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The Rate Of Saving In Wynne Godley’s Models

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In Krugman’s blog post which is dismissive of Wynne Godley’s work (referred in my previous post) he (Krugman) makes the following claim:

First involved consumption spending. Conventional Keynesian consumption functions suggested that the savings rate would rise as incomes rose — and this wasn’t just the Keynesian interpreters, Keynes himself made the same claim.

which shows that Krugman has less clue about what he talks. Funny, the profession is ruled by clowns like him.

In Wynne Godley’s models, there is a propensity to consume out of income and out of wealth – represented in his models by the parameters α1 and α2 and the rate of saving in any period is given by the model. So in the simplest model – for example in Godley’s book with Marc Lavoie Monetary Economics, the rate of saving can has the following dynamic:

Disposable Income - G&L

Rate Of Saving - G&L

(image screenshot via amazon.com “Look Inside”)

(Note: In the above model, money is the only asset). This is starting from scratch but similar behaviour can be seen if one starts with some initial self-consistent configuration.

This is contrary to what Paul Krugman claims of Keynesian models. The above shows how the rate of saving first rises and then starts to fall and this whole adjustment will happen with a time lag given by a “stock-flow norm” and can be fast.

The reason it happens is simple. It is clear Krugman doesn’t realize the underlying stock-flow dynamics. As households’ saving and income rises because of a rise in government expenditure, they are also accumulating wealth. So a scenario where saving rises forever is meaningless because they would start consuming from their wealth as well.

Krugman continues:

This, in turn, led to predictions of rising savings rates after World War II, and hence a persistent shortage of demand — hence the secular stagnation theory briefly prominent. (There was even an early Heinlein novel built in part around the secular stagnation theory. As I recall, it was pretty bad.)

which is quite wrong – as stock-flow consistent dynamics suggests otherwise.

I’ll hold it to make any generic statements but it is clear that Krugman doesn’t know a thing or two about Keynesian Macroeconomics 🙂

*Many times standard textbooks use a Keynesian consumption function of the form

C = α0 + α1·YD

where C is the consumption, and YD is the disposable income.

It is then easy to see that C/YD decreases with YD and this is what Krugman is talking of.

However only slight improved modification where the consumption function depends on wealth as well leads to a different behaviour as highlighted in the main text. So it is strange Krugman dismisses consumption functions and instead talks of “failures that it seemed could have been avoided by thinking more in maximizing terms” !

*I thank Nick Edmonds in pointing this out.

Wynne Godley: The Keynes Of Flow Of Funds

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Monetary and financial data, so far as they are based on institutional balance sheets and prices in organized markets, are abundant. Modern machines have made it possible to improve, refine and expand the compilation of these data, and also to seek empirical regularities in financial behavior in the magnitude of individual observations. On the aggregate level, the Federal Reserve Board has developed a financial accounting framework, the “flow of funds,” for systematic and consistent organization of the data, classified both by sector of the economy (households, nonfinancial business, governments, financial institutions and so on) and by type of asset or debt (currency, deposits, bonds, mortgages, and so on). Although many people hope that this organization of data will prove to be as powerful an aid to economic understanding as the national income accounts, this hope has not yet been fulfilled. Perhaps the deficiency is conceptual and theoretical; as some have said, the Keynes of “flow of funds” has yet to appear.

– James Tobin in Introduction (pp xii-xiii) in Essays In Economics, Volume 1: Macroeconomics, 1987.

[bolding: mine]

Paul Krugman writes in his blog responding to a recent Times article on Wynne Godley with a dismissive tone with mischaracterisation on saving etc. He writes:

But it is kind of funny to see a revival of old-fashioned macro hailed, at least by some, as the key to a reconstruction of the field.

Strange. First it is the story of a journalist from NYT who presented it the way it was. The NYT article was fine – what more can we ask from the journalists? But the funny thing is Krugman’s blog post itself which appeals to Friedmanism. Even funnier is the fact that Paul Krugman himself has turned to Keynesianism in recent times and talks about Michal Kalecki but when it suits his purpose, he dismisses Godley’s ideas as old fashioned!

