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Recommended Readings

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The crisis has a lot of connections with the way Macroeconomics was done in the 1970s and this interests me a lot. Of course the equally important reason was that Nicholas Kaldor and Wynne Godley were highly involved in the public discussions. Here are some books I collected which have special importance to the Cambridge Economic Policy Group (CEPG):

I could manage to only get used copies of the first two books.

The book has the paper New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, by Martin Fetherston and Wynne Godley and comments by others such as Alan Blinder – which I mentioned in the post Debt Monetization. The book is also available from Wiley but you have to pay $500+ for it!

This one got the title right – it wasn’t Keynesianism versus Monetarism. It was New Cambridge versus Keynesianism versus Monetarism.

The following book by Peter Kenway was first published in 1994 but was republished recently because the crisis has deep roots with debates in the 1970s!

It has nice discussions about the various types of income/expenditure models of the 1970s in the UK with a lot on the CEPG. It gives nice lists of all models – some of them here (via amazon.com preview):

Here’s a short autobiography by Wynne Godley (written around 1999) on how he dissented from the profession. Here’s a Google Books preview from the book A Biographical Dictionary of Dissenting Economists edited by Philip Arestis and Malcolm C. Sawyer

click to view on Google Books

I like this:

 … I had extraordinary difficulty in understanding, not the sentences, but what real life state of affairs mainstream ‘neoclassical’ macroeconomics could possibly be held to be describing. I went through the standard textbooks on macroeconomics and then back to the underlying professional literature (the locus classicus being, as I now see it, Modigliani. 1944 and 1963). I taught myself how to draw the diagrams and solve the equation systems, but for years could not make any connection between these and the real world as I knew it…

One of the things which made Godley dissenting was the proposal to control imports as the paper title suggests:

(click for link to the journal)

This was met with huge hostility as a Times article (from the late 70s) shows. Economists confused it as “selective protectionism”:

(click to enlarge and click again)

Sovereignty In The Euro Area

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Nouriel Roubini tweets about Trichet’s plan to save the Euro Zone and wonders about sovereignty:

click to view the tweet on Twitter

Two things:

My guess is Trichet’s plan involves a Euro Area institution setting fiscal policy. Trichet’s plan seems to involve some set of technocrats taking control of fiscal policy of a weak nation and then deflating domestic demand and hence not solving anything at all or making it worse. Here it is – clear from the following:

For the European Union, a fully fledged United States of Europe where nation states cede a large chunk of fiscal authority to the federal government appears politically unpalatable, Trichet said.

An alternative is to activate the EU federal powers only in exceptional circumstances when a country’s budgetary policies threaten the broader monetary union, he said.

Secondly, Nouriel Roubini thinks it “undermines national sovereignty” but the Euro Area nations had given this up long back! So while Euro Area nations surrendered sovereignty long back,  Trichet’s plan involves removing more powers from governments without the possibility of those nations receiving fiscal equalization in return!

Trichet’s plan hence has a “central government” with no fiscal authority! There was no sovereignty to begin with and no institution taking up the sovereignty either.

The Man Who Saw Through The Euro had a profound way of looking at how economies function. Wynne Godley already understood in 1992 that by joining the Euro Area, nations surrender their sovereignty. In his article 20 years back Maastricht And All That, Godley said:

But there is much more to it all. It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues.

and that:

… I recite all this to suggest, not that sovereignty should not be given up in the noble cause of European integration, but that if all these functions are renounced by individual governments they simply have to be taken on by some other authority. The incredible lacuna in the Maastricht programme is that, while it contains a blueprint for the establishment and modus operandi of an independent central bank, there is no blueprint whatever of the analogue, in Community terms, of a central government.

and also that:

If a country or region has no power to devalue, and if it is not the beneficiary of a system of fiscal equalisation, then there is nothing to stop it suffering a process of cumulative and terminal decline leading, in the end, to emigration as the only alternative to poverty or starvation.

In an article Commonsense Route To A Common Europe in 1991 in The Observer, Godley said:

If we are to proceed creatively towards EMU, it is essential to break out of the vicious circle of ‘negative integration’— the process by which power is progressively removed from individual governments without there being any positive, organic, all-European alternative to transcend it. The nightmare is that the whole country, not just the countryside becomes at best a prairie, at worst a derelict area.

The Monetary Economics Of Sovereign Government Rating

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If a government (outside monetary unions) can make a draft at the central bank, why do rating agencies rate governments’ creditworthiness?

In this post, I will attempt to describe the dynamics of defaults and restructurings by going through some monetary economics of open economies.

Carmen Reinhart and Kenneth Rogoff wrote a book in 2009 titled This Time Is Different: Eight Centuries Of Financial Folly or simply This Time Is Different arguing that governments do indeed default – both in debt denominated in the domestic and foreign currencies. They blame the public debt and the government for the public debt – hence giving the innuendo that governments across the planet should attempt to cut public debt by tight fiscal policies. This is an illegitimate conclusion – on which I will say more below.

At another extreme are the Chartalists who argue that the government cannot “run out of money” and hence fiscal policy has no monetary constraints. Sometimes they qualify this statement by saying that the currency they are discussing are “sovereign currencies”. Now, there are various definitions of what a sovereign currency is but it is frequently pointed out by them that nations who have seen restructuring of government debt did not have a “sovereign currency” – because the currency is either pegged or fixed or it is the case that the government had a lot of debt in foreign currency which presumably allows defaults/restructuring of government debt in the domestic currency as well. The motivation behind this is Milton Friedman’s idea that nations should freely float their currencies in international markets and that markets will clear and that the State intervention in the currency markets can only make things worse. Hence Reinhart/Rogoff don’t prove them wrong – according to them – since the situations are supposedly different.

We will see that while there is some truth to it, the notion of a “sovereign currency” is highly misleading. Such intuitions are coincident with the incorrect notion that indebtedness to foreigners (in domestic currency) is just a technical liability and there’s nothing more to that!

Here’s S&P’s article on the methodology it uses to assign ratings on governments: Standard & Poor’s – Sovereign Government Rating And Methodology. One can see the importance it gives to the external sector. However, S&P does not provide a mechanism on how a government will finally end up defaulting. The purpose of this post is to look into this.

Before this let us make a connection between the public debt and the net indebtedness of a nation. Most people in the planet confuse the two. The former is the debt of the government whereas the latter is the (net) indebtedness of the nation as a whole. This is the net international investment position (adjusting for traditional settlement assets such as gold) with the sign reversed. This can be obtained by consolidating all the sectors of an economy and the consolidation involves (for example) netting of the assets of the domestic private sector held abroad and also its gross indebtedness to the rest of the world.

