...against fictions and other tall tales

Tuesday, 14 October 2014

Deficit, Deficit, Who's got the Deficit? (Secular stagnation edition)

Over 50 years ago, James Tobin wrote an article for the New Republic entitled "Deficit, Deficit, Who's got the Deficit" (1963) that explains why the US federal government almost always needs to run a budget deficit.

The article is a gem. It has everything a good macroeconomics article should have: lots of debunking, all the relevant data, and a good dose of policy recommendations.

Unfortunately, the article is nowhere to be found on the internet. This post seeks to fix that by providing some key excerpts. Another purpose of this post is to use Tobin's analytical framework in that article and apply it to today's economic environment in the US.

Tobin on US Sectoral Financial Balances, circa 1963

The article starts off by describing the fundamental (iron?) law of financial balances:
For every buyer there must be a seller, and for every lender a borrower. One man's expenditure is another's receipt. My debts are your assets, my deficits your surplus. 
If each of us was consistently "neither borrower nor lender," as Polonius advised, no one would ever need to violate the revered wisdom of Mr. Micawber. But if the prudent among us insist on running and lending surpluses, some of the rest of us are willy-nilly going to borrow to finance budget deficits. 
In the United States today one budget that is usually left holding a deficit is that of the federal government. When no one else borrows the surpluses of the thrifty, the Treasury ends up doing so. Since the role of debtor and borrower is thought to be particularly unbecoming to the federal government , the nation feels frustated and guilty. 
Unhappily, crucial decisions of economic policy too often reflect blind reactions to these feelings. The truisms that borrowing is the counterpart of lending and deficits the counterpart of surpluses are overlooked in popular and Congressional discussions of government budgets and taxes. Both guilt feelings and policy are based serious misunderstanding of the origin of federal budget and surpluses. (1963:10)
Tobin then goes on to explain that both the household and financial sectors were running large financial surpluses (worth $20 billion combined in 1963):
American households and financial institutions consistently run financial surpluses. They have money to lend, beyond their own needs to borrow. As a group American households and non-profit institutions have in recent years shown a net financial surplus averaging about $15 billion a year -- that is, households are ready to lend, or to put into equity investments...more than they are ready to borrow. [...] In addition, financial institutions regularly generate a lendable surplus, now of the order of $5 billion a year. For the most part these institutions -- banks, saving and loans associations, insurance companies, pension funds, and like -- are simply intermediaries which borrow and relend the public's money. Their surpluses result from the fact that they earn more their lending operations than they distribute or credit to their depositors, shareowners, and policyholders. [...]
The article goes on to list the sectors of the economy that must borrow the $20 billion in surplus funds available from households and financial institutions:
State and local governments as a group have been averaging $3-4 billion a year of net borrowing...Unincorporated businesses, including farms, absorb another 3-4 billion a year. To the rest of the world we can lend perhaps $2 billion a year. We cannot lend abroad -- net -- more than the surplus of our exports over our imports of goods and services, and some of that surplus we give away in foreign aid. [...]
The remainder -- some $10-12 billion -- must be used either by nonfinancial corporate business or by the federal government. Only if corporations as a group take $10-12 billion of external funds, by borrowing or issuing new equities, can the federal government expect to break even. [...]
Tobin then follows into a discussion about the policy implications of these lending and borrowing dynamics:
The moral is inescapable, if startling. If you would like the federal deficit to be smaller, the deficits of business must be bigger. Would you like the federal government to run a surplus and reduce its debt? Then the business deficits must be big enough to absorb that surplus as well as the funds available from households and financial institutions. 
That does not mean business must run at a loss -- quite the contrary. Sometimes, it is true, unprofitable business are forced to borrow or to spend financial reserves just to stay afloat; this was a major reason for business deficits in the depths of the Great Depression. But normally it is business with good profits and good prospects that borrow and sell new shares of stock, in order to finance expansion and modernization...The incurring of financial deficits by business firms -- or by households and governments for that matter -- does not usually mean that such institutions are living beyond their means and consuming their capital. Financial deficits are typically the means of accumulating nonfinancial assets -- real property in the form of inventories, buildings and equipment. 
When does business run big deficits? When do corporations draw heavily on the capital markets? The record is clear: when business is very good, when sales are pressing hard on capacity, when businessmen see further expansion ahead. Though corporations' internal funds -- depreciation allowances and plowed-back profits -- are large during boom times, their investment programs are even larger. [...]
Recession, idle capacity, unemployment, economic slack -- these are the enemies of the balanced government budget. When the economy is faltering, households have more surpluses available to lend, and business firms are less inclined to borrow them. (1963:11)
The Corporate Sector: From Deficits to Large Surpluses

Of course, at the time Tobin wrote this article, US financial balances weren't exactly the same as they are today. Households as a group were running financial surpluses, the US was mostly a net lendor to the rest of the world, and the corporate sector was a net borrower of funds. Essentially, three things have changed since the mid-1980s with respect to financial balances (see charts below, double-click to enlarge).




First, starting in the mid-1980s, the US has become a net borrower to the rest of the world. Second, since the early 1990s and until the financial crisis, households were net borrowers to other sectors; since 2007, the household sector has returned to its traditional role of being a net lender. Finally, since the 1990s, the corporate sector has been at different times either a net lender or net borrower. However, since 2009, the corporate sector has been running a very large net financial surplus.*

What is the main policy implication to take-away from this state of affairs?

