Is there a trade-off between employment and the household sector financial balance?

As Canadian policymakers try to get the household sector out of its financial deficit position, it's important to keep in mind that households are the sector that has been doing a lot of the heavy lifting in terms of boosting demand in recent decades.

Policymakers can attempt to get households to borrow less, but unless they can think of a way for another sector to offset the resulting reduced demand, it seems unlikely that the unemployment rate will remain at current low levels once households decide to reduce their net borrowing.

I posted these charts before but it's worth posting them again:

As household net borrowing increases, the rate of unemployment declines

A closer view of recent years

Steve Keen on interest and capitalism's main dilemma

A few fine words from Steve Keen:

Interviewer: On a broader topic, is interest a kind of rent in the classical sense? Is it income without a cost of production?  

Steve Keen: Absolutely. This is why...I see the main dilemma in capitalism as being the conflict between financial capital and industrial capital. Industrial capital is ultimately productive. And if you look at workers and capitalists, they both ultimately benefit out of the technological developments over time and demands over wages. If unemployment is not gigantic, they benefit out of the improvements in current technology and out of productivity at the time as well. The real albatross around the neck of capitalism is financial capital [inaudible] when you let it get beyond the level necessary to simply finance working capital in some new investment. And it’s what happens every time capitalists take over...

...The thing I think we’re both in agreement on is we have to stop people, and particularly social classes, becoming dependent upon unearned income. Ultimately the only way to get a functioning capitalist society—or a society in general—is to have one where the source of income is earned, not unearned. And when you look at land speculation, or you look at any other form of speculation, people are trying to get income without earning it. That’s the real dilemma in capitalism. And if we direct ourselves toward that particular principle then we’re both on the same side. (Renegade Economists, April 21, 2010, at 13:30)

There's lots of good insight here. A fine glimpse of "Keensian" economics.  And I totally agree with the general point of the last sentence: "...then we're both on the same side". There's plenty of commonalities out there. We just need to focus on these.

PS: I'm entering a busy period at work. Posting will be limited and mainly consist of short thoughts on and snippets from economists I find interesting.

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

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

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

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

E. Domar

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

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

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

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

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

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

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

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

Then, Domar describes the merits of a budget deficit:

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

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

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

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

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

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

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

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

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

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

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

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

References

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

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

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

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.

Another round of QE: More of the same?

I once had a boss who always asked for briefing material of "no more than 100 words". He'd also say "Give me charts, please. Charts!" Here's a snapshot of what he would get if I was asked to update him on the effect of the Fed's quantitative easing (QE) strategy.

Recall that the Fed implements QE by buying financial assets from banks and other private institutions in the aim of putting downward pressure on yields and thus reducing interest rates. QE as a policy measure is easily identifiable in charts since it increases massively the amount of excess reserves in the banking system.

Given that Chairman Bernanke announced a new round of QE last week, I thought these charts might be of interest.* Not all of these indicators are related to QE's stated objectives. Still, given the centrality of QE in the Fed's overall strategy, I think it's useful to include them.

So, to summarize, since the start of QE, bank lending standards have returned to normal...

 

...business loans have rebounded, though not at pre-QE levels...

...the rate of increase in manufacturers' new orders has normalized...

...corporate profits have continued to rise well beyond pre-QE levels...

...the cost of borrowing for businesses (as reflected in the rate of 10-year inflation protected securities) has come down...

...as did the 30-year conventional mortgage rate...

... and stocks have recovered.
 

On the other hand, home prices have remained depressed...

...the employment-population ratio has flattened...

...and, finally, the rate of unemployment is still stubbornly high.

In a speech earlier this year, the President of the San Francisco Fed, John Williams, called the level of unemployment in the US a "national calamity that demands our attention". From the charts above, it's clear that another round of QE is unlikely to do much to help create more jobs moving forward.

* All charts and data are from the St. Louis Fed, FRED.

