Posted by: Dirk | November 25, 2015

Rethinking development strategies – fiscal space

The UNCTAD has a new book on development strategies (free pdf available). There is a section of fiscal space, which is an idea that is discussed quite a lot these days. Here is a paragraph from that section:

Fiscal space is an essential aspect of the policy space needed by the developmental State (see TDR 2014, chapter VII). Even if governments are allowed to conduct some development policies within the multilateral, regional or bilateral frameworks, they still need to finance them. To that end, strengthening public domestic revenues is key, given that they are more sustainable in the long run than relying on aid or debt, as well as being less subject to restrictions and conditions that hamper policy space.

I think that the crucial thing here is to recognise that even thought government in developing economies can create unlimited amounts of currency, the weakness of the “public domestic revenues” (=taxes) might lead to the problem that every “Peso Queso” created and spent at the margin leads to households converting them at the earliest instance into hard currencies, like USD, CHF, EUR and so on. That would mean that the exchange rate would drop as a result of increased government spending. This also what Warren Mosler, one of the founder of Modern Monetary Theory (MMT), says in the context of the Russian default of 1999:

All throughout this process, the Russian Government had the ABILITY to pay in rubles. However, due to its choice of fixing the exchange rate at level above ‘market levels’ it was not, in mid August, WILLING to make payments in rubles. In fact, even after floating the ruble, when payment could have been made without losing reserves, the Russian Government, which included the Treasury and Central Bank, continued to be UNWILLING to make payments in rubles when due, both domestically and internationally. It defaulted on ruble payment BY CHOICE, as it always possessed the ABILITY to pay simply by crediting the appropriate accounts with rubles at the Central Bank.

Why Russia made this choice is the subject of much debate. However, there is no debate over the fact that Russia had the ABILITY to meet its notional ruble obligations but was UNWILLING to pay and instead CHOSE to default.

I absolutely agree with Mosler. Now the tricky question for developing countries is: if because of free capital flows and speculators driving the exchange rate up and down the volatility of the exchange rate is too high to attract serious foreign (direct) investment, what can you do? You can protect yourself by piling up USD reserves at the central bank. If in crisis, you can defend your exchange rate from falling “too much” (“undershooting”). In a boom, you can use your own currency to buy foreign currency and hence appreciate your own anyways.

To conclude: developing countries should not have over-valued exchange rates, since a correction might lead to a steep fall in the exchange rate and create lots of inflation (via more expensive foreign goods). This reduces real purchasing power and is surely recessionary. If, in such a situation, government uses fiscal policy it might only deepen the problem. The private sector, once it gets an additional “peso queso”, instantly sells it for USD in the expectation of more depreciation to come. And come it will – this is a self-fulfilling prophecy! Government should then increase government spending and taxes in lockstep, which would mean that the fiscal multiplier would be very low. Perhaps a suspension of free capital movement would be the only solution if things are really, really bad. This is not something that never happened to developing economies.

Marc Lavoie in his new “Post-Keynesian Economics – New Foundations” has a table (1.4) with fallacies of composition: when all actors do the same thing, they defeat themselves. Perhaps another fallacy should be added?

This pretty much sums it up. There is a book from Mark Blyth which is more serious.

Posted by: Dirk | November 19, 2015

Income inequality and the Great Depression II

More than five years ago (actually, six) I had wondered whether it is a coincidence that inequality in the US hit a peak in 1929 and 2007. While I did not have time to follow-up on this with an academic paper, Christian Belabed of the IMK just did. Here is his abstract:

There is a growing literature comparing the current financial crisis or Great Recession to the worst economic crisis of capitalism, the Great Depression. However, the role of rising income inequality, which has risen dramatically before both crises, is rarely discussed. In this paper we discuss the rise of top-end inequality and its effects on household consumption, saving, and debt for the 1920s by applying a non-standard theory of consumption, the relative income hypothesis, to the period of interest. We argue that income inequality is linked to the increase of household consumption and the simultaneous decline of household savings as well as rapidly increasing household debt. Thus, the rise of top-end inequality in connection with a broader institutional change, such as the deregulation of financial markets, has contributed to a build-up of financial and macroeconomic instability, in the period leading to the Great Depression.

The paper finds that households financed consumption through debt, which connects to the story of Thorstein Veblen on conspicuous consumption. Let’s not forget that the US experience a real estate and stock market bubble that both burst in 1929 and the following years. So, the build up of private sector debt papered over a structural weakness in demand that probably was rooted in the income inequality of the Roaring 2os. Interesting result, especially with a view on today’s situation.

Posted by: Dirk | November 16, 2015

Wage growth and inflation

The St Louis FED has a blog which has recently presented this figure:


This is very interesting since most economists still think that it is monetary aggregate(s) that are driving the inflation rate. I have done a quick&dirty job and assembled changes in monetary base, M1, M2 and M3 in the figure below:
The time span has been chose to increase readability. When the Great Financial Crisis broke out, the monetary base was increased by at times 100%, which ruins my figure. Anyway, it seems quite clear that the data says that change in the price level (=inflation) seems to depend more on the development of wages than the development of some monetary aggregate.

