at the Community level”. What the Report fails to recognise is that the very existence of a central system of taxation and expenditure is a far more powerful instrument for dispensing “regional aid” than anything that special “financial intervention” to development areas is capable of providing.

The Community’s present plan on the other hand is like the house which “divided against itself cannot stand”. Monetary union and Community control over budgets will prevent a member country from pursuing full employment policies on its own – from taking steps to offset any sharp decline in the level of its production and employment, but without the benefit of a strong Community government which would shield its inhabitants from its worst consequences.

Some day the nations of Europe may be ready to merge their national identities and create a new European Union – the United States of Europe. If and when they do, a European Government will take over all the functions which the Federal government now provides in the U.S., or in Canada or Australia. This will involve the creation of a “full economic and monetary union”. But it is a dangerous error to believe that monetary and economic union can precede a political union or that it will act (in the words of the Werner report) “as a leaven for the evolvement of a political union which in the long run it will in any case be unable to do without”. For if the creation of a monetary union and Community control over national budgets generates pressures which lead to a breakdown of the whole system it will prevent the development of a political union, not promote it.

But it would be also dangerous to dismiss the Werner Report on the ground that it is not likely to be implemented, particularly if Britain is inside the Community and will have a voice in deciding what happens. For the problems that led to The Hague decisions and to the Werner Report are genuine enough: the framework of institutions and arrangements which make up the present European Community do not constitute a viable system. The Community must either go forward towards full integration (via a political union) or else relax the rigidity of its present arrangements, particularly in regard to agriculture and exchange rates. And it would be hopeless for Britain to join the Community not knowing whether it wishes to move in one direction or the other.

[italics in original, boldening mine]

Nicholas Kaldor On The Common Market

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… Some day the nations of Europe may be ready to merge their national identities and create a new European Union – the United States of Europe. If and when they do, a European Government will take over all the functions which the Federal government now provides in the U.S., or in Canada or Australia. This will involve the creation of a “full economic and monetary union”. But it is a dangerous error to believe that monetary and economic union can precede a political union or that it will act (in the words of the Werner report) “as a leaven for the evolvement of a political union which in the long run it will in any case be unable to do without”. For if the creation of a monetary union and Community control over national budgets generates pressures which lead to a breakdown of the whole system it will prevent the development of a political union, not promote it.

[italics in original]

That was written in 1971! In The Dynamic Effects Of The Common Market first published in the New Statesman, 12 March 1971 and also reprinted (as Chapter 12, pp 187-220) in Further Essays On Applied Economics – volume 6 of the Collected Economic Essays series of Nicholas Kaldor.

Further excerpts from the article:

Page 202:

The events of the last few years – necessitating a revaluation of the German mark and a devaluation of the French franc – have demonstrated that the Community is not viable with its present degree of economic integration. The system presupposes full currency convertibility and fixed exchange rates among the members, whilst leaving monetary and fiscal policy to the discretion of the individual member countries. Under this system, as events have shown, some countries will tend to acquire increasing (and unwanted surpluses) in their trade with other members, whist others face increasing deficits. This has two unwelcome effects. It transmits inflationary pressures emanating from some members to other members; and it causes the surplus countries to provide automatic finance on an increasing scale to the deficit countries.

Page 205:

… This is another way of saying that the objective of a full monetary and economic union is unattainable without a political union; and the latter pre-supposes fiscal integration, and not just fiscal harmonisation. It requires the creation of a Community Government and Parliament which takes over the responsibility for at least the major part of the expenditure now provided by national governments and finances it by taxes raised at uniform rates throughout the Community. With an integrated system of this kind, the prosperous areas automatically subside the poorer areas; and the areas whose exports are declining obtain automatic relief by paying in less, and receiving more, from the central Exchequer. The cumulative tendencies to progress and decline are thus held in check by a “built-in” fiscal stabiliser which makes the “surplus” areas provide automatic fiscal aid to the “deficit” areas.

[italics in original]

Page 206:

…What the Report fails to recognize is that the very existence of a central system of taxation and expenditure is a far more powerful instrument for dispensing “regional aid” than anything that special “financial intervention” to development areas is capable of providing.

The Community’s present plan on the other hand is like the house which “divided against itself cannot stand”. Monetary union and Community control over budgets will prevent a member country from pursuing full employment policies on its own- from taking steps to offset any sharp decline in the level of its production and employment, but without the benefit of a strong Community government which would shield its inhabitants from its worst consequences.

page 192:

Myrdal coined the phrase of “circular and cumulative causation” to explain why the pace of economic development of the various areas of the world does not tend to a state of even balance, but on the contrary, tends to crystallise in a limited number of fast-growing areas whose success has an inhibiting effect on the development of others. This tendency could not operate if changes in money wages were always such as to offset difference in the rates of productivity increase. This, however is not the case; for reasons that are not perhaps fully understood, the dispersion in the growth of money wages as between different industrial areas tends always to be considerably smaller than the dispersion in productivity movements. It is for this reason that within a common currency area, or under a system of convertible currencies with fixed exchange rates, relatively fast-growing areas tend to acquire a cumulative competitive advantage over relatively slow growing areas. “Efficiency wages” (money wages divided by productivity) will, in the natural course of events, tend to fall in the former, relatively to the latter – even when they tend to rise in both areas in absolute terms. Just because the differences in productivity increases, the comparative costs of production in fast-growing areas tend to fall in time relatively to those in slow-growing areas and thus enhance their competitive advantage over the latter.