So one can think of two extremes:

  1. Japan – with a high public debt of about 195% of gdp (includes just the central government debt),  while being a net creditor of the world. It’s NIIP is about 50% of gdp (data source: MoF, Japan)
  2. Australia – with a low public debt of 18% of gdp and NIIP of minus 59% of gdp.

So in the case of Japan, while the government is a huge debtor, the nation as a whole is a creditor, whereas in the case of Australia, it is the opposite. So the rating agencies get it wrong or opposite!

Let us first assume a closed economy. The greatest starting point in analyzing economies is the sectoral balances approach. For a closed economy it is:

NAFA = DEF

where NAFA is the Net Accumulation of Financial Assets of the private sector and DEF is the government’s budget deficit. If the private sector wants to accumulate a lot of financial assets, and the government wants to run the economy near full employment, the public debt will be higher, the higher the propensity to save, for example. (This is not as straightforward as presented here but can be shown in a simple stock-flow consistent model). So unlike what neoclassical economists think, the level of public debt is somewhat irrelevant. Neither does the government has too much trouble in financing its debt because the public debt is the mirror image of the private sector net financial asset position.

Now let us take the case of an open economy. The sectoral balances identity now is

NAFA = DEF + CAB

A deficit in the current account implies an increase in the net indebtedness to foreigners. Unless the markets miraculously clear with the exchange rate adjusting to bring the CAB in balance, a deficit in the current account implies the nation as a whole has to attract foreigners to finance this deficit i.e., via a lower NAFA or higher DEF. In the long run, the private sector is accumulating financial assets (or has small positive NAFA) and the whole of the current account balance is reflected in the public sector balance.

So the debate fixed vs floating doesn’t help too much. A relaxation of fiscal policy may spill over into higher imports with the public debt and the net indebtedness to foreigners keeps rising forever to gdp. Hence nations typically have to curb growth to bring the current account into balance.

An excellent reference for this is New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, 1978, by Martin Fetherston and Wynne Godley.

This is theory. So let’s look at an open economy mechanism of an event of default by the government as a story.

In the following, I will use the phrase “pure float” instead of the dubious terminology “sovereign currency”.

Here’s the simplest model:

In the above, a nation with its currency on a pure float and with zero official sector liabilities in foreign currencies has a somewhat weak external position in 2012. Now, according to some of the Neochartalist arguments this nation can’t default on its government debt. However this is a wrong conclusion as the scenario above hightlights. In the scenario constructed, the balance of payments position weakens over the years (and I have mentioned that roughly in 2020 it weakens). In 2022, foreigners are no longer willing to finance the debt. This may be due to a capital flight or due to the inability of the banking system to maintain a low net open position in foreign currency. The depreciation of the domestic currency isn’t sufficient to clear the fx markets and the official sector (either the central bank or the government’s treasury) necessarily has to intervene in the foreign exchange markets by issuing debt denominated in foreign currency. The government is then acting as the borrower of the last resort and the objective is to use the proceeds to partially have more foreign exchange reserves and/or to sell the foreign currency proceeds from the debt issuance to clear the fx markets. The government is then left with a net liability position in the foreign currency. Soon the external situation worsens to the point requiring official foreign help – such as from the IMF – which promises to help and requires a restructuring of the debt both in domestic and foreign currencies.

Free marketers have a blind belief in the markets and the theories are built on the assumption that markets always clear. The recent crisis has highlighted that this isn’t the case. Even for the case of Australia – whose currency can be considered closed to being pure float – has had issues in the external sector and the Reserve Bank of Australia had to borrow in US dollars from the Federal Reserve (via swap lines) to help Australian banks meet their foreign currency funding needs during the crisis.

Of course the above is not typical but to prevent the external vulnerability to go out of control, governments keep domestic demand low and a lot of times, they over-do this.

The point of the exercise is to prove that it is not meaningless to think of nations becoming bankrupt in whichever situation one can think of and it doesn’t help to laugh at the rating agencies and make fun of them – possibly with the exception for the case of Japan. Statements such as “government with a sovereign currency cannot become bankrupt” are simply misleading. In the above, the Chartalists would argue that the currency was not sovereign and they were not wrong about the default but the currency was sovereign in their own definition in 2012!

Here are some comments on some nations.

Japan: As mentioned above, Japan is a net creditor of the rest of the world and partially as a consequence of that, most of the Japanese government’s debt is held internally. The rating agencies are aware of this but in spite of this continue to make comments on the creditworthiness of the Japanese government. It is possible that residents may transfer funds abroad for unknown reasons (which the raters for some reason suspect) but it may require just a minor interest rate hike to prevent this from happening. Japan has a relatively strong external situation and hence has no issues in financing its government debt.

Canada: Nick Rowe of WCI mentioned to me on his blog that worrying about the balance of payments constraint is like “beating a dead horse” – citing the example of Canada which has floated its currency and it seems has no trouble with its external sector. But this ignores other things in the formulation of the problem. Canada is an advanced nation and an external situation which is not weak. However, a growth of the nation much faster than the rest of the world will lead to a worsening of the external situation. To some extent the nation’s external situation has been the result of its relatively better competitiveness of exporters compared to its propensity to import and a demand situation which either as a conscious attempt of demand management of the government or by pure fluke has helped its external situation remain non-vulnerable.

United States: The US dollar is the reserve currency of the world and slowly over time, the United States has turned from being a creditor of the rest of the world to becoming the world’s largest debtor nation. (Again not due to its public debt but because of its net indebtedness to foreigners). The US external sector is a great imbalance and any attempt to get out of the recession by fiscal policy alone will worsen its external situation leading to a crash at some point. S&P is right! So to come out of the depressed state, the nation has to complement fiscal expansion with improvement of the external situation such as by (and not restricted to) asking trading partners to not revalue their currencies. Still for some reasons bloggers at the “New Economic Perspectives” think that

… Bernanke also knows that the US has infinite ability to finance these fiscal components, that there is no solvency issue and that the policy rate and both ends of the yield curve are under the direct control of the Fed.

Back to This Time Is Different. While Reinhart and Rogoff’s analysis of government debt may be useful, their conclusions can be destructive for the world as a whole. The domestic private sector of a nation needs continuous injection from outside so that it can run surpluses in general and tightening of fiscal policies will lead to a depression. Global imbalances is crucial in understanding the nature of this crisis (and not public debt alone) and even coordinated attempts to reflate economies may provide only a temporary relief. Since failure in international trade restricts the growth of nations and their attempts to reach full employment, what the world needs is an entirely different way to run the economies under managed trade with fiscal expansion. Ideas of “free trade” such as that outlined here by Alan Blinder simply help some classes of society at the expense of others because it relies on the “market mechanism” which has failed over and over again.

