Secular stagnation, secular exhilaration and fiscal policy

Paul Krugman is right: secular stagnation has historically always referred to a situation of persistent low demand, which, according to my old 1971 Samuelson and Scott textbook, renders it inappropriate for governments to attempt to balance the budget over the business cycle (as per the principle of countercyclical compensation).

While in a secular stagnation (Is the shorthand 'SecStag' catching on?), Samuelson and Scott suggest that constant or near-constant government budget deficits are needed to sustain an adequate level of demand to achieve full employment, as shown here:

Samuelson and Scott (1971:437)

The policy stance required during secular stagnation contrasts with the stance needed during periods of so-called "secular exhilaration" (with high demand), during which the right policy is running budget surpluses as a way to avoid overheating the economy and reduce inflationary pressures.

It's true that sustained deficits will increase public debt; however, the low cost of borrowing that usually comes with secular stagnation should help to ensure public debt levels won't get out of hand.

But hasn't the experience of Japan in the 1990s taught us that big deficits don't work to stimulate a stagnant economy, you might ask?

The answer is no. Kenneth Kuttner and Adam Posen demonstrated in "Passive Savers and Policy Effectiveness in Japan" that low tax revenues caused by a weak economy were to blame for the rising debt levels, not expansionary fiscal policy.

Of course, it's important that the spending be directed toward productive use.

I can think of two ways to achieve this goal. First, governments should invest in early childhood learning, an investment that's well known to pay-off in the long-run. Second, investing in infrastructure is also a good bet, as demonstrated several years ago by David Aschauer and Alicia Munnell, and as recently recommended by the IMF.

References

Aschauer, D., 1989, "Is Public Expenditure Productive", Journal of Monetary Economics, Vol. 23, pp. 177-200.

IMF, "Is it time for an infrastructure push? The macroeconomic effects of public investments", Chapter 3, October 2014.

Kuttner, K. and A. Posen, "Passive Savers and Policy Effectiveness in Japan", Institute for International Economics, 2001.

Munnell, A., 1990, "Why has productivity declined? Productivity and Public Investment" New England Economic Review, Federal Reserve Bank of Boston, January/February issue, pp. 3-22.

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

Impact of the US Payroll tax cut...and tax hike

This is a very informative (and short) piece by economists at the NY Fed on the effect of the 2011 US payroll tax cut and its recent expiration.

Here's a good summary:

Overall, our analysis suggests that the payroll tax cut during 2011-12 led to a substantial increase in consumer spending and facilitated the consumer deleveraging process. Based on consumers’ responses to our recent survey, expiration of the tax cuts is likely to lead to a substantial reduction in spending as well as contribute to a slowdown or possibly a reversal in the paydown of consumer debt. These effects are also likely to be heterogeneous, with groups that are more credit and liquidity constrained more likely to be adversely affected. Such nuances may be lost in the aggregate macroeconomic statistics, but they’re important for policymakers to consider as they debate fiscal policy.

Reference

Zafar, B., van der Klaauw, W., My Two (Per)cents: How are American Workers dealing with the Payroll Tax Hike, Federal Bank of New Work, Liberty Street Blog.

Moving past the 90 percent threshold: Focusing on growth

Now that the proposition of a 90 percent threshold (of public debt-to-GDP above which countries' economic growth would significantly slow) associated with the work of Carmen Reinhart and Ken Rogoff has been refuted, it's important that the debate now turn to the critical issue of how best to achieve growth moving forward.

On this point, one important aspect to keep in mind is that the uses toward which public debt is directed and the composition of public debt tend to have a significant impact on a country's economic growth.

A recent study by the IMF entitled "Public Debt and Growth" appears to support this view. The study, which examined the public debt dynamics in over 30 countries, found that, although the elasticity of growth with respect to public debt is -0.02, the elasticity of other variables that positively impacts growth offsets this number. For instance, as Iyanatul Islam has noted, the study shows that the elasticity of growth to initial years of schooling is above 2.0.

In other words, it's quite likely that public debt directed toward productive uses has the effect of supporting growth by cancelling out some of the negative effects associated with high public debt that impede growth.

These are the sort of issues policymakers should be discussing moving forward. I think it would go a long way to help us get out of the economic doldrums we're facing today.

Reference

Manmohan and Jaejoon, Public Debt and Growth, IMF, July 2010

Inequality in the recent business cycle

This is a good speech by Governor Sarah Bloom Raskin of the Federal Reserve (also available in audio here). It was given during the Hyman Minsky Conference held at the Levy Institute earlier this week.

