Which unconventional monetary policies hold most promise?

Kudos to Biagio Bossone, Chairman of the Group of Lecce and former central banker (and circuit theorist par excellence), for his first-rate analysis (see here: part 1 and part 2) of the different types of unconventional monetary policy measures that have been implemented and proposed in the last few years!

Bossone's piece does a fantastic job of presenting the different policy proposals into six distinct categories based on their implied transmission channel and the degree of cooperation between the fiscal and monetary authorities that is required in order to implement the proposed measures.

The main take-away from the analysis is that Bossone finds the proposals that aim to boost aggregate demand via fiscal actions are the most promising. According to Bossone, the benefits of fiscal measures (with or without actions by the monetary authority) are that their effect is more direct than policy measures such as quantitative easing (which works indirectly via its impact on interest rates) or forward guidance (which works indirectly via its effect on the public's expectations on future interest rates).

In the concluding paragraph, Bossone writes,

...this result vindicates the proposed measures to expand the money supply via overt monetary financing or neo-chartalism, which aims to inject new money independently of central banks' interest-rate policies, especially if these are limited by the zero lower bound.

Reference

Bossone, B., Unconventional monetary policies revisited, Part 1 and Part 2, Vox, October 2013

Does the concentration of finance matter?

It may sound like a strange question in light of all the talk about "too big to fail" during the last few years. But, believe or not, the idea that bank concentration has an impact on real economic activity isn't the standard view. Here's from a recent blog post by NY Fed economists Mary Amiti and David Weinstein:

The notion that financial institutions are large relative to the size of economies is not something that plays a prominent role in traditional economic theory. Macroeconomic textbooks tend to treat economies as composed of representative firms that are infinitesimal in size compared to any given market. As a result, positive and negative idiosyncratic shocks [movement in bank loan supply net of borrower characteristics and general credit conditions] to financial institutions cancel out due to the law of large numbers. 

However, this representation stands in stark contrast with the reality of concentration in financial markets. A striking regularity is that a few banks account for a substantial share of an economy’s loans.

Starting from this basis, Amiti and Weinstein have examined Japanese aggregate bank lending data and other aggregates and were able to demonstrate the following: banks matter, bank concentration matters, bank lending matters. No small feat.

On the issue of bank concentration and aggregate lending, they found that

...if markets are dominated by a few financial institutions, cuts in lending due to some change in financial conditions in just a small number of banks have the potential to substantially affect aggregate lending. Moreover, if firms find it hard to find good substitutes for loans like issuing equity or debt, then it is possible for their investment rates to fall as well. 

As for their take on banks' impact on the real economy, the conclusion to their paper (on which their blog post in based) gives a good summary:

Our paper contributes to this literature by providing the first evidence that shocks to the supply of credit affect firm investment rates. We find that even after controlling for firm credit shocks, loan supply shocks are a significant determinant of firm-level investment of loan-dependent firms. This result is particularly surprising because our sample is comprised of listed companies that have, by definition, access to equity markets. Moreover, the fact that so much lending is intermediated through a few financial institutions means that idiosyncratic shocks hitting large financial institutions can move aggregate lending and investment. We show that about 40 percent of the movement in these variables can be attributed to these granular bank shocks. This means that the idiosyncratic fates of large financial institutions are an important determinant of investment and real economic activity.

And the implication for policy, according to Amiti and Weinstein, is significant. Here is the relevant excerpt of their blog post on this point:

...[P]olicymakers without detailed information on the major financial institutions are likely to have a difficult time understanding the causes of lending and investment fluctuations. A large portion of Japan’s aggregate economic fluctuations can be traced to the country’s banking problems. 

While many researchers have focused on the implications of banks being “too big to fail,” we show that even if large banks do not fail, granular bank shocks can have substantial impacts on aggregate investment. 

For example, reductions in bank capital at large financial institutions can cause investment declines by firms that would like to borrow, while recapitalization of the right institutions can stimulate investment. In sum, this study shows that what happens to large financial institutions is important for understanding aggregate investment behavior. 

While their paper looks specifically at Japanese data, the authors suggest that the overall conclusions are relevant to the situation in the US given that it too has a very concentrated banking sector.

Amiti, Mary and David Weinstein, How much do banks shocks affect investment: Evidence from matched bank-firm loan data, NY Fed staff paper 604, March 2013

Helicopter money: an operational view

Much has been written about Adair's Turner suggestion that central banks should consider financing public spending but I thought this short exchange between Adair Turner and economist Mario Seccareccia at an INET conference in 2011 is worth pointing out.

Here's Adair Turner's question:

[About Japan]...why wouldn't it been better still to do what Friedman said was the correct policy post facto in the 1930s, which is "helicopter money". Why wouldn't a better policy had been for the Japanese government to simply run fully, overtly, monetized deficits so that the last [inaudible] percent of GDP was not in the form of a debt contract held by the Japanese private sector but was in the form of absolute, categoric fiat money? (at 2:30 here)

This is Mario Seccareccia's response:

[About the] issue which had been raised about fiscal policy and the "helicopter drop" [vs conventional deficit spending]. That's a false dichotomy. I mean, deficit spending is -- in a sense -- monetization all the time. [Bond issuance is] how the central bank then behaves to clear or sterilize -- so to speak -- those reserves in the system in order to meet its interest rate policy. Period. There is no such thing as a "helicopter" doing this. It's always done through deficit spending fundamentally, I would argue. (at 9:00 here)

The point to remember when thinking about a central bank's ability to inject exogenous increases in reserve balances is that in a monetary regime such as Japan (and the UK for that matter) where the central bank targets an interest rate and the remuneration rate on reserves balances isn't set at the same level as its target interest rate, the central bank can't conduct offensive open market operations aimed at increasing the amount of reserve balances without simultaneously frustrating its goal of keeping its benchmark interest rate on target. Under such a regime the central bank's ability to control money growth is essentially limited to conducting defensive open market operations aimed at keeping its interest rate on target.

UPDATE: A very detailed look at the "helicopter drop" issue is found in Scott Fullwiler's article "Helicopter drops are fiscal operations" (2010). For a general discussion on offensive vs defensive open market operations, see Lombra, Herendeen and Torto, Money and the Financial System, page 425, 1980.

Does the endogenous nature of money weaken the case for NGDP targeting?

One charge that's often directed against those who espouse nominal GDP targeting within a quantity theory framework (e.g., market monetarists) is that they fail to take into account the endogenous nature of money in their analyses.

In my view, such a charge is misplaced, as there are economists within the quantity-theory tradition who support NGDP targeting and who acknowledge the endogenous nature of the money supply.

Take, for instance, Robert Hetzel, senior economist at the Federal Reserve Bank of Richmond and a strong advocate of NGDP targeting (and sometimes considered a precursor of today's market monetarists).  Hetzel has a deep understanding of the operational aspects of central banking and recognizes the implications for policy formulation posed by the endogenous nature of money.  Consider the following:

First, Hetzel understands that credit creation is at the root of deposit creation (i.e., "loans create deposits") and that the supply of reserve balances is demand-determined in a monetary regime where the central bank targets an interest rate.  Here is an excerpt from Hetzel's 1986 paper "A Critique of Theories of Money Stock Determination":

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)

Second, Hetzel recognizes the inapplicability of the textbook money multiplier model of money stock determination in monetary regime where the central bank targets an interest rate and understands that the main constraint imposed on banks (for credit creation) under such a monetary regime is the price of reserve balances set by the central bank rather than their quantity:

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)

Third, Hetzel recognizes the operational implications of endogenous money for monetary control. Consider the following excerpt from his 2004 article "How does the central bank control inflation?":

Because the Federal Open Market Committee (FOMC) uses the funds rate rather than the monetary base or bank reserves as its policy variable, money is endogenously determined. (2004:48) 

Stated differently, Hetzel recognizes that when the central bank uses an interest rate instrument the central bank cannot exogenously control the money supply:

[W]ith an interest rate as the policy variable, monetary control does not imply an exogenous money stock. (footnote at 48)...In the case of an interest rate instrument, the central bank privatizes control over reserves provision by turning the decision on the quantity of reserves over to the financial market...It takes direct control over the setting of the interest rate (55)

Finally, Hetzel understands that central bank purchases of government debt is not in itself inflationary.  Consider the following statement made recently by Hetzel during a presentation in Europe:

Somehow the Buba has this idea that if you buy government debt, that in itself is inflationary. Well, you gotta buy something to be able to create the monetary base that sustains money creation. So you gotta buy something. And you can buy baskets of government debt. But buying government debt is not inflationary. That's pursuing it far too much. (75 minutes)

So what differentiates Hetzel's views from the one of Keynesian-inspired economists who accept the endogenous nature of money (such as post-Keynesians)?

