It's baaack: Paul's Japan paper (monetary policy and expectations in an era of low inflation) (trying not to be wonkish)

One of the ongoing debates in economic policy these days is the question of whether a central bank on its own can be effective at getting an economy out of the doldrums.

The most famous exposition of the idea that a central bank, by itself, has the ability to boost economic activity is Paul Krugman's paper entitled "It's baaack: Japan's Slump and the Return of the Liquidity Trap" (1998).

In the paper, Prof. Krugman explains that, in a (hypothetical) world of Ricardian equivalence in which fiscal policy has no effect on the real economy, the central bank can get households and firms to borrow and spend by announcing it will bring about higher inflation in the future.

Prof. Krugman knows that the assumption of Ricardian equivalence is far fetched and unrealistic; he only includes this simplifying and unrealistic assumption in his paper to make the point that the central bank can on its own stimulate the economy when fiscal policy is unavailable as a policy option (due to policymakers ideological aversion to public spending, the presence of high public debt, etc.).

Now before I go any further I want to say that I'm a huge fan of Paul Krugman. I think he's one of the most sensible economic commentators out there and I agree with almost all his views on policy. On the effectiveness of central banks alone to boost economic activity during a deep recession or depression, however, I'm quite skeptical.

The logic in Prof. Krugman's paper can be summarized as follows:

• households and firms will borrow and spend if they expect higher inflation in the future;
• borrowing and spending is influenced by the real interest rate (i.e., the nominal rate of interest less the expected rate of inflation); and 
• a rise in expected inflation is for all intents and purposes equivalent to (i.e., has the same effect as) a fall in the real interest rate.

In other words, Prof. Krugman is saying that an increase in expected inflation of, say, three percent will have the same expansionary effect as a three percent cut in interest rates.

All this makes for a plausible story. However, things aren't as simple in the real world.

The problem is that Prof. Krugman's 1998 paper makes inflation a function of expected future inflation, as in the New Keynesian Philips curve (which, in passing, since it assumes no trade-off between inflation and output gap stabilization, is "neither Keynesian or a Philips curve", as Robert Solow once quipped).

In the real world -- and the evidence and the current state of economic activity seem to support this -- inflation is a function of backward-looking expectations: inflation displays significant inertia. Peoples' beliefs about expected inflation are based on past and present inflation. The notion that past inflation is irrelevant, as embodied in the New Keynesian Philips curve, seems to me implausible.

Prof. Krugman is aware of this criticism. Economists Robert Gordon, Alan Blinder and Martin Neil Baily all raised this point during the discussion that took place following the presentation of his paper. Here are the minutes that were recorded from that discussion:

Robert Gordon...criticized the assumption in Krugman's models that the monetary authorities can easily change inflationary expectations for the future -- that the announcement of a policy will change expectations despite present slack in the economy. He believed that agents' expectations depend largely on actual experience, and that they will experience increased inflation only when there is pressure in the markets for goods, services, and labor. Alan Blinder agreed. He thought that Krugman's inflationary policy would work if it could be implemented; but that would require the Bank of Japan to create expected inflation, which, in turn, would require persuading people that the future was going to be fundamentally different from the past. Japan had zero inflation in the past six years, and the average in the previous decade was 1.8 percent per year. Thus to create expected inflation of 4 percent, with actual inflation lagging behind, would be difficult.[Martin] Baily concurred, observing that it would be easy for Russia to be credible in announcing inflationary policy but hard for Japan. (Krugman, 1998:201)

True believers in the power of central banks will respond to this line of criticism by reverting to this old saw: a credible central bank would not have let inflation get too low in the first place, thus people's expectations would never had been unhinged as a consequence. To this, I say: wishful thinking!