This brings me to “sovereignty”. As argued, the concept “sovereign currency” is almost vacuous (except highlighting the problems of the Euro Area) but sovereignty as argued by Wynne Godley in his great 1992 article Maastricht And All That and by Anthony Thirlwall in the same year on FT (my post on it here Martin Wolf Pays A Generous Tribute To Anthony Thirlwall) definitely have great importance. Some of Thirwall’s concepts of economic sovereignty in the article were: the ability to protect and encourage strategic industries, the possibility of designing systems of managed trade to even out payments imbalances, the ability to protect against certain countries with persistent surpluses, differential taxes which discriminate in favour of the tradeable goods sector.

Debt Monetization

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Let us take the public sector budget equation:

G – T = ΔH + ΔB

Inspired by Milton Friedman’s popularity in the 1970s and the 80s, most textbooks and journal articles incorrectly claim that the central bank “controls” the money stock (such as M0, M1, M2 etc). Simultaneously they also claim – rightly – that the central bank targets the short term interest rates.

Recently, Alan Blinder – formerly Vice Chairman of the Federal Reserve Board – said this in New York Times’ Room For Debate (h/t wh10):

Remember “conventional” monetary policy? The Federal Reserve shortens recessions by creating more bank reserves (“printing money”), which fuels a multiple expansion of the money supply and credit because banks don’t want to hold excess reserves. So they get rid of them making more loans and deposits, which also lowers short-term interest rates. Compare that to current reality: Banks are content to hold over $1.6 trillion in excess reserves, short-term interest rates are stuck near zero, and Fed policy often works on long-term interest rates instead. No, this is not your father’s monetary policy, and the old ways of teaching about it simply won’t do.

Einstein declared that everything should be made as simple as possible, but not more so. The crisis has made the “but not more so” part more important.

Alan Blinder is a good economist, but I guess the best way to put it is that the usual story is pure fantasy.

(To be a bit technical, let us assume – in what follows – till the next section that the central bank is targeting overnight interest rates using a corridor system)

Apart from the chimerical money multiplier story, neoclassical economists also bring in the government’s budget into the story. So the story goes that if the government wants to increase its expenditures, it will sooner or later ask the central bank to “monetize” its deficit. So the government’s Treasury and the central bank can decide the proportion of the deficit which is financed by issuing H (high-powered-money or currency notes and reserves/bank settlement balances) and B (government bills and bonds). This – higher issuance of H will cause a sequence of events involving higher private expenditure inevitably resulting in price rise and higher inflation in this story.

In my post Open Mouth Operations, I discussed two kinds of open market operations – temporary and permanent. As we saw, when the private sector needs more currency notes, the central bank must neutralize this outflow by engaging in permanent open market operations. The central bank just targets/sets the short term interest rates and simply cannot be anything but defensive.

Neoclassical economists however, think of this as purely being decided by the central bank (or the central bank acting under pressure by the government) and the process is called debt monetization. Since this involves purchases of government bonds, debt monetization is a process of purchases of government bonds by the central bank (directly from the government or in open markets) in order to increase the stock of money.

We however saw that this decision of the central bank is based purely on the private sector’s needs for currency or banks’  need for higher reserves/settlement balances and the central bank must act defensively.

This was understood well by members of the “New Cambridge” School and some of their critics. In an article attempting to show the full working of their model, New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, 1978, Martin Fetherston and Wynne Godley say:

… It will further be assumed that domestic monetary policy involves supplying cash and bonds in whatever amounts necessary to maintain private (and overseas) portfolio equilibrium at given (i.e., baseline) rates of interest…

This was from a conference Public Policy In Open Economies and Alan Blinder understood this – in a reply to the New Cambridge model, Whats New And Whats Keynesian In The New Cambridge Keynesianism (same link as above) he said:

Fiscal policy can, therefore, have no immediate effect on these asset demands. (It has a longer-run effect through raising net wealth.) The central bank monetizes just enough government debt to keep interest rates from rising, so there can be no “crowding out.”

on the New Cambridge model. i.e., as we move forward in time, because the private sector has higher wealth, the Bank of England will purchase government debt depending on how much of this wealth the private sector wants in the form of money.

Hence we can say that monetization is endogenous. So if the central bank purchases more government bonds than it is supposed to, banks will have more settlement balances and the central bank’s target will fall to the lower end of the corridor and will be forced to sell bonds in equal quantities. The description of the corridor and floor systems can be found in the post Open Mouth Operations.

The Floor System And Central Bank Large Scale Asset Purchases

In recent times (since the last three years), central banks especially the Federal Reserve – who have adopted a floor system – have been purchasing a lot of domestic government bonds in the open markets (and also other securities such as “agency debt” and “agency MBS”). This is also called “QE”, and it’s a bad phrase. However does this mean the private sector has “excess money”? The private sector’s wealth allocation decision depends on its portfolio preferences between various forms of wealth and since purchases also lead to a reduction of long term government bond yields (as compared to the case when the asset purchase program hadn’t been carried out) and hence the private sector wishes to hold less of its wealth in the form of government bonds and more in the form of money – hence sold the bonds the Federal Reserve intends to buy!

Of course the result is that banks have more central bank reserves than they wish to hold, but as a whole the banking system won’t convert these settlement balances into currency notes unless the non-bank private sector wishes to hold them. If the non-bank private sector needs more currency notes, banks will easily accommodate this need and so will the central bank and this need is not a function of how much settlement balances the banking system holds. And it won’t cause price rises either because “money” doesn’t lead to inflation. The strategy of the central banks in reducing long term bonds comes with asking the banks to hold the settlement balances for some time (and keeping them happy by paying interest on the reserves) and the Federal Reserve may sometime phase out the program by an “exit strategy”. However this has nothing to do with “inflation expecations” or some chimerical story about runaway inflation waiting to happen.

The Federal Reserve’s strategy has been to create more demand by reducing long term rates so that depending on the interest elasticity (as opposed to income elasticity) of investment by the private sector and/or its animal spirits, there may be higher activity. But since income elasticity effects are stronger, the LSAP hasn’t really worked as desired.

Private expenditure depends mainly on private income and LSAPs do not directly affect private expenditure. There can be indirect effects due to portfolio preferences – because LSAPs may induce the private sector to purchase other asset classes such as corporate equities leading to a rise in stock prices, leading to wealth effects via capital gains. Hence we see a lot of references to James Tobin’s work in central bank papers on this.

There were other effects which didn’t work as desired – such as refinancing of existing mortgages due to lower interest rates and this leading to extra demand because it was thought that households will be able to refinance in huge numbers and this will lead to higher consumption because they will spend the difference they gain due to lower monthly outflows to the banking system.

Of course, none of this has anything to do with the fantasy story that there is an excess of money appearing out of nowhere and which will be eliminated via higher expenditures resulting in a permanent price rise and fantasy stories such as that.

