The Keynesian-Monetarist debates and reverse causation (or how Keynesians destroyed monetarism using only logic)

Traditional monetarist theory held that changes in the money stock are the best indicator of monetary influence on the economy, and that these influences have a significant impact on the course of economic activity over the business cycle.

The idea that "money matters" in this sense is not new. In many ways, monetarism's basic premise dates back to the beginning of political economy as a discipline. However, in the 1950s, the idea gained prominence when a number of "money supply theorists", as they were called back then, began producing studies and charts that appeared to lend support to the view that changes in the money supply had a predominant role in causing fluctuations in (nominal) income and output.

Initially, (neo-)Keynesian economists -- who as a result of their reading of events of both the onset of and recovery from the Great Depression viewed income (output) as determined largely by aggregate demand or the spending of firms, government and household spending -- were not phased. At first, Keynesians responded by saying that their preferred theoretical approach, the Hicks-Hansen IS-LM model, already recognized the role of money in affecting economic activity via the LM curve.* However, these Keynesians also argued that, while money does have a role in driving economic activity, it was of secondary importance, behind consumer and investment spending.**

Also, while Keynesians admitted that fluctuations in the money supply can affect economic activity, they also argued that the seemingly causal relationship between money and output portrayed in monetarist studies could partly be explained by changes in the public's demand for money, the propensity to hold financial assets in the form of money.

The debate intensified when Milton Friedman and other monetarists produced studies (seemingly) showing the empirical importance of money over spending and investment in explaining output fluctuations. In order to show that fluctuations in the money supply cause fluctuations in output, monetarists had to demonstrate that the demand for money was stable (to support their view regarding the predominant role of the money supply in affecting economic activity), and that fluctuations in aggregate demand were a weak source of fluctuations in income.

With respect to the stability of the demand for money, Keynesians argued that the demand for money was not stable (i.e., as a stable function of interest rates, expected inflation, wealth and other variables), nor predictable (thus countering the monetarist view that the predictability in the demand for money would enable the monetary authority to expand or contract the money supply to offset any predicted changes in money demand). The neo-Keynesian view was later proven right when the stability in money demand collapsed in the 1970s and 1980s in the US.

As for the monetarist claim that money supply fluctuations outperformed the traditional Keynesian drivers such as investment and other forms of spending in explaining output fluctuations, which figured most prominently in Friedman's "A Monetary History of the United States", neo-Keynesians responded in several ways.

First, Keynesian critics proposed that the apparent causal relationship stemming from money to income (and economic activity overall) might be a fallacious case of post hoc ergo propter hoc (i.e., what comes before must therefore be the cause), or at the very least, a statistical illusion caused by the fact that investment is recorded in national income accounts in periods subsequent to monetary aggregates, which capture the same transaction but at an earlier stage when investors first come to the money market.

Also, Keynesians challenged the methodological approach used by Friedman and other monetarists to support their claim that the money supply is the key variable explaining fluctuations in output. Most importantly, Keynesian critics suggested that Friedman's approach in the "Monetary History" of assuming an exogenous money supply under the full control of the monetary authority and completely independent from the influence of other economic variables, was unrealistic and overstated the influence of money on economic activity.

Over 50 years ago, neo-Keynesian economists John Kareken and Robert Solow, using simple logic, pointed out the fatal flaw in the monetarist assumption of the exogeneity of the money supply:

The unrealiability of this line of argument is suggested by the following reducio ad absurdum. Imagine an economy buffeted by all kinds of cyclical forces, endogenous and exogenous. Suppose that by heroic, and perhaps even cyclical variation in the money stock and its rate of change, the Federal Reserve manages deftly to counter all disturbing impulses and to stabilize the level of economic activity absolutely. Then an observer following the Friedman method would see peaks and troughs in monetary changes accompanied by a steady level of economic activity. He would presumably conclude that monetary policy has no effects at all, which would be precisely the opposite of the truth.