What is also influencing inflation should be the exchange rate, with depreciations potentially increasing the inflation rate and appreciations decreasing it. However, since a cheaper USD means more exports, it should also translate into inflation through changes in wages via the labor market.

Forecasting inflation is much more difficult if it is depending to a large extent on developments on the labour market because these are not independent from development of credit, fiscal stance (G-T) and trade stance (EX-IM).

Posted by: Dirk | November 13, 2015

The euro was pointless, recent conference finds

An article on FT’s Seeking Alpha makes the point that euro was pointless from the very beginning:

In retrospect, it’s clear the euro simply shifted risk from exchange rate fluctuations to defaults (for foreign creditors) and nominal income (for domestic workers and businesses). This wasn’t sufficiently obvious at the time, however, or we wouldn’t have seen such massive growth in cross-border banking and portfolio flows within the currency bloc before 2008.

Contrary to what the euro’s founders believed, it now appears the absence of monetary union is what’s needed to channel capital flows most productively across borders. That’s the real tragedy of the single currency: it was pointless from the start.

Participants were high-ranking policy makers and mainstream academic economists, which is a bit surprising. It seems that now, eight years after the sub-prime crisis and the following euro crisis, the policy makers finally consider the idea that the euro was not a good idea. It can be fixed, and it should be. Else, the European Union will disintegrate. UKIP in the UK and Front National in France are putting political pressure on the governing elite, it seems. The recent events in Portugal might also play a role. Otherwise, why is the criticism coming up only now? Heterodox economists have been saying for many years that the euro would not work, and most American, British and Swedish economists agreed (which is why the latter two countries opted out of the euro).

Let me also point out that I do not agree with the above article. Channeling capital flows is not as important as it is made out to be by the orthodox economists. Savings are not needed for investment, bank loans are. So, the orthodox economists are still short of understanding what happened in the euro zone.

Liberty Street Economics at the Fed NY has an interesting article on discount window (DW) stigma:

Although it discouraged DW borrowing, the Fed generally kept the DW rate below the market rate, in part because the Fed lacked independence from the Treasury and was obliged to keep the DW rate below the market rate to help the federal government finance its deficits at low rates. The Treasury–Federal Reserve Accord of 1951 freed the Fed from pressure from the Treasury, but the Fed continued to maintain the DW rate below the market rate despite recommendations to the contrary. It did so because it believed that banks that legitimately needed DW funds should not face a punitive rate. Thus, between 1914 and 2003, the DW rate was generally below the market rate on banks’ primary sources for short-term funding (in other words, the commercial paper rate before 1954 and the federal funds rate since 1954; see chart below).

I have come across many economists who believe that the interest rate on treasury bonds is market-determined. In my forthcoming book I explain why the short-term interest rate set by the central bank has a very strong influence on the interest rates and yields of government bonds (and notes). Here you hear it from the Fed NY. Supply and demand for government bonds do not determine the interest rate the government pays. Therefore, loanable funds theory is plain wrong and so is the IS/LM model with crowding out and liquidity trap.

The article contains another clarification which I also describe in my forthcoming book – banks can borrow required reserves if they don’t have sufficient reserves:

Indeed, these requirements may have led market participants to presume that if a bank was borrowing from the DW, it must be in trouble, even if, in fact, the bank was borrowing to address a temporary funding shortfall or to meet reserve requirements.

This means that reserves requirements have to be fulfilled ex-post, being calculated after lending has occurred. Hence a lack of reserves cannot stop banks from lending.

Posted by: Dirk | November 11, 2015

Keynesian New Economics

As macroeconomics was transformed in response to the Depression of the 1930s and the inflation of the 1970s, another 40 years later it should again be transformed in response to stagnation in the industrial world.

Larry Summers wrote these lines in a recent article at the Washington Post. Since I have been doing research on “Keynesian New Economics” in response to the crisis, let me briefly summarize what I came up with.

  1. methodology: Keynesian New Economics should be based on a balance sheet view of the world. We know for some considerable time that money spent creates incomes; we also know that it makes sense to examine private, public and external sector and their respective net debt balances as well as the changes thereof
  2. equilibrium: we have to move away from the idea that markets clear because supply equals demand at some equilibrium price; this is not how labour markets or the money market work. So, two out of three markets do not work with this neoclassical closure but instead rely on different mechanisms
  3. money: student and scholars need to present the way actual monetary systems work; how is central bank money created/destroyed? what about government bonds? what about endogenous bank money (=deposits)?
  4. NIPA/FOF/BOP: understanding the interactions of the economic subjects should be at the core of Keynesian New Economics. National Income and Product Accounts, Flow-of-Funds and Balance of Payments need to be explained step-by-step so that it is clear which parts are moving and which are reflections of changes elsewhere. In a financial system run by double entry book-keeping, not all entries arise from rational behaviour of individuals. This is especially so for aggregated like the current account of a nation or the public debt.
  5. policy: we have to understand that public debt is something fundamentally different from private debt. While in a sovereign monetary system the government cannot run out of money, this is a big problem for the private sector (or parts of it). Fiscal policy can have unwanted side effects (like current account deficits), but it is not the expansionary fiscal spending per se that is bad. Monetary policy has in effect been used to finance one private sector bubble after the other and apparently cannot do so anymore because we hit the zero lower bound. More government spending is needed for the private sector to create the next big leap forward.