When it comes to the role of expectations in explaining macroeconomic outcomes, Robert Solow warned that it should be used with caution (though Solow said this in a different context):

...[T]o rest the whole argument on expectations -- that all-purpose unobservable -- just stops rational discussion in its tracks. I agree that the expectations, beliefs, theories, and prejudices of market participants are all important determinants of what happens. The trouble is that there is no outcome or behavior pattern that cannot be explained by one or another drama starring expectations. Since none of us can measure expectations (whose?) we have a lot of freedom to write the scenario we happen to like today. Should I respond...by writing a different play, starring somewhat different expectations? No thanks, I'd rather look at the data. (Solow and Taylor, 1998:93)

The problem with economics and economic policymaking these days is that too much of it relies on monetary policy and the role of the central bank. There are limits to what central banks can do because people do not believe central banks are omnipotent and have the ability to control inflation expectations on demand. For this reason, Old Keynesians had it right: fiscal policy must be resorted to bring about normal economic activity.

To summarize: Inflation displays inertia and peoples' expectations about the future cannot be dictated by the central bank alone. Basically, inflation is the result of the interplay of supply of demand for goods and services. When you have more demand than supply, prices and inflation accelerate; when you have more supply than demand, prices and inflation decelerate. It's that simple. That's the secret to understanding what creates inflation, barring the effect of any bottleneck issues.

The central bank can have an impact on future inflation, but mainly as a result of its influence in affecting aggregate demand and real economic activity in the present and future, not as a result of its ability to affect expected inflation and overall expectations in general.

The ongoing low inflation affecting economies at present despite considerable monetary stimulus and the use of unconventional monetary policies such as forward guidance in countries such as the U.S., the U.K, and Japan is evidence that expected inflation relies on past and actual inflation and that central banks' ability to stimulate economies at present via the so-called expectations channel or by attempting to increase expected inflation is currently severely limited.*

To follow me on Twitter, just look me up @circuit_FRB.

References

Solow, Robert, and John Tayor, Inflation, Unemployment and Monetary Policy, (MIT Press: Cambridge MA), 1998

Krugman, Paul. It's Baaack: "Japan's Slump and the Return of the Liquidity Trap", Brookings Papers on Economic Activity, 2:1998

* This post is dedicated to my heroes in macroeconomics: Robert Solow, Alan Blinder, Robert Gordon, Martin Neil Baily and Paul Krugman, to whom I owe so much for their insights

Public investment and productivity growth: How to provide properly for the future

Just as I was thinking about the moral aspects of economic policy, here comes Paul Krugman with a fantastic commentary on how governments today are shortchanging future generations by not taking advantage of record low interest rates and not spending on productivity-enhancing public investments:

Fiscal policy is, indeed, a moral issue, and we should be ashamed of what we’re doing to the next generation’s economic prospects. But our sin involves investing too little, not borrowing too much — and the deficit scolds, for all their claims to have our children’s interests at heart, are actually the bad guys in this story. 

So true. This reminds me of something the late economist Robert Eisner wrote:

...balancing the budget at the expense of our public investment in the future is one way that we really borrow from our children - and never pay them back. (1996)

The reason for this is that the "deficit equals bad" crowd is completely oblivious to the fact that public investment adds to the stock of productive assets that help to enhance private sector productivity in the long run. And public spending on infrastructure, education, basic research and the development of new technology is essential to achieve the level of productivity necessary to improve our standard of living in the future.

And at a time when we are facing an aging population, increasing our future productivity growth should be a (if not the number one) priority.

A good explanation for this is provided by Francis Cavanaugh, former senior US Treasury Department economist and former CEO of the Federal Retirement Thrift Investment Board, who argues that

Significant productivity increases will be necessary as a diminished labor force is called on to support an expanded group of retirees. Without such increased production per worker, a shortage of goods will lead to price increases, and it is likely that the baby boomers will suffer a significant decline in the purchasing power of their retirement dollars. Inflation could soon decimate their retirement savings. That's the economic reality; if you're not working, you're dependent on the productivity of those who are. (1996)

In other words, the best protection against the potential losses that come with an aging population is to take measures today aimed at increasing the productivity growth of tomorrow. This should be the long term goal of policymakers right now.

So Prof. Krugman is right: contrary to what most politicians and commentators believe about how to improve our long-run prospect, slashing government spending is exactly the wrong thing to do at this time. 