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

Canada: Government deficit shrinks, Household sector deficit soars

Canada's first quarter 2012 National Income and Expenditure Accounts were released today.  Here's a brief summary, courtesy of Statistics Canada:

Real gross domestic product (GDP) rose 0.5% in the first quarter, the same pace as in the previous quarter. Business investment contributed the most to first-quarter GDP growth. Final domestic demand grew 0.3%. On a monthly basis, real GDP by industry edged up 0.1% in March.

As was the case throughout 2011, business investment continued to fuel growth. Business investment in plant and equipment advanced 1.2%, the ninth consecutive quarterly increase. Housing investment expanded 2.9%, well above the previous quarter's pace of 0.8%. Non-farm business inventories increased in the first quarter.

Consumer spending on goods and services, another main contributor to GDP growth in 2011, slowed to 0.2% in the first quarter of 2012, after a 0.7% gain in the previous quarter.

In the first quarter, final domestic demand advanced 0.3%. Growth in final domestic demand has been slowing since the first quarter of 2011. Average quarterly growth in final domestic demand was 0.5% in 2011, following 1.1% in 2010.

While exports have been increasing since the second quarter of 2011, they remain below the level reached in the third quarter of 2008. Exports grew 0.6% in the first quarter of 2012, after gaining 1.7% in the previous quarter.

Imports rose 1.1% in the first quarter, almost double the pace of the fourth quarter of 2011.

Growth of real gross domestic product and final domestic demand, Source: Statistics Canada

Two things. First, although the increase in employment in March and April will surely boost consumer spending in Q2, it's very unlikely that the economy will improve markedly for the remainder of the year.  The current slowdown in the US economy and weak European prospects will likely weigh down on both exports and business investment. Second, additional government cutbacks will continue to remove much needed demand from the economy, weakening both employment and growth.

Finally, one important piece of information that the statistical agency isn't highlighting in its summary is the massive increase in the household sector deficit during the first quarter.  According to today's figures, the household financial deficit (i.e., net borrowing or difference between quarterly sectoral spending minus revenue) increased by over $7B during Q1 ($42.5 to $49.4 B).  This is the highest level since the third quarter of 2008.  As for the public sector financial deficit, it has narrowed by approximately $9B ($66.6 to $55.1 B).

Source: Statistics Canada

In a previous post, I explained that the inverse relationship between the government sectoral balance and household sectoral balance is evidence that the goal of public sector deficit reduction is incompatible with the objective of eliminating the household sector financial deficit, one of the key priorities of the Governor of the Bank of Canada, Mark Carney.  More on this theme in my next post.

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.

A microeconomic perspective on the “loans create deposits” meme

By Joseph Laliberté

A private bank’s “cash and cash equivalent” position as shown on its balance sheet typically includes its deposits with other banks, excess reserves at the central bank and vault cash.  In financial accounting, the cash flow statement illustrates the main elements impacting the cash and cash equivalent position of a business between the beginning and the end of a given period.

Perhaps one of the most fascinating aspect concerning the obsession of mainstream macro economists with banks’ cash and cash equivalent position (excess reserves, in particular) is the near irrelevant status this component has in banking and financial circles.  Below is an extract from a letter of the German Banks Association (Bankenverband) to the International Accounting Standards Board (IASB) that illustrates perfectly the lack of interest that many have in regard to banks’ cash position:

One of the major objectives of the boards' proposals is to provide information which is relevant to predicting future cash flows.  We agree that the issue of liquidity presents a significant challenge for the banking sector.  Nevertheless, cash flow statements cannot help to assess future liquidity in any way.  No financial analyst, for example, has ever queried any of our member banks about, or given any great consideration to, the cash flow statement.  If the IASB has information pointing in another direction, we would be interested in the details. (emphasis added)