Paul Krugman in his debates with heteredox economists has been exposed with his poor understanding of the nature of money. Wynne Godley’s approach on the other hand goes into a detailed look at the nature of money using the flow of funds among other things in a Keynesian way.

Now Krugman’s post is hardly a critique of any sort to deserve a response. But I thought quoting James Tobin is a good way to advertise Wynne Godley’s work because he has achieved what Tobin dreamed of and could not do it himself.

Also Wynne’s own idea about his work and aims can be seen from his writing in his article Keynes And The Management Of Real National Income And Expenditure, (in Keynes And The Modern World, ed. George David Norman Worswick and James Anthony Trevithick, Cambridge University Press, 1983):

… I have been forced to the conclusion that Keynes was a long way from achieving a coherent theoretical basis for maintaining them [correct ideas], and largely for this reason, his ideas have proved very vulnerable to the attacks from many different directions to which they have been subjected, particularly in the last fifteen years.

Wynne Godley’s work lays the foundation for Keynesian Economics. And Wynne Godley is the Keynes of flow of funds.

Correction: I am mistaken about Jonathan Schlefer’s background. He is in academics.

NYT On Wynne Godley

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There’s a nice new article on Wynne Godley today in The New York Times.

An interesting thing in the article is the mention of intuition via models while mentioning his book Monetary Economics.

Why does a model matter? It explicitly details an economist’s thinking, Dr. Bezemer says. Other economists can use it. They cannot so easily clone intuition.

That is so right. The models in the books of Wynne Godley – both Monetary Economics with Marc Lavoie and Macroeconomics with Francis Cripps give a good idea about the authors’ intuitions. Of course, needless to say the man was bigger than his models.

Wynne Godley - NYT

Holier Than Tobin?

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It sometimes happens that important insights of great contributors to an academic field are missed. One of the most important things in Monetary Economics is Tobin’s asset allocation theory which although is well known is sometimes poorly understood.

James TobinJames Tobin (Source: Econometric Theory)

But sometimes a holier-than-thou attitude can lead one to miss an important and insightful aspect of a work.

The blogger Winterspeak – well aware of some of Tobin’s work such as his paper Commercial Banks As Creators Of “Money” from  1963 has written as post A Bank is not a Financial Intermediary and concludes that

… This then is the conceptual fallacy at the heart of academic macro and what it thinks about banks, and it goes at least all the way back to 1963.

Winterspeak is stuck on a quote from Tobin-Brainard paper (1963) which says:

…the essential function of financial intermediaries, including commercial banks, is to satisfy simultaneously the portfolio preferences of two types of individuals or firms. On one side are borrowers, who wish to expand their holdings of real assets… On the other side are lenders who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default.

This is also repeated in Tobin’s Commercial Banks As Creators Of “Money” which obviously states explicitly that loans create deposits and that the money mutliplier view is highly inaccurate:

According to the ‘new view’, the essential function of financial intermediaries, including commercial banks, is to satisfy simultaneously the portfolio preferences of two types of individuals or firms. On one side are borrowers, who wish to expand their holdings of real assets – inventories, residential real estate, productive plant and equipment, etc. – beyond the limits of their own net worth. On the other side are lenders, who wish to hold part or all of their net worth in assets of stable money value with negligible risk of default. The assets of financial intermediaries are obligations of the borrowers – promissory notes, bonds, mortgages. The liability of financial intermediaries are the assets of the lenders – bank deposits, insurance policies, pension rights.

Winterspeak is adamant about the usage of the phrase “intermediary” and that since banks create deposits out of thin air, they shouldn’t really be called intermediary and that Tobin’s views are equivalent to the loanable funds view. For the first part – maybe but Winterspeak seems to crucially miss out the mediating role played by banks in the portfolio allocation decisions of wealth owners such as households. See my comments in that blog.

First it is crystal clear that Tobin knows loans create deposits. Second, he presents a “new view” in which the distinction between “money” and “bonds” is blurred and this led him subsequently to his asset allocation theory. It is true that Tobin’s model was far from complete and this was improved substantially by Wynne Godley, but nevertheless Tobin’s insights were wonderful and the work of a genius.