To summarize, stories around money leading to inflation, excess money due to central bank government debt purchases etc have all led to tragic debates around macroeconomic issues.

Here’s from Marc Lavoie’s Changes In Central Bank Procedures During The Subprime Crisis And Their Repercussions On Monetary Theory (working paper here):

The financial crisis has made these features of the real world even more obvious and it should make clear that nearly all of mainstream monetary theory as applied to central banking is nearly worthless, as is for instance the infamous money multiplier fable and the presumed causal relationship running from bank reserves at the central bank to price inflation.

Also, while central bankers simply did not know that a crisis was going to hit but did good work (in my opinion) in preventing an implosion of the financial system, there is simply no need to congratulate them for having purchased government debt such as as done by Paul McCulley here and as done by Adair Turner here at the recent INET conference. Their arguments sound something like: central banks prevented a deflation of prices by purchasing government debt!

SMP

A qualification needs to be made in the above analysis on the purchases of Euro Area governments’ debt by the Eurosystem under the ECB’s Securities Markets Progam (SMP). Here some government debt markets have/had the potential to become “dysfunctional” (ECB’s phrase) and NCBs purchase(d) government bonds in the secondary markets to prevent government bond yields from rising forever as a result of a self-fulfilling prophecy of financial markets and its inability to absorb government debt because of suspicions that some governments could become insolvent in the long run. This is useful because it just postpones the day of reckoning or buys some time to reach an economic state of lower activity to keep some Euro Area nations’ net foreign indebtedness in check.

The ECB website and communications stress that these operations are being “sterilized” and hence keeps price stability in check but the explanation is right if there is a Monetarist causality from money to prices!

Seven Unsustainable Processes – Original

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Of all the economists, Wynne Godley had the rarest of rare ability to model and imagine the economic dynamics of the whole world. “… a full macroeconomic model in his head, which, by some sort of subconscious process, he computed.” as his obituary from FT said.

In the recent INET conference paper, Dirk Bezemer discusses Wynne Godley’s approach (among others’) and also refers to his paper Seven Unsustainable Processes from 1999.

I obtained this original scanned copy of the paper Seven Unsustainable Processes – Medium Term Policies For The United States And The World by Wynne Godley from 1999 from the Levy Economics Institute and  thought that since this version is missing for some reason from the levyinstitute.org website, I’ll post it here (after asking them if I may post).

Click to see the pdf.

Seven Unsustainable Processes from 1999

Here’s the link to the updated version of the paper from the year 2000. The original had a typo. Two columns in Table 1 appeared with incorrect headings (should have been the reverse).

Wynne Godley at the Levy Institute

Godley warns of the private sector indebtedness:

… Moreover, if, per impossibile, the growth in net lending and the growth in money supply growth were to continue for another eight years, the implied indebtedness of the private sector would then be so extremely large that a sensational day of reckoning could then be at hand.

Wynne Godley never liked the chimerical and primitive view of economists where anything and everything is traded in the markets via supply and demand. So,

The difference between the consensus view and that put forward here could not exist without a profound difference in the view of how the economy works. So far as the author can observe, the underlying theoretical perspective of the optimists, whether they realize it or not, sees all agents, including the government, as participants in a gigantic market process in which commodities, labor, and financial assets are supplied and demanded. If this market works properly, prices (e.g., for labor and commodities) get established that clear all markets, including the labor market, so that there can be no long-term unemployment and no depression. The only way in which unemployment can be reduced permanently, according to this view, is by making markets work better, say, by removing “rigidities” or improving flows of information. The government is a market participant like any other, its main distinguishing feature being that it can print money. Because the government cannot alter the market-clearing price of labor, there is no way in which fiscal or monetary policy can change aggregate employment and output, except temporarily (by creating false expectations) and perversely (because any interference will cause inflation).

No parody is intended. No other story would make sense of the assumption now commonly made that the balance between tax receipts and public spending has no permanent effect on the evolution of the aggregate demand. And nothing else would make sense of the debate now in full swing about how to “spend” the federal surplus as though this were a nest egg that can be preserved, spent, or squandered without any need to consider the macroeconomic consequences.

The seven unsustainable processes were:

(1) the fall in private saving into ever deeper negative territory, (2) the rise in the flow of net lending to the private sector, (3) the rise in the growth rate of the real money stock, (4) the rise in asset prices at a rate that far exceeds the growth of profits (or of GDP), (5) the rise in the budget surplus, (6) the rise in the current account deficit, (7) the increase in the United States’s net foreign indebtedness relative to GDP.

As it happened, the United States went into a recession but recovered quickly because of further deregulations and low interest rates which led to more borrowing, and a fiscal stimulus which put a floor on the downfall. However, the private sector went back into deficits and its indebtedness kept rising relative to income. The current balance of payments also went deeply in deficit rising to about 6.43% at the end of 2005 – hemorrhaging the circular flow of national income at a massive scale. See the related post here: The Un-Godley Private Sector Deficit.

Not only did Godley see the crisis coming, he also figured out that the United States will soon run into policy issues and will have less room to come out of a crisis. In this 2005 strategic analysis paper The United States And Her Creditors – Can The Symbiosis Last? he and his collaborators (Dimitri Papadimitriou, Claudio Dos Santos and Gennaro Zezza) pointed out that:

The range of strategic policy options for the United States is beginning to narrow … As the normal equilibrating forces (changes in exchange rates) are being subverted, it is very far from obvious what the United States can do on her own …

In his last ever article, Prospects For The United States And The World – A Crisis That Conventional Remedies Cannot Resolve (from which I got the subtitle of my blog!), Godley and collaborators (Dimitri Papadimitriou and Gennaro Zezza) said:

The prospects for the U.S. economy have become uniquely dreadful, if not frightening. In this paper we argue, as starkly as we can, that the United States and the rest of the world’s economies will not be able to achieve balanced growth and full employment unless they are able to agree upon and implement an entirely new way of running the global economy.

Stressing the need for concerted action (from which I got the title of my blog!), the authors said:

… Fiscal policy alone cannot, therefore, resolve the current crisis. A large enough stimulus will help counter the drop in private expenditure, reducing unemployment, but it will bring back a large and growing external imbalance, which will keep world growth on an unsustainable path …

… What must come to pass, perhaps obviously, is a worldwide recovery of output, combined with sustainable balances in international trade. Since this series of reports began in 1999, we have emphasized that, in the United States, sustained growth with full employment would eventually require both fiscal expansion and a rapid acceleration in net export demand. Part of the needed fiscal stimulus has already occurred, and much more (it seems) is immediately in prospect. But the U.S. balance of payments languishes, and a substantial and spontaneous recovery is now highly unlikely in view of the developing severe downturn in world trade and output … By our reckoning (which is put forward with great diffidence), if the United States were to attempt to restore full employment by fiscal and monetary means alone, the balance of payments deficit would rise over the next, say, three to four years, to 6 percent of GDP or more—that is, to a level that could not possibly be sustained for a long period, let alone indefinitely …

… It is inconceivable that such a large rebalancing could occur without a drastic change in the institutions responsible for running the world economy—a change that would involve placing far less than total reliance on market forces.