There is a long way to go, but some economists already started (here is a simple model which incorporates issues 1-5). If economics fails to reform, the times of economists as influential advisers of policy makers will be over.

The ECB held a conference at Sintra near Lisbon this summer and the book with the papers is available as pdf here. As you probably know, US economists have been critical of the euro for a long time – and rightly so. So, I am happy to see that Robert J. Gordon was allowed to voice his critique, responding to Jordi Gali (my highlighting):

3. Why was the euro area unemployment rate so high in 2014?

This question can be rephrased – why in May 2015 was the unemployment rate in Germany 4.7% while that in Greece was 25.6%, that in Spain 22.5%, and that in Italy 12.4%? The weighted average for the euro area was a rate of 11.1%. The ultimate answer to the apparent puzzle of high average euro area unemployment is that the euro was not a good idea, as many economists predicted before 1999, because of the lack of a centralised fiscal budget and insufficient labour mobility. The German economy is thriving and is able to impose its version of tight money on the peripheral countries, most of which suffer from severe forms of structural unemployment and perverse labour-market institutions.

Learning from mistakes is difficult but important. UK economists and Swedish economists were against the euro, too, by the way. Willem Buiter chipped this in at the conference (again, my highlighting):

To close the output gap, the euro area needs effective combined monetary and fiscal stimulus. Unfortunately, the deeply flawed original design of EMU has not been meaningfully revised since its inception, except as regards the creation of a (too) small sovereign liquidity and bank recapitalisation fund (the European Stability Mechanism (ESM)), some quite impressive, but still incomplete, steps towards banking union and a regrettable increase in the scope and scale of own-risk financial operations by NCBs. Without deep reforms, I believe the euro area will not survive – and does not deserve to.

It seems that things are moving in the right direction. There are many more critical economists who had and still have something to say about the euro, and they deserve to be heard.

Posted by: Dirk | October 26, 2015

Portugal: the euro zone strikes back

While the German press does not seem eager to report this (for instance, there is no article on SPON), one can turn to British (non-euro zone) news to get the story (from The Telegraph):

Eurozone crosses Rubicon as Portugal’s anti-euro Left banned from power

Constitutional crisis looms after anti-austerity Left is denied parliamentary prerogative to form a majority government

Portugal has entered dangerous political waters. For the first time since the creation of Europe’s monetary union, a member state has taken the explicit step of forbidding eurosceptic parties from taking office on the grounds of national interest.

Anibal Cavaco Silva, Portugal’s constitutional president, has refused to appoint a Left-wing coalition government even though it secured an absolute majority in the Portuguese parliament and won a mandate to smash the austerity regime bequeathed by the EU-IMF Troika.

He deemed it too risky to let the Left Bloc or the Communists come close to power, insisting that conservatives should soldier on as a minority in order to satisfy Brussels and appease foreign financial markets.

That is what the euro has done to Europe, intentionally or not. Before, the Portuguese did not have the problem of foreigners holding their debts and if so, they held them in escudos. If the exchange rate dropped, it was the problem of the investor, not the Portuguese government. In the context of what was done to the Greeks this should not surprise anyone.

As it stands, Europe is sacrificing, or better, has sacrificed democracy for the euro. Most political parties are absolutely ok with that. It is up to voters now to express their opinion. However, it seems that their voice will be ignored if the popular demands do not coincide with those of “Brussels and [..] foreign financial markets”. (I assume that The Telegraph uses financial markets as a polite phrase instead of rich people.) Francis Coppola at Forbes compares Europe to the Soviet Union, by the way. I think that there is a difference – the Soviet Union never claimed to be democratic – but from the actual results in Greece and Portugal one might expect things to deteriorate. There is still time to revive the ideals of European Enlightenment. Nevertheless, it is getting shorter and shorter…

Sometimes a picture says more than a 1,000 words, but nowadays video is more appealing. Please watch the video below which shows Princeton University’s news conference for the Nobel Prize in economics winners Christopher Sims and Thomas Sargent that took place Oct. 10, 2011. Start with the question that is asked at 14 minutes and 10 seconds:

The competing view comes from Bill Mitchell, no Nobel prize and no significant claims to fame, unknown in the wider profession, presenting in front of students in Helsinki, Finland (watching the first couple of minutes should be enough to get an impression):

Of course, Mitchell addresses the crisis while Sargent and Sims did not (plan to). But nevertheless I would ask you: which type of economist would you prefer: the Nobel prize winners or the “worldly philosopher”? Choose your economists wisely!

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