Perhaps I would have worded what Tobin wrote differently if I were to teach this but this is just a matter of emphasis.

Perhaps “the essential function” is better worded with “an essential function” so that the reader doesn’t take it to mean that the concept I will come to,  isn’t taken to mean “the only function” or “the most essential function”.

The mediation role played by banks is related to the super-version of “loans create deposits” – asset purchases by banks also create deposits.

So when a bank purchases say a government bond from a household (or a mutual fund selling in response to redemptions by a household), banks create more deposits in the process. In the opposite case, there is a destruction of deposits.

Now suppose for some reason – such as improved animal spirits of entrepreneurs, firms borrow more from banks and the expenditures transfers funds to households. Coincidentally – for different reasons – households wish to hold less of their wealth in deposits and more in bonds or other securities. There is now a discrepancy and it is reconciliated by banks standing ready to sell bonds to households. This decreases the stock of money (monetary aggregate) in existence so that there is no discrepancy at all. There is of course another way in which this may happen – i.e., by price changes (of financial secruities and not that of goods and services) bringing supplies equal to demand but this needs a full course on asset allocation theory discovered by nobody else than James Tobin himself!!

Of course there are other ways. There is the reflux mechanism and more complicated mechanisms involving asset allocation theory such as higher issuance of equities by production firms. In the reverse case when households desire to hold more of their wealth in deposits, firms may need to borrow more from banks so that the “supply” of money is equal to the “demand”.

In contrast there is the Monetarist hot potato process which mainly relies on prices changes of goods and services. In ideas such as the asset allocation theory including the mechanism of the mediating role of banks is a blow to the Monetarist hot potato.

Of course there is the notion of convenience lending – one favoured by Basil Moore – in which household volitionally hold bank deposits non-volitionally but it is too artificial.

This mediating role of banks (and not the most important if you like) is also endorsed by some Post-Keynesian authors such as Wynne Godley and Nicholas Kaldor.

In an article In his essay Keynes And The Management Of Real Income And Expenditure, (in Keynes And The Modern World, ed. George David Norman Worswick and James Anthony Trevithick, Cambridge University Press, 1983), Wynne Godley says (p 151):

Even though I am not going in detail into monetary mechanisms it is worth drawing attention to the fact that the commercial banks’ role, apart from creating credit to finance certain kinds of expenditure, is to mediate the non-bank private sector’s portfolio choice, given the income flows and the central authorities’ funding policy.

Nicky Kaldor’s The Scourge Of Monetarism (Oxford University Press, 1982) is more clearer than simply stating:

As it is, a highly developed banking system already provides such facilities on an ample scale, since it is prepared to accommodate the public’s changing demand between different types or financial assets by altering the composition of the banks’ assets or liabilities in a reverse direction. If the non-banking public wishes to switch its holding of gilts for interest-bearing bank deposits, the banks are ready to supply such deposits at the minimum of inconvenience, and at the same time to place their surplus funds into the gilts which were previously held by the public. Similarly the banks provide easy facilities to their customers for switching balances on current accounts into interest-bearing deposit accounts, or vice versa. Hence, while the annual increment in the total holding of financial assets of the private sector (considered as a whole) is nothing more than the mirror-image of the borrowing requirement of the public sector (in a closed economy at any rate), neither the Government nor the banks can determine how much of this increment will be held in the form of cash (meaning notes and current deposits) and how much in the near-equivalents to cash (such as interest-bearing demand deposits) or in various forms of public sector debt. Thus neither the Government nor the central bank can control how much or the total financial assets the public prefers to hold in the form of ‘money’ on one particular definition or another.

Again in 1997 in Money Finance And National Income Determination Wynne Godley repeats himself although criticising Tobin but nevertheless realising the importance of his work – this time writing an explicit model for the whole thing which incorporates Tobin’s ideas:

… I am saying that (within strict limits e.g. concerning credit-worthiness) banks respond passively to the needs of business for loans and to the asset allocation activities of households (as well as providing the means of payment).