Illustrative of the non-importance of a bank’s cash flow statement is that the very definition of “cash and cash equivalent” used for the purpose of building the cash flow statement appears far from standardized across the banking industry.  Some banks, such as Deutche Bank, divide “cash and cash equivalent” on the asset side of its balance sheet into “cash and due from banks” and “interest-earning deposits with banks”. However, for the purpose of its cash flow statement, Deutche Bank defines “cash and cash equivalent” as “cash and due from banks” PLUS “interest earning deposits with banks” MINUS “term deposits with banks”.  For its part, the French bank Société Générale presents on the asset side of its balance sheet two categories (i.e., “cash, due from central banks” and “due from banks”) while for the purpose of its cash flow statement it defines "cash and cash equivalent" as follows: (“cash, due from central banks” MINUS “due to central banks”) PLUS (“due from banks” MINUS “due to banks”).  Closer to home, ScotiaBank defines “cash and cash equivalent” as “cash and non-interest-bearing deposits with banks”, thereby excluding interest-bearing deposits with banks, while National Bank includes cash and all deposits with financial institutions.  Go figure!  One would assume that banks would find it necessary to settle on a common definition of “cash and cash equivalent”, especially since we are often told by the financial press and many economists that this asset component is so critical in analyzing banks’ capacity to extend loans.

That said, even if all banks would settle on a common definition of “cash and cash equivalent”, this asset category would still say very little about a bank’s liquidity.  The reason for this is that any given bank could have a cash and cash equivalent position of zero and still be considered highly liquid thanks to its holding of cash management bills/T-Bills/government bonds. 

Furthermore, the cash and cash equivalent position says nothing about a bank’s capital ratio, the critical element in determining a bank’s capacity to extend credit.  Banks’ capital is allocated to balance sheet expansion through loan and deposit creation, not banks’ cash or reserve position.  As per the cash flow statement of a deposit-taking institution, net additional loans to customers are considered a use of funds, and net additional deposits from customers are a source of funds.  Therefore, once a loan is granted and the customer’s checking account is marked up by the same amount, the cash and cash equivalent position of the bank is left unchanged.  From a microeconomic banking perspective, loans create their own source of funds, or stated differently, "loans create deposits".  Assets-liabilities duration mismatch (interest rate risk) is of course an important consideration, and this is where the discussion ties in with the central bank’s decision on interest rate.

One last point that deserves to be highlighted is that, although a bank’s "cash and cash equivalent" position generally says nothing about its capital position and, consequently, its regulated lending capability, an increase in this asset item may sometimes reflect improved liquidity.  This was arguably the case with QE1 when the Fed purchased mortgage-backed securities (MBS) by crediting private banks’ reserve account at the Fed.  Moreover, if one assumes that with QE1 the Fed engaged in fiscal policy by overpaying for MBS (relative to their market value), then it could be argued that QE1 may have also helped to improve banks’ capital position as well as their regulated lending capability.

In the case of Canada, a QE1 style program was put in place, but since reserves were “mopped up” with the issuance of Canadian government bonds, there was no impact on banks’ “cash and cash equivalent” position, a situation that led to an improvement in their liquidity position (as it did in the U.S).  As for the matter of bank capital, contrary to the U.S., there was no direct injection of public funds to recapitalize the banking sector in Canada.  However, just like what happened in other jurisdictions, accounting authorities proved accommodative.  Changes to the Canadian Institute of Chartered Accountants Handbook in October 2008 allowed banks to re-classify financial assets from “held-for-trading” to “held-to-maturity” under specific circumstances.  Use of this re-classification put some banks on stronger regulated capital footing than would have been the case otherwise.

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Europe! It's not too late to reverse austerity

The following article was written by the author of the Classic Indeed blog.  The article is cross-posted on both blogs.  Readers are invited to post comments on either blogs.

Months ago we outlined the challenges that presented themselves to Italy and Greece, and to Germany, France and the United Kingdom.  We opted against austerity, trusting that the technocratic appointments of Messrs Monti and Papademos could transform governments in Italy and Greece, and enable their respective legislatures to both recommend alternative and optimal public expenditure policies and to restrain policymakers from endorsing imposed fiscal restrictions while constraining budgets any further.

Unfortunately for the global economy and markets, Messrs Monti and Papademos initiatives did the contrary.  They aspired towards the heroic in adhering to a sub-optimal detriment and have now emerged as the scapegoats for political and investment désenchantées.