The speech focuses on the obstacles to recovery associated with household debt deleveraging and the decline in wealth for low-income households since the financial crisis. That low- and middle-income households held a disproportionate share of wealth in housing prior to the crisis meant they were highly exposed by the decline in house prices.

Raskin notes:

...[W]hile total household net worth fell 15 percent in real terms between 2007 and 2010, median net worth fell almost 40 percent. This difference reflects the amplified effect that housing had on wealth changes in the middle of the wealth distribution. The unexpected drop in house prices on its own reduced both households' wealth and their access to credit, likely leading them to pull back their spending. In particular, underwater borrowers and heavily indebted households were left with little collateral, which limited their access to additional credit and their ability to refinance at lower interest rates. Indeed, some studies have shown that spending has declined more for indebted households

Although later in the speech Governor Raskin discusses the Fed's strategy to address these issues (mainly by the use of unconventional monetary policies aimed at lowering long-term interest and mortgage rates), there is unfortunately no mention of the possible role of the Fed's current quantitative easing (QE) strategy in amplifying wealth inequality via the use of unconventional policies.

Since the start of the Fed's asset purchases programs (i.e., QE), we have seen stock indexes recover their losses while the decline in house prices has stayed flat (see charts below - Note: Increases in the monetary base is a good indicator of the magnitude of QE). In a context where the Fed is also hoping QE to sustain economic activity through the "wealth effect" channel (whereby a rise in asset prices causes investors to feel more secure about their wealth and, consequently, spend more), it's only normal to question whether current strategy is contributing (albeit unintentionally) to the wealth gap.

Source: Federal Reserve

Source: Federal Reserve

Josef Steindl on why austerity fails: A Keynesian-Kaleckian view of stagnation policy and the endogenous budget deficit

This policy of stagnation is likely to continue, since governments are preoccupied with inflation and the public debt. Budget deficits can only disappear if private investment soars again. This is unlikely in view of excess capacity, which would only disappear if there were fiscal expansion. Josef Steindl (1979)

Surely the person who wrote the statement above would have no difficulty explaining what's wrong with the world economy today.

Josef Steindl was a great Keynesian-Kaleckian economist who was a master in the art of national accounts analysis. He was a close associate of Michal Kalecki and authored several articles on the important role of government and private debt in the economy. A quick glance at some of the titles of Steindl's work reveals that his articles on these issues might be of some relevance right now. (For more on Josef Steindl, see Nina Shapiro's excellent article published last year in Monthly Review)

Steindl's work was aimed primarily at uncovering the causes of economic stagnation. According to Steindl's "stagnation theory", one reason why economies trend toward stagnation is due to the behavior of firms when they refuse to reduce prices sufficiently relative to wages during periods of low demand. Low wages relative to prices lead to a fall in demand for goods and services, which in turn compels firms to reduce investment and creates a vicious cycle of falling profits and further cost reduction and reduced investment (resulting in additional unused capacity and unemployment and falling demand).

Steindl also argued that economies stagnate as a result of "stagnation policy", ill-advised government austerity measures intended to reduce or eliminate budget deficits when the economy is weak. Contrary to conventional wisdom, Steindl argued that austerity policies only make matters worse under such circumstances.

Steindl criticized austerity because he understood that the government's financial balance in the modern era was largely an endogenous variable that is determined primarily by changes in the financial position of other sectors of the economy, not by the autonomous policy decisions of the fiscal authorities. It is the influence of government automatic stabilizers and the growing importance of both consumer credit and foreign trade in the modern economy that render the government's financial balance largely endogenous.

The core of Steindl's approach to macroeconomic analysis is intuitive and similar to that of other Keynesian economists, including James Tobin (1963), Robert Eisner (1986) and Wynne Godley, all of whom analyzed the workings of the economy by examining how different sectors of the economy interact with one another. He divided the economy into four sectors (the government, households, businesses and the foreign sector) and examined how money flowed between them.

Steindl's analysis focused on credit flows and on how changes in one sector impacted other sectors. In doing so, Steindl basically applied an elementary principle of accounting to national economies: for every borrower there must be a lender. His method relied heavily on the use of national accounts data to identify trends and changes in financial flows. According to Steindl,

[t]he instrument for analysing the circular relations in an economy are the national accounts. They are a double entry book-keeping for the society, whole groups like households, business or government being represented by separate accounts, as are also activities like investment, consumption and so on. The systematic development of national accounting received its great impetus from Keynes and his theory [...] It offers a convenient way between the sterility of the Walrasian general equilibrium and the limited scope of the partial analysis of Marshall, because it is couched in terms of variables which are statistically measurable and at the same time relevant for national economic policy.(1985)

Steindl understood that, in terms of national accounts, the government deficit finds its counterpart in the surplus of at least one other sector of the economy. Since the surpluses and deficits of the various sectors (government, households, foreign and business) must balance, Steindl recognized that a huge deficit in one sector is always offset by surpluses elsewhere.