Conclusion

It is true that PKE authors and bloggers do have a much better understanding of monetary matters than mainstream economists but in trying to emphasise this point, sometimes they miss out on important matters. There is no need to say (as Winterspeak says “Tobin … sees … [banks as] something which brings efficiency and eases friction between the actual lender and borrower.”) especially when Winterspeak doesn’t seem to understand the mediating role of banks in the portfolio allocation decisions of financial asset owners which really has less to do with any “friction”. Perhaps the word intermediary is not the best but it is a minor point. In fact the ideas of the 1960s and later are missed by younger ones.

Thomas Palley On International Coordination

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Thomas Palley has a new article Coordinate Currencies or Stagnate on international coordination of exchange rates. (h/t Matias Vernengo). He has a nice small critique of the Chicago school according to which “market forces” work toward resolving imbalances.

It is great such a thing has been raised because the importance of policy coordination (in general – monetary, fiscal and exchange rates) is often forgotten.

In an article Agenda For International Coordination Of Macroeconomic Policies, Tobin wrote [1]

Coordinate policies! So economists urge governments. Financiers, journalists, pundits, politicians take up the cry. Central bankers and finance ministers agree, as do presidents and prime ministers. They meet, they talk, they announce progress. It turns out to amount to very little…

But the global imbalance has worsened and it has now created a situation in which such coordination is more badly needed.

Wynne Godley had been warning of such things in the 2000s. In a 2005 article [2] with his collaborators, he wrote:

A resolution of the strategic problems now facing the U.S. and world economies can probably be achieved only via an international agreement that would change the international pattern of aggregate demand, combined with a change in relative prices. Together, these measures would ensure that trade is generally balanced at full employment…Those hoping for a market solution may be chasing a mirage.

I have also found the last words in academic literature very insightful [3]:

… 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.

Time will tell how right he was 😉

References

  1. James Tobin, Agenda For International Coordination Of Macroeconomic Policies, Ch 24, p 633, Essays In Economics, Volume 4: National And International, The MIT Press, 1996.
  2. Wynne Godley, Dimitri Papadimitriou, Claudio Dos Santos and Gennaro Zezza – The United States And Her Creditors: Can The Symbiosis Last?, Levy Institute Strategic Analysis, September 2005. Link
  3. Wynne Godley, Dimitri Papadimitrou and Gennaro Zezza – Prospects For The United States And The World – A Crisis That Conventional Remedies Cannot Resolve, Levy Institute Strategic Analysis, December 2008. Link

Kenneth Rogoff Is Back With Another Sneaky Article

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Kenneth Rogoff is back with more unscholarly stuff.

In a new article for Project Syndicate Europe’s Lost Keynesians, Rogoff subtly tries to belittle Keynesians and Keynes himself.

According to him,

The eurozone’s difficulties, I have long argued, stem from European financial and monetary integration having gotten too far ahead of actual political, fiscal, and banking union. This is not a problem with which Keynes was familiar, much less one that he sought to address.

Now, Keynes himself was aware of problems that arise in an open economy, the above quote tries to mislead the readers into thinking that neither Keynes nor his followers were aware of the problem.

It was in fact Keynesians who warned about the troubles the Euro Area would face. Last year, I dug out an article by Nicholas Kaldor from 1971 which shows how highly prescient he was. The article 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 is written as if it was written yesterday!

Here is from the article:

… 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]

To read more excerpts from the article please read the following two posts from this blog:

  1. Nicholas Kaldor On The Common Market
  2. Nicholas Kaldor On European Political Union

In fact Nicholas Kaldor had already figured that the kind of fiscal union Europeans were thinking was a kind of a pseudo fiscal union – as can be seen by reading the excerpts (see the second post above).

Also Wynne Godley – a close friend of Nicky Kaldor – also reminded the dangers of the Maastricht Treaty in his 1992 LRB article Maastricht And All That.

Kenneth Rogoff is being ignorant and unintellectual. First he writes as if Keynesians had no clue about the problem and secondly he is unaware of the fact that the kind of fiscal union in talks in Europe is a pseudo fiscal union which Keynesians such as Nicholas Kaldor have pointed out since 1971.