Karaken and Solow in this example were not suggesting that the money stock was endogenous in the sense that the money supply was negatively correlated with aggregate spending shocks. Rather, they were suggesting that abstracting from the actual behavior of the central bank as Friedman did could result in flawed conclusions about the magnitude of monetary policy's impact on the economy.***

Also, this line of reasoning suggested that the statistically significant relationship (correlation) between money and output highlighted by the monetarists should not be understood as implying that changes in the supply of money cause changes in income. Instead, this objection suggested the possibility that the observed relationship could just as well be the consequence of reverse causality, that is, that spending shocks, by affecting money demand and generating pressure on the interest rate, led to accommodating changes in the supply of reserves provided by the Fed during that period, and ultimately resulted in changes in the money supply.

Having then demolished the Friedman assumption of an exogenous money supply, neo-Keynesians in the 1960s thus allowed for the possibility that the relationship between money and economic activity could be the result of actions from the public, as they respond to current economic conditions, and that these actions from the public could have such a significant influence on observed movements in the money stock that one could not tell the direction of causality between money and economic activity simply by looking at measurements of monetary aggregates and income.

For a few years later, a lively debate on reverse causation followed between monetarists and the economic staff of the St. Louis Federal Reserve Bank on one side and neo-Keynesians and staff economists of the Federal Reserve Board on the other. Empirically, a breakthrough in favor of the reverse causation argument occurred in 1973 when two staff economists of the Federal Reserve Board, Raymond Lombra and Raymond Torto, demonstrated in a paper entitled "Federal Reserve Defensive Behavior and the Reverse Causation Argument" that during the 1953-1968 period the supply and demand for money was interdependent and that this interdependence provided an avenue for the reverse influence of the business cycle on money.

In doing so, Lombra and Torto confirmed the endogeneity of the monetary base and money supply resulting from the Fed's offsetting and accommodating actions whenever it sought to stabilize conditions in the money market by pegging the level of short-term interest rates over the short-run:

If the demand for money is, in part, a function of the level of economic activity and the supply of money has been at least partially demand determined, then the money stock is endogenous whether or not the Fed has the power to control it

However, the conclusions by Lombra and Torto were eclipsed by the conclusions of a paper published one year earlier by Christopher Sims utilizing newly developed statistical techniques which contended that the hypothesis of unidirectional causality running from money to income could not be rejected. Of course, monetarists, in their attempt to support their case, cited this work with approval since it appeared to support the monetarist assumption of an exogenous money supply.

In 1982, Sims published another paper recognizing that his earlier work and work based on it was open to serious question. This paper along with Lombra and Torto's paper should have demolished the monetarist case from the start. Unfortunately, such an attack was not enough to stop the monetarist ascendancy that was gathering support within and outside the economics profession (such as the St.Louis Federal Reserve Bank) in the 1970 and 80s.

Today, we know that this monetarist view influenced later New Keynesians (not older New Keynesians like Stiglitz, Akerlof and Blinder). Some Post Keynesians adhere to reverse causation in their monetary economics.

* The LM curve had been relegated to the background (as a supporting role) during the war years and early post-war years when interest rates were pegged as a result of the Treasury-Fed accord

** The main changes through which the real money supply affects the economy are: the real balance effect, the portfolio effect, and money as a medium of exchange effect.

*** More specifically, by assigning total control over the money supply to the central bank in their model, Friedman and other monetarists were effectively dismissing the potential influence of both the banking system and the real economy in influencing the money supply.

Austerity in Canada: Then and Now

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

Chart 1 Real GDP growth, quarterly % change

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Economist James Tobin said it best several years ago:

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

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

Update:

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


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

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

Reference

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

Old Keynesian themes in Modern Monetary Theory

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

References

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

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

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

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

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

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

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

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

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

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

Uses of the IMAs

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

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

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

Chart 1

Chart 2

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

Chart 3

Chart 4

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

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

Reference

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

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.

Eliminating Canada's household sector deficit: A sectoral balances view

Earlier this month, the Governor of the Bank of Canada, Mark Carney, pointed out in a speech that it is important for Canada's household sector to eliminate the net financial deficit it has incurred during the past decade as a result of several years of increased indebtedness*. (For a visual depiction of the interaction between sectoral financial balances and debt-related indicators, refer to Chart 1).