To answer this question and better understand how Hetzel is able to reconcile the above views with his attachment to the quantity-theory tradition, it's important to understand that Hetzel's framework for analyzing monetary policy relies on a natural rate (of interest) model, in which monetary control depends on how well the central bank can adjust its interest rate in a manner that tracks the natural rate of interest (i.e., the real interest rate that would exist in the absence of monetary disturbances*).  This is where Hetzel differs entirely from post-Keynesians.

In Hetzel's view, as mentioned above, in a context of endogenous money, the central bank doesn't control money creation via the textbook money multiplier process or by exogenous injections or withdrawals of base money.  Rather, Hetzel views money creation as the consequence of the central bank keeping its interest rate below the natural rate.  The reverse, money destruction, occurs when the central bank keeps its interest rate above the natural rate.  Hetzel explains the difference between his and the old monetarist description of money creation as follows:

The real world counterpart to the quantity theory conceptual experiment of an exogenous increase in money is a failure by the central bank to move its interest target in a way that tracks the natural rate (2004:51).

In other words, in Hetzel's quantity theory framework, money creation and the monetary transmission mechanism has little to do with adjusting the size of the monetary base or manipulating the textbook money multiplier in such a way as to expand the money supply by means of a multiple expansion of deposits.  (One exception is in today's case, where the Fed has the ability to control the amount of reserve balances.  In such a context, Hetzel considers the money multiplier model of money stock determination as relevant given that the money supply expands as a result of open-market purchases.)

So if it's not the money multiplier, what's the monetary transmission mechanism then?

Another point of divergence between Hetzel's view and the post-Keynesian view -- and this is important for understanding his framework for boosting NGDP (and thus enabling the central bank to hit its NGDP growth target) -- is that he holds a view emphasizing the central bank's ability to force portfolio rebalancing by the public and thereby control the public's dollar expenditures.  Liquidity or portfolio rebalancing involves the purchase by the public of illiquid assets such as consumer durables, equities, real estate, etc.  Hetzel explains the central bank's ability to foster portfolio rebalancing as follows:

Assume that the central bank purchases an illiquid asset, for example, shares in a mutual fund holding equities.  The public will rebalance its portfolio through the purchases of physical assets like land and equities.  The rise in their prices will raise their value as collateral and this facilitates the access to credit of the holders of these assets.  Increased liquidity from increased access to credit augments the portfolio rebalancing effect by decreasing the demand for the liquidity services of money.  The increase in the price of physical capital relative to its replacement cost stimulates investment. (2004:56)

There is no need to get into the other aspects of Hetzel's framework in support of NGDP targeting (e.g., role of central bank credibility and inflation expectations, establishment of a monetary rule...) since it is not altogether relevant to the basic point of this post, which is to say that the arguments about the irrelevance of the money multiplier or the endogenous nature of money that are sometimes made to counter the case in favor of NGDP targeting don't get to the core aspects of the debate, such as the issue of the natural rate.

Conclusion

The point of this post is simple: the arguments concerning the endogenous nature of money and the irrelevance of the textbook money multiplier do very little to challenge the case in favor of NGDP targeting (or inflation targeting, for that matter) and the general theoretical construct used by market monetarists.  As I've shown, the case for NGDP targeting can be made (at least theoretically) using a quantity theory approach that is consistent with the endogenous nature of money.

Therefore, from a debating standpoint, those who support a functional finance approach to economic policy (as I do) would gain more by focusing their efforts on challenging notions such as the natural rate of interest and in demonstrating the inadequacies of an approach to monetary policy whose monetary transmission mechanism relies largely on the portfolio balancing effect.  While the issue of the natural rate is largely a theoretical problem (Does it exist? Can it be measured?), the question of the portfolio balance effect is essentially an empirical issue (Is the portfolio rebalancing effect substantial? Can the central bank control it for policy purposes?)

As for the bloggers and economists who think that post-Keynesians and MMT economists are wrong about the endogenous nature of money and its implications for central bank operations, I would suggest they review the work of Robert Hetzel.  His take on these matters is in line with the post-Keynesian/MMT view.

* Another definition is "the real rate of interest consistent with keeping real aggregate demand in line with potential output" (see here).  Without getting into too many theoretical details, from a practical standpoint, central bankers tend to interpret decreases in rates of resource utilization (increases in the unemployment rate) as indicative of a real interest rate in excess of the natural rate (and vice-versa).

References

Hetzel, R., A critique of theories of money stock determination, Working Paper, Federal Reserve Bank of Richmond, 1986

Hetzel, R., How Do Central Banks Control Inflation?, Federal Reserve Bank of Richmond, 2004

Federal Reserve Bank of San Francisco, The natural rate of interest, FRBSF Economic Letter, October 2003

Fiscal austerity: A solution looking for a problem

Since the release earlier this month of the paper by IMF economists Olivier Blanchard and Daniel Leigh, I've noticed a lot of comments on blogs and news websites suggesting that the IMF economists and their inability to properly measure the size of the fiscal multiplier earlier are to blame for making political leaders believe that fiscal austerity could be expansionary and for misleading them into enacting austerity measures within their respective nations.

That's nonsense.  As if the decision to go down the road of austerity depended on a technical detail such as the potency of the fiscal multiplier.  Such a statement is as implausible as suggesting that some of the ill-advised military interventions in the Middle East during the last decade would have been prevented had those leaders who decided to enter those wars had been provided better intelligence.

Those looking to blame someone for the current disaster created by fiscal austerity should instead turn to the real culprits, the politicians themselves, as well as their horde of political aides who recommended a course of action that flies in the face of both common sense and empirical evidence.

As I discussed in an earlier post, the case against expansionary austerity was well established even before nations decided to enact austerity measures.  And amazingly, the empirical evidence against expansionary fiscal austerity stems from one of the most highly circulated economics papers of 2009, which, ironically, was branded as supporting the case for expansionary fiscal austerity.

This paper is the study by Alberto Alesina and Sylvia Ardagna, which found that the combination of austerity and growth occurred in 25 percent of the relevant episodes recorded by the OECD between 1970 and 2007 (2009, Data Appendix:Table A2).

In other words, the study demonstrated that the odds of successfully reducing public debt levels and achieving increased growth through austerity were 1 in 4.  As far as empirical support in favor of expansionary fiscal austerity goes, that's pretty weak.  With such information available, going ahead with austerity was tantamount to someone deciding to intentionally leave their umbrella at home knowing that there is a 75 percent chance of rain that day.  So much for the theory of the rational decision-maker!

And now economists are to blame?

The bottom line is that the disaster of austerity is not about economists getting it wrong.  Rather, it is a typical example of a policy-making failure: policymakers making decisions without regard for the facts.  But, more importantly, fiscal austerity was a prepackaged "solution to a problem" that fits with today's dominant policy-making ideology, which holds that governments have little or no purpose other than catering to financial interests and leaving the path clear for free-market actors to find solutions to every problem facing society.

To conclude, fiscal austerity is simply another example of a "solution looking for a problem", an empty and empirically ineffectual idea with no clear rationale other than giving the appearance that "something is being done".  In this sense, fiscal austerity joins the list of other well-known solutions looking for problems that have been tried and failed in the last thirty years such as deregulation, privatization, supply-side economics and so on.

References

Alesina, A and Ardagna, S., "Large Changes in Fiscal Policy: Taxes vs Spending", NBER Working Paper No. 15438, October 2009

Blanchard, O. and D. Leigh, "Growth Forecast Errors and Fiscal Multiplier", IMF Working Paper WP/13/1, January 2013

Austerity in Canada: Then and Now

Canada's economic accounts for the third quarter of 2012 were released last week.  They show a very weak quarter.  Real gross domestic product barely stayed positive, growing by a mere 0.1 percent (see chart 1).  The details can be found here, courtesy of Statistics Canada (click on charts to expand).