The endogenous budget deficit and the fallacy of austerity

Steindl was critical of the ("pre-Keynesian") tendency of many economists to view government budget deficits as an irritant to be eliminated. According to him, deficits in the modern era accomplished the opposite: they helped to boost aggregate demand when the economy is weak.

As mentioned above, Steindl viewed the budget deficit as a passive symptom of a weak economy rather than a problem to be actively addressed: actively trying to eliminating budget deficits would only worsen the situation. Steindl recognized that the size of the budget deficit is largely determined by the spending flows occurring among the other sectors of the economy. In this sense, he viewed the budget deficit largely as an endogenous variable that can't be easily controlled by policymakers. On whether the government has the ability to control the size of the budget deficit by changing its level of expenditures and/or revenue, Steindl argued the following:

While it is possible, in principle, to control the volume of government spending or taxation, the same is not true for the budget deficit. This is determined by the level of GDP resulting from the interplay of lending and borrowing of the various sectors. Let me refer to the well-known identity

( I – S_B) + (X – I) + (G – T) = (S_H – H)

Which says that the budget deficit G – T together with the borrowing of business I – S_B and of the outside world X – M equals the lending of households (i.e., excess of household saving S_H over investment in dwelling houses H) of households S_H – H.

Which of these sectors plays an active role depends on institutional circumstances. The budget deficit, in connection with Keynesian policies, used to be regarded as an active element, incurred on purpose by the government. In present circumstances it is more likely to play a passive role, and to be dominated by the other sectors. This is due to the large share of taxation in an additional GDP, to the strong and quick reactions of consumers to a change in income and to the fact that the foreign balance is more often dominated by outside influences than by domestic policy (by the GDP). In consequence attempts at reducing the budget deficit by retrenchment are mostly doomed to failure. [...]

If the foreign account is balanced, the budget deficit has simply to fill the gap between the household financial saving and the borrowing of business. This will apply to some approximation in countries where the role of the foreign balance is small as compared with that of other sectors. It will fully apply to all countries taken together because they form a closed system. For them the budget deficit given the financial surplus of the households, will be largely settled by the amount of private investment. On the other hand, in countries where the foreign balance can take large values it will, together with private investment, dominate the size (and sign) of the budget deficit. In both cases the budget deficit is predominantly suffered rather than contrived.

The conclusion is not pleasant to contemplate for the treasurer because it means that he can control the deficit, if at all, only by indirect routes: Business investment, and a fortiori the foreign balance, are not easy to control. (1983) (my emphasis)

That said, according to Steindl, there are circumstances in which the budget deficit can be made to decrease. Such favorable conditions are the same as those which lead to growth in private sector investment, namely, a satisfactory utilization of capacity and a growing market. In this regard, Steindl concludes that

[o]n certain conditions it would seem therefore that the best way to combat a deficit is to increase spending. The conditions are that there are unemployed resources, and that the additional spending is not drained away by imports. In these circumstances a policy of "reflation" should have a good chance of succeeding without adding to the budget deficit at all. On the one hand, the built-in stabilisers in modern welfare state are very strong. About half of the additional spending will come back to the treasury. On the other hand we have a modern destabiliser in the form of consumer's credit and durable goods consumption which will prevent the multiplier from being too low. This response of consumption will be very quick in contrast to the response of business investment which may take one or two years at least. In the interval business will merely accumulate additional saving. At the same time the consumers, owing to the expectation of a persistently higher level of income, will increase their spending on durables more than their disposable income has increased; they will therefore, taken all together, dissave (borrow) on balance, at the margin. (1983)

Now, it's important to point out that Steindl wrote the above at a time when growth in consumer credit could function as a way to counter the deflating effect of deficit reduction. Today, this is not the case, as consumers are seeking to repair their balance sheets following the financial crisis. This means that the only solution would be the one articulated in Steindl's quote found at the top of this post.

To conclude, there is growing appreciation these days among economists and commentators of the self-defeating nature of austerity and deficit reduction measures. The difficulties that many European nations are now facing in their quest to bring down deficits is consistent with Steindl's view that government austerity is exactly the wrong strategy for reducing the size of the budget deficit and bringing down debt during a period of slow growth.