Chart 1 (Click on image to expand)

According to Mr Carney, the most effective way to remedy this situation without hindering economic growth would be for Canadian businesses to increase their level of investment in upcoming years. The intended objective of increasing corporate investment is to offset the gap in the economy that is likely to occur as a result of increased household deleveraging during the next few years.

One commentator applauded Mr Carney for being the only government official at the moment to "speak the truth", that is, to tell Canadians the true state of the country's economy and exhort businesses to take this opportunity to improve their productivity and competitiveness by investing in their operations.

Still, there remains one 'truth' that has yet to be mentioned by anyone, including Mr Carney. And that is the fact that the federal government's commitment to balance its budget is highly incompatible with the objective of seeking to eliminate the household sector's net financial deficit.

To be sure, Mr Carney did mention in his speech that one way to reduce the deficit of the household sector is for governments to increase spending. But given that the speech later implies that this option is not sustainable, it is hard to tell whether Mr Carney would actually endorse the view that government deficit reduction at this time is an impediment to reducing the net financial deficit of the household sector.

The notion that government deficits have a positive effect on the financial balance of the household sector may sound like a far-fetched economic theory. But, in the case of Canada, as I have demonstrated previously, it is a well-supported empirical fact that is statistically (and intuitively) significant.

As you can see from Chart 2 below, based on Statistics Canada's sectoral net lending figures dating from 1961 to present, there is a strong relationship between the (consolidated) government deficit and the net financial surplus of the household sector. The reverse is also true, as government surpluses tend to be associated with household sector deficits.

Chart 2

 
The only important exception to this longstanding economic reality surfaced in 2008 when the net financial position of the government sector fell back into a deficit (after several years of surpluses) as a result of the sharp drop in Canadian exports, a situation that enabled the foreign sector to return to a considerably large surplus position (see Chart 3). And against the backdrop of a massive and persistent corporate sector net financial surplus starting in the year 2000, the current government sector's deficit has not proven sufficiently large to return the household sector to its traditional net financial surplus position (see Chart 3).

Chart 3

So, given the above, what should the federal and provincial governments do to help eliminate the net financial deficit of the household sector?

First of all, although it now appears likely that the federal government may be headed in that direction, the federal and provincial governments should immediately abandon or, at a minimum, postpone their plans to reduce their deficits and/or balance their budgets. At present, as explained above, the government deficit is actually enabling the household sector's net financial deficit from increasing any further.

Second, governments should take immediate steps to cut down on public expenditures that result in an outflow of funds away from the Canadian economy. As the above analysis suggests, large scale spending on foreign goods has the effect of both increasing the surplus of the foreign sector while simultaneously increasing the size of Canada's public sector deficit. In this regard, there is a strong case to be made for the federal government to cancel its planned purchase of American-made fighter jets.

Similarly, provincial and local public transit authorities should aim, as much as possible and in a manner consistent with established principles of economy and efficiency, to purchase equipment produced in Canada. It should be stressed that the cost-efficiency criterion for choosing among different bids for these public works projects should not be cast aside so as to ensure minimal impact on the tax burden imposed on households and businesses.

Third, as recommended in a previous column, the government should encourage firms to undertake productive investment by imposing a small, yet noticeable tax on retained earnings or on the turnover of corporate financial instruments. These measures would create incentives for firms to reinvest their profits in business operations by increasing the cost of undertaking unproductive activities (e.g., speculative investment) with profits.

Finally, the federal government should reconsider the decision taken in 2008 of requiring the Employment Insurance (EI) fund to balance within a given period. As it stands, when the fund goes into a deficit (as it has been since 2008 due to the rise in unemployment), the government must seek to eliminate the deficit in the short- to medium-term by increasing employer and employee contributions. While such a mechanism may help to reduce the size of the government deficit, it should be emphasized that this policy is highly pro-cyclical given that it acts as an impediment to reducing the net financial deficit of the household sector by decreasing the disposable income and purchasing power of households at a time when they most need it.