He ends the article by saying

… there still will be no simple Keynesian cure for the single currency’s debt and growth woes.

which is ignorant. The solution if it comes about is Keynesian and Keynesians had warned it will be difficult to resolve a future crisis because of political difficulties which arise.

Rogoff’s attitude is that of a person who ignores the doctor’s warning continuously and then ridicules the doctor when  medical problems finally appear. Just like the cure will come from the doctor, so will the resolution via Keynesianism.

Endogeneity, Exogenous, Et Cetera

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Louis-Philippe Rochon and Sergio Rossi have a very interesting article Endogenous Money: The Evolutionary Versus Revolutionary Views in the Review Of Keynesian Economics. I think it was written many years back and was in an unpublished form and has been published now. It is a nice critique of views of some Post-Keynesians such as Victoria Chick and also others such as Basil Moore. For instance, the paper quotes Moore’s view from 2001:

[w]hen money was a commodity, such as gold, with an inelastic supply, the total quantity of money in existence could realistically be viewed as exogenous.

Click the image to visit the ROKE website.

roke_cover

There are also some nice articles in a recent issue of JPKE on neoliberalism and the financial crisis.

Some gossip: The JPKE was initially supposed to have been called Journal of Keynesian Economics but it didn’t make it because the acronym would have been JOKE.

Also, Jayati Ghosh has written an excellent blog article on Thatcherism – the ‘triumph of private gain over social good’ (borrowing words from her).

Matias Vernengo has a recent blog post on the persistence of poverty in the United States. Which reminds me of an interview clip of Anwar Shaikh titled “The Sin Of Our Era”:

click to watch the video on YouTube

Back to formal matters.

What does it mean when an economist says words such as “endogenous”, “exogenous”? Most of the times, economists – mainstream economists – themselves confuse these terms and hence you see a lot of usage of these words in Post-Keynesian economics.

I was reading an article on econometrics by Fischer Black (of the Black-Scholes fame) titled The Trouble with Econometric Models

An exogenous variable is supposed to be a causal variable, if the structure of a model has economic meaning. In fact, it is usually just a variable that is put on the right-hand side of equations in a model, but not on the left-hand side.

Similarly, an endogenous variable is supposed to be a caused variable. In fact, it is usually just a variable that shows up at least once on the left-hand side of an equation

which is fair but there exists another language.

There is however another usage – that is in the control sense.

In an outstanding paper Federal Reserve “Defensive” Behavior And The Reverse Causation Argument, Raymond E. Lombra and Raymond G. Torto point out the following in the footnote:

Apparently no generally accepted concept of an endogenous money stock (or monetary base) has been defined. In statistical theory a variable is endogenous if it is jointly determined with other variables in the system. However, many monetary theorists have chosen to call a variable endogenous only if its magnitude is not under the control of policymakers. Such semantic problems have undoubtedly prolonged this debate.

For the money stock measure such as M1, M2 etc., there shouldn’t be any confusion. The trouble arises for things such as interest rates. For example, some economists may say that if inflation rises, the central bank may/will raise the short-term interest rate and it is endogenous while others will say it is up to the central bank to decide how much to change the interest rate, if at all. Such things lead to a lot of debate.

I like the latter usage (the control sense) but I think it is difficult to exclusively have the same usage.

The word “control” is also misunderstood. Here is a fine article on Wynne Godley in The Times from 16 June 1978 where he details on how misunderstood the word is:

Leading Economist Insists That You Cannot Control M3

(click to expand)

Margaret Thatcher’s Gigantic Con Trick

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There have been too many praises for Mrs Thatcher after her death today.

Wynne Godley once described the Thatcher “miracle” as a gigantic con-trick. Here is from a newspaper article:

I regard the Thatcher miracle as a gigantic con-trick. Almost every major indicator – output, unemployment, industrial investment, and the balance of payments has performed poorly over the nine Thatcher years taken as a whole … The ‘con’ trick has been achieved by the enrichment of part of the community at the expense of a minority, by skilful but thorougly dishonest presentation of the facts, by the ruthless use of patronage and the exploitation of an ugly vein of populism in the British people.