PS: I recently stumbled upon this comment by economist Herbert Simon discussing Steindl's brand of economics:

It is pleasant, in an econometric world that has become idolatrous of mathematical "elegance," to encounter an author who thinks that mathematics is a tool - one of several - to aid in carrying out reasoning about economic matters.

References

Eisner, R., How Real is the Federal Budget? (New York: Free Press), 1986

Steindl, J., “The Role of Household Saving in the Modern Economy”, Banca Nazionale del Lavoro Quarterly Review, p.83, March, 1982

Steindl, J., "J.M. Keynes: Society and the Economist", Keynes' Relevance Today (London: MacMillan) 1985.

Steindl, Josef. “The Control of the Economy”, Banca Nazionale del Lavoro Quarterly Review, pp. 235-248, 1983

Shapiro, N., "Keynes, Steindl, and the Critique of Austerity Economics", Monthly Review, Vol 64, No.3, 2012

Simon, H., "Random Processes and the Growth of Firms: A Study of the Pareto Law" by Josef Steindl: Review, Journal of the American Statistical Association, Vol. 61, No. 316 (Dec., 1966), pp. 1232-1233

Tobin, J., Deficit, Deficit, Who's Got the Deficit, January 1963. New Republic, 1/19/63, Vol. 148 Issue 3, p10. 

The BIS's new long series on private non-financial credit

The Bank for International Settlements has introduced a new data series on total non-financial credit (loans and debt securities) covering 40 economies and spanning an average period of 45 years. The new series are intended to improve comparisons between different countries and across time. One interesting aspect of these new series is that they account for credit from all sources, not only that extended by domestic banks.

Here is a short article that gives a good overview of the new series. It contains several BIS signature-style charts and, for illustration purposes, provides a look at the evolution of total private non-financial credit worldwide:

While total credit has generally risen substantially relative to GDP, levels and trends in private sector borrowing have varied across countries to a surprising degree. For instance, in several economies, total credit-to-GDP ratios already significantly exceeded 100% in the 1960s and 1970s. Equally, in a number of countries, the share of domestic bank credit in total credit has actually increased substantially over the last 40 years – that is, banks have become more, not less, important. And finally, sectoral breakdowns show that there has been a general shift towards more household credit. In some countries, households now borrow even more than corporates.

Evsey Domar's "On Deficits and Debt": A survival guide for making sense of today's economic challenges

As I look back to 2012, I'm reminded about how relevant the work of economist Evsey Domar, the late Professor of Economics at MIT and previously a Federal Reserve staff economist, is for making sense of the predicament facing the US and the world economies today.  Three news stories during the last year provided a good backdrop for presenting Domar’s views on public debt, budget deficits and economic growth.

First, there was the surprising about face during the summer months when European leaders switched from advocating austerity to voicing their support for actions that promote growth.  Professor Domar would have most likely approved of this change of heart by Europe’s ruling elite given that, many decades ago, Domar authored “The Burden of the Debt and National Income” (1944), a paper which argues that “the problem of the burden of the debt is a problem of achieving a growing national income” rather than one associated with the size of the budget deficit or national debt.

E. Domar

Specifically, in his paper, Domar demonstrated that, in the long run, the ratio of debt to GDP will gradually approach the ratio of the fraction of GDP borrowed each year to the rate of growth of GDP.  So, for instance, the US federal government borrowed approximately 7 percent of GDP in 2012.  If the borrowing continued at the same rate and the GDP (in money terms) grows at 2 percent per year, the ratio of debt to GDP will approach 3.5; with a 3 percent growth, it will be 2.3.

Thus, Domar showed that "less attention should be devoted to the problem of the debt and more to finding ways of achieving a growing national income" (1945:415)

According to Domar, attempting to reduce the public debt by cutting government expenditures (thus removing a significant source of income and growth from the economy) is largely self-defeating and exactly the wrong course of action if undertaken when the economy is struggling.

Then, in the fall, there was the debate among economists and bloggers about the intergenerational burden of the public debt.  Had he been around, Professor Domar would have probably been disappointed to learn that issues addressed (and, for many, put to rest) decades ago are still being debated.

And now we're facing the so-called ‘fiscal cliff’, a metaphor depicting the slowdown facing the US economy as a result of the expiry of tax breaks enacted at a time when the US federal fiscal budget situation was in better shape.  In the face of such a situation, Domar would have understood that the last thing policymakers should do when the economy is weak is to increase taxes which take away purchasing power from the economy.

As we enter a New Year, it is worth remembering Domar’s views on these and other related issues.  And nowhere are these matters best addressed than in his short, three-page article “On Deficits and Debt” published in 1993.  In this article, Domar challenges many of the widely held beliefs about debt and deficits. 