G&L’s Monetary Economics – Second Edition

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I got my copy of Monetary Economics by Wynne Godley and Marc Lavoie yesterday. I know some people were waiting for the second edition of the book, and had postponed their purchase to get the newer edition – so they can get it now!

There aren’t any changes in this edition – except for correction of some typos and that this edition is a paperback while the first one was hardcover. I already knew this as Marc Lavoie told me “don’t buy it” – but of course how can I not!

One thing I noticed is a nice summary by Wynne Godley which he wrote after the first edition was published.

Here’s an autograph from Marc Lavoie I got last year in May – live to tell!

I hope I live up to it 🙂

The first time I saw something called the Transactions Flow Matrix in a Levy Institute paper, I rushed to buy the book. When I started reading it, it became clear that nobody has ever come close to it! After a while – and solving the models on a computer gives one greater intuition – it slowly started becoming clear to me why so much effort has been put in.

Wynne Godley always wanted to write a textbook to help others understand Cambridge Keynesianism, as he often thought that while top economists from Cambridge knew how economies work together, they never attempted to share this knowledge. I think his aim was also to sharpen his own knowledge and to think of scenarios which one may not be able to foresee using simple arguments.

With this aim, he made a first attempt with his partner at “New Cambridge”, Francis Cripps.

I really like this from the book’s introduction:

… Our objective is most emphatically a practical one. To put it crudely, economics has got into an infernal muddle. This would be deplorable enough if the disorder was simply an academic matter. Unfortunately the confusion extends into the formation of economic policy itself. It has become pretty obvious that the governments of many countries, whatever their moral or political priorities, have no valid scientific rationale for their policies. Despite emphatic rhetoric they do not know what the consequences of their actions are going to be. Moreover, in a highly interdependent world system this confusion extends to the dealings of governments with one another who now have no rational basis for negotiation.

This was a great book but didn’t receive much attention except for a small group who thought (rightly!) it was a work of genius. He wanted to do more and so we see him mention in an article on him – praising his prescience on writing the fate of the British economy on the wall in the 70s and the 80s. Here’s from the Guardian:

… What I’m doing is abolishing economics as currently understood, conducting an enormous sanitary operation upon a very clogged profession. I’m going to push a dose of salts through that system. It is a ruthless application of logic and accountancy to macroeconomics.

(click to enlarge and click again)

When Wynne Godley lost the partnership of Francis Cripps (whom Wynne called the smartest Economist he ever met), he was forced to do a lot of things himself and probably felt somewhat alone. After writing some amazing papers in the 1990s, he needed someone like Cripps to write a book. Fortunately he met Marc Lavoie and they collabrated for many years in writing papers and articles and finally the book.

Marc Lavoie recalls the memories in this article from the Godley conference last year.

In an article A Foxy Hedgehog: Wynne Godley And Macroeconomic Modelling – reviewing the book and Wynne Godley’s models, Lance Taylor says:

The fox knows many things, but the hedgehog knows one big thing.

… Surely someone who puts so much effort into one complicated construct is more like Plato than Aristotle, Einstein than Feynman, Proust than Joyce.

Open Mouth Operations

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In the previous post Is Paul Krugman A Verticalist?, I discussed the confusions economists and market commentators have on open market operations. Even top economists such as Krugman suffer from confusions on central banking and monetary matters.

I also mentioned the work of Alfred Eichner on bringing out more clarity on the defensive nature of open market operations. Let’s look at these matters more closely.

Before this let’s look at what people in general think. Most people think of open market operations as some kind of extra activity on the part of the central bank in collaboration with the bureau of engraving and printing and think of it as operational implementation of Milton Friedman’s helicopter drops! So when a central bank such as the Federal Reserve changes its target on interest rates – such as lowering the “Fed Funds target rate”, people start commenting as if the Federal Reserve is undertaking a mystical operation.

This is Monetarist or Verticalist intuition. It is easy to show that open market operations have nothing to do with fiscal policy and as we saw in the previous blog – very little with monetary policy itself. The open market operation of the central bank is not an income/expenditure flow such as government expenditure flows or tax flows and the former does not affect the net worth of the change the net worth of either the domestic private or the foreign sector. Hence it is hardly fiscal. Yet commentators and economists keep arguing that the central bank is “injecting money” into the economy!

Even Paul Krugman erred on some of these matters and was shown how to do good economics by Scott Fullwiler in his post Krugman’s Flashing Neon Sign. Missing everything Fullwiler was saying, Krugman wrote another post A Teachable Money Moment which has the following diagram:

Below we will see how Krugman’s Neoclassical/New Keynesian (whichever) intuition is flawed.

Setting Interest Rates

These matters (the public understanding) have become worse ever since the Federal Reserve and other central banks around the world started purchasing government debt in the open markets on a large scale – in programs called Large Scale Asset Purchases (also called “QE”). In the following I will consider cases when there is no “asset purchase program” by the central bank and tackle this issue later in another post.

A simple case to highlight how a central bank defends an interest rate (as opposed to changing it) is considering the corridor system. There target for overnight rates is usually at the midpoint of this “corridor”. At the lower end of the corridor banks get paid interest on their settlement balances they keep at the central bank while at the upper end it is the rate at which the central bank lends.

Because banks settle among each other on the books of the central bank, this gives the latter to fix the short-term rates and indirectly influence long term rates.

Why do banks need to settle with each other?

One of the first economists to understand the endogenous nature of money was Sir Dennis Holme Roberston who used to work for the Bank of England. In 1922, he wrote a nice book simply titled Money.

 From page 52:

. . . If A who banks at bank X pays a cheque for £10 to B who banks at bank Y, then Bank Y, when it gets the cheque from B, will present it for payment to Bank X: and bank X will meet its obligation by drawing a cheque for £10 on its chequery at the Bank of England. As a matter of fact, the stream of transactions of this nature between big banks is so large and steady in all directions that the banks are enabled to cancel most of them out by an institution called the clearing-house:  but the existence of these chequeries at the Bank of England facilitates the payment of any balance which it may not be possible at the moment to deal with in this way …

Because banks finally settle at the central bank finally, central banks have learned since their creation that they can set interest rates. This is strongest at the short end of the “yield curve” but directly or indirectly central banks also influence long term rates.