References

Cavanaugh, F., The truth about the national debt, Boston: HBSP, 1996

Eisner, R., "The balanced budget crusade", The Public Interest, Winter 1996

Behind the deficit: high interest rates and recessions

As a follow-up to my previous article, I thought I would post this chart:

Primary government balance, Source: Statistics Canada

It shows Canada's consolidated government financial balance with and without interest on the debt.  The government's primary budget balance (i.e., current revenue less spending excluding interest on debt) is a good indicator of the magnitude of fiscal policy, declining during downturns and rising when real GDP increases. (Refer to this Statistics Canada table to view the relevant data)

The chart shows a few things.  First, it shows that interest on the debt (and the Bank of Canada's high interest rate policy in the 1980s) was an important contributing factor to the size of the deficit in the 1980s and early 1990s.  Notice how the gap between the two series shrinks as we move towards the 1990s.

Second, it drives home the point that recessions have a significant impact on the size of the government budget deficit by increasing the use of automatic stabilizers (i.e., unemployment benefits and other expenditures) and reducing government tax revenues.  Note that the primary government balance reached a surplus during the late 1980s as a result of the deficit reduction efforts of the federal Tories under Mulroney and of the provinces (see arrow).  The primary government balance only declined again as a result of the recession of the early 1990s.  The end of the recession restored the primary surplus.

Third, it makes it clear (given the above) that the series of government surpluses that Canada witnessed starting in the mid- to late-90s had their roots in the fiscal policy measures of the 1980s (e.g., tax increases and spending cuts) rather than solely in the cutbacks of the 1990s under the federal Liberals and of the provinces.  This is a point that very few commentators in Canada appreciate.

But the main lesson to take away from the above is that the large budget deficit of the early 1990s was caused by the recession. It was not a consequence of 'out of control' government spending, as most are led to believe.

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

Marvin Goodfriend on QE3: "This is a game changer for the Fed"

From a Bloomberg interview on QE3 with Marvin Goodfriend (click on "OK"):

I think this is a game changer for the Fed. I think it's a return to what we called a few decades ago "go and stop" monetary policy, which is to say, go all-in on a low unemployment target until the actual inflation rate rises enough to alarm the public.

As previously mentioned, I'm not sold on the idea that a new round of quantitative easing (QE) by the Fed will have much impact on the US economy. So, in a way, I don't reject Goodfriend's view that QE could involve diminishing returns down the road. However, I disagree with Goodfriend in regard to the inflationary risks that QE poses in future. Here, it may be worth highlighting an important point advanced by Oscar Jorda, Moritz Schularick and Alan Taylor in their paper "When Credit Bites Back: Leverage, Business Cycles and Crises" (2011), which discusses the after-effects of financial crises from a historical perspective:

...[O]ur results speak more directly to the question of whether policy-makers risk unleashing inflationary pressures by keeping interest rates low. Looking back at business cycles in the past 140 years, we show that policy-makers have little to worry about. In the aftermath of credit-fueled expansions that end in a systemic financial crisis, downward pressures on inflation are pronounced and long-lasting. If policy-makers are aware of this typical after-effect of leverage busts, they can set policy without worrying about a phantom inflationary menace. (2011:6)

That said, the interview nonetheless contains a lot of valuable insight on the policy implications of QE3 moving forward, as well as the reasons that may have prompted FOMC members to go ahead with another round of QE right now.

Finally, I also think Goodfriend makes a valid point when he suggests that the Fed is not providing sufficient information to the public about both the specific unemployment (or any other labor market indicator) target for QE3 and the evidence to justify additional QE at this time. That Goodfriend focuses on this last point is not surprising given that he's been a longtime advocate of central bank transparency, a principle that I too find important, although for different reasons. While Goodfriend views transparency as necessary for policy effectiveness, I believe it is a commendable principle for government organizations to follow for reasons of public accountability.

References

Jorda, O., M. Schularick and A. Taylor, When Credit Bites Back: Leverage, Business Cycles and Crises, Federal Reserve Bank of San Francisco, Working Paper, November 2011.

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

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.

Sense and nonsense about the aging of the population

Earlier this week, the federal minister responsible for overseeing Canada's public pension and old age security programs, Diane Finley, suggested that the aging of the population and the future cost of social programs targeted to retirees and seniors will lead to massive increases in taxes, crippling debt and a huge debt burden on future generations.  To remedy the situation, Minister Finley is proposing to raise the eligibility age to Canada's old age security program as a way to reduce future costs and preserve the "sustainability" of federal budget costs.