I would venture that the main take-away is that it's unlikely the US federal government will balance its budget any time soon unless households and/or firms start spending again.

In a recent article for an IMF publication entitled "Secular Stagnation: Affluent Economies Stuck in Neutral", economist Robert Solow (MIT) discussed the business sector's net lending position as a possible sign that there may be a "shortage of investment opportunities yielding a rate of return acceptable to investors" or, stated differently, that the "real rate of interest compatible with full utilization is negative, and not consistently achievable", a situation associated with the notion of "secular stagnation":
In the United States, at least, business investment has recovered only partially from the recession, although corporate profits have been very strong. The result, as pointed out in an unpublished paper by Brookings Institution Senior Fellows Martin Baily and Barry Bosworth, is that business saving has exceeded business investment since 2009. The corporate sector, normally a net borrower, became a net lender to the rest of the economy. This does smell rather like a reaction to an expected fall in the rate of return on investment, as the stagnation hypothesis suggests. (see chart below)
Source: Baily and Bosworth, 2013
Secular Stagnation

So what can be done? Paul Samuelson and Anthony Scott asked a similar question in the 1971 Canadian edition of their Economics textbook:
What if our continental economy is in for what Harvard's Alvin Hansen called "secular stagnation"? - which means a long period in which slowing population increase, [...], high corporate saving, the vast piling up of capital goods, and a bias toward capital-saving inventions will imply depressed investment schedules relative to saving schedules? Will not active fiscal policy designed to wipe out such deflationary gaps then result in running a deficit most of the time, leading to a secular growth in the public debt? The modern answer is "Under these conditions, yes; and over the decades the budget should not necessarily be balanced." (1971:436-7)
In my next post, I'll write more about secular stagnation and policy responses to address its possible eventuality.

* This post by Brian Romanchuk contains many useful charts and information on financial balances, as well as discusses secular stagnation from a stock-flow consistent perspective.

Update: I added charts on 2014-10-14, following a comment by Ramanan.

References

Baily, M. N., B. Bosworth, "The United States Economy: Why such a weak recovery", September 11, 2013, Brookings Institution, Washington DC.

Samuelson and Scott, Economics, 3rd Canadian Edition, McGraw-Hill, 1971

Solow, R., "Secular Stagnation: Affluent Economies Stuck in Neutral", in Looming Ahead, Finance and Development, vol. 51 , no.3. September 2014.

Tobin, J., "Deficit, Deficit, Who's got the Deficit?", New Republic, January 19, 1963

Sunday, 12 October 2014

Paul Krugman on currency independence, circa 1999

If there's one macroeconomic observation that has gone from obscure to remarkably mainstream in recent years, it's that a nation that has given up its currency independence is at a big disadvantage relative to nations with independent, sovereign currencies, especially when it comes to options for addressing economic downturns and overcoming the aftermath of financial crises.

Paul Krugman has been a main proponent of this view. And he's been at it for a while.

Here's an excerpt from a classic piece by Krugman from 1999 on the ills faced by Argentina after it experimented with dollarization in the 90s:
The problem, you see, is that the same rules that prevent Argentina from printing money for bad reasons--to pay for populist schemes or foolish wars--also prevent it from printing money for good reasons such as fighting recessions or rescuing the financial system. [...] 
Now, these problems with a rigidly fixed exchange rate are not news. But for a while, currency-board enthusiasts managed to convince themselves that they weren't significant. They argued that as long as governments themselves followed stable policies--and as long as the economy was sufficiently 'flexible' (the all-purpose answer to economic difficulties)--there would be few serious recessions. 
But it turns out that history does not stop just because the currency is stable. And faced with a politically inconvenient recession, the Peronists find that there is nothing they can do. They cannot print money. They cannot even borrow money for some employment-generating public spending, because fiscal indiscipline would undermine the peso's hard-won credibility.
Read the entire column here.

Reference 

Krugman, P., Don't laugh at me Argentina, Slate, July 20, 1999

Sunday, 5 October 2014

It's the demand, stupid! The role of weak demand on productivity growth

I couldn't resist the title.

Last week I was invited to give a short talk on what I thought was the most pressing policy issue facing the world economy today.

So I presented the findings from a very interesting paper entitled "Explaining Slower Productivity Growth: The Role of Weak Demand Growth" by Someshwar Rao and Jiang Li.

The paper examines the link between demand and productivity growth in both Canada and OECD countries. This issue has been an interest of mine ever since I read these lines in a book by Alan Blinder several years ago:
Economic slack...discourages business investment because companies that cannot sell their wares see little reason to expand their capacity. In consequence, the nation gradually acquires a smaller, older, and less efficient capital stock. 
[A]lthough the state of the national is far from the only factor, who doubts that a booming economy provides a better atmosphere for inventiveness, innovation, and entrepreneurs than a stagnant one? As the cliché says, a rising tide raises all boats...From 1962 to 1973, our generally healthy economy experienced only one mild recession, an average unemployment rate of 4.7 percent, and productivity growth that averaged a brisk 2.6 percent per annum. [Between 1974 and the mid-1980s] the economy [was] frequently...out of sorts. We...suffered through two long recessions and one short one, with an average unemployment rate of 7.3 percent and a paltry average productivity growth rate of 1 percent. This association of high unemployment with low productivity growth is no coincidence. 
Surveying these concomitants of high unemployment -- lack of upward mobility for workers, sluggish investment, lackluster productivity growth -- suggests an ironic conclusion: the best way to practice supply-side economics may be to run the economy at peak levels of demand. (1986:36).
This still makes lots of sense to me.