Chart 1 Real GDP growth, quarterly % change

Many reasons have been given to explain the economy's weak performance, including the slowdown in China, the fiscal and financial situation in Europe, as well as tepid growth in the US during the summer months.

Of course, as usual, no one is pointing to the fact that Canada is currently undergoing its second most important (i.e., longest and sharpest) bout of public sector austerity in half a century.  One would think that commentators would highlight this reality in their analyses.

As you can see from the chart below, real (consolidated) government expenditure (excluding transfers) has been in decline since the fourth quarter of 2010.  Historically, such a decline in real government spending has only occurred once: during the period of fiscal restraint of the mid-1990s.

Chart 2: Real government expenditures, Source: Statistics Canada and author's calculations

The reason why commentators don't think of austerity as the potential cause of the current weak performance is that Canadians live under the illusion that government spending cuts have little or no impact on the economy.  This stems from the fact that the fiscal austerity put forth during the 1990s gave Canadians (and especially their political leaders) the false impression that cuts in government spending generally help to boost the economy.

Visually, this is how most commentators interpret Canada's experience with austerity in the 1990s (note: I'm not seeking to show a correlation between the two series. I'm simply overlapping both sets of data on a common timeline):

Chart 3: The vanishing deficit and the road to surpluses, Source: Statistics Canada

The standard view holds that fiscal austerity during the 1990s helped to shrink the deficit, thus enabling Canada to run a series of budgetary surpluses throughout the early- to mid- 2000s.  Also, this view holds that fiscal austerity played a crucial role in helping Canada recover from the recession of the early 1990s and contributed to Canada's strong economic performance during the period from the mid-1990s until the financial crisis. 

The problem with this interpretation is that it completely disregards the fact that the Canadian economy during the mid-1990s was impacted by a massive increase in demand stemming from the domestic household and external sectors.  Consider the following charts showing that, as fiscal austerity was undertaken, net borrowing by both the household and external sector exploded in Canada during that period:

Chart 3: Household sector falls into net financial deficit, Source: Statistics Canada and author's calculations

Chart 4: Increased foreign demand to the rescue, Source: Statistics Canada and author's calculations

Net borrowing is the difference between a sector's total spending and income.  It is a key indicator of the demand generated by any sector of the economy. 

Supported by a much easier monetary policy and falling exchanging rate (a consequence of US President Clinton's desire to "have a strong dollar"), the increased net borrowing generated by these two sectors was effective in offsetting the decline in net borrowing of the government sector caused by fiscal austerity.

The increase in net borrowing by the household sector between the mid-1990s and the mid-2000s was unprecedented.  Between 1995 and 2007, net borrowing by the household sector increased by close to 10 percent of GDP (see arrow going down).  As for net borrowing of the foreign sector, it increased by approximately five percent of GDP.  Combined, this additional demand was more than sufficient to offset the decline in demand caused by fiscal austerity.

Today, unlike in the 1990s, the household sector is seeking to reduce its level of borrowing.  And the foreign sector, due to the strength of the Canadian dollar and the weakness of the world economy as a result of global austerity, cannot be a significant source of demand at this time.*

As a result, any attempt by Canada's policymakers to balance the budget in such a context is self-defeating and actually exacerbating the problem given that it is taking away purchasing power from households and firms.  And, as we are witnessing now, it is taking its toll and slowing GDP growth as a consequence.

Economist James Tobin said it best several years ago:

Deficit reduction is not an end in itself. It's rationale is to improve productivity, real wages and living standards of our children and their children. If the measures to cut deficits actually diminish GDP raise unemployment, and reduce future-oriented activities of government, business and households, they do not achieve the goals that are their raison-d'être; rather, they retard them. This perverse result is likely if deficit reduction measures are introduced while the economy is as weak and as constrained by effective demand as it is now.

It's time to think more clearly about these issues.  What "worked" in the past need not be the appropriate course of action today.  The Canadian economy now is not like the one that existed back then.  It's time to move forward.  Trying to relive the "success" of the 1990s will only make matters worse. 

Update:

Chart 2 should be entitled "Real consolidated government expenditures (all levels of government) (millions of chained 2002 dollars)". The title and headings in charts 3, 4 and 5 are accurate.  All data comprises expenditures on goods and services, as well as on capital formation. They exclude transfers.


*  The critical point to remember is that, as I've explained before, the government deficit cannot be reduced in isolation from the other sectors of the economy.  Public sector deficits are from an accounting standpoint the equivalent of surpluses in the private sector, plus additional net imports.  The reason for this is that government deficit spending adds to the net accumulation of private holdings of households and businesses (and/or the foreign sector, where applicable).

In other words, any reduction in government spending or tax increase has a direct impact on the financial position of the private sector.  To believe otherwise is wishful thinking.  If external demand and/or increased demand from another domestic sector (households or businesses) are not high enough to offset the demand shortfall created by reduced government expenditures, continued attempts at fiscal austerity will impose additional deflationary pressure on the economy.

Reference

Tobin, J., "Thinking straight about fiscal stimulus and deficit reduction", Challenge, March 1, 1993

Old Keynesian themes in Modern Monetary Theory

Readers of this blog know I'm generally supportive of the views espoused by proponents of Modern Monetary Theory (MMT). The reasons are fairly simple. First, MMT considers unemployment to be an important problem that must be quickly and effectively addressed by the government authorities.  I agree with that.  Also, MMT makes a good case on the important role of fiscal policy in ensuring stable and equitable economic growth.  Again, I agree with that.

But there is another reason I'm generally in agreement with MMT on many issues.  This has to do with the fact that MMT builds on some pretty solid economic thinking, much of which was well understood and accepted by earlier generations of Keynesian economists.  As someone who has a lot of respect for and who finds much insight from this earlier Keynesian tradition, I'm quite pleased to see MMT, a more recent school of thought, disseminate these views.

I was reminded of some of these - let's call them - "Old Keynesian" tenets in a recent blog post by Paul Krugman, in which he discusses a trifecta of issues relating to (1) the benefits of monetary sovereignty (i.e., where a nation issues and uses its own currency), (2) the debate on the supposedly inflationary nature of deficit spending financed via money creation or bond issuance and (3) the recent controversy regarding the potentially expansionary consequences of a "loss of confidence" in US government bonds by international investors .

The first of these views concerns monetary sovereignty, a central MMT theme.  This was also a well understood concept by earlier Keynesian economists.  For instance, monetary sovereignty was a key aspect highlighted in the work of economist Robert Eisner, who brilliantly described in his book The Misunderstood Economy (1994:74) why the US greatly benefits from being a currency issuing nation:

[One] point that is widely misunderstood or unrecognized is that this debt, relatively small as it is, is all owed in its own currency, US dollars.  We pay interest and principal in US dollars.  And our Treasury and Federal Reserve can always create all the dollars we need.  One may object that such money creation or the monetization of the interest-bearing debt may have undesirable consequences, particularly greater inflationary pressure.  But it may also have the desirable effect of stimulating the US economy if that is in order. In any event, the fact that US debt held by foreigners is virtually all denominated in US dollars rules out the possibility of unvoluntary default on US government obligations.

We are not in the position of many third world or other debtor nations that sadly had obligations in foreign currencies, frequently the US dollars.  The only way they could service their debt was to obtain foreign currencies. [...]

The "world's greatest debtor nation" gave the American public visions of the US going bankrupt.  Since the debt was essentially in our currency, however, this made no sense.  We could "print" out own money to pay it off or, in more sophisticated fashion, have the Federal Reserve create the money. (1994:74)

Several other Keynesian economists also held similar views, including economist Lorie Tarshis who emphasized this point in Elements of Economics (1947), the first Keynesian textbook to be published in the US.

Secondly, concerning the ever-lasting debate on the supposedly inflationary nature of deficit spending financed via money creation or bond issuance, MMT considers that the latter should be viewed as more inflationary than the former since the interest payments paid by government on its debt results in a greater expansion in the money supply (in the long run) than if the deficit is financed by money creation.