– Wynne Godley in Why I Won’t Apologize, September 18, 1988, Observer. 

The article scan is below:

Wynne Godley - Why I Won't Apologize

Wynne Godley, Why I Won’t Apologize
(click to enlarge and click again)

Also see the papers which describes the right facts:

  1. Coutts, K. and Godley, W. (1989), The British Economy Under Mrs Thatcher. The Political Quarterly, 60: 137–151. (Link)
  2. Godley, W. (1990), The British Economy Under Mrs Thatcher: A Rejoinder. The Political Quarterly, 61: 101–102. (Link)

Thatcher’s bluff was caught very early by Godley. The huge rise in unemployment (to 3 million) was predicted first by Wynne Godley himself in 1979.

Reference: Godley W., ‘Britain’s chronic recession-can anything be done?’ in W. Beckerman (ed.) Slow Growth in Britain, Oxford University Press, 1979.

His King’s College Obituary (Annual Report, 2011) had this to say about Thatcherism:

Wynne rather relished his reputation as the ‘Cassandra of the Fens’. He famously made a double prediction: that under current policies of the first Thatcher government unemployment would inevitably rise to three million, but – the second prediction – that this would not in fact happen, on the grounds that, since in post-war Britain three million unemployed had to be an electoral suicide note, the policies would have to be changed. He was right with the first prediction, and – misreading the not-for-turning dispositions of the Iron Lady – wrong with the second. The actual outcomes appalled him. For Wynne the fundamental economic responsibility of a government was to ensure ‘full employment’. In pursuit of that aim he was uninhibited as Keynes himself and perhaps rather close in his motivation. He believed it was essential to use fiscal levers to stimulate demand, and was even prepared – though under very strict conditions – to countenance temporary import controls to protect and strengthen economic activity. His ideas were controversial and, like the man himself, often stood at an odd angle to the contemporary world, but the moral imagination which informed them was large and generous.

Claims Economists Make

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Economists struggle with simple things. Two examples.

National Saving, Trade Deficits etc.

In a blog article Has Anyone Heard of the Trade Deficit?, Dean Baker uses the sectoral balances identity to make a claim which is presented like a no-go theorem.

Baker says:

Fans of arithmetic (a tiny minority among DC policy types) like to point out that a large trade deficit implies negative national savings. In other words, if we have a trade deficit then by definition the United States as a whole has a negative saving rate.

This means that we either must have budget deficits (negative public savings) or negative private savings, or both. There is no way around this fact.

Baker confuses saving with saving net of investment – just like the Neochartalists. (Confuses S with S minus I)

Without proof, the sum of saving of a whole economy is given by

S = I + BP

where (here) S is the sum of the savings of all resident sectors of the economy – the “national saving”, I is the total investment expenditure of the resident sectors of the economy (i.e., both private and public) and BP is the current account balance of international payments.

So it is possible for an economy to have a trade deficit and hence a negative BP (although it’s not always the case that the trade deficit translates into a current account deficit) and still have I + BP positive if investment is sufficiently high. So an economy can have positive national saving with a trade deficit.

Of course it must be said that the persons he is attacking are wrong. The claim (of the persons he is criticizing) is that the United States should save more (by a reduction in budget deficits brought about by a tightening of fiscal policy and/or higher propensity to save of the private sector achieved in some way). This is illegitimate as such a policy will induce a recession in the United States. Via the paradox of thrift, an increase in the private sector propensity to save can lead to lower saving of the private sector. Investment will fall because of lower sales expectations and the recession in the United States caused by the fiscal tightening will most likely lead to a recession in the rest of the world reducing its exports so that the only thing achieved is higher world unemployment.

Debt/GDP Ratio

In a series of posts aimed at showing something, Randall Wray claims the following:

… To simplify, if the interest rate is higher than the economy’s growth rate, then the debt ratio rises continuously…

Of course he also claims that if g>r, the debt ratio stabilizes.