Verdoorn's Law

During my talk I described the paper as lending support to the well-known findings of economist Petrus J. Verdoorn, who several decades ago published research showing a positive relationship between labour productivity growth and real output growth.

In retrospect, I probably shouldn't have discussed this since it led to a number of questions on Verdoorn and his research, which shifted the focus away from the paper and the real purpose of my talk, which was to drive home the point that there is considerable evidence that productivity growth shouldn't be viewed as solely a supply-side phenomenon.

Specifically, the paper supports the -- in my opinion, common sense -- view that a slowdown in domestic and external demand is detrimental to growth in labour productivity, real incomes and economic activity because of the negative impact of weaker demand on scale and scope of economies, formation of physical and human capital, innovation and entrepreneurial activity.

Here are the paper's main findings:
Our major findings is that 93 percent of the fall in average labour productivity growth between 1981-2000 and 2000-2012 can be attributed to the drop in real GDP growth between the two periods...In addition, our new empirical research shows that a slowdown in growth of domestic and external demand also impacts negatively some of the key drivers of productivity growth, such as, gross fixed capital formation, M&E investment (including ICTs) and R&D spending, thus leading to lower trend labour productivity. (2013:14)
I concluded my presentation by discussing some of the policy implications outlined by the paper's authors. At this point, I was hoping my comments would get the attention of the government policy analysts and economists in the audience.

First, I suggested that it would be prudent for governments to ensure that deficit and debt reduction measures are gradual in nature so that their negative impact on domestic demand would not be excessive.

Then, I explained that it's always a good idea for governments to spend on productivity-enhancing public investment, even during a period of economic slowdown, as it contributes to both today's demand as well as future productivity growth.

References

Blinder, A., Hard Heads, Soft Hearts, (Mass: Perseus Books)

Rao, Someshwar and Jiang Li, "Explaining Slower Productivity Growth: The Role of Weak Demand Growth", International Productivity Monitor, Spring 2013.

Sunday, 28 September 2014

Anthony Atkinson on the public debt and intergenerational equity

It's been a long time since my last post. Much of my spare time has been spent reading and thinking about the best way to think about the economy. In the end, I've come to the conclusion that it's the big picture that matters.

Take the question of the public debt. Much of the discussion in the popular press relating to the national debt focuses on the liabilities of the government and actuarial concerns (dealing with "how to pay it off"), but it rarely discusses the link between public debt and private wealth, wealth distribution and intergenerational equity.

Anthony Atkinson, I believe, summarized it best here:
Much of the rhetoric of fiscal consolidation is concerned with the national debt as a burden on future generations [...] One lesson of the public economics literature on the national debt is that we have to look at the full picture. We pass on to the next generations:
  • national debt, 
  • state pension liabilities, 
  • public financial assets, 
  • public infrastructure and real wealth, 
  • private wealth, 
  • state of the environment, and
  • stocks of natural resources.
We need to look at the overall balance sheet, where assets as well as liabilities are taken into account. This does not mean that the position is a healthy one. If we consider the difference between the assets of the state and the national debt, expressed as a percentage of the total national wealth, then in the 1950s the net worth of the [UK] state was negative, but it was becoming less negative, and turned positive in the 1960s [...]

The direction of change since the 1970s has however been in the wrong direction [...] In effect the process of privatisation, with the proceeds used largely to fund tax cuts, transferred wealth from the state to the personal sector. We saw that it was at the end of the 1970s that personal wealth began to rise faster than income. The worsening of the public balance sheet is the other side. Personal wealth has risen faster than national wealth since the 1970s because, in effect, assets have been transferred from the public to the private sector. We are passing on more privately to the next generation but less publicly.

Reversing this pattern can be achieved not only by reducing the national debt, but also by increasing public assets.
Now, to say that more wealth is being passed on privately rather than publicly does not mean that it's being passed on equitably.

For instance, when the government sells-off public sector assets such as parks and decommissioned military bases, the government can use the proceeds to pay down the debt, but the assets get transferred to the purchasers of those assets in the private sector, who, most of the time, don't have the same class and socio-economic profile as that of the whole population (i.e., the former "owners" of those assets).

So here's the bottom line: paying down the debt by selling off public assets to the financial interests has contributed immensely to the wealth inequality that is being discussed these days.

And the corollary to this statement is that there's still lots of wealth "out there" that could be used for public purposes and has the potential to be passed on to future generation in a more equitable manner. It hasn't disappeared, it's just changed hands.

Reference

Atkinson, A.B., "Public economics in an age of austerity", January 12, 2012

Sunday, 9 March 2014

When the Fed supported a Job Guarantee policy (and the economist who made it happen)

Circuit here. I'm back from a few months hiatus following the birth of my second child, a baby girl. Thanks to all readers for your continued interest in this blog.