More ironic is that both men had very little to do with the original debacle.  They were recommended to their nation’s legislatures to clean up a mess.  Instead, as a result of attempting to implement austerity measures, they have generated more anxiety in world markets than expected.

Unfortunately, the recent economic deterioration and rising social tensions within their respective economies has become their responsibility, and the political disenchantment surfacing within the electorate is also their responsibility.  Worse still, the time for apologetics is long past and is now irrelevant.  At jeopardy is their leadership, the credibility they endorse for their visions of the future and the overall well-being of their citizenry.

Mr. Draghi and Mrs. Lagarde have voiced a redemptive message.  Both had professed that the worst was over.  For instance, in a speech on March 26 of this year, Mr. Draghi said the following:

“I would like to take this opportunity to provide you with my assessment of the current situation in the euro area and shed light on recent signs of improvements in the overall outlook.  I would particularly like to draw your attention to the effectiveness of the policy measures implemented by the Eurosystem, the EU institutions and national authorities.  And to remind you of the measures that we all must continue to pursue over the coming months and years with great diligence in order to continue on this path of stabilisation.”

As for Mme Lagarde, on March 18 of this year, the Managing Director of the IMF sought to reassure the audience of the 2012 China Development Forum with the following statement:

“There are signs that strong policy actions—especially in Europe—are making a difference. Financial markets have become a little calmer…”

Yet, Spanish yields are rising, as are those of Italy and Greece, and there is more and more talk of a potential third bailout for Greece although the IMF and the ECB have reassured the investment communities that changes in Greece are being introduced as promptly as possible and will be enacted effectively.

Any remnant stress in markets, according to the institutional duo is a result of the misperception by the interested communities that the consolidations proposed by the ailing economies cannot be achieved.

The emerging doubt on behalf of investment communities and investors in general should not be surprising.  After all, it’s their money and it’s their perception that underscores investment decisions.

One daresay that the investment community saw the collapse of the system much earlier than either the IMF or the ECB, although the leadership of the latter two has been proactive in attempting to stabilize investor sentiment and mitigate between some form of restraint and investment in growth and employment.  Notwithstanding, the reassessment that further bailouts will be necessary is now the swan song of European austerity politics.

Unfortunately, European policymaker perceptions of the bond markets are completely skewed as a result of their own biases.  What is difficult for them to appreciate is that there is no basis left for growth.  Unemployment is up, with Spain leading at 23.6% followed by Greece at 21.0%.  And in those Eurozone countries where unemployment rates are low, many of the employed are part-time workers and, as such, susceptible to labour volatility during these turbulent times.

Moreover, capacity utilization in the manufacturing sector over the last four quarters is dropping across the Eurozone at alarming rates.  Order books are not being filled as quickly as desirable, and their durations and size are shorter than required to support additional investments.  As a result, business investment is stalling as management constrains expenditures and saves its liquidity for dividends in lieu of growth to stabilize share values, foreboding that equity markets react adversely to this dilemma and possibly falter.

What most pundits expected from the emerging markets may not be realized: trusting that BRIC plug the slowdown in Europe, with China leading the way.  Unfortunately, there is no plug.  Most informed observers now mitigate between a slowdown and an ease in aggregate demand, with China’s future growth rates in question.  Projections for the region suggest that China’s growth potential could be in the midst of a major contraction with rates dropping to 7.5% from anticipated 8% and over.

Given the above, the most difficult challenge in domestic politics is for any Government to admit that it followed the wrong track.  There is no shame in being part of a bigger bloc of nations that propound fiscal consolidations even if austerity is showing itself as being the ineffective solution to the Eurozone’s financial crisis, a crisis which is now becoming an economic and political crisis.

It actually takes great courage in admitting that the austerity programs recommended may not work out.  The experiences of other nations in the matter, elicit danger signals that can’t be overlooked.  In such a case, the consolation is that if one’s admission is timely, the Government may come out of an unfortunate situation looking respectful and remarkably diligent.  There is still time for Europe to turn back its political agendas before turning the wrong corner.

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