To conclude, Mr Carney was right in highlighting the urgency of addressing the current net financial deficit of the household sector. However, it is similarly urgent for government officials in Canada to realize that the objective of balancing public sector budgets is self-defeating and will make matters worse for households given that it reduces a source of employment and revenue. Now, it is very likely that officials of the Bank of Canada are aware of this fact but feel it is not their role to make such an observation. The purpose of the above analysis is a modest attempt to get the word out. Such is my hope and recommendation for 2012. So, on that note, I leave the reader with an excerpt of a letter by John Kenneth Galbraith addressed to President John F. Kennedy dated March 1959 summarizing the point of this column quite nicely:

I have always found that the most useful answer to [those who believe the government must balance its budget] is that the Federal Government, by unbalancing its budget, can help the man who needs a job balance his budget. (1998:29)

* A sector's net financial balance is the difference between its quarterly sectoral savings and investment as a share of gross domestic product. The sum of all sectoral balances must add to zero, which explains why the surplus of one sector is always offset by the deficit of at least one other sector.

References

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

Galbraith, J.K., Letters to Kennedy (ed. James Goodman) (Boston: Harvard University Press), 1998

Godley, W. and A. Izurieta, "The US economy: weaknesses of the strong economy", PSL Quarterly Review, vol. 62, nn. 248-251 (2009), 97-105

Seccareccia, M., "Growing household indebtedness and the plummeting saving rate in Canada: an explanatory note", Economic and Labour Relations Review, Vol. 16, no. 1, July, 2005, pp. 133-51

BoC Governor Mark Carney: Growth in exports, government spending or business investment needed to eliminate the household net financial deficit

A quick post. The Governor of the Bank of Canada, Mark Carney, gave a speech today on the risks facing Canada and the world economies. While the speech contained many of the same themes covered in the December edition of the Bank's Financial Stability Report released last week (see here), a noticeable emphasis was placed on the issue of Canada's household indebtedness. This is not surprising given that Canada's 2011Q3 National Balance Sheet figures are expected to be released tomorrow.

From a Canadian standpoint, the most important part of the speech was when M. Carney's discussed the different ways in which the net financial deficit of Canada's household sector can be eliminated. According to M. Carney, the deficit of the household sector could be eliminated through a combination of export growth, government spending and business investment.

But it is clear from the speech that M. Carney would prefer that Canada's business sector, which is currently running a significant net financial surplus, take a leading role in helping to stimulate the economy while households are seeking to reduce their level of debt. This approach may sound familiar to regular readers of this website. Here is the relevant excerpt of the speech:

To eliminate the household sector’s net financial deficit would leave a noticeable gap in the economy. Canadian households would need to reduce their net financing needs by about $37 billion per year, in aggregate. To compensate for such a reduction over two years could require an additional 3 percentage points of export growth, 4 percentage points of government spending growth or 7 percentage points of business investment growth.

Any of these, in isolation, would be a tall order. Export markets will remain challenging. Government cannot be expected to fill the gap on a sustained basis.

But Canadian companies, with their balance sheets in historically rude health, have the means to act—and the incentives. Canadian firms should recognize four realities: they are not as productive as they could be; they are under-exposed to fast-growing emerging markets; those in the commodity sector can expect relatively elevated prices for some time; and they can all benefit from one of the most resilient financial systems in the world. In a world where deleveraging holds back demand in our traditional foreign markets, the imperative is for Canadian companies to invest in improving their productivity and to access fast-growing emerging markets. (emphasis added)

Functional finance, public capital budgeting and the productivity-enhancing role of public investment

I really enjoy the interviews that the folks at the Institute for New Economic Thinking (INET) have been producing recently. They provide a quick and easy way of learning about new and different approaches to economics.

One interview that I think is particularly interesting from a policy standpoint is the one with economist Mario Seccareccia of the University of Ottawa. The topics discussed during the interview include the pre- and post-crisis approaches to fiscal and monetary policy, functional finance, the financial flows view of macromanagement, public capital budgeting and the productivity-enhancing role of public investment.