A few weeks ago, Rolling Stone magazine ran a piece by Jesse Myerson supporting the idea that the government should guarantee a job to anyone who is willing to work. In their recent work, Dean Baker and Jared Bernstein also give support to this policy proposal. Randy Wray, Warren Mosler and other modern money (MMT) economists have been pushing for this idea for a long time. On the center-right and right, the idea is being promoted by Peter Cove and Kevin Hasset.

This is good news. I certainly welcome a good debate on this idea. That said, it's too bad that commentators who are skeptical of the idea simply dismiss it as a non-starter for policymakers.

This, of course, is overstating the case somewhat. It's worth recalling that in the 1970s none other than the Chairman of the Federal Reserve supported the idea that the federal government should be the "employer of last resort". Here's the former Fed Chairman Arthur Burns back in 1975:
I believe that the ultimate objective of labor market policies should be to eliminate all involuntary unemployment. This is not a radical or impractical goal. It rests on the simple but often neglected fact that work is far better than the dole, both for the jobless individual and for the nation. A wise government will always strive to create an environment that is conducive to high employment in the private sector. Nevertheless, there may be no way to reach the goal of full employment short of making the government an employer of last resort. This could be done by offering public employment -- for example, in hospitals, schools, public parks, or the like -- to anyone who is willing to work at a rate of pay somewhat below the Federal minimum wage. 
Burns
With proper administration, these public service workers would be engaged in productive labor, not leaf-raking or other make-work. To be sure, such a program would not reach those who are voluntarily unemployed, but there is also no compelling reason why it should do so. What it would do is to make jobs available for those who need to earn some money. 
It is highly important, of course, that such a program should not become a vehicle for expanding public jobs at the expense of private industry. Those employed at the special public jobs will need to be encouraged to seek more remunerative and more attractive work. This could be accomplished by building into the program certain safeguards -- perhaps through a Constitutional amendment -- that would limit upward adjustment in the rate of pay for these special public jobs. With such safeguards, the budgetary cost of eliminating unemployment need not be burdensome. I say this, first, because the number of individuals accepting the public service jobs would be much smaller than the number now counted as unemployed; second, because the availability of public jobs would permit sharp reduction in the scope of unemployment insurance and other governmental programs to alleviate income loss. To permit active searching for a regular job, however, unemployment insurance for a brief period -- perhaps 13 weeks or so -- would still serve a useful function.
The idea was even supported by one of the most respected names in economics at the time: Franco Modigliani.  When asked to comment on Chairman Burns's proposal during a testimony before the Congressional Banking committee in 1976, Modigliani said the following:
...the idea of a public employment program as an employer of last resort, which is an alternative to unemployment compensation, strikes me as a very sound idea (p. 110).
Interestingly, the economist who got Burns and the Fed to put serious thought into the idea of a job guarantee was another well-respected contributor to US public policy during that period: Eli Ginzberg.

Job Creation through Public Service Employment

Eli Ginzberg was a Professor of Economics at Columbia University and author of numerous books on human resources and manpower economics. He was also -- in the language of Harold Wilensky and organizational sociology -- a "contact man", a person who provides ideas and furnishes intelligence to decision-makers on the political and ideological tendencies in the society at large. Ginzberg played this role throughout his career as presidential adviser for many administrations and through his affiliation with the Manpower Demonstration Research Corporation (MDRC), which recently marked its 40th year of operation.

Ginzberg was an institutional economist in the tradition of John M. Clark and Wesley C. Mitchell who believed fervently that "people, rather than physical or financial capital, were the principal source of productivity and wealth" (1987:107). For this reason, Ginzberg believed it was critical for the government to eliminate unemployment as quickly as possible through the use of a publicly-funded jobs program.