At the end of each day, some banks will be left with excess of settlement balances (if they see more inflows than outflows) and some banks will face the opposite situation. Because they need to satisfy a reserve requirement at the central bank (which can be zero as well), some banks would need to borrow funds from others. Borrowing means paying back with interest and this is where the central bank’s ability to target rates comes enters the picture.

For suppose some bank X needs funds and other banks wish to lend bank X at a very high interest rate. In this scenario bank X can simply borrow from the central bank, while other banks who demanded higher interest will see themselves with excess settlement balances earning less than the target rate. So it would have been better for the latter to have lent than keep excess balances. (Of course the qualifier is that these things are valid under scenarios when there is less stress on the financial system). Also with the same logic, the rate at which banks lend each other will not fall below the corridor because it will be foolish of a bank to have lent settlement balances to another bank when it could have earned higher by just keeping excess settlement balances at the central bank.

Here is a diagram from the post Corridors And Floors In Monetary Policy from FRBNY’s blog which explains central bank’s operations:

The other system as per this post is the floor system – in which the central bank’s target is the interest paid on settlement balances itself, rather than the midpoint of any corridor. This is what has been followed by the US Federal Reserve in recent times.

Back to the corridor system, an important question arises. Hopefully the reader is convinced that the overnight rate at which banks lend each other is between the corridor. However it is still unclear how and why the central bank can keep it at the midpoint.

If the central bank and the bankers understand the system well, it is possible for the central bank to be quite perfect in this. This happens for example in the case of Canada, where the bank is quite accurate in its objective.

The reason is that the central bank can easily add and subtract settlement balances by various means.

Take an example. Suppose the interest on reserves is 2.25%, the target is 3.00% and the discount rate – the rate at which the central bank lends overnight – 3.75%. If the central bank observes that banks are lending each other at 3.25% – slightly away from the target of 3.00%, it can simply create excess balances. Among the many ways, there are two –

  1. purchase/sale of government securities and/or repurchase/reverse repurchase agreements.
  2. shifts of government deposits from the central bank account into the Treasury’s account at banks or the opposite.

So the central bank knows how the curve in the figure above looks like and adds/subtracts settlement balances by the above methods (mainly). So banks are lending each other at 3.25%, the central bank will add settlement balances; if they are lending each other at 2.75% – the central bank will drain settlement balances.

More generally the “threat” by the central bank is reasonably sufficient to make banks lend at the target!

Open Mouth Operations

Let us suppose the central bank had been targeting 3.00% for three months now and decides to decrease rates.

What does it do?

Almost nothing!

The announcement itself will make banks gravitate toward the new target!

In his paper Monetary Base Endogeneity And The New Features Of The Asset-Based Canadian And American Monetary Systems, Marc Lavoie says:

When they [central banks] are not accommodating—that is, when they are pursuing “dynamic” operations as Victoria Chick (1977, p. 89) calls them—central banks will increase (or decrease) interest rates. As shown above, to do so, they now need to simply announce a new higher target overnight rate. The actual overnight rate will gravitate toward this new anchor within the day of the announcement. No open-market operation and no change whatsoever in the supply of high-powered money are required.

Hence the term “open mouth operations” which was coined by Julian Wright and Greame Guthrie in their paper Market-Implemented Monetary Policy with Open Mouth Operations.

Open Market Operations

The above paper by Marc Lavoie is an excellent source for open market operations and looking at central banking from an endogenous money viewpoint.

I mentioned in the previous post that the open market operations are defensive. In my analysis in this post till now, I ignored the factors which cause settlement balances of the banking sector as a whole to change. Let us bring in this complication.

Apart from banks, the Treasury – the domestic government’s fiscal arm – and other institutions such as foreign central banks, governments and international official institutions (such as the IMF) also keep an account at the (domestic) central bank. When these institutions transact, there is an addition/subtraction of banks’ settlement balances at the central banks.

Here’s one example. Suppose the Treasury transfers funds of $1m to a contractor for settlement of a project done by the latter. When the funds are transferred, the contractor’s bank account increases by $1m and the bank in which he banks sees its deposits and settlement balances rise by $1m while the central bank will reduce the Treasury’s deposits by $1m.

This may lead to a deviation of banks’ lending rate to each other and the central bank needs to drain reserves. The central bank can achieve this by shifting government funds at a bank into the central bank account. If the central bank transfers $1m of funds, banks’ deposits and settlement balances reduce by $1m and the Treasury’s account at the central bank will increase by $1m.

This is not an “open market operation” but another way of adding/draining reserves. In general, depending on institutional setups, the central bank may also do purchase/sale of government securities and/or repurchase agreements.

But this has nothing to do with policy itself – rather it is to maintain status quo. (Of course “large scale asset purchases” is a slightly different matter – first one needs to understand the corridor system).

In other words, this is a defensive behaviour on part of the central bank.

Alfred Eichner

In the previous post and in Alfred Eichner And Federal Reserve Operating Procedures, I mentioned about the contribution of Eichner. In an essay in honour, Alfred Eichner, Post Keynesians, And Money’s Endogeneity – Filling In The Horizontalist Black Box, (from the book Money And Macrodynamics – Alfred Eichner And Post-Keynesian Economics) Louis-Philippe Rochon says:

For Eichner, the overall or “primary objective [of the central bank], in conducting its open market operations, is to ensure the liquidity of the banking system,” which applies to either the accommodating or defensive roles. In either case, Eichner argues that “the Fed’s open market operations are largely an endogenous response to . . . the need both to offset the flows into and out of the domestic monetary-financial system and to provide banks with the reserves they require”; that is, resulting from the demand for money and the demand for credit respectively (1987, 847, 851).

And while the accommodating argument has been debated at length by post-Keynesians, the defensive role has been virtually ignored and only recently rediscovered (see Rochon 1999). Yet it is certainly Eichner’s greatest contribution to the post-Keynesian theory of endogenous money. . .

. . . The “defensive” behavior is defined by Eichner as the “component of the Fed’s open market operations [consisting] of buying or selling government securities so that, on net balance, it offsets these flows into or out of the monetary-financial system,” leaving the overall amount of reserves unchanged. This is the result of changes in portfolio decisions and increases or decreases in bank (demand) deposits. As a result of an increase in the nonbank’s desire to hold currency, for instance, “in order to maintain bank reserves at the same level, the Fed will need to purchase in the open market government securities equal in value to whatever additional currency the nonbank public has decided to hold” (Eichner 1987, 847).