On this point, it may be instructive to recall that economists Alan Blinder and Robert Solow demonstrated long ago that the "potency" of deficit spending via money creation or bond issuance is not strictly related to the manner of financing.  In fact, Blinder and Solow demonstrate in "Analytical Foundations of Public Finance" (1974) that deficit spending financed via issuance of bonds has under normal, steady-state equilibrium conditions a greater fiscal multiplier than deficit spending via monetary financing in the long run:

When we correct an oversight committed by almost all previous users of the government budget constraint, a still more odd result emerges.  The error has been to ignore the fact that interest payments on outstanding government bonds are another expenditure item in the budgetary accounts. [...]

Under a policy of strict monetary financing, [in a stable system, the long-run government expenditure multiplier is simply the reciprocal of the marginal propensity to tax].  But the issuance of new bonds means a greater multiplier in the long run. (1974:50). (original emphasis)

Finally, as for Krugman's contention that a loss of confidence in US government bonds by investors may have potentially expansionary consequences for the US economy, economist Bill Vickrey presented a similar argument in his article entitled "Fifteen Fatal Fallacies of Financial Fundamentalism" (1996).  On whether a sell-off of US government bonds by foreign investors would have a detrimental effect on the US economy, Vickrey suggested the following:

It is not intended that the domestic government debt should be held in any large quantity by foreigners.  But should foreigners wish to liquidate holdings of this debt or any other domestic assets, they can only do so as a whole by generating an export surplus, easing the domestic unemployment problem, releasing assets to supply the domestic demand, and making it possible to get along with smaller deficits and a less rapidly growing government debt.  The same thing happens if domestic investors turn to investing in foreign assets, thereby reducing their drain on the domestic asset supply.

All that to say that, in my opinion, both Paul Krugman and proponents of MMT stand on solid ground regarding these issues.

References

Blinder, Alan and Robert Solow, "Analytical Foundations of Fiscal Policy," in A. S. Blinder, et. al., The Economics of Public Finance, The Brookings Institution, 1974, pp. 3-115.

Eisner, Robert, The Misunderstood Economy: What counts and how to count it, Boston: HBSP, 1994.

Tarshis, Lorie, The Elements of Economics, New York: Houghton Mifflin, 1947.

Vickrey, William. "Fifteen fallacies of financial fundamentalism: A disquisition on demand-side economies", Proceedings of the National Academy of Sciences of the United States of America, Vol. 95, No. 3, February 1998, pp. 1340-1347.

The Federal Reserve staff on the evolution of US household net worth and related financial flows during the last decade

The Federal Reserve released an informative discussion paper this week that presents background on the Integrated Macroeconomics Accounts (IMAs) of the US.  The IMAs is a long-term interagency project between the Fed and the Bureau of Economic Analysis aimed at linking saving, capital accumulation, investment in financial assets and balance sheet data within an integrated framework using consistent definitions, classifications, and accounting conventions.

In the IMAs, each of the sectors of the economy is depicted according to a consistent set of statistical accounts: the current account (production and distribution of income accounts), and the accumulation accounts (capital, financial, other volume changes, and revaluation accounts).  These accounts allow one to trace the factors leading to changes in the net worth position on the balance sheet of each sector.

The paper contains lots of useful information for those interested in the analysis of national income and flow of funds accounts.

As a way to help demonstrate the usefulness of the IMAs, the authors of the paper have included a section describing the evolution of household net worth and its components during the last decade, thus enabling the reader to understand some of the underlying causes and subsequent effects of the recent financial crisis. 

As you read the excerpt below, keep in mind the following basic rule of thumb: a key indicator of the demand generated by any sector of the economy is its net borrowing (i.e., the difference between its total spending and income).

Uses of the IMAs

The recent financial crisis has vividly shown that analyzing the change in net worth and its composition is critical to understanding the health, risks, and prospects of an economic sector.  Net worth is a broad measure of the wealth of a sector, often used in conjunction with other variables, such as income and interest rates, to study variables such as consumption and saving.

The IMAs enable one to analyze net worth and its composition, clarifying how the current balance sheet position came about by distinguishing between saving, borrowing, holding gains or losses, and other changes in volume.  As an example, we can look at the IMAs for the household and [Non-Profit Institutions Serving Households] sector.  In the first half of the last decade, the household sector shifted from being a major lending sector to a major borrowing sector, rivaled only as a borrower by the federal government sector. It was at this same time that the rest of the world sector became the predominant lending sector.

At the same time, household net worth surged rapidly and the ratio of household net worth to disposable personal income reached record levels (chart 1 -- click on chart to expand).  This surge was caused not by elevated savings, but by sizable capital gains both on housing wealth and on stock-market wealth (chart 2).

Chart 1

Chart 2

Indeed, the ratio of both housing wealth and stock market wealth to disposable personal income surged to historically unprecedented levels (chart 3).  Not surprisingly, household debt also ballooned.  The ratio of household debt to disposable personal income surged from around 90 percent at the beginning of the decade to an all-time high of around 130 percent in the middle of 2007 (chart 4).

Chart 3

Chart 4

This ratio dropped to 111 percent by the end of 2011 as consumers borrowed less and as a significant amount of mortgage debt was written off. [...] [T]he household sector shifted back to being a major net lender in 2008.

Net borrowing by the federal government, on the other hand, ballooned to over $1.3 trillion in both 2009 and 2010. In 2009, the rest of the world sector was a significant lender, along with the financial business sector. The nonfinancial corporate business sector, traditionally a net borrower, became a net lender in 2009, as capital expenditures remained relatively low and retained earnings elevated (Cagetti et al, 2012:6-8).

Reference

Cagetti, M., Elizabeth Ball Holmquist, Lisa Lynn, Susan Hume, McIntosh and David Wasshausen, The Integrated Macroeconomic Accounts of the United States, 2012-81, Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C.

Thoughts on endogenous money

The author of Unlearning Economics has written two good posts on the endogenous nature of money (i.e., the notion that the money supply adjusts to the demand for money). I agree with the author's assertion that recognizing the endogenous nature of money is important in order for policymakers to properly address issues relating to financial instability.

Just to add to this discussion, the key aspect about the endogenous nature of money is its ambivalent effects on the working of the economic system. On the one hand, as stressed by many post-Keynesian monetary economists (especially circuitistes and modern monetary theorists), the endogeneity of money enables both the level of investment and growth to surpass what it would otherwise be in a context of self-financing.

According to this view, a recognition of the endogeneity of money frees us from the "fictitious" constraint of a fixed money stock and, as such, opens up new possibilities (from a economic policy standpoint) for achieving full employment and improved living standards (e.g., via public investment financed by government deficit financing and money creation). Also, it forces us to look for a better explanation in regard to the causes of inflation and to reconsider the popular view that inflation occurs solely as the result of an excessive rate of growth in the money supply or as a consequence of government deficit spending. In a context of endogenous money, the causality between increases in prices and the money supply can also be considered as flowing from prices and output to money rather than uniquely the other way around, as is most often believed.

On the other hand, as recently emphasized by the staff economist of the Bank for International Settlements (BIS), the endogenous nature of money, by allowing investment to surpass the capacity of self-financing, also acts to intensify the inherent risks and instability of the modern economy (in which finance plays a critical role) by creating the conditions that lead to unsustainable booms in credit and asset prices that "can eventually lead to serious financial strains and derail the world economy" (Borio and Disyatat, 2011:27).

Now, let me be clear: I'm not saying that these approaches are irreconcilable, or that they exclude each other's views on the issue. On the contrary, one has to look very closely to uncover the difference between the views on the monetary system of post-Keynesian monetary economists and those of BIS economists. They are quite similar in many respects, as recently highlighted by economist Bill Mitchell. For instance, recall that the late Hy Minsky, a post-Keynesian economist, emphasized long ago the destabilizing effect of the modern financial system, a notion that is closely aligned with the views of the BIS economists today. So, in this sense, all I mean to suggest is that the focus of these two groups of economists tends to be different, not that both views are necessarily different in scope.* (For instance, modern monetary economists have been doing some excellent work to address the financial stability issue. See, for instance, Randall Wray and Eric Tymoigne.)