The rationale for the proposed program changes is based on the fact that the ratio of working-age people to seniors is projected to decline in the next decades or, as Minister Finley puts it, "as we go forward, we’re going to have three times the expense in Old Age Security as we do now, but we’re only going to have half the population to pay for it".

But is it really correct to say that the government is headed for a demographic shift that will jeopardize the sustainability of the federal budget in years to come?  I am not convinced. And here's two reasons why I think the problem of population aging is currently overblown.*

The ratio of workers to seniors

First of all, it's important to understand that the so-called "ratio of workers to seniors" is, by itself, a fairly uninformative concept for analyzing the issue of population aging.  The reason for this is simple: the ratio of workers to seniors tends to distort the true burden associated with the aging of the population.  Focusing on the ratio of workers to seniors, as most commentators and policymakers are currently doing, obscures the fact that seniors are, and will remain, a relatively small share of the total population.  Also, it's important to keep in mind that the working population must also "support" itself and the youth, in addition to supporting the senior population.

Instead, a more useful concept for analyzing the impact of population growth on the economy is the ratio of the total population to working-age population.  By using this ratio, one gets a much better sense of the real impact of population growth on the economy and, as a result, on future government budget outcomes.

Figure 1, Source: OCA, 2010

Figure 2, Source: OCA, 2010

Figure 1 provides a good snapshot of the increase in population projected (broken down for each age category) between 2011 and 2030 in Canada (see Figure 2 for the period 2011-2050).**  As shown in Figure 3 below, if the focus is solely on the population over age 65, the picture looks worrisome: over the next two decades (2011 to 2030) the number of people 65 and older will rise 78% relative to those 20 and 64.  When adding those under 20 to those 65 and older, the dependency ratio rises by 36% over the next two decades.  And when the entire population is considered relative to the working-age population, we note that the ratio rises from 159% to 180%, a much more manageable 13% increase over the next two decades (note: 13% of 159 is 21).

In other words, the actual "burden" of aging based on current projections consists of an additional 13% more people per working-age person.  This is much smaller than the 78% that is currently being mentioned by commentators and politicians.

Figure 3, Source: OCA, 2010 and author's calculations

Figure 4, Source: OCA, 2010 and author's calculations

Now, some people may argue that this amount is still quite high and, as a result, the government should nonetheless intervene to reduce future outlays to seniors.  This brings me to the second reason why I'm skeptical about the argument that population aging will have deleterious effects on the economy and public sector budgets: productivity growth. 

Productivity growth

Discussions about the aging of the population rarely, if ever, highlight the critical role that productivity growth plays in enabling the economy to afford the cost of programs destined to retirees and seniors.  Yet, the role that productivity growth plays is actually very important because as people become more productive at work, more income is generated to support those who aren't in the labour force such as the youth and seniors. 

In fact, if we look at the average rate of productivity between 1981 and 2011 for Canada, we find that productivity grew at a rate of approximately 1.3 percent per year (Martel et al., 2011).  This productivity gain greatly contributed to helping the Canadian economy shoulder the increased burden of aging during previous decades.  In 1981, the ratio of workers to seniors was approximately six to one whereas today it is approximately four to one. In 2030, it is expected to be below three to one (Statistics Canada, 2011).  Therefore, assuming that the average rate of productivity will remain at this level until 2031, we find that productivity will have nearly doubled between 1981 and 2031.***

Thus, once you consider the impact of productivity growth, the picture doesn't look so bleak anymore:  three workers in 2031 are expected to produce approximately the same level of output that six workers produced in 1981, fifty years earlier.  In other words, because of productivity growth, the worker in 2031 will generate almost twice as much output per hour as the worker from 1981.