In making the distinction between temporary and permanent open market operations, Rochon also quotes Scott Fullwiler:

Outright or permanent open market operations are primarily undertaken to offset the drain to Fed balances due to currency withdrawals by bank depositors. . . . Temporary open market operations are aimed at keeping the federal funds rate at its target on average through temporary additions to or subtractions from the quantity of Fed balances. Temporary operations attempt to offset changes in Fed balances due to daily or otherwise temporary fluctuations in the Treasury’s account, float, currency, and other parts of the Fed’s balance sheet, in as much as is necessary to meet bank’s demand for Fed balances. (2003, 857)

Paul Krugman

All this is completely opposite of Paul Krugman’s position that

. . . And currency is in limited supply — with the limit set by Fed decisions.

And Krugman’s mistake is not minor – it seems he is completely unaware of the huge difference money endogeneity makes.

So what is the difference between Krugman’s diagram and the one from FRBNY blog – even though they look similar? The difference is that the latter is descriptive of behaviour when policy is unchanged and is useful for describing open market operations etc while Krugman uses the same to describe policy changes – which in reality happen via open mouth operations. Paul Krugman confuses open market operations and open mouth operations. So much for a “teachable money moment”.

Krugman also shows his Monetarist intuition by claiming:

And which point on that curve it chooses has large implications for the economy as a whole. In particular, the Fed can always choke off a private-sector credit boom by moving up and to the left.

implying that the central bank in reality controls the monetary base and thence the money stock.

Some Post Keynesians argued since long ago that the central bank cannot control the money stock:

Here’s on Wynne Godley from from The Times, 16 June 1978:

(click to enlarge)

More National Accounts: Consumption Of Fixed Capital

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In one of my recent posts, Saving Net Of Investment, I went into gross saving versus saving net of consumption of fixed capital. I showed how depreciation – or more appropriately, consumption of fixed capital – is treated in the flow of funds accounts.

Since the transactions flow matrix is a powerful tool for visualizing flow of funds, the question is where depreciation makes an appearance. The following table created by me using shows how for a simple economy.

FIGURE 1. Transactions Flow Matrix (click to enlarge)

Here “Firms” is a shorthand for all production firms as a sector and I took the consumption of fixed capital of firms only for illustration purposes. (Else I would have needed to break the households’ accounts into current and capital accounts – eating up space).

Investment here is gross investment and consumption of fixed capital makes its appearance in the line 3. It is a negative item in the current account and a positive item in the capital account. So it more of a book-keeping device but an important one because depreciation is not unimportant. The definition of profits is that of Wynne Godley and is slightly different from National Accounts. Also, while undistributed profits is a source of funds, CFC is also!

In my posts Net Worth and Net Worth: Part 2, I went into how net worth is defined. Also for a background on sources and uses of funds, see this post Sources And Uses Of Funds.

So undistributed profits (FU) and consumption of fixed capital (CFC) are both sources of funds. (Positive signs denote sources of funds and negative – uses of funds). This can be confusing because depreciation is a negative for net worth. The reason is that, as I have mentioned before, revaluations need to be done before end of period stocks are calculated. And it is where consumption of fixed capital will make a reappearance – subtracting from net worth due to a reduction in the value of nonfinancial assets.

It is important to keep in mind that equities are also sources of funds as the last line (above Σ) shows. So net saving (undistributed profits for firms) and consumption of fixed capital add to changes in net worth. (Note: Net is net of consumption of fixed capital here and not net of investment!).

This can be seen from the UK Blue Book 2011.

FIGURE 2.  UK Blue Book 2011 Accumulation Accounts (click to enlarge)

A Digression

What is the origin of the confusing phrase “net saving” – saving net of investment? I believe it came from Nicholas Kaldor himself who originated the sectoral balances approach. Here’s from The Scourge Of Monetarism, 1982, pp 48-50:

The PSBR in any year can be defined as the public sector’s net de-cumulation of financial assets (net dissaving) which by accounting identity must be equal to the net acquisition of financial assets (net saving) of the private sector, home and overseas; which in turn can be broken down to the net acquisition of financial assets of the personal sector, of the company sector, and the overseas sector (the latter is the negative of the balance of payments on current account).

Exorbitant Privilege

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My last post was on U.S. net income payments from abroad and how it continues to be in the favour of the United States. The late Wynne Godley had been analyzing this since 1994. In an article titled U.S. Trade Deficits: The Recovery’s Dark Side?, written with William Milberg, he had a section called “Foreign indebtedness and the foreign income paradox” where he said:

So far, the practical consequences of the United States having become “the world’s largest debtor” have not been all that significant… But it would be an error to suppose that, because the net return on net assets has been negligible in the recent past, the same thing will be true in the future…

… Why did the net foreign income flow remain positive for so long after 1988? In order to understand this apparent paradox, it is essential to disaggregate stocks of assets and liabilities and their associated flows, and to distinguish (in particular) between financial assets and direct investments… The reason that net foreign income remained positive for so long can now be understood (at least up to a point) by making a comparison of the flows shown in Figure 3 with the stocks shown in Figure 2. The net inflow that arises from direct investment has been roughly equal to the net outflow on financial assets in recent years, even though the stock of financial liabilities has been about five times as large as the market value of net foreign investments. In other words, the rate of return on net direct investments far exceeded the rate on net financial liabilities

Figure 2 referred to is below:

and Figure 3:

which is what I redrew with updated data in my previous post. But as we saw the net income payments from abroad continues to be positive (!!) even till date but the reason is similar. Foreign direct investment in the United States has risen to $2.8T at the end of 2011 as per Federal Reserve’s Z.1 Flow of Funds while U.S direct investment abroad rose to $4.8T – significantly higher (even as a percent of GDP) than in the mid-90s.

The net direct investment has seen huge returns (both via income and holding gains) and so this killing has brought in good fortunes for the United States. Of course with the whole current account of balance of payments in deficit, the external sector bleeds the circular flow of national income in the United States and contributes to weak demand there.

So a current account deficit is bad for the United States but financing this deficit has been easy for the United States given that the US Dollar is the reserve currency of the world. Why do nations require reserve assets? The late Joseph Gold of the IMF gave a nice description in his book Legal and Institutional Aspects of the International Monetary System: Selected Essays:

click to view on Google Books

What makes the US dollar the reserve currency of the world is difficult to argue. However it cannot be taken for granted that the United States may enjoy this exorbitant privilege given that the Sterling was once the darling of the financial markets and central banks.

After writing the previous post, I came across this interesting paper From World Banker To World Venture Capitalist – U.S. External Adjustment And The Exorbitant Privilege by Pierre-Olivier Gourinchas and Hélène Rey written in 2005.

Their argument is similar – direct investments have made huge returns for the domestic private sector of the United States and gives a good account of the external sector. Here’s a graph of the United States’ net international investment position using data reported by the Federal Reserve’s Z.1 Flow of Funds Accounts as well as the BEA’s International Investment Position:

Why the difference is a topic for another post. I don’t know it yet. Gourinchas and Rey have some answers. The Federal Reserve’s data is till 2011 end and quarterly (and seasonally adjusted) while BEA data is yearly and available till 2010.