Finally, I will just conclude by saying that, in Canada (where I reside), empirical evidence pointing to the endogeneity of money (i.e., that money supplied by the central bank is demand-led) has been around for a while. Consider this excerpt from Bank of Canada Technical Report 16: Monetary Base and Money Stock in Canada by economists Kevin Clinton and Kevin Lynch arguing against the notion of an exogenous money supply:

...the findings contrary to the monetarist position are strongly enhanced by evidence that emphatically demonstrates causality running from money to the base. The historical association observed between the two arises primarily from the influence of deposits on bank reserves, not vice versa, so that the existing correlation, weak though it may be, could give an exaggerated impression of how well the money supply could be controlled via the base. [...] The empirical tests reject the notion that there is "direct" link between bank reserves and bank deposits and that changes in bank reserves cause changes in bank deposits. (4,40)

This technical report was published in 1979. I know of no convincing evidence that refutes these findings (keeping in mind that Canada no longer requires banks to hold reserves).


* The difference between the two approaches lies mainly in their views regarding the existence of the Wicksellian notion of natural rate of interest. Although this is not an insignificant issue, for the purpose of this post there is no need to elaborate further on this point.

References

Borio, C., and P. Disyatat, Global imbalances and the financial crisis: Link or no link? Bank for International Settlements Working Paper No. 346, May 2011.

Clinton, K. and K. Lynch, Bank of Canada Technical Report 16: Monetary Base and Money Stock in Canada, Bank of Canada, 1979

Myths about the burden of the welfare state: Insights from Harold Wilensky's new book

It's not uncommon these days to hear that the problems affecting the public finances of European nations are linked to the high welfare standards that are characteristic of European public administration.  According to this view, the cost of welfare programs, including social security and other forms of government-protected minimum standards, are simply too expensive and must be cut dramatically if Euro countries such as Greece, Spain and Portugal are to "regain control" of their public finances.

A related claim also suggests that the high level of taxation required to support welfare state systems stifles growth and undermines a nation's commercial competitiveness.  Accordingly, cutting social programs is viewed as a necessary first step toward lowering corporate tax rates and, ultimately, attracting businesses and promoting growth.  One commentator recently summed up this view as follows: "To thrive, Euro countries must cut the welfare state".

In my opinion, there are several problems with this line of reasoning.  The first is that viewing the European sovereign debt crisis as a consequence of the degree of generosity of welfare state policies completely disregards the fact that several Europeans nations with elaborate welfare systems are not suffering the same problems as, for instance, Greece and Spain.  Kurt Huebner has summarized the problem of linking the European debt default crisis to the costs of welfare state entitlements succinctly in a recent policy note:

If too high entitlements, in other words high welfare state standards, have caused the sovereign debt default crises, we would expect that societies with the highest and most generous welfare states would be top-ranked in the group of sovereign debt default economies. According to general prejudice this would be Sweden, Denmark, Norway, Finland and Germany, Austria and the Netherlands. The last time I checked nearly all of those economies were ranked in the top – but in the group of economic high-achievers and not high debtors. In other words: making a causal link between sovereign debt crises and welfare state entitlements is not confirmed by empirical data.

As for the claim that the high levels of taxation that is required to support welfare state systems is detrimental to economic growth, this too is unfounded.  In a recent blog post, Martin Wolf refuted the argument that lower taxes are the principal route toward better economic performance.  On the contrary, Wolf demonstrates that, not only are today’s most solvent countries highly taxed, but also that the level of taxation has no incidence on economic growth.  For this reason, Wolf suggests that the current focus among policymakers and commentators on reducing the tax burden is misguided:

Indeed, among the eurozone countries shown, crisis-hit Ireland, Spain and Italy had relatively low average tax rates. (They also had fiscal surpluses or negligible fiscal deficits, prior to the crisis. But that is a topic for another occasion.) The heavily taxed eurozone countries on the right hand side of the chart (from Germany on up) are all now relatively crisis-free.

The conclusion to be drawn is that a tax burden (within the range of 30 per cent to 55 per cent of GDP) tells one nothing about a country’s economic performance. It is far more a reflection of different social preferences about the role of the state. What matters far more are culture, quality of institutions, including law, levels of education, quality of businesses, openness to trade, strength of competition and so forth.

But what about the impact of welfare policies as a whole on a nation's economic performance?  Surely, one would assume that high welfare standards would be a net cost to the economy and society?  Again, as with the claim that a high tax burden is detrimental to growth, this too is a misguided assumption.

The most comprehensive explanation of why the welfare state is not a drag on economic performance is found in the work of the late Harold Wilensky, Professor Emeritus of Political Science at UCLA, Berkeley.  Wilensky's most recent book entitled American Political Economy in Global Perspective (2012) provides a highly detailed and up-to-date analysis on the political economy of the welfare state.

In this book, Wilensky presents findings stemming from over 40 years of in-depth research on 19 rich democracies that, among other things, support the view that modern welfare policies do not have adverse effects on productivity and national income.  The book points to empirical evidence that supports this conclusion and lays out in a clear and convincing manner the argument that welfare systems are not a drag on economic performance (2012:7-14; 46-55). 

According to Wilensky, there are two main reasons why the welfare state is not detrimental to a nation's economy.  First, Wilensky argues that many sectors of social policy are simply productivity enhancing.  The following excerpt from the book summarizes this point quite well:

Mass access to medical care and health education via schools, clinics, and child care facilities reduces long-term medical costs and in some measure enhances real health and lifetime productivity; preventative occupational health and safety programs in the workplace reduce absenteeism and turnover and other labor costs; active labor market policies supplement and in some countries reduce reliance on passive unemployment insurance and public assistance and improve the quality of labor; innovative family policies reduce the cost of both mayhem and poverty, they also reduce income inequality and gender inequality, which are a drag on economic growth.  These are substantial offsets for the costs of welfare-state benefits to the nonworking poor, handicapped, and the aged.  The net economic effect of all the programs labeled the "welfare state" is therefore either positive (before 1974) or neutral (since 1974). (Wilensky, 2012:6)

As for the second explanation of why high welfare standards are not detrimental to economic performance, Wilensky argues that nations with highly developed welfare state systems are also nations with institutional structures and legal frameworks that foster the habit of consensual bargaining among the government, businesses, unions, interest groups and other social partners, whether it be through public institutions (e.g., legislative assemblies, intergovernmental relations) or private institutions  (e.g., governance boards, conflict resolution committees).  More specifically, nations with these types of institutional structures and bargaining arrangements in place (e.g., Norway, Sweden, Finland, Denmark, Netherlands) promote coalition-building among political and societal groups, as well as effective labor relations.  In addition, these institutional structures and bargaining arrangements foment a politics of moderation that minimizes confrontation between social actors, as well as reduces both policy paralysis (i.e., inaction by government even though there is strong support for certain policies by citizens and dominant social actors) and political brinkmanship between partisan groups.

In sum, nations with consensual bargaining arrangements in place encourage the development of public policies that are more reflective of the aspirations of the electorate and, as a consequence, that are less apt to fall prey to polarizing partisanship or result in costly citizen backlash and/or rollback, as is common in more confrontational democracies such as the US (e.g., tax-welfare backlash).

According to Wilensky, the most significant economic benefit flowing from this consensual form of political bargaining is that it facilitates productive trade-offs among the government, political parties, businesses and unions, many of which have positive impacts on productivity and economic performance.  The trade-offs favorable to good economic performance and typical of consensual democracies include the following:

• Labor embraces restraint on nominal wages in return for social security and related programs based on social rights and modest increases in real wages;
• Employers provide job protection in return for wage restraint, labor peace and sometimes tax concessions (e.g., lower taxes on corporations and capital gains);
• Employers provide participatory democracy in the workplace or community in return for labor peace and wage constraint;
• In return for all of the above, the government improves its tax-extraction capacity (i.e., capacity to increase taxation with minimal backlash from public), thus enabling it to offer more generous and popular social programs;
• Faced with strong unions and with the habit of making such trade-offs, management tends to cooperate with labor in return for the implementation of a wide range of government policies, including less intrusive regulations and more effective implementation of laws and executive orders. (Wilensky, 2012:46-49).

In addition to these trade-offs, Wilensky points out that consensual democracies benefit from lower strike rates, a higher rate of gross fixed capital investment and wage restraint during economic shock periods (2012:51).  According to Wilensky, the higher rate of capital investment and lower strike rate are the main causes of good economic performance for these nations.  Also, these nations benefit from less confrontation between social and political actors and strong countervailing sources of consensus where, for instance, the dominant influence of big business is matched by the power of big labor.  Finally, as a result of the greater degree of cooperation that exists between social partners in consensual nations, policy paralysis is more easily overcome and economic shocks are more quickly and effectively addressed and mitigated.