A simple rule of thumb is that population aging remains "sustainable" as long as productivity rises faster than population.  Therefore, assuming an average productivity of 1.3% per year between now and 2031 (the same level as for the period from 1981 to today), we find that productivity will grow 28% whereas population will grow by 13%, as shown in Figure 3.  This is a noticeable difference that would enable Canada's economy to shoulder the burden of population aging while also increasing the population's standard of living.  Comparing this amount to the projected increase in population of 13%, we see that productivity growth will more than make up for the future increase in population.

Now, it is possible that future gains from productivity may not be entirely reflected in increased income for workers (via rising real wages).  Productivity gains may end up being disproportionally absorbed by businesses through increased profits.  However, it is important to understand that this problem is an entirely different one from that of the sustainability or solvency of public pensions and retirement programs.

In the event that future productivity gains get absorbed disproportionally into business profits, the remedy would be for government to ensure that a fair share of the gains from productivity be diverted toward real wage growth for workers.  Certainly, such a scenario would not warrant making drastic changes to the federal government's old age security program by raising the program's eligibility age from 65 to 67, as Minister Finley is proposing to do.

To conclude, I am not saying that taxes will not need to be raised by some amount to cover the future cost of public pensions and other retirement benefits.  The point here is that increased costs to taxpayers and workers should not be overly onerous.  The resources will be there to support the senior population in the future since productivity growth should more than make up for the 13% growth in the total population that working-age people will have to support in the coming decades.

The FRB blog invites your comments. Please share your thoughts below.

* This analysis is based on the excellent article by Spriggs and Price (2005).
** All figures are based on OCA, 2010, p. 96 and author's calculations. See Figure 5 below.
*** An average rate of productivity of 1.3 percent between 2011 and 2031 is a conservative assumption. Some economists are suggesting that Canada's future rate of productivity will rise in the coming decades. See Arlene Kish's IHS Global Insight dated October 2011, as well as the October 2011 edition of the Bank of Canada's Monetary Policy Report, (p. 19) regarding the expected increase in productivity the next few years. Note: a quick and easy way to approximate the number of years it takes for a variable growing at a constant rate to double is to use the "Rule-of-70" or dividing 70 by the chosen growth rate.

Figure 5, Current population and projections,
Source: OCA, 2010 (in thousands) and author's calculations

Hoc dicatur meum filium Vincent, cui futurum quasi electa ut sol. Ut non factus hostiam logica. 



References

OCA (Office of the Chief Actuary), The 25th Actuarial Report on the Canada Pension Plan, November 2010

OCA (Office of the Chief Actuary), The 10th Actuarial Report Supplementing the Actuarial Report on the Old Age Security Program, August 2011

Martel, L. et al., Projected trends to 2031 for the Canadian Labour Force, Statistics Canada, August 2011

Spriggs, W. and Lee Price, Productivity Growth and Social Security's Future, Economic Policy Institute Issue Brief #208, May 2005.

Statistics Canada, Revisions to Canada and United States Annual Estimates of Labour Productivity in the Business Sector 2006-2009, March 2011 (Table 4)

Fiscal policy vs monetary policy to control inflation: MMT perspective, by Joseph Laliberté

In the comment section of a previous post, I suggested that Modern Monetary Theory (MMT) was a form of "quantity theory", and that it would be to MMT's advantage to develop on this point. The following is an excellent piece on this topic by fellow blogger Joseph Laliberté. This article is cross-posted in French on Joseph's blog, Défricher l'économie.

Scott Fullwiller once pointed out that MMT is also a quantity-theoretic model of changes in the price level:

Interestingly, MMT is also a quantity-theoretic model of changes in the price level. The differences are (1) net financial assets of the non-government sector, rather than traditional monetary aggregates, is MMT's preferred measure of “money,” and (2) desired leveraging of the non-government sector is akin to what one might call “velocity.” In MMT, the two of those together (net financial assets of the non-government sector relative to leveraging of existing income) set aggregate demand and ultimately changes in the price level, at least the changes that are demand-driven.

Net financial assets of the non-government sector are equivalent to past accumulated government deficits (a government deficit is a surplus for the non-governmental sector, see here for the accounting demonstration). As per MMT formulation, we have: (I think Warren Mosler was the first to come up with the MMT interpretation to this famous economic equation)

1) M*V = P*Q

Where M is net financial assets of the non-government sector and V is the desired leveraging of the non-government sector (V could also be seen as the inverse of the desire to save of the non-governmental sector); P is the price level and Q is the output.

