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

From the article:

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

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

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

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

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

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

Greg Mankiw wonders if teaching students empirics is feasible and answers in negative:

Noah Smith says introductory economics needs to be more empirical. I understand his argument, and have some sympathy with it, but I wonder if the substantial change he seems to be proposing is practical. Economists usually do empirical work with statistical tools that most college freshmen have not yet learned.

We teachers of introductory economics can and should explain where and why economists disagree. That is part of helping students develop their critical thinking skills. But I doubt students are in a position to try to evaluate the competing empirical work that shapes the differing views.

In the end, introductory economics is just that: an introduction to the economist’s way of thinking. That means giving students basic concepts–comparative advantage, supply and demand, market efficiency and market failure–that will make them more perceptive readers of the newspaper.

The failure to teach empirics to students and how it distorts their vision was well understood by Wynne Godley. In a 1993 article Time, Increasing Returns And Institutions In Macroeconomics, in S. Biasco, A. Roncaglia and M. Salvati (eds.), Market and Institutions in Economic Development: Essays in Honour of Paolo Sylos Labini, (New York: St. Martins Press), pp. 59-82 he wrote:

… But my objection goes beyond skepticism that the world we live in is being described realistically. My additional concern is that the NCP [neoclassical paradigm] is prejudicial with regard to the understanding of some of the most important processes going on in the world today. Thus in the ‘classical’ version of the NCP real output is determined by supply side alone; fiscal policy is entirely impotent and the government can only affect anything by changing the money supply; even then all it can do is affect the price level. The idea that fiscal policy is impotent, which seems to be based entirely on this model, has been extremely influential in contemporary political discussion; it is not just a provisional result suitable for a week or two in an elementary class.

Then the abolition of time prejudices the perception of inflation as an evolutionary process; the equilibria generate ‘explanations’ of price levels not changes, and theories of inflation cannot be convincingly coaxed forth. As if this were not enough, the whole construction leads by virtue of its axioms to the conclusion that wage and price flexibility, in combination with free trade, will generate full employment and convergence, if not equalisation, of living standards between countries and between regions within countries. In sum, while the absence of processes occurring in historical time means that the NCP does not encourage students to go and look up figures in books, if and when they are forced to do so their vision is likely to have been for ever distorted.

[emphasis added]

Steve Keen has a new article on sectoral balances here.

First apologies in advance for sometimes criticizing heterodox economists more but needless to say, such criticisms are of a totally different nature than criticisms of mainstream economists.

Anyway, I am surprised at why Keen mixes accounting identities, especially when it involves banks in the analysis. In the new article, Keen has an equation:

 Bank lending p.a. = Nominal GDP growth / Velocity of Money + Government Deficit + Trade Surplus

I don’t get this. The correct sectoral balances equation (in a simplified three-sector setting) is:

Net Lending = Government Deficit + Current Account Balance of Payments

Here, net lending is that of the private sector. The terminology net lending is something national accountants use, while Wynne Godley used NAFA  — net accumulation of financial assets which means a slightly different thing in national accounts, but this point is irrelevant here.

Keen’s equation seems to mix many things and it has a term for GDP growth which actually needs a model and is not something that can be derived from an accounting identity. Morever, Keen seems to forever blur bank lending and lending in general and hopefully he gets these things right in the future. The hidden assumption in Keen’s models —something which has been pointed out by Nick Edmonds — is that non-bank lending has no effect on aggregate demand which (the assumption) doesn’t make sense.

The original sectoral balances identity was used by Wynne Godley with a behavioural model around it, although he started building his models when he realized in the 70s that the accounting identity itself is a great revelation. And a narrative around the three balances makes a good story especially for telling a story about future scenarios and so on.

Keen, on the other hand has a relation which is not really an identity but a behavioural equation. By itself there’s nothing wrong but given his mixing things up, it really ends up adding confusions. Keen’s blog title uses the phrase “arithmetic” which simply means a manipulation of numbers but has an equation which is more than arithmetic. Reading his article suggests that he has improved the sectoral balances to take into account bank lending. But the sectoral balances equation is an identity even if banks exists. And Keen seems to derive his equation as if it were an accounting identity.

Again goes on to show, it is highly important in macroeconomics to know flow of funds properly.