Now, I should emphasize that Wilensky is not suggesting that nations with consensual bargaining arrangements have stronger economies than nations with more "confrontational" bargaining arrangements (e.g., US, Canada, UK, etc).  On the contrary, Wilensky makes it clear that during the last four decades there has been "two roads" to good economic performance; nations with consensual bargaining arrangements (i.e., "high road" strategy) and nations with more confrontational bargaining arrangements (i.e., "low road" strategy) have performed equally well when examined from a purely economic standpoint.  The difference is that nations that have adopted the metaphorical "high road" do much better in terms of social and political performance (e.g., income and gender inequality, health, job security and education).  In other words, according to Wilensky,

[e]ither [road] can at various times and places result in good economic performance.  The sharp contrasts appear in social and political performance.  The choice is a matter of one's values. (Wilensky, 2012:190).

Before concluding, I should address one common objection that is often made by critics of the view presented above, which is that recent global developments such as increased immigration, international competition, the spread of multinational corporations (MNCs), and the deregulation of labor markets, to name but a few, pose significant challenges to the viability of the consensual bargaining model of governance and undermine the economic base that enables the trade-offs above to materialize.  In other words, the critique suggests that this model is outdated and no longer adapted to the modern world economy.  However, according to Wilensky, such developments have only had a moderate to small influence on consensual bargaining.  For instance, on the impact of MNCs, Wilensky notes that there is little evidence that MNCs have undermined the nation's capacity to accommodate the conflicting interest of social partners by means of consensual bargaining.

That said, Wilensky argues that there is one recent development that does threaten the survival of consensus-enabling arrangements and institutional structures that help sustain effective welfare state systems: the increasing power and ideology of central banks and the internationalization of finance.  Wilensky's view on this issue is highlighted in the following excerpt:

Perhaps one recent trend does undermine the capacity of modern democracies to shape their economic destinies: unregulated internationalization of finance and the increasing independence of central banks, a clear threat to collaborative relations among labor, industry, and the state and to flexible use of fiscal policy (taxes and spending).  Reinforcing this trend is the flow of recently ascendant American economic doctrines across national boundaries: a blend of 19th century liberalism (unmodified free markets, private property, minimum government), Reaganomics, and monetarist ideology.  This was the ideological base for the deregulation of the financial sector at the root of the meltdown and Great Recession. (2012:151) (my emphasis)

A word on the Eurozone crisis and the need for a countervailing force to the ECB

Although American Political Economy in Global Perspective does not address the current European sovereign debt crisis, my impression is that Wilensky would have given preference to a solution that would not only directly address the financial problem facing the periphery Euro nations (either through the creation of "Eurobonds" or the ECB purchase of periphery nation debt) but also promote the emergence of a countervailing force that would match the influence of the ECB.

In my view, two sets of proposals could help to achieve such a result, namely, the creation of stronger EU institutions (including a democratically elected EU president, see Charles Goodhart's recommendations here)*, as well as the proposal to implement European-wide wage-setting (see Andrew Watt's article here), a proposal that I think could give rise to a stronger, more centralized labor presence at the EU level.

Here are the relevant sections of the book relating to the concept of countervailing power and central bank independence and influence:

The German labor movement for decades remained a major countervailing force to the Bundesbank...[T]he postwar record of low inflation with only medium unemployment is a product not only of the Bundesbank's autonomy but of a labor movement that has traded off wage restraint and industrial peace for social benefits and worker participation.[...] The consensual bargaining between labor, government, and industry eases the Bundesbank's task of controlling inflation without greatly reducing employment.  The ascendance of the European Central Bank, however, changed all that.[...] (Wilensky, 2012:128)

That several of the countries whose central banks had limited autonomy before 1990 (Japan, Austria, Norway, or Belgium, 1965-1974, 1985-1989) outperformed countries with more independent central banks (Canada, Netherlands, Denmark, or the US before 1980) should give pause to those who adopted the "Bundesbank model" for the European Central Bank without the German labor, management, state, political, education and training and other institutions that made it work.  Unfortunately, the European Union has neither the offsetting institutions to constrain such a bank's behavior nor the European-wide welfare state and job creation antidotes to its strong deflationary medicine. (Wilensky, 2012:132) (my emphasis)

* Paul McCulley has also suggested that the ECB president "needs a boss" to whom he or she would be directly accountable. I very much agree.

References

Huebner, Kurt, Political Exploitation of the Crisis of the Eurozone, Policy Brief, Institute for European Studies, University of British Columbia, February 2, 2012

Wilensky, Harold, "Trade-Offs in Public Finance: Comparing the Well-Being of Big Spenders and Lean Spenders", International Political Science Review, Vol. 27, No. 4, 333-358, 2006 (to view an earlier version of this article, see here)

Wilensky, Harold, American Political Economy in Global Perspective, Cambridge: Cambridge University Press, 2012

Wilensky, Harold, Rich Democracies: Political Economy, Public Policy and Performance, Berkeley: UCLA Press, 2002

Employment and productivity growth

Like clockwork, the National Post published yet again another article pointing out the bafflement of economists toward Canada's stubbornly weak productivity growth.  Of course, the dismay of economists is easily understood.  As the article points out, for years economists prescribed – and were able to persuade federal and provincial authorities to adopt – a series of remedies deemed necessary to improve the competitiveness of industry, including tax cuts, deregulation, free trade, low and stable inflation, government debt reduction and low interest rates.

All of these initiatives were intended to minimize the cost of business inputs, help the business sector become more competitive and improve overall productivity.  Essentially, the focus was on putting forth a set of so-called "market-friendly" policies that would provide the incentive for firms to operate in a leaner manner and to increase output.

After over a decade of considering productivity mainly a microeconomic problem and putting forth these "market-friendly" policies, it's safe to say that this approach to boosting productivity has been a failure.  And there is even evidence that the route taken by policymakers has been ill-advised.  Take, for instance, this excerpt from the 2007 OECD Employment Outlook, which offers a skeptical view on the effectiveness of these types of policies on productivity growth:

It has been claimed by some that only countries which emphasise market-oriented policies (characterised by limited welfare benefits and light regulation) may enjoy both successful employment performance and strong labour productivity growth simultaneously, unambiguously improving GDP per capita. This claim is not supported by the evidence in this chapter, however. (2007) (emphasis added)

Contrary to the microeconomic/market approach, my take is that productivity is very much a macroeconomic issue.  In this regard, I side with post-Keynesian economists Nicholas Kaldor and Robert Eisner, both of whom argued that the level of employment and the degree of competition in labour markets have an incidence on productivity and overall growth.  James Galbraith summarizes this point succinctly when he argues that

...full employment production foments ample competition in product markets, high rates of technical change, and declining costs, as business seek ways to save on scarce and expensive labor.  In other words, productivity growth accelerates because of full employment itself. (emphasis added)

Now, it's important to recognize that employment growth irrespective of the type of employment probably won't do much to increase productivity.  As highlighted in the OECD report cited above (and implied in the quote by Galbraith), the type of employment growth is a critical factor impacting on productivity.  For this reason, it is best if policymakers seek to prioritize employment growth in the manufacturing sector, the sector that is most amenable to improvements in productivity (see here for more on why manufacturing matters for productivity growth).

Furthermore, in the case of Canada, there is now evidence that the slowdown in productivity during the last decade – of which half originated in the manufacturing sector – was mostly caused by lower levels of capacity utilization (Baldwin et al., 2011).  From an exports standpoint, this means that growth in productivity could be achieved by increasing the external demand for Canadian products via a more competitive exchange rate. 

References

• Baldwin et al., Export Growth, Capacity Utilization and Productivity Growth: Evidence from Canadian Manufacturing Plants, Statistics Canada, Economic Analysis and Research Series, December 2011

• Galbraith, J.K. Fed Ache, Washington Monthly, July/August 2004

• OECD, More jobs but less productive? The impact of labour market policies on productivity, Employment Outlook, Chapter 2, 2007

Interview: Raymond Lombra on the US economy and economic policy

The optimism about the US economy that took hold earlier this year is fading.  Consumer confidence fell last week to the lowest level in four months and the US job market is weakening, as evidenced by the higher than expected number of unemployment claims.  And on the stock market front, the month of May has been a disappointment as major US indexes fell back to levels not seen since January.