Now, the debt sustainability conditions relating the interest rate and the growth rate of output are misleading. I showed this two posts back, where I showed that the claim that the condition that g>r ensures stabilization of the public debt/gdp ratio is incorrect. The above quote claims the opposite and is equally erroneous and misleading.

An economy can have the growth rate lower than the interest rate and still not have an exploding debt ratio.

A standard error in such analysis is to treat the budget deficit as exogenous. 

Consider an economy without a strong balance of payments constraint and with inflation less of a trouble. A fiscal expansion brings about an increase in output and this has the effect of stabilizing the debt ratio in two ways: the higher output itself and an increase in tax revenues of the government due to higher output. The budget balance may go into primary surplus automatically even though the government may not be targeting this.

In other words, if r>g, the sequence dn given by the relation

dt – dt-1 = λdt-1 – pbt

(where λ is equal to (r-g)/(1+g) and  dt is the debt/gdp ratio at the end of time period t and pbt is the primary budget balance of the government in the period) would seem to explode because of the first time on the right hand side. But higher output will automatically lead to a dynamics for pbt ensuring sustainability.

How this works was shown by Wynne Godley in an article The Dynamics Of Public Sector Deficits And Debts written in 1994 written by his co-author Bob Rowthorn in J. Michie and J. Grieve Smith (eds), Unemployment in Europe (London: Academic Press), 1994 pp. 199-206 and which was originally a paper to the UK Treasury around ’92-’93.

For a demand constrained economy:

… Note that the primary budget balance adjusts automatically so as the stabilise the debt to GDP ratio. This spontaneous adjustment occurs through induced variations in GDP. The government cannot directly determine the primary balance. It can only control r, θ and G, and once the time path of these is fixed as above, the variable Y will evolve so as to stabilise the ratio B/Y. If this ratio is too large, Y will grow rapidly and generate sufficient tax revenue to bring this ratio down.

There is a standard proposition that the government cannot permanently maintain a primary deficit if the interest rate is greater than the growth rate (r>g) … even if true, the statement can be misleading. In a demand-constrained economy, the level of Y relative to G will automatically adjust so as to produce a primary balance (deficit or surplus) to stabilise the ratio B/Y …

[Emphasis mine]

(θ is the tax rate in the model in above paper). Also see this post Wynne Godley And The Dynamics Of Deficits And Debts

It is counterproductive to go around making statements about the conditions on interest rate and the growth rate without qualifications and care and considering a situation/history and future scenarios.

There is one place where this condition is useful. Consider a balance of payments constrained economy. In studying the sustainability of the external debt of a country, one can conclude that if r>g (where r is the effective interest rate paid on foreign liabilities), then the debt dynamics will lead to an exploding debt even if the trade balance is held constant. Of course that doesn’t mean if r<g alone ensures sustainability.

Wynne Godley And The Dynamics Of Deficits And Debts

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In a five-part series in his blog, Functional Finance and the Debt Ratio Scott Fullwiler claims that if the interest rate is held below the growth rate of output, sustainability of the public debt/gdp ratio is guaranteed in the sense that the ratio converges and does not keep increasing forever. This is erroneous and his conclusions are misleading.

Wolfgang Schäuble understands the connection between public finances and international competitiveness, although his solutions are all wrong. Heteredox economists should understand this connection as well!

Rather than write a detailed essay, I thought I should directly get to the point and pinpoint his errors. Of course, several Post Keynesians even before Fullwiler wrote his 2006 paper Interest Rates And Fiscal Sustainability (referred in his posts) have made this claim and this criticism applies to them as well.

While there are future scenarios, where growth improves the public debt/gdp ratio, it does not mean that all scenarios lead to a convergence. Fullwiler has examples in his posts where he shows how the convergence happens. But it doesn’t prove much.

Fullwiler’s error is a simple mathematical one. He sums the series for debt-sustainability equation and shows the the public debt/gdp ratio converges to

– pb/(g – r)

where pb is the primary balance/gdp ratio, g is the growth rate of output and r the interest rate. [notations are changed somewhat without any effect on conclusions]

This is a wrong result because it assumes that the primary balance is constant as a percentage of gdp. The series he sums need not converge if the primary balance in each period is different. One such scenario is when the deficit in each period is bigger than the deficit of the previous period. Fullwiler claims:

… in terms of convergence or unbounded growth of the debt ratio, as Jamie Galbraith put it, “it’s the interest rate, stupid!” since any level of primary deficit can converge if the interest rate is below the growth rate.