Assuming that the economy is operating at capacity (denoted by Q’) at a given price level (P’), any increase in M or V would be inflationary (i.e. would increase the price level beyond P’). Therefore, if the government decides to increase net financial assets of the non-governmental sector by running a deficit, in such scenario, inflation would result. However, mainstream economics would argue that the increase in net financial assets of the government sector need not be inflationary to the extent that the Central Bank could influence the desired leveraging of the non-governmental sector (denoted by V) by manipulating the interest rate. In a nutshell, the Central Bank could offset the inflationary effect of an increase in M with a corresponding increase in the interest rate (denoted by r) so that V decreases. Therefore V is a function of the interest rate, or V(r).

Assuming that we have a "super Central Bank" that is always able to set its policy interest rate at a level where monetary policy always offset the inflationary effect of fiscal policy, we have in period 0:

2) M₀*V(r₀) = P’*Q’

Since the economy is operating at capacity, the government should normally aim at balancing its budget in period 1. Instead, let's say that the government decides to run a one-time deficit in period 1, which adds to the net financial assets of the non-government sector. The Central Bank would then increase the interest rate in period 1 to decrease V in order to make sure that the government deficit is non-inflationary. We would then have:

3) (M₀ + ΔM₁)*V(r₀ + Δr₁) = P’*Q’

Where ΔM₁ is the government deficit in period 1, and Δr₁ is the increase in the interest rate in period 1 necessary to decrease V and keep inflation in check.

In period 2, assuming that the government withdraws its economic stimulus and goes back to a balance budget, then M would still rise as a result of the increase in interest that took place in period 1 (note: assuming that government debt in circulation is all short-term, then r is also the interest rate on government debt, therefore it is the interest rate at which net financial assets of the non-government sector compound). To make sure that this increase in M is non-inflationary, the Central Bank would need to raise the interest rate further by Δr_2. (I'm assuming here that the Central Bank adjusts r even it means an increase of a fraction of a basis point). We would then have:

4) M₂*V(r₀ + Δr₁ + Δr₂) = P’*Q’

Where M₂ = (M₀ + ΔM₁)*(1 + Δr₁)

A similar logic would prevail in period 3:

5) M₃*V(r₀+ Δr₁+ Δr₂+Δr₃) = P’*Q’

Where M₃ = (M₀ + ΔM₁)*(1 + Δr₁+ Δr₂ )

Again, a similar logic would prevail in period 4:

6) M₄*V(r₀ + Δr₁ + Δr₂ + Δr₃ + Δr₄) = P’*Q’

Where M₄ = (M₀ + ΔM₁)*(1 + Δr₁+ Δr₂ + Δr₃ )

And so on.

One can see clearly from the demonstration above that the Central Bank’s action is both the solution and the source of the problem: its increase in the interest rate in period 1 expands the net financial assets of the non-government sector (M) in period 2, which renders necessary a further increase in the interest rate to decrease V in period 2 in order to keep inflation in check, and this further increase in interest rate further expands M in period 3, which commands still a further increase in the interest rate to decrease V in period 3...and so on, and so forth.

The only definitive solution to this vicious cycle would be to use fiscal policy rather than monetary policy to eliminate the inflation threat originally caused by the government deficit in period 1. This would mean generating a budget surplus in period 2 that would exactly offset the budget deficit of period 1 plus the interest payment. The size of the budget surplus relative to GDP necessary in period 2 could be expressed as follow:

(M₀* Δr₁) + ((ΔM₁)*(1 + Δr₁)) / (P’*Q’)

Flowing from this analysis is the following critical policy implication: the longer the country tries to fight inflation with monetary policy, the bigger the size of the budget surplus relative to GDP that is necessary in the future to eliminate the inflation threat. For example, in period 4, the size of the budget surplus relative to GDP necessary would be:

 

(((M₀* (Δr₁ + Δr₂ + Δr₃ )) + (ΔM₁ *(1 + Δr₁ + Δr₂ + Δr₃))) / (P’*Q’)