Another reason why Ginzberg believed the government ought to be employer of last resort is that he understood that economies sometimes face a shortfall in jobs that makes it impossible for all unemployed workers to find work:
Just as reality has mocked the ethos of equality of opportunity for many minority children, the counterpart doctrine that adults are responsible for their own support and that of their dependents has been undermined by the continuing shortfall in jobs. The existence of high unemployment rates make it socially callous, even reprehensible, for a society to continue to affirm the doctrine that all adults who need income should work and then not provide adequate opportunities for many of them to fulfill this imperative. 
Although the US experimented with federally financed job creation in the 1930s and again in the 1970s, the record in retrospect must be viewed as equivocal. Most students believe that on balance the New Deal was right to put large numbers of the unemployed to work on governmentally financed programs rather than to keep them on the dole as the British did. (1987:162) 
Ginzberg
On this last point concerning whether income transfers or guaranteed work should be the centerpiece of US social policy, Ginzberg's view was informed by the work he did during the Great Depression. Here's how Ginzberg summarized the conclusions of a 1947 book entitled The Unemployed that he co-authored on the topic of unemployment during the Great Depression:
The principal lessons I extracted included the superiority of work relief over cash support...; the cause of unemployment being rooted in a shortfall in demand for labor, not in the inadequacies of the unemployed; the centrality of work and self-support for the integrity of the individual worker, his family, and the community. By the time our investigation was concluded, [we] were convinced that no society concerned about its security and survival could afford to remain passive and inert in the face of long-term unemployment. We argued that in the absence of an adequate number of private sector jobs, it was the responsibility of government to create public sector jobs. (1987:111)
Ginzberg also believed that guaranteed work for those who are able and willing would find greater acceptability among Americans than a policy that would require government providing a guarantee income to everyone. According to Ginzberg, providing guaranteed income to everyone would conflict with the powerful American ethos of self-reliance and the American population's highly favorable view toward the culture of work:
There is no simple way, in fact, there is no way to square the following: to provide a decent minimum income for every needy person/family in the US, given the differentials in living standards, public attitudes, and state taxing capacity, and at the same time avoid serious distortions in basic value and incentive systems that expect people to be self-supporting through income earned from paid employment. (157)
For this reason, Ginzberg believed that a job guarantee should play a key role in social policy:
Accordingly, I would like to shift the focus from welfare to work, from income transfers to the opportunity to compete, from dependency status to participation in society. In advocating this shift toward jobs and earned income and away from unemployment and income transfers, the planners must focus on two fundamentals: the developmental experiences that young people need in order to be prepared to enter and succeed in the world of work; and the level of employment opportunities that a society must provide so that everybody able and willing to work, at least at the minimum wage, will be able to do so. (157)
In the 1970s, Ginzberg held the position of Chairman of the National Commission for Manpower Policy, a government-mandated commission that produced some of the best policy-oriented research on the topic of public service employment, including an excellent paper entitled "Public Service Employment as Macroeconomic Policy" by Martin Neil Baily and Robert Solow (1978) that explains how public service employment (PSE), while not necessarily more stimulative than the normal kind of fiscal policy (e.g., government spending on goods and services and tax measures), can be a perfectly sensible policy if the program is well-administered and the jobs that are created provide useful social output:
Solow and Baily
We conclude that the main advantages of PSE over conventional fiscal policy are: (a) that it can be targeted to provide jobs for hard-to-employ groups in the labour force, and for especially depressed cities and regions; (b) that PSE employment, correctly targeted, may be slightly less inflationary than the same amount of ordinary private sector employment, so that total employment can safely be a little higher with a PSE component; and (c) that PSE can be coordinated with other forms of social insurance -- public assistance and unemployment insurance, for instance -- to make them perhaps more effective and certainly more acceptable to public opinion. (1978:30)
Solow later revisited the issue of public service employment in Work and Welfare (1998), in which he argued that any attempt to reform the welfare system in order to get the unemployed back to work would only succeed if every able and willing worker is given access to a job through public service employment and/or by offering incentives to businesses to hire the unemployed.

The Deal 

It was in the 1970s that Ginzberg persuaded Chairman Burns to call on the US federal government to become the employer of last resort.  Here's Ginzberg's account of how he was able to get the Fed Chairman to support the job guarantee:
I made a deal with Arthur Burns when he was the head of the Federal Reserve, that I would try to control the amount of money we asked for from the Congress for manpower training if he would come out in favor of the government as the employer of last resort. And he did it. It took him a year, but I negotiated with him and he did it.
A final word. Although Ginzberg supported the idea of a job guarantee, he fully recognized the high budgetary cost that such a policy would entail and the practical challenges facing public administrators in terms of successfully implementing a public service employment program. To address these concerns, he believed the government authorities should make improvements to the program using trial and error and cautious experimentation. But the key, he would argue, is to ensure that the jobs created through these measures provide productive social output:
There is no big trick to put more and more people on public service employment. If that is the only thing that one is interested in, obviously, the Federal Government can create the money by fiat and put more people on public service employment. The question is what are the short- and long-run implications of doing that in terms of keeping our economy productive, competitive and innovative....So I do not think it is just jobs; it is productive jobs and that is another way of saying that the Federal Government can go only part of the way in terms of assuring that we have a productive economy. 
References

Baily, Martin N. and Robert Solow, "Public Service Employment as Macroeconomic Policy", National Commission for Manpower Policy, 1978

Ginzberg, Eli, The Skeptical Economist, Boulder and London: Westview Press, 1987

National Commission for Manpower Policy, "Job Creation through Public Service Employment: An Interim Report to the Congress", 1978

Solow, Robert, Work and Welfare, Princeton, NJ: Princeton University Press, 1998

Tuesday, 19 November 2013

On the (ir)relevance of the money multiplier model: The Fed view

It has long been known within the Federal Reserve System -- especially among economists who worked in the FRS in the 1970s and 1980s when much of the research agenda was directed at issues of monetary control -- that the money multiplier model of money stock determination is not the most realistic (or useful) way to understand how central banks conduct monetary policy.