Needless to say, I believe the issues discussed in this interview are of fundamental importance to the modern practice of economic policymaking. The part of the interview that I found most interesting is when M. Seccareccia explains the importance of public investment, and the critical role it plays on enhancing productivity.

For those who are interested in knowing more about public capital budgeting, I recommend this excellent short paper by the late economist Richard Musgrave, a pillar in the area of public finance. R. Musgrave's ideas are discussed during the interview.

Reference:

Musgrave, R., "Budget Balance and Sound Finance"

Deficit myths (Part 3): The effect of budget deficits on business profits

Martin Wolf is right in saying that government fiscal tightening will hurt business profits. As Wolf correctly points out: "In order to reduce huge government deficits, surpluses must fall elsewhere".

For the UK, this means that the only way the government can succeed in balancing its budget is if the reduction in the government deficit is offset by a reduction of equivalent magnitude in the surplus of at least one other sector of the economy (i.e. household, corporate or foreign sector). And according to Wolf, the surplus sector that is most likely to be affected by the government's plan to reduce the deficit is the corporate sector because, at the moment, the household sector is not willing to incur additional debt (and fall back into deficit) and UK exporters are unlikely to reverse the flow of wealth currently exiting the UK economy (thereby reducing the surplus of foreigners).*

In a way, Wolf could just easily have argued that, in the UK right now, it is the government deficit that is enabling the corporate sector to run a surplus. And when households are deleveraging and exports are declining, business profits can only be realized if the government runs a deficit. Thus, by cutting the deficit, the government is in effect reducing an important source of business profits.

Proof of this direct, positive relationship between government deficits and business profits is best demonstrated by manipulating the basic national income accounting identity in a manner consistent with the approach of economists John Maynard Keynes and Michal Kalecki. The following arithmetic demonstrates that government deficits have a positive effect on business profits.

Let Y=Total Output; C=Consumption; I=Investment; G=Government Expenditures; X=Exports; M=Imports; T=Taxes; R=Retained Earnings by Firms; Hs=Household Net Savings

Let the combination of the above (X - M) = Current Account Balance or Net Exports; (G - T) = Government Deficit; (Hs + R) = (Y - T - C) = Total Net Private Savings

To start off, here is the basic national income identity, as taught in all macroeconomic textbooks:
Y = C + I + G + (X - M)

Subtract taxes (from both sides of the equation) to achieve an equation "net" of taxes:
Y - T = C + I + G + (X - M) - T

Rearrange the equation to isolate total net private savings on the left side and to subtract taxes from government expenditures:
Y - T - C = I + (G - T) + (X - M)

Since (Y - T - C) can be broken down into household net savings (Hs) and retained earnings by firms (R), the equation can be stated as follows (see Krugman, 1994:313):
(Hs + R) = I + (G + T) + (X - M) 

...and can be rearranged as such:
R = (I - Hs) + (G - T) + (X - M)

In plain English, this translates into:
Firms' Retained Earnings = Investment - Household Savings + Government Deficits + Net Exports

The above equation clearly demonstrates that business profits are positively impacted by government deficits, net exports and private sector investment.* Household net savings, on the other hand, have the effect of reducing firms' retained earnings. Similarly, balanced budgets and government surpluses have either no impact on profits or have the effect of reducing them.

One objection to this line of reasoning often invoked by economists is that government deficits increase the level of private sector savings (as households and businesses reduce consumption in anticipation of future tax increases). This claim is known as the Ricardian Equivalence proposition. However, there is little empirical evidence that this claim holds true and that the impact of government deficits gets neutralized (or offset) by a corresponding increase in private sector savings. As Douglas Bernheim argued in his seminal work on the topic:

...the case for long-run neutrality is extremely weak, in that it depends upon improbable assumptions that are either directly or indirectly falsified through empirical observation...[B]ehavioral evidence weighs heavily against the Ricardian view (1987:213)

To conclude, it should be emphasized that the purpose of economic policy is not to enable firms to realize profits, but to maximize employment and ensure that the product of industry is beneficial to the overall economy. Business profits, by creating an incentive for firms to invest and employ available resources, can help to promote these objectives. In the above analysis, my aim is to show that government deficits cannot be looked at in isolation from the financial positions of other sectors of the economy. Whether it is to stabilize aggregate demand or to provide for much needed public goods, deficits serve an important purpose. Attempting to reduce government deficits without considering its impact on the overall economy is not a sound basis for policy.