This demonstration above explains why MMT holds that monetary policy is really an ambivalent tool when it comes to fighting inflation as increasing the interest rate could be both expansionary and contractionary with regards to aggregate demand. This observation holds even if one assumes that a "super all-knowing central bank" exists that is always able to adjust the interest rate perfectly in order to keep inflation in check. (i.e., the Central Bank is able to perfectly control the desired leverage of the non-governmental sector through monetary policy). (Note: most MMTers would argue that a central bank is incapable of doing such a thing to begin with)

Does this demonstration have any implications in the real world? In the Canadian context, I would say yes. To the extent that one deems the budget surpluses of the 1990s in Canada necessary, the high interest rates of the early 1990s likely made these “required” budget surpluses even larger.

Furthermore, one could speculate that a quid pro quo took place in the mid-1990s between the government and the Central Bank whereby the Central Bank accepted to slowly reduce interest rates if the federal government started tackling its deficit.

Guest post by Joseph Laliberté: “Prudential liquidity” for a country with its own floating currency: frivolous and meaningless

The following is a translated version of a post originally published in French on Joseph Laliberté's blog, Défricher l'économie, dated November 19, 2011. In the post, Joseph examines a recent announcement by the Bank of Canada using insight from Modern Monetary Theory.

The Bank of Canada recently announced its intention to increase to 20% the share of the debt issued by the federal government that it buys directly at government debt auction (note: it should be noted that the auction itself is managed by the Bank of Canada). This initiative is set in motion in the context where the federal government wants to increase its 'prudential liquidity' by $35 billion.

A logical question from this would be where will the Bank of Canada find the $7 billion (that is to say, 20% multiplied by 35 billion)? The answer is nowhere. This money will appear on the balance sheet of the Bank of Canada as if by magic. Here's what will happen to the balance sheet of the Government of Canada and the balance sheet of the Bank of Canada when the operation is realized:

Government of Canada
Asset	Liability
+ Deposit at the Bank of Canada	+ Issued bonds

Bank of Canada
Asset	Liability
+ Government of Canada bonds	+ Deposit from the Government of Canada

All the Bank of Canada needs to create such accounting entries is...a computer with a spreadsheet program (for instance, a 286 computer equipped with the 1993 version of Lotus would do). It should further be noted that this transaction is internal to the federal government given that the Bank of Canada is a Crown corporation that is ultimately owned by the people of Canada.

I can already hear the good "old school" post-Keynesians saying that the example above holds only for the 20% share of new debt issuance that the Bank of Canada buys directly at auctions.

Moreover, these critics may also point out that in countries having their own currency, but where the central bank is not allowed to buy bonds directly from the government (i.e. its treasury or finance department), the above example would also not hold. In my view, it would still hold, but one small step would need to be introduced. Using the United States as an example, the Fed would need to first buy Treasuries (à la QE2) on the secondary market from private banks, and credit these banks’ checking account at the Fed (called excess reserves):

Fed
Asset	Liability
+ U.S. Treasuries	+ Excess reserves

Then the U.S. Government would issue new treasuries on the market, which would simply result in excess reserves being transferred from private banks’ checking account at the Fed to the U.S. government deposit account also at the Fed (that is, bonds issuance by the U.S. government would “mop up” or drain excess reserves):

Fed
Asset	Liability
No change	- Excess reserves + Deposit from the U.S. Government

Therefore, in technical term, it is the capacity of a country with its own floating currency to create reserves at will that renders the issue of whether such a country has enough "prudential liquidity" frivolous and irrelevant. Although Warren Mosler’s saying that a country with its own currency never has or does not have its own currency has been the subject of some friendly criticism lately, I still find it relevant: in both examples, Canada and the United States are not richer, poorer, safer or riskier because they suddenly have more prudential liquidity in their account at the central bank.

In a nutshell, the concept of prudential liquidity is relevant for countries that do not have their own floating currency (e.g. Greece, Ireland, Portugal, France, etc), just like it is relevant for households and businesses, but it is meaningless for a country with their own floating currency (e.g. U.S., Canada, Sweden, Japan, United Kingdom, etc).