Here is the former Fed Governor, the late Sherman Maisel, during a conference on the theme of 'Controlling Monetary Aggregates' in 1971:
It is clear that, as a matter of fact, the Federal Reserve does not attempt to increase the money supply by a given amount in any period by furnishing a fixed amount of reserves on the assumption that they would be multiplied to result in a given increase in money [...] 
Many unsophisticated comments and theories speak as if the Federal Reserve purchases a given quantity of securities, thereby creating a fixed amount of reserves, which through a multiplier determines a particular expansion in the money supply. Much of modern monetary literature is actually spent trying to dispel this naive elementary textbook view which leads people to talk as if (and perhaps to believe) the central bank determines the money supply exactly or even closely--in the short run-through its open market operations or reserve ratio. This incorrect view, however, seems hard to dislodge. (1971:153, 161)
Briefly, the money multiplier is basically a relationship between deposits (D) and reserves (R), D = mR, (or M = mB) where m is called the money multiplier (or M is money stock and B is the monetary base). According to the model, if banks keep excess reserves to a minimum and reserve requirements are applied to all deposits, then the multiplier can be constant and the central bank -- if it retains control of the volume of reserves -- can control the amount of deposits (Goodfriend and Hargraves, 1983:5). However, if the central bank does not exercise control over the amount of reserves, the multiplier model is inoperable and cannot be exploited for monetary control purposes.

The Classic Fed View

In the US, the Fed's inability to control the quantity of reserves in recent decades (before October 2008) is said to be because of the introduction of lagged reserve requirements in the late 1960s and the Fed's almost continuous use of an interest rate operating procedure.

Former St. Louis Fed economist, R. Alton Gilbert, discussed the impact of lagged reserve accounting on Fed operations in his article "Lagged Reserve Requirements: Implications for Monetary Control and Bank Reserve Management" (1980):
[Lagged reserve accounting] breaks the link between reserves available to the banking system in the current week and the amount of deposit liabilities that banks can create in the current week. If banks increase aggregate demand deposits liabilities in response to an increase in loan demand, they are under no immediate pressure to reduce their deposit liabilities...Under LRA, the Federal Reserve tends to adjust total reserves each week in response to the total deposit liabilities that banks created two weeks earlier. (1980:12)
With lagged reserve requirements in effect the volume of reserves is determined by banking system demand. Reserve demand is simply accommodated and required reserves serve only to enlarge the demand for reserves at any given level of deposits. Under LRA, the change in R occurs as a result of changes in D, the exact opposite of the money multiplier model.

Former Richmond Fed economist, Marvin Goodfriend, discussed the relevance of the money multiplier model when lagged reserve requirements are in effect in his paper "A model of money stock determination with loan demand and a banking system balance sheet constraint(1982):
...[T]he discussion has shown that the money multiplier is not generally a complete model of money stock determination and is actually irrelevant to money stock determination for some monetary control procedures. Specifically, the money multiplier is irrelevant to determination of the monetary aggregates if lagged reserve requirements are in effect. (1982:15)
As for the other institutional factor relating to the Fed's use of an interest rate operating procedure, Robert Hetzel of the Richmond Fed highlighted the following in his paper "A Critique of Theories of Money Stock Determination(1986):
Deposits and reserve demand are determined simultaneously with credit creation. As a consequence of defending its rate target, the monetary authority, by creating an infinitely elastic supply of reserves, accommodates whatever reserve demand emerges...In a regime of rate targeting, neither the quantity of reserves nor the desired reserves-deposits ratio of the banking system exercises a causal role in the determination of the money stock (1986:6) [...]
Interest rate smoothing by the monetary authority makes reserves and the money stock endogenous...Since [Chester] Phillips (1921), reserves-money multiplier formulas have been derived from a model of the banking sector summarized in the multiple expansion of deposits produced by an injection of reserves. The existence of markets for bank reserves, however, renders this model untenable. Phillips' model assumes that the individual bank is constrained by the quantity of its reserves and that its asset acquisition and deposit creation are driven by discrepancies between actual and desired reserves. Given the existence of markets for bank reserves, such as the fed funds and CD markets, however, individual banks are constrained by the price, rather than the quantity, of reserves they hold. (1986:20) (emphasis added)
A succinct and detailed discussion of the problems associated with multiplier models of money stock determination is found in the excellent article "Understanding the remarkable survival of multiplier models of money stock determination(1992) by former Fed economist, Raymond Lombra:
Assuming textbook authors reveal their intellectual and pedagogical preferences and beliefs, a careful survey of the leading intermediate textbooks in money and banking and macroeconomics reveals a uniform and virtually universal consensus – the multiplier model of money stock determination is widely viewed as the most appropriate and presumably most correct approach to the topic...Since such consensus is not, in general, an enduring characteristic of monetary economics, one is tempted to “let sleeping dogs lie”. The problem is that the multiplier model, whether viewed from an analytical or empirical perspective, is at best a misleading and incomplete model and at worst a completely misspecified model. (Lombra, 1992:305) (emphasis added)
Lombra's article is especially useful because it groups together the different critiques of the multiplier approach into two categories (the article discusses a third set of critiques relating to the predictive accuracy of multiplier models but this issue is less relevant for this post). 

The first set of critiques identified by Lombra is that the multiplier model "is not structural but rather is a reduced-form", a point first made in the 1960s by proponents of the "New View" (including James Tobin in "Commercial banks as creators of "money")*. Lombra summarizes this critique as follows:
Succinctly stated, the critique emphasizes that the multiplier approach abstracts from the short-run dynamics of adjustments by banks and the public, leaves the role of interest rates implicit rather than explicit, and proceeds that the movements in the monetary base (or reserves) are orthogonal to fluctuations in the multiplier. The multiplier model, it is argued, implies that deposit expansion is quantity constrained through the Fed's control over the sources of bank reserves (chiefly, the Fed portfolio of securities). One of the most forceful and articulate crafters of the critique, Basil Moore, concludes that "as a result, the money multiplier framework is of no analytical or operational use".