* Paul McCulley provided a similar analysis (2010).
** A different, yet equally effective approach to examining the relationship between profits and government deficits is found in Levy et al. (2008:16).

References

Bernheim, D., "Ricardian Equivalence: An Evaluation of Theory and Evidence", NBER Macroeconomics Annual 1987, S. Fischer, ed., Vol. 2, pp. 263-316, (Mass: MIT Press), 1987

Krugman, P., International Economics: Theory and Policy 3rd Ed., (New York:Harper-Collins), 1994

Levy, D., et al., Where Profits come from? Answering the Critical Question that Few Ever Ask, The Jerome Levy Forecasting Center, LLC, 2008

McCulley, P., Facts on the ground, Policy Note, Levy Institute of Bard College, 2010

Canada's real GDP declines

Canada's second quarter economic accounts were released today. Real GDP declined 0.1%, largely due to the 2.1% drop in exports (see Charts 1 & 2). Also, business inventories have increased, income growth has slowed and goods production has decreased.

Chart 1 (Source: Statistics Canada)

Chart 2 (Source: Statistics Canada)

Honestly, there isn't much in these accounts to be optimistic about. That said, I still hold a glimmer of hope that business investment might be able to sustain economic activity for the next few quarters. Here are a few excerpts from the summary prepared by Statistics Canada:

Business investment in plant and equipment continued its upward trend, rising 3.7% in the second quarter, a sixth consecutive quarterly increase. Machinery and equipment has contributed the most to growth in overall investment in plant and equipment in four out of six quarters[....]

Government expenditures on goods and services grew 0.4%, after remaining unchanged in the first quarter. All levels of government increased spending on goods and services this quarter[...]

Consumer spending on goods and services rose 0.4% in the second quarter. Consumers increased their purchases of durable goods (+0.4%), as well as services (+0.8%). Purchases of non-durable goods edged down 0.1%, while purchases of semi-durable goods declined 0.8%.

Other than for the positive trend in business investment, it's clear that the second quarter of 2011 was a disappointment. This is definitely not the time to be cutting government expenditures. Instead, federal and provincial policymakers should be drawing up plans to inject additional stimulus into productive, job creating initiatives.

As for Canada's exports, let's face it, there is little hope that these will increase significantly. The strength of the Canadian dollar combined with the weak economy of Canada's main trading partner, the United States, make that goal close to impossible to achieve. A repeat of Canada's export boom in the mid-1990s is highly unlikely (see here). Also, it's simply not a sensible approach right now to expect consumers to be the source of economic growth. As I've explained in previous posts (here and here), the household sector in Canada is currently in the process of accumulating less debt. And that is a good thing given that household and personal indebtedness are currently at worrisome levels.

Therefore, the best bet for policymakers right now would be to abandon plans to cut public expenditures and ensure that business investment continues to expand.

For more on how to achieve the goal of increasing business investment, please refer to my previous post entitled "The right way to balance the budget: target the corporate surplus, not the government deficit".

Consumer credit and spending continues to slow

The August edition of the Canadian Economic Observer is out. For many months now, my eye has been fixed on the declining growth in consumer credit and household expenditures. This is a clear sign that households are accumulating less debt.

Growth in business investment is also slowing, but its current level is from a historical standpoint still very high. No doubt the strength of the Canadian dollar is helping firms update their machinery and equipment.

On the bright side, government expenditures have turned up a tad after several months of decline. Also, capacity utilization rates are continuing their upward trend.

