Sala-i-Martin does not understand Rajoy, Mundell-Fleming model

Xavier Sala-i-Martin has a post on his website (in Spanish) in which he attacks the economic consultants of Mariano Rajoy, the Spanish president, asking the hypothetical question: “But who is consulting Rajoy?”. Rajoy and others are asking Germany to introduce expansionary fiscal policies in order to help the deficit countries in the periphery, among them Spain. Now Sala-i-Martin analyzes the question of an increase in government spending with the help of a model, namely the IS/LM/BP (or Mundell-Fleming) model. That, as such, is laudable. However it seems to me like Sala-i-Martin does not apply the model correctly. Before I critique his views it is necessary to expose them (in English). I duplicate the graph Sala-i-Martin uses below, followed by his story. (Some knowledge of economics is needed, sadly I cannot explain the whole IS/LM model here plus its extension concerning the balance of payments.)

The graph is from the Carlin and Soskice textbook “Macroeconomics” and shows the case of expansionary fiscal policy in a fixed exchange rate regime. This would be the graph that Sala-i-Martin uses for Germany. This is how the model works according to both Sala-i-Martin and the textbook.

1. As Germany increases government spending, the IS curve shifts to the right and incomes increase.
2. More income leads to higher imports, as imports are a share of consumption which depends on income.
3. As another of 1., the interest rises. Why? Because income (y) rises, and with rising income people demand more money since the value of transactions now increases.
4. As a result of that, the interest rate increases as people sell securities to get their hands on liquidity (=money). The price of bonds is falling, and as we know the effective interest rate is the inverse, so that …
5. … this leaves the German interest rate above the world interest rate, so potentially capital flows from the rest of the world to Germany are triggered, which would lead to a rise in the value of the German currency.
6. That is not acceptable, since we have assumed a fixed exchange rate regime and now the central bank intervenes and increases the money supply in order to buy up the inflowing foreign currency. Foreign reserves at the central bank are increasing.

Actually, I’m being nice to Sala-i-Martin here since I tell the story in a bit more detail than he is. Anyway, let’s look at the Spanish side now. Sala-i-Martin draws up another graph, this time there is only a left-shift of the LM curve. This represents the capital flow from Spain to Germany as a result of a rise in the interest rate there. So the conclusion of Sala-i-Martin is:

Conclusión: una política fiscal expansiva en un país como Alemania tendrá consecuencias positivas en Alemania pero consecuencias MUY NEGATIVAS para todos los países que tengan su misma moneda. Eso es, al menos, lo que concluye la teoria keynesiana de la macroeconomía, que no es mi teoría sino la teoría de los que dicen que el estímulo fiscal es deseable.

Let me translate that (sticking very close to the Spanish words that are the same in English):

Conclusion: an expansive fiscal policy in a country like Germany will have positive consequences in Germany but VERY NEGATIVE consequences for all countries which have the same currency. This is, at least, what comes out of the Keynesian theory of the macroeconomy, which is not my theory but the theory of those who say that fiscal stimulus is desirable.

On my part I entertain serious doubts about the use of the Mundell-Fleming model by Sala-i-Martin. I am not a big supporter of the model, but I leave out my criticism of the model for now and only refer you to my latest working paper (which is more general than the Mundell-Fleming model and includes it as a special case). In the following I only comment on Sala-i-Martin’s use of the model as it is. Let me go through these issues one by one. When I quote from Mundell, I use his reprint from the Readings in International Economics book.