The consensus view of the staff and policymakers within the Federal Reserve, as revealed in numerous publications, embraces much, if not all, of the critique advanced by Moore and others. In particular, the Fed adheres to the view that the system is equilibrated through the movements of interest rates, which through their effects on bank revenues and costs, determine banks' and the public's desired asset and liability positions. In this view, money is controlled by using open market operations to affect interest rates which in turn affect demand and thus the uses of bank reserves (chiefly, required reserves).  (307)
The second set of critiques discussed by Lombra concerns the issue of the endogeneity of reserves, that is, the notion that the quantity of reserves is in practice determined by the banking system:
This contention, which is related to the lagged reserve accounting scheme...and the Fed's interest rate operating procedure in effect for virtually all of the post-Accord period, implies the multiplier model is completely irrelevant for the determination of the money supply. (308)
Lombra's article concludes with a discussion on why, despite these important flaws, the multiplier approach continues to be popular among economists. The reason, he argues, is that when applied to longer term horizons the models track monetary growth reasonably well:
The model lives on with model-builders who are confirmed adherents to the Law of Parsimony and skilled in the use of Occam's Razor. The high correlations and identities so tightly linking reserves (or the base) and money over the longer run provide all the comfort most empiricists need to proceed as if the concerns noted above matter little. (312)
Still irrelevant?

Recently, Fed economists Seth Carpenter and Silva Demiralp concluded in their paper "Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?" that the money multiplier is not a useful means of assessing the implications of monetary policy for money growth or bank lending in the US.

Not only does their paper discuss the institutional factors that render the money multiplier inoperable (including those discussed above), it also demonstrates empirically that the relationships between reserves and money implied by the money multiplier model do not exist.

These conclusions should, however, be viewed with caution given that the period under investigation in the paper ends in 2008, just prior to the Fed's shift toward the use of unconventional monetary policies.

Interestingly, Robert Hetzel now believes that the money multiplier model has actually gained relevance since the Fed started with its large-scale asset purchases in 2008.

Here is an excerpt from Hetzel's recent book, The Great Recession:
Starting in mid-December 2008 when the FOMC lowered its funds-rate target to near zero with payment of interest on bank reserves, the textbook reserves-money multiplier framework became relevant for the determination of the money stock. The reason is that the Fed's instrument then became its asset portfolio, the left side of its balance sheet, which determined the monetary base, the right side of its balance sheet. As a result, from December 2008 onward, the nominal (dollar) money stock was determined independently of the demand for real money. Although the reserves-money multiplier increased because of the increased demand by banks for excess reserves, the Fed retained control of M2 growth. Even if banks hold onto increases in excess reserves, the money stock increases one-for-one with open market purchases. (2012:237) (emphasis added)
In other words, Hetzel is saying that, as a result of its ability to determine the monetary base (B), the Fed now exercises considerable control over the change in deposits (D). And by doing so, Hetzel is suggesting that the Fed -- in one way or another -- is currently exploiting the money multiplier framework.

Here's a chart that appears to support Hetzel's claim:


The chart shows that since 2008 changes in B -- resulting from Fed asset purchases -- are clearly associated with changes in M**. For the period prior to 2008, there is no such relationship.

Hetzel's claim about the relevance of the multiplier approach could help to explain why some commentators have found causal relationships between changes in the monetary base and other variables for the period since December 2008.

For instance, Market Monetarist proponent Mark Sadowski recently pointed to empirical evidence that changes in the monetary base have had some causal role since December 2008:
I’ve done Granger causality tests on the monetary base over the period since December 2008 and find that the monetary base Granger causes the real broad dollar index, the S&P 500, the DJIA, commercial bank deposits, commercial bank loans and leases, the PCEPI, and 5-year inflation expectations as measured by TIPS.
So what's the bottom line? Does this mean the money multiplier model is now relevant?

On the one hand, I'm not convinced the model is entirely applicable (for instance, the textbook treatment implies that banks keep excess reserves to a minimum, which is obviously not the case today). On the other hand, it's unlikely that Hetzel is somehow wrong here.

Fortunately, I don't think it matters much one way or another, unless perhaps you are a Fed technician or an econometrician. What does matter is that the Fed currently exercises control over the monetary base. This, in itself, is a significant development for understanding the policy options now available to the Fed.

One thing is for sure, this recent development provides an excellent illustration of a crucial point often highlighted in Raymond Lombra's work:
The specific procedures ("policy rule") employed by the Fed and the reserve accounting regulations governing bank reserve management play a crucial role in determining causal relationships and system dynamics. (1992:309)
------

* The 'New View' focused on the role of assets, both real and financial, and the relative price mechanism in monetary analysis. From an operational standpoint, it contended that the Fed has little control over the money stock and that the money stock plays only a minor role in the transmission mechanism linking Fed actions to the real sectors of the economy.