First, the article begins by taking on the popular view that considers the US federal government debt as analogous to household debt:

Our old puritanical injunctions against running into debt remain valid when applied to a private person. He or she can disregard them only at his or her peril.  A large corporation has more leeway: it can borrow by issuing bonds, and replace them with new ones when they fall due. If many large corporations simultaneously decided to pay off their debts, our economy would collapse: it is based on credit, the inverse of debt. Still any corporation, however large can go bankrupt...But, the Federal government is in a class by itself: so long as its debt is expressed in dollars (which fortunately is the case), it can always print as many dollars as it needs to pay the interest, though nowadays it would issue bonds, sell them in the market and, if necessary, have the Federal Reserve repurchase them. The Federal government, the creator of the Federal Reserve System, is its own banker.

Then, Domar describes the merits of a budget deficit:

By definition, a budget deficit means that the government spends more money then it receives, or, in other words, that it creates more purchasing power by its expenditures than it destroys through taxes.  Is this good or bad? It depends. If the economy is working to capacity, the creation of extra purchasing power will do little good and much harm: it will cause an inflation, which is easy to start and hard to stop. But when the economy has plenty of unused resources, the additional purchasing power is welcome. At such a time, we should rebuild our physical infrastructure, improve our education, health, and environment, and intensify our scientific and industrial research efforts, without raising taxes and without reducing or eliminating other needed services, always keeping a watchful eye on economic barometers to make sure that we do not overdo it.

All this sounds nice and easy, perhaps too easy to avoid suspicion. Are we to get something for nothing, as the old saying goes? Is there such a thing as a free lunch, after all? The offer of a free lunch is strictly temporary; it lasts only so long as unused resources, and particularly unemployed labor, are available, because they can be put to use with little, if any, social cost. But one they are gone government expenditures, however, desirable, must be matched with revenue.

Later in the article, Domar explains that the true burden of the national debt is distributional in that it involves a transfer of resources from one group to another group within the economy:

Some early proponents of fiscal policy argued that the size of the debt and of interest payments on it are not important because “ we owe it to ourselves”...There is some truth in this argument, but it should not be exaggerated. Even if all the Federal bonds were owned by Americans and all interest on the debt received by them, problems created by the existence of a large debt and by the need to transfer [billions of dollars] from the taxpayers to the bondholders would remain...

On the other hand, this does not mean that the...interest paid on the debt represents a net loss to the country...[T]hat interest go to other Americans, directly or not and that much of it is subject to Federal income taxes. President Eisenhower, who disliked deficits and debts, is reported to have said, shortly before he left the White House, that every American baby born at the time carried on its neck a tag indicating its share of the Federal debt. Perhaps it did; but it must have also borne a second tag showing its share of the value of the Federal bonds.

The article then presents some interesting views about whether the country’s ratio of debt to GDP is an appropriate indicator of the state of the economy:

Does the ratio of the debt to GNP matter? Yes, it does. Other things being equal, I would prefer a smaller rather than larger ratio...Other things are not equal. There are times and conditions calling for a deficit. Without it, unemployment may rise and the GNP may fall, thus raising, rather than lowering the debt burden.

The article concludes with a comment on how to best address the “debt problem”:

The proper solution of the debt problem lies not in tying ourselves into a financial straight-jacket, but in achieving faster growth of the GNP, a result which is, of course, desirable by itself. To the Republican and other politicians who are hell-bent on reducing the deficit and even repaying the debt, I would like to address a very short and simple question: Why? Are we suffering from an excess of purchasing power now?

As we head into the New Year and get ready to face many of the same concerns as in 2012, I think it would be a good idea to keep in mind these points.

On that note, I wish all readers of this blog a very Happy New Year!

UPDATE: The third paragraph was revised on January 12, 2013.  It originally indicated that Domar demonstrated in his 1944 paper that the ratio of deficit to GDP would equal the ratio of the fraction of GDP borrowed each year to the rate of growth of the economy.  Rather, Domar focused on the ratio of debt to GDP.  I also added a subsequent paragraph (after paragraph 3) which includes a reference to Domar's article "The Burden of the Debt: A Rejoinder" (1945).

References

Domar, E., "The Burden of the Debt and the National Income", American Economic Review, 34(4), December 1944

Domar, E., "The Burden of the Debt: A Rejoinder", American Economic Review, 35(3), June 1945, pp. 414-418.

Domar, E., "On Deficits and Debt", American Journal of Economics and Sociology, 52(4), October 1993, 475-478.