I don’t have the copyrights to reproduce the whole article The Dynamic Effects Of The Common Market, so this is so much I can quote. You can read the rest from the book (Collected Essays 6). Also, there are five chapters on the Common Market.

Kaldor’s Growth Plan

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Dani Rodrik has a Project Syndicate article titled No More Growth Miracles and in my view rightly identifies problems of the world economy, although has less to say how to resolve the crisis.

These were most well understood by Nicholas Kaldor (who was touched by genius in Wynne Godley’s words). In the previous post How To Find Nicholas Kaldor’s Works, I recommended his Rafaelle Matiolli Lectures which appeared in a book form titled Causes Of Growth And Stagnation In The World Economy.

The lectures were given in May 1984.

In the fifth and final lecture Kaldor – who understood the shortcomings of Keynesian economics – after having lectured on the causes of growth and stagnation in the world economy, summarizes the situation (page 86):

The fact that OPEC (as a group) is now in deficit on its current balance, and that Britain’s current account surpluses have virtually disappeared while the United States is in a large deficit, makes it a great deal easier for other developed countries to expand their economies than at any time since 1973. But there is still need for coordinated action, at least among the members of the European Community. As the French example has shown, an expansionary budget which is out of line with the fiscal stance of the other main countries of the group, quickly gets a country into serious payments difficulties owing to the resulting imbalance in trade.

But – as is the case now – and even back then policy makers meet and don’t do much ….

The lack of agreement on the fundamental lines of a policy for economic recovery is acutely felt, and the need for it is shown by the increasing frequency of inter-Governmental meetings at various levels: the next world summit meeting in which the heads of the leading western powers all participate is due to take place in London in a few weeks’ time.

If, by some miracle, this summit meeting, unlike all its predecessors, resulted in a constructive programme of recovery, what should its main provisions contain? I should like to end this series of lectures by suggesting the outline of a world-wide agreement on the necessary policies for recovery. The programme could be summed up under four main heads:

In present times, there are very few – in my opinion – who recognizes what needs to be done. Kaldor continues:

1. The first is coordinated fiscal action including a set of consistent balance of payments targets and “full employment” budgets [footnote]. If this does not prove to be politically feasible, it is inevitable that the growth of unemployment will sooner or later force governments to take measures that would make it necessary for them to expand demand without being frustrated by the inevitable balance of payments consequence of expanding their economies relative to their trading partners. This means that there needs to be some form of restriction that would limit the increase in “competitive” imports to some target ratio in relation to exports. Trade liberalisation, which played such an important part in the rapid economic progress during the years of expansion, becomes a serious obstacle to economic recovery in the case of prolonged stagnation due to the inability of countries to achieve a coordinated set of policies. But, given a proper recognition of the problem, that under conditions of unrestricted free trade the actual volume of production and trade may in fact be considerably less than under some system of regulated trade – a system which relates the volume of imports in manufactures from a particular group of countries, such as the members of the EEC, to some mutually agreed ratio to the exports of individual members to the rest of the group – there is no reason why full employment should not be restored through policies of expansion, preferably directed by the expansion of State investment. This coordinated action by all countries, instead of isolated actions by each country, is the first and most important requirement of recovery.

Keynesians and others who have come to understand fiscal policy are however too late. A unilateral fiscal expansion by one country will soon lead to balance of payments problems for it with the result that fiscal policy has to give in and become endogenous sooner or later. (Such is the case with India now, for example). So fiscal expansions need to be coordinated with other countries.

Also there is a footnote suggesting how the endogeneity of the budget deficit is commonly misunderstood:

Footnote: At present all countries have fairly large deficits in the general government budget, but these are largely the consequence of the low level of activity. On a “full employment” basis they would show a highly restrictive picture – they would show surpluses and not deficits. Contrary to appearances, the requirement of stability is for expansionary budgets with lower taxes and higher expenditure, and not further fiscal restriction (as is advocated, for example, by M. de Larosiere of the International Monetary Fund).

Point 2 is about bringing interest rates to as low as possible and this we already have in the present crisis. Point 3 is about stabilization commodity prices and point 4 about the problem of inflation which was more troublesome in the past due to trade unions’ bargaining.

Point 1 is the most important and relevant to the current scenario. Over the years, credit-led growth led to a boom which finally went bust but leaving the world with more “global imbalances”. Economists and politicians wish to resolve the crisis without giving up the doctrine of free trade. At least there is a pressure from the developed world to maintain status quo in spite of resistance from the developing world. As a recent article Protectionism Alert from The Economist recognizes, there is a tendency to move toward more protectionism in practice however which the magazine wishes to alert to the world – so that it is noted and steps taken beforehand to prevent it and free trade is pushed even more.

It should be noted that Kaldor’s plan is more than “coordinated fiscal expansion”. It is also about managing trade instead of relying on market forces. As argued by his “New Cambridge” colleagues, and stated by Kaldor, this will not lead to a decrease in world trade but actually an increase because of higher national output and income!

The first head of the programme is indeed what the world needs at the moment.

One of the listeners of his lectures was Mario Monti! More interestingly, Monti has a question to ask on this plan of Kaldor.

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