One economist who did not expect 2012 to be very different from last year is Raymond Lombra, a Professor of Economics at Penn State University and former Fed staff economist.  In an interview last September, Lombra explained to host Peter Schiff that the US economy's "lack of momentum" was set and that there was very little that the US fiscal and monetary authorities could do in the short-term to improve the situation.  Rather, Lombra's take is that the US government should continue to support aggregate demand to ensure the recovery takes hold and focus on promoting long-term growth and stability.

I highlight the views of Lombra for three reasons.  Firstly, there are very few people in the US who know more about the banking system, central bank operations and economic policymaking overall than Lombra.  Secondly, the views expressed by Lombra in the interview are strikingly similar to those of Chairman Bernanke in his February 2, 2012, testimony before the House of Representatives' Committee on the Budget, one of Bernanke's better performances in recent months.  Here is an important excerpt from Bernanke's testimony entitled The Economic Outlook and the Federal Budget Situation:

Even as fiscal policymakers address the urgent issue of fiscal sustainability, they should take care not to unnecessarily impede the current economic recovery. Fortunately, the two goals of achieving long-term fiscal sustainability and avoiding additional fiscal headwinds for the current recovery are fully compatible--indeed, they are mutually reinforcing...[A] more robust recovery will lead to lower deficits and debt in coming years.

The last reason why I'm highlighting this interview is that the exchange between Schiff and Lombra is actually quite interesting.  Although Schiff interrupts Lombra throughout the interview, I thought Lombra did a good job in refuting the radical views of the host.  Lombra covers a lot of ground in his responses and provides some very good insight on economic policy, the state of the US economy and on ways to improve the current economic situation. 

The interview is dated September 22, 2011. Here is also the transcript of the interview:

Peter Schiff: Joining the conversation is Dr. Raymond Lombra. He is a Professor of Economics at Penn State University. He is Associate Dean of Research and College Advancement. He is a former Associate Professor of University of the District of Columbia and George Washington University. He is also a former staff economist at the Federal Reserve Board of Governors. He has actually consulted with the US Banking Committee in Congress, the Federal Reserve, the Congressional Budget Office, the US Congress Joint Economic Committee, the IMF, the Senate Banking Committee and the US Treasury. Dr. Lombra, welcome to the show. 

Raymond Lombra: Morning Peter.

PS: So have you consulted with anyone in Congress or at the Fed recently?

RL: Well, I’d say informally with various staffers and I also consult with some Wall Street firms. But just because they talk to us doesn’t mean they follow the advice they get! (laughter)

PS: Ok, so then it’s not your fault if they are not following your advice. They are ignoring it! (laughter)

RL: Yes, but I’m not saying we have the right answers either.

PS: What is your advice? I mean, I just went before Congress last week to testify on what they can do to help the economy, or more importantly, how they can stop hurting it. But what is your advice? What are you telling Congress and the Fed? What should they be doing right now?

RL: Well, I think we need to dial back a little here. We’ve obviously entered the "silly season" – the run up to the next election. And you can ask yourself “what reasonably can be accomplished over the next thirteen months?” And I think a lot less than people are imagining.

PS: Well, I don’t think we should be pursuing monetary and fiscal policy with the goal of an election in mind. Our leaders need to be thinking longer term.

RL: Oh, I agree with that. But we know that – more the Congress and the President, of course, than Ben Bernanke and his colleagues – they certainly are fixed on the next election. As you are suggesting, this is going to lead to bad policy. I mean, the whole idea of setting the Fed they way they were set up was to give it the freedom to act in the best long run interest of the nation even if not in the best short run and political interest of its elected leaders.

PS: But it never seems to do that. It always seems to try to re-elect who the incumbents are. That’s generally how they pursue policy.

RL: I think there have certainly been periods like that. And I don’t know if you want to turn this into a discussion about Ben Bernanke, but I’m sure you’ve talked about the Republican’s letter to him in front of the Federal Open Market Committee. I mean, he’s worried about the economy and the question is “what, if anything, can the Fed do?” Well, I would say that the actions they took yesterday are pretty modest. I think that if we got him hooked up to a lie detector and said “do you really think this alone, these two actions that were announced, are going to make a big difference?”, he would say “probably not”.

PS: Well, I think if we hooked him up to a lie detector, it would probably break due to the excess activity. (laughter) You know, I think he’s going to ultimately give the market what it wants, which is more money from helicopters because this economy is imploding. The problem is that they are trying to resurrect a Frankenstein economy. We have to let the US economy die so that a real one can be born to takes its place. We can’t try to preserve an economy by just spending borrowed money. That’s what the Fed is trying to do and it won’t work. Meanwhile, the banks that were bailed out before are all going to fail. So what’s the Fed going to do? Is the Fed going to let them fail this time?

RL: Well, you’ve covered a lot of ground there. I would say that Ben Bernanke knows more than most people on the globe about both the Great Depression and, I would say, the lost decade in Japan. And I think the common threads he draws from those experiences is that it is worth trying something even if in retrospect they didn’t do much good as opposed to doing nothing. And history is going to have to be the judge about which specific initiatives made a difference. But I do want to go back a little bit because there is a tendency to look at what’s happened in the United States over the last few years as akin to a normal recession. The way we talk to our students about it is the economy catches a cold or maybe even the flu. When to my mind what the economy suffered was more like a stroke and we know that the recovery from stroke can be long and it’s going to take a lot patience and attention to long run therapies. But unfortunately our political system is not very patient.

PS: I think the problem is that every time we actually caught a cold in the past, the way the government cured it was just to cover up the symptoms and let us get sicker. And now we’re so sick from all these prior government stimuluses that this last one is actually the one that’s going to kill us. And that’s why the economy is dying because the government continues to administer the toxic medicine that prevents the free market from healing itself.

RL: Well, I certainly agree that, if we took the stance that policymakers are kind of out of short run remedies, this may be a good thing. The question is whether the longer run adjustments in taxes and expenditures and regulations, in particular, on the fiscal policy side can create a more stable environment for businesses and consumers to make good decisions. And there’s really not much hope that any of that is going to happen in the next fourteen months unless the economy slides a lot more than most consensus forecasters see it at the moment.

PS: Listen, I think we’re in a recession already because I think we’re in a depression. So I don’t think it ever ended and I don’t think it’s going to end. I think it’s going to be with us probably for the balance of this decade because I don’t know that the government is ever going to do the right thing. I think they are going to keep on stimulating and we’re never going to get out of this and we’re just going to dig the hole deeper.

RL: Part of it is maybe instant analysis and the 24/7 discussions and the way politicians can get trapped sometime by saying things that maybe in the more full reflection they don’t really believe. But it seems to me that we’re in an environment where, just to take one example, this discussion about “should we or shouldn’t we raise taxes on the rich”. If we stopped the average person on the street – I’m guessing, I think it’s true – that the President and most of the Democrats understand that the wackiest thing you could do between now and when the economy were to regain its feet would be to raise taxes. But that nuance, it gets to be a discussion about raising taxes now and cutting Social Security benefits and Medicare. That would be crazy. I think what the markets are looking for – and I’m guessing what you’re imagining the economy needs – is a path to a more sustainable fiscal environment. And the path would have to be sensitive to where we’re starting from. The great mistakes that were made in the Depression were that we allowed aggregate demand to contract even as it needed to be boosted. We need to avoid that.

PS: Well, I would disagree with that. I think we’ve had too much demand. We bought things we couldn’t afford. That’s the problem. We need more savings. We need to produce more. But the whole thing on taxes and the problem with our economy is not that the rich aren’t taxed enough. The rich are paying plenty of taxes. But when people object to raising taxes in a recession, they do that because it takes money away from individuals. Well so does government spending. The problem is that when you run a deficit as opposed to raising taxes, this damages the economy even more than the taxes. So if politicians are worried about draining the economy of resources from taxes, they really need to be worried about draining the resources from government spending. So what we really need right now is massive cuts in government spending. That’s the only stimulus that going to help: massive cuts in government spending!

RL: Yeah, I would disagree that that is the route out of this – where we are right now today. I think that over the longer run, there’s no question that government spending is too large. You know, Milton Friedman certainly understood that actually the route to long run prosperity was to cut spending for reasons... (inaudible).