1. The first issue when applying any model is to check whether the assumptions hold. On p. 488 Mundell starts his actual model with the following two sentences: “The assumption of perfect capital mobility can be taken to mean that all securities in the system are perfect substitutes. Since different exchange rates exist this implies that existing exchange rates are expected to persist indefinitely …”. Sala-i-Martin writes about this: between Spain and Germany we have perfect capital mobility and a kind of fixed exchange rate (“Entre España y Alemania hay perfecta mobilidad de capital y un tipo de cambio fijo (e igual a uno ya que ambas economías utilizan el euro)”). I disagree with this. There is no fixed exchange rate since the countries have the same currency. Just as you would not analyze California and Washington using the Mundell-Fleming model because they share the same currency you would not want to do that with Spain and Germany. The reason why the model was published in a book called Readings in International Economics is that it deals with international economics. If you are inside a currency area, you are not supposed to use models of international economics. Note that while this might seem strange to the non-economist, the distinction between international economics and regional economics is that there is no exchange rate in the latter. Mundell did not write his book for an (optimum) currency area, but had in mind different currencies.
2. Connected to the first issue, I doubt that Spanish and German securities are perfect substitutes. For sure there is a bigger risk of default with Spanish than with German sovereign bonds, and these have a huge market share in overall financial assets. Since last week, the Spanish sovereign bonds have ceased to be that since they carry collective action clauses, which are against the Spanish constitution. This is hardly what Mundell meant by perfect substitutes.
3. Before I continue let me point out that I would not recommend that use of the Mundell-Fleming model to anyone asking about what happens to Spain and Germany if Germany would run expansionary fiscal policies. The assumptions are not fulfilled and any result must be examined with respect to these. So in continue only with major doubts in my mind. I am not done with the assumptions yet. In the Mundell’s text he writes in the introduction that I assume the degree of mobility that prevails when a country cannot maintain an interest rate different from the general level prevailing abroad (p. 487). If one looks at the euro zone one might wonder whether Germany fits this description. Germany is about a third of the euro zone and before it used to be the European country that provided the yard stick interest rate. All other interest rates on sovereign bonds from euro zone members are building on the German one, it seems, plus a risk premium. If that is so, the assumption of a small, open economy does not hold for Germany. Germany could have whatever interest rate she desires. However, the existence of the euro zone complicates this a bit, since the ECB actually decides on the interest rate.
4. Sala-i-Martin misrepresents the model by not following through the German adjustment to the expansionary fiscal policy. As I have described above, [m]ore income leads to higher imports, as imports are a share of consumption which depends on income. The German expansion hence leads to higher imports, which must lead to more exports of Spain. Sala-i-Martin assumes a two-country model here, which is a little bit dangerous since there are more countries in the euro zone than Spain and Germany. Nevertheless, an increase in fiscal spending will lead to more exports from the rest of the world, and one part of that is Spain. Sala-i-Martin forgets about this. If he would take that into account, he would show an expansionary shift of the IS curve in the graph showing the Spanish situation. Therefore, the positive feedback from the expanding German economy to Spain is left out. That is a serious mistake.
5. Another serious mistake is to assume that expansionary fiscal policy in Germany would increase the interest rate there. First of all, as I already stated Germany in the euro zone is not small open economy. Apart from that, we are surely in the liquidity trap where money is hoarded. An increase in demand for money while excess reserves are hoarded in the system would lead to horizontal LM curve. During a liquidity trap fiscal policy is not leading to higher interest rates as money is hoarded. The rise in transactions liquidity demand is compensated by reducing hoarded money, thus leaving the interest rate unaffected. The situation would look like this:
6. Consequently, in a liquidity trap the rise of the interest rate is a non-event, therefore not leading to a contractionary shift of the money supply in Spain. (The capital flight has already happened in the real world, by the way.) So, Spain is left with the spillover from expansionary fiscal policy in Germany, which led exports to increase, in turn increasing incomes. Hence the picture for Spain would look like this:

At the end of the day, when using the Mundell-Fleming model under the conditions of a liquidity trap, there is a case for expansionary fiscal policy in Germany which would lead to higher incomes in both Spain and Germany.

However, since many (all?) of the important assumptions of the model do not hold in reality, these results must be taken with caution. Apart from that, the Mundell-Fleming model assumes that the central bank can control the monetary aggregate, which is not the case. The ECB sets an interest rate, and banks determine the monetary aggregates under the rules for borrowing (using collateral).

Nevertheless, the conclusion of the economic consultants of Mr Rajoy that they get from the Mundell-Fleming model are right. An increase in fiscal spending in Germany under conditions of the liquidity trap would very likely lead to higher incomes in Spain, not lower incomes like suggested by Sala-i-Martin. Mr Rajoy, who in autumn 2011 was member of the confidence fairy club, seems to have changed his opinion about economic models. Austerity, which does not rely on a model but on an assumption (cutting government spending will lead to more growth), is out, and expansionary policies as explained by the Mundell-Fleming model, are in. A change for the better, I say.