So, from the graph above, the United States became a net debtor of the world around 1986. The indebtedness has been rising mainly due to the huge current account deficits the nation manages to run and is partly offset by “holding gains”.

Here’s a graph of the current account deficit plotted with other “financial balances” (since they are related by an identity)

I also discuss this in my post The Un-Godley Private Sector Deficit.

By the way, the U.S. was a creditor of the world when the Bretton Woods system of fixed exchange rates collapsed. Some authors describe this collapse by saying that money has become fiat since 1971 – whatever that means!

Gourinchas and Rey point out – correctly in my opinion:

The previous discussion points to a possible instability, even in an international monetary system that lacks a formal anchor. The relevant reference here is Triffin’s prescient work on the fundamental instability of the Bretton Woods system (see Triffin 1960). Triffin saw that in a world where the fluctuations in gold supply were dictated by the vagaries of discoveries in South Africa or the destabilizing schemes of Soviet Russia, but in any case unable to grow with world demand for liquidity, the demand for the dollar was bound to eventually exceed the gold reserves of the Federal Reserve. This left the door open for a run on the dollar. Interestingly, the current situation can be seen in a similar light: in a world where the United States can supply the international currency at will and invests it in illiquid assets, it still faces a confidence risk. There could be a run on the dollar not because investors would fear an abandonment of the gold parity, as in the 1970s, but because they would fear a plunge in the dollar exchange rate. In other words, Triffin’s analysis does not have to rely on the gold-dollar parity to be relevant. Gold or not, the specter of the Triffin dilemma may still be haunting us!

Gourinchas and Rey’s arguments depend on estimating a tipping point – the point where the net income payments from abroad turn negative. This of course depends on various assumptions but let us look at it.

The gross assets of the United States held abroad and liabilities to foreigners keep changing as the nation is able to increase its liabilities and use it to make direct investments abroad. The reserve currency status has provided the nation with this privilege as central banks around the world are willing to hold dollar-denominated assets. The positive return (as well as revaluation gains from the depreciation of the dollar – when it depreciates) helps reduce the net indebtedness but the current account deficit contributes to increasing it.

The following is the graph of gross assets and liabilities – using the Federal Reserve’s Z.1 Flow of Funds Accounts data and also BEA’s data for the ratio:

So assuming assets held abroad A make a return rA and liabilities L to foreigners lead to payments at an effective interest rate rL income payments from abroad will turn negative whenever

rA · A − rL · L < 0

So A and L are changing due to the current account deficits and revaluation gains on assets and liabilities. Meanwhile, the effective interest rates are themselves changing in time because of various things such as short term interest rates set by the central banks, market conditions, state of the economy etc. Also, if the private sector of the United States makes more direct investments abroad, this will contribute to increase rA (if successful) and the process can go on with net income payments from abroad staying positive for longer. The tipping point is defined by Gourinchas and Rey as the ratio L/A beyond which the the net income payments turn negative. According to their analysis (based purely on historical data), this is 1.30.

If the net income payments from abroad turns negative, international financial markets and central banks may start suspecting the future of the exorbitant privilege according to the authors. Of course, it may be the case that even if it turns negative, the United States’ creditors don’t mind – this has been the case of Australia. The following is from the page 18 of the Australian Bureau of Statistics release Balance of Payments and International Investment Position, Australia, Dec 2011 and in their terminology – which is the same as the IMF’s – it is called “net primary income”)

(Australia’s Q4 2011 GDP was around A$369bn for comparison) and the above graph is quarterly.

So, to conclude the process can continue as long as foreigners do not mind. It shouldn’t be forgotten however that Australian banks had funding issues during the financial crisis and the RBA used its line of credit at the Federal Reserve via fx swaps to prevent a run on Australian banks and it is difficult to design policy without keeping in mind the possibility of walking into uncharted territory.

Once net primary income turns negative, the process can quickly run into unsustainable territory due to the magic of compounding of interest unless the currency depreciates in the favour of the nation helping exports. Else demand has to be curtailed to prevent an explosion but this hurts employment. Other policy options include promotion of exports and asking trading partners to increase domestic demand by fiscal expansion.

The Un-Godley Private Sector Deficit

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Economists worry too much about the government’s deficit although they seem to not know about the private sector deficit.

Goldman Sachs’ chief economist Jan Hatzius came to know about the sectoral balances approach and called the difference between United States’ private expenditure and income in “The Un-Godley Private Sector Deficit”. He later included the sectoral balances approach in his forecasting models.

Here’s the sectoral balances for the United States using data from the Federal Reserve’s Z.1 Flow Of Funds Accounts Of The United States:

GDP appears in Table F.6 and sectoral balances in Table F.8 – as “Net Lending(+)/Net Borrowing(-)”. The above is using quarterly seasonally adjusted data. Easy work. Excel data is available at the Federal Reserve’s page here

It can be verified that

Private Sector Balance = Government Deficit + Current Balance of Payments

The red line is the private sector balance and is the difference between the private sector income and expenditure. When positive, the private sector is in surplus and when negative, it is in deficit.

For most of history having been positive (and back to being positive now), the private sector balance made a dramatic shift in the mid-1990s reaching as low as as -5.8% in Q1 2000 (and hence “private sector deficit”). This implied that before the recession, growth in the United States was driven by higher private expenditure relative to income. The flip side of this growth was that due  to the Un-Godley private sector deficits, the budget went into a surplus while private indebtedness continued to rise.

This was enough to cause a recession in the early 2000s and the US government had to provide a massive fiscal stimulus to prevent a severe recession. The Federal Reserve also provided stimulus by keeping interest rates low but the private sector went into a deficit again – rushing to participate in a boom. The result of all this was the increase in the current account deficit of the United States to about 6.43% of GDP at the end of 2005 – hemorrhaging the circular flow of national income at a massive scale and cracks started to appear in the foundations of growth – as warned by a series of articles from the Levy Institute.

This appears a bit like Scenario 4 in a Levy Institute paper Debt And Lending – A Cri De Coeur by Wynne Godley and Gennaro Zezza from April 2006 – the “gloomiest variant” according to the authors – where a drastic fall in private expenditure relative to income induces a recession in the United States, reducing the current account balance dramatically and increasing the budget deficit (to eventually enough to become the central debate in US politics).

And it turned out that the private sector deficit quickly went into a surplus – faster than the scenario presented above because the private sector could not handle the rise in indebtedness. The fall in private expenditure relative to income also meant – as mentioned above – that the United States went into a deep recession – from which it is still recovering.