[italics and link in original]

This is repeated:

… More importantly, given an interest rate lower than GDP growth, any primary budget deficit will eventually converge …

Now this doesn’t make sense. The claim that “any” level of primary deficit can converge if the interest rate is below the growth rate is incorrect. For example, if we have primary balances pb0, pb1, pb2 and so on and each of them is growing sufficiently faster, the debt/gdp ratio is explosive even if interest rate is less than the growth rate of output. His result is valid if each of the balances pb0, pb1, pb2 … are equal to each other and not in general.

In other words, if g>r, the sequence dn given by the relation

dt – dt-1 = λdt-1 – pbt

where λ is equal to (r-g)/(1+g) need not converge for general values of pbn and only converges in special circumstances (if suppose the pbn are all equal or more realistic if there is a mechanism to bring the primary deficit into a surplus which may or may not be a discretionary attempt by the government.)

Example

Nothing of the above is purely academic. So in what situation can the public debt explode?

Let us assume an open economy. Let us assume that a country’s exports is X0 and not growing because of its inability to increase its market share or because of limited demand in world markets due to deflationary policies adopted by the rest of the world. Or both.

If one imagines a scenario in which there is growth in output and hence income, imports rise as well in a world of free trade.  This implies the current account deficit explodes. While growth may work to improve the debt/gdp ratio, the current account deficits work to worsen the debt ratio. The net effect is that “growth” instead of improving the debt/ratio worsens it.

This can be seen if one remembers that the sectoral balances identity connects the public sector deficit and the current balance of payments. We have

NAFA = PSBR + BP

where NAFA is the private sector net accumulation of financial assets, PSBR is the public sector borrowing requirement (the deficit) and BP is the current account balance of international payments.

Since the private sector typically wishes to have a positive NAFA (else there is another unsustainable process!), an exploding BP leads to an exploding PSBR if output grows much faster than exports. This implies the public debt/gdp grows forever and growth is not sustainable.

Now Fullwiler can potentially claim that the government can “simply credit bank accounts” and public debt/gdp and external debt/gdp rising forever is no cause for trouble but then why write a post claiming convergence of the ratios!

There is a diagram in the post which I modified below with a red line for a path for the sectoral balances. Is the claim that this line extrapolated leads to a stabilizing debt ratio?

[image updated]sf-p4-fig9-modified-corrected

Wynne Godley And Debt Dynamics

The above was pointed out by Wynne Godley in the 1970s. The following brings it out clearly. It is from an appendix to an article written by his co-author Bob Rowthorn in J. Michie and J. Grieve Smith (eds), Unemployment in Europe (London: Academic Press), 1994 pp. 199-206 and was originally a paper to the UK Treasury around ’92-’93

The main conclusions are as follows. Consider an economy in which neither inflation nor the balance of payments is a constraint on output, so that any permanent increase in demand leads to an equal and permanent rise in output. In such an economy, tax cuts or additional government expenditure are eventually self-financing. They lead to some increase in government debt, but not to an explosion, since this debt will ultimately stabilise. The factor stabilising the debt is the behaviour of output. Following a fiscal stimulus, output will rise and tax revenue will automatically increase. Moreover, the expansion will continue to the point where additional tax revenue is sufficient to halt government borrowing and stabilise the debt. In an inflation-constrained economy, the expansionary process will lead to an unsustainable inflation and the government will be compelled to half the expansion before tax revenue has increased sufficiently to stabilise the government debt. In a balance of payments constrained economy, the government debt will grow without limit because the output multiplier will be too small to generate the tax revenue required to stabilise government debt. The counterpart to expanding government debt will be an expanding national debt to foreigners.

Conclusion

Now this may sound as a pessimistic view for any individual nation or the world as a whole. The real problem is free trade – the most sacred tenet of the economics profession.