** It's clear that the monetary base is not pulled upward due to increased deposit creation by banks.

References

Carpenter, S and S. Demiralp, Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?", Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.2010

Gilbert, R.A., Lagged Reserve Requirements: Implications for Monetary Control and Bank Reserve Management", Monthly Review, Federal Reserve Bank of St.Louis, 1980:

Goodfriend, M., A model of money stock determination with loan demand and a banking system balance sheet constraint", Federal Reserve Bank of Richmond Working Paper, 1982

Goodfriend, M. and M. Hargraves, A historical assessment of the rationales and functions of reserve requirements, Federal Reserve Bank of Richmond Working Paper, 83-1, 1983

Hetzel, R., A Critique of Theories of Money Stock Determination, Federal Reserve Bank of Richmond Working Paper, 86-6, 1986

Hetzel, R., The Great Recession: Policy Failure or Market Failure, Cambridge University Press, 2012

Lombra, Raymond. Understanding the remarkable survival of multiplier models of money stock determination, Eastern Economics Journal, Vol 18, No 3, 1992

Maisel, S., Controlling Monetary Aggregates, Federal Reserve Bank of Boston Conference Proceedings, 1971

Tobin, J., Commercial banks as creators of "money" 1963

Wednesday, 6 November 2013

Deficit spending got the US out of the Great Depression: Paul Samuelson on helicopter money

Paul Samuelson, circa 2008 (see here at 1:31):
I'm full of sensible heresies. How do you think we got out -- in Roosevelt's time -- got out of that depression? How do you think the pernicious Adolf Hitler -- inheriting about the same, at least one third unemployment -- got out of it? And both of us got out of it in about the same number of years as you are getting to 1939. If you look at Mrs Schwartz's analysis of that, it's completely remote from the truth. 
This is not how it happened, but this is equivalent to how it happened: somebody invented helicopters. And somebody went to the printing press and printed-off millions and billions of legal tender. And then those helicopters flew over the poorer rural regions and the slums of the city. And it wasn't a problem of whether the money was going to be saved or wasn't going to be spent. It had nothing to do with pump-priming...It had nothing to do with jump-starting. [...] It was not a Federal Reserve operation.[...] 
Now, Mrs Schwartz and her collaborator, who's name I forgot at this moment [laughter], would say "well that helped to keep the M up". That's a joke! [The banker] didn't go out and start making new loans. He acquired more Treasury certificates, which had a yield of essentially zero. 
So we never got out of the Great Depression? Yes, we did. We did it essentially by deficit spending [...] 
The rest of this excellent discussion is well worth a careful listen.

Addendum : An ingenious reader has created a direct link to this excerpt on You Tube (see here). 2013-11-07

Sunday, 3 November 2013

The Old Keynesian prescription to get out of a deep recession

In my previous post, I highlighted an article that shows the most promising unconventional monetary policies for boosting ailing economies right now are overt monetary financing and the policy measures advocated by neo-chartalists.

It's worth mentioning that, from a practical standpoint, this is essentially what the traditional, Keynesian IS-LM model would prescribe in a context of high public debt combined with nominal interest rates at the zero lower bound.

A good example of the application of IS-LM toward this end is Robert Gordon's analysis of the difficulties facing Japanese policymakers in the 1990s:
If monetary policy is impotent because it cannot reduce the interest rate any further, a fiscal stimulus is required to end the slump and bring back the output ratio back to its desired level [...]
The low level of the Japanese interest rate created a policy dilemma in Japan. Monetary policy could not push interest rates appreciably lower, yet fiscal policymakers felt constrained in achieving a large fiscal stimulus by the high existing level of the fiscal deficit in Japan and by the fact that the public debt in Japan had reached 100 percent of real GDP. 
However, the IS-LM model suggests a way out of the Japanese policy dilemma... [:] a combined monetary and fiscal policy stimulus that shifts the LM and IS curves rightward by the same amount can boost real GDP without any need for a decline in interest rates [...]
Also, with such a combined policy there is no need for a further increase in the national debt held by the public, since to achieve its monetary expansion, the central bank can buy the government bonds issued as a result of the increased fiscal deficit [...]
Why did the Bank of Japan resist what seemed to be the obvious solution, which was that the Bank buy up the government bonds issued as a result of the fiscal stimulus? This solution, sometimes called "monetizing the debt", would be the real-world equivalent of shifting the LM curve rightward along with the IS curve, in contrast to the increased interest rates that would result if the IS curve were pushed rightward without a corresponding rightward LM movement. Bank of Japan policymakers retreated into the traditional fear of central bankers that monetizing the debt would undermine the Bank's independence and credibility, two goals that are embedded in the structure of beliefs of central bankers. In fact, as a result of rapid inflation after World War II, the Bank is legally banned from buying bonds directly from government, although it is still able to purchase government bonds indirectly through financial markets. 
The traditional reason for the historic reluctance of central bankers to monetize the debt and conduct a simultaneous monetary and fiscal expansion has been fear of inflation. Yet Japan's problem in the late 1990s was deflation, not inflation [...]
While the prescription of the IS-LM model in favor of a combined monetary-fiscal expansion seemed clear, implementing this policy recommendation was blocked by the reluctance of the Bank of Japan's to give up its historic commitment to price stability. (137-138) (emphasis added)
One final word. This type of policy solution goes back a long way. A variant of this mechanism -- minus the IS-LM language -- is even found in (Keynesian) Lorie Tarshis's textbook published in 1947.

Reference

Gordon, R., Macroeconomics, Eighth Edition, 2000.