PS: Then, how do you think we get out of this? We run big deficits? Let the government spend a bunch of money? I mean, how does the economy recover?

RL: I don’t know any economist – well, I shouldn’t say that. Most economists, rational economists, believe that we need a lot more fiscal discipline over the longer run than we’ve seen.

PS: But we don’t need any now?

RL: The question is how you get there.

PS: But what about right now? What do we need to do right now? What should the fiscal policy be right now? What should the monetary policy be right now?

RL: I don’t think the Fed could or should do much more than it’s done already. We got plenty of liquidity in the system and a little tick down in interest rates isn’t going to make any difference. As you know, it’s small businesses and consumers that can’t get access to credit for a lot of reasons, including the aftermath of the 2007 recession.

PS: Right, but the last thing we want is more consumer credit because we don’t want more spending on borrowed money. We want that credit available for investment and production. So, that would be a bad thing is consumers got more credit.

RL: Well, consumers are rebuilding their balance sheets and what you’re suggesting is that the government needs to rebuild its.

PS: Absolutely.

RL: And I agree with that over the longer run. But I think cutting aggregate demand right now would be exactly the wrong policy. On the other hand, laying out a path, and I’ve seen a lot of different plans. And certainly the deficit reduction committee – the earlier one and the one that is operating now – understand both the need for a path and the general outline of what it’s going to involve. The question is: “Is the political will there to do it?”

PS: But what you’re suggesting is to make that path more difficult. You’re saying we have to run bigger deficits now so that we can tackle the deficits later. But the bigger we make them now, the more difficult it is and the less likely we’re ever going to tackle them.

RL: Well, I don’t think you asked me what I would do on fiscal policy today.

PS: I did ask you. What would you do?

RL: My first order of business would be to lay out the path to fiscal balance over the next five to ten years. That would be the first thing I would do.

PS: We’re going to have to hold that thought until after the break. But I would like to know what we’re going to do about the deficit this year, next year, right away, not the path of the future because we can’t force Congress to follow that path. What counts is what we actually do right now. Think about that and we’ll be right back.

(Break)

PS: So not about a plan for the future, what do we do right now. What does Congress do for this current fiscal year, if anything to make the economy grow?

RL: Well, I would say “damn little” that they can do to improve the economic performance over the next year. I would say that because a lot of the momentum – or lack thereof – is already set in place, I think that we are going to be given a lot of false hope by some. I would have thought we already learned the lesson that there aren’t really such things as shovel-ready projects. So we’re hearing more about infrastructure – I guess the President today was going to be at some bridge in Kentucky saying that this is what we can fix up. But what we’ve learned is that by the time Congress enacts something until a job gets created is a very long time and it has much smaller impact than were envisioned at the time that the policies were pushed. I think that is not the route forward for the next fourteen months. I think extending the payroll tax cut won’t hurt and could help. But I think the most important thing that Congress can do is get together on a longer run framework for cutting spending and, I think, adjusting tax revenues. We can debate whether it should be closing loopholes and lowering rates but we need to be able to adjust the revenue.

PS: But how do they do anything long term when whatever they pass today is not binding on any future Congress? Whatever they do can be undone.

RL: That’s a really good question and I’ve thought about that. You know, political scientists have looked at whether term limits would make a difference. I remember when I was back in Washington for quite a while the Gramm-Rudman-Hollings budget rule that was put in place did have some significant impact on retaining spending. And looking back on that kind of approach might make some sense.

PS: It couldn’t have worked too well because we got rid of it. That was part of the problem, right? We got rid of it.

RL: I think it did restrain spending relative to what it otherwise would have been and then it got abandoned so let’s learn from that. This time around the committee that is meeting knows that if some agreement on deficit reduction isn’t made there will be very large cuts to the military. And some of them are not too happy about that. So there may be a lever that’s been uncovered here that helps bring some discipline over and above what rule they agree to. There are institutional arrangements that have to be adjusted here. There isn’t an argument that you’re going to make or that I’m going to make that by itself is going to change the path to fiscal stability.

PS: I think big cuts in military spending would be a good thing. So I just assume let them go through. I don’t think that would jeopardize our security. I think what is jeopardizing our security is all the money we’re wasting on excess military spending, among other things. But here’s the problem. See, if I’m right and the economy never recovers then how are they ever going to deal with these deficits? They are always going to say “we can’t raise taxes in a recession and we can’t cut spending in a recession”. And eventually, interest rates are going to go up because inflation is going to be such a problem that they are not going to able to stay down. And then what do we do? What do we do with all of this debt that is financed with T-bills when interest rates are going up? Is the government going to spend all of its money on interest and nothing on anything else or are we just going to turn the money presses full steam?

RL: Well, I think that’s a little extreme but I’m thinking that’s one of the reasons you recommend people be in precious metals. But I’m not as pessimistic as you are at the moment, I think.

PS: About what? You don’t think interest rates can go up?

RL: Look, as we’re speaking, the Dow is down (inaudible) points...(inaudible)

PS: You don’t think interest rates are even going to go up? No, I’m not talking about today...(inaudible)

RL: It’s floating though. It’s floating every day.

PS: Right, but I’m saying, let’s say over the five to ten years. Do you think interest rates are going to stay at these ridiculously low levels?

RL: No, of course not.

PS: Alright, so what happens when they go up to a normal level? The government can’t afford to service the national debt with normal interest rates, let alone high interest rates.

RL: Well, not if you hold everything constant. But everything else is hardly ever constant.

PS: What do you think is going to happen? Are we going to have enormous economic growth that’s going to make these huge deficits financeable at higher levels of interest?

RL: Not with the current set of policies we have in place.

PS: Right. But we could have higher interest rates. We could certainly have a big pick-up in inflation. What if the Chinese decide to...(inaudible)?

RL: I wouldn’t expect that to happen until aggregate demand strengthens considerably.

PS: What about aggregate demand in China? What if the Chinese come to their senses and let the dollar drop against the RMB and the Chinese currency were to sky-rocket in value and China was to go on a global buying spree?

RL: Well, that would be one thing that didn’t stay equal. We could list all sorts of things which would change the economic outlook and that would certainly be a significant one. And policy would need to be adjusted in light of that. And we’d have to hope and expect the Federal Reserve would extract a lot of the liquidity that’s in the system to deal with the inflation that was beginning to emerge.

PS: You keep focusing on this aggregate demand that we need the government to supply. All that government does supply is inflation. All they do is buy what’s been produced. They don’t increase supply. They just increase demand so prices have to go up, or prices are prevented from falling, which might be something that would help the economy. But just having government spend money isn’t going to grow the economy.

RL: Well, I think it’s a component of aggregate demand. It’s not the only source. We also have the consumer...(inaudible)

PS: But where does the government get the money? I mean, if the government spends it somebody else doesn’t have it.

RL: The consumer is the most important part of the economy, proportionally. The consumer is rebuilding its...(inaudible)

PS: Well, I would disagree because if nothing is produced what is he going to consume? Where is the consumer if there is no producer?

RL: Well, producers will produce when demand picks up.

PS: But there’s always demand. I mean, everybody “wants” things. The question is you have to be able to supply it. You have to be able to create it. There are all sorts of things that I’m sure you would like to have but don’t have because you can’t afford it. It’s not because you don’t have demand. You just don’t have the means.

RL: You’re trying to push me into a debate. This is an old debate: does demand create supply or does supply create demand? And the fact is that markets reflect both supply and demand. So that’s my position. I’m saying that, right now, the economy is operating well below its potential. Firms have less employees. Their plants are more idle than they would be in the face of a pickup in their orders. That’s just going to have to work its way out of the system.

PS: Yes, I think what is preventing them from producing is that they lack the capital. They can’t do it at a low enough price to produce goods that propose can afford.

RL: What capital? Firms are sitting on an enormous amount of funds right now.

PS: Well, funds...but that’s not a factory. Just because they have paper doesn’t mean they have a machine.

RL: Oh, there are very few firms today that will tell you they are not hiring because they don’t have more factories to put them to work in. There are a few but there aren’t many.

PS: But they can’t produce things at a competitive price that people can afford to buy. That is the problem. We have to restructure the economy. Hey, this is an interesting discussion. Maybe we can continue it on another program. Thanks for stopping by.