Finally, no sign that Canada's current account balance will improve any time soon (see here for more on export potential and Canada's sectoral balances).

The right way to balance the budget: target the corporate surplus, not the government deficit

Deficit reduction is back on the agenda in Canada. And according to recent statements made by Tony Clement, the minister assigned the task of balancing the federal budget, it appears likely that significant cutbacks in public sector spending will occur in the next few years.

This is most unfortunate. At a time when household debt is at a record high and the personal saving rate is near the 40-year low (see chart 1), slashing government budgets is the last thing Canadians need right now. Think about it: for every dollar of reduction in government expenditures, there is one less dollar of income earned in the economy (similarly, if the funds are spent on imports such as US-made fighter jets, the money leaves the domestic economy). The same goes for any tax increase used to balance the budget: each dollar of taxes collected by the government represents one less dollar in private sector bank accounts.

In other words, it is impossible for the government to decrease its deficit in isolation, and any reduction in government spending or tax increase will have an impact on the private sector. In fact, there is a strong argument to be made that the decline in the personal saving rate and the overall weakness in the household sector's financial position during the last two decades is partly the result of the deficit reduction efforts of the federal and provincial governments in years past.

As I've shown elsewhere, public sector deficits are from an accounting standpoint the equivalent of surpluses in the private sector, plus additional net imports. The reason for this is that government deficit spending adds to the net accumulation of private holdings of households and businesses (and/or the foreign sector, where applicable).

Chart 1 (double click to enlarge) proves that this basic principle is supported by the facts*. As you can see, whenever Canada's government sector (all levels of government combined) is in a deficit, the private sector runs a surplus (or reduces its deficit). The relationship is so close to being perfect that it looks as though each financial balance is a mirror image of the other. If you take into account net imports, you get perfect symmetry (see chart 2).

Chart 1

Chart 2

The Corporate Surplus

A much more sensible approach to balancing the federal budget would take into account the fact that Canada right now has a massive corporate sector surplus (see chart 3). The reason for this large accumulation in corporate savings is that during the last decade the corporate sector significantly reduced its share of productive investment in the economy in favour of short-term investments and speculative activity (Baragar and Seccareccia, 2008).

Chart 3

Based on official statistics (and my own calculations), Canada's corporate sector ran on average a net surplus of 3.7 percent of gross domestic product since 2001. This is a huge jump from the previous 40 years when the corporate sector maintained an average deficit of 1.3 percent. If corporations were to invest these funds in productive, job-creating initiatives, the deficits of both the government and household sectors would shrink significantly without the need to make contractionary cuts to public expenditures.

A good way to achieve this would be for the government to encourage firms to undertake productive investment by imposing a small, yet noticeable tax on retained earnings or on the turnover of corporate financial instruments, as suggested last year by Yves Smith and Rob Parenteau in relation to the case of the US. Marshall Auerback also makes an excellent case here in favour of imposing a tax on the corporate sector to achieve this purpose. As for the idea of a financial speculation tax, economist Dean Baker recently explained the benefits of this policy here.**

According to Smith, Parenteau and Auerback, these measures would create incentives for firms to reinvest their profits in business operations by increasing the cost of speculating with profits.

In a context where the potential for large export growth is weak (due to the current strength of the Canadian dollar and the challenges facing the US, Canada’s major trading partner), enticing firms to increase productive investment is likely to be the only way to balance the federal budget without further causing the household sector’s deficit to grow. 

So next time you're concerned over the size of the federal government's budget deficit, keep in mind that the more pressing matter at the moment is to reduce the massive corporate surplus. Such a policy would not only help to reduce the size of the federal government's deficit, but it would also go a long way in eliminating the current financial deficit of the household sector.

Baragar, F. and M. Seccareccia, Financial restructuring: Implications of recent Canadian macroeconomic developments, Studies in Political Economy, Vol 82 (2008).

* All charts were produced using official Statistics Canada sector accounts/net lending data and my own calculations. 

** This sentence was added on May 28, 2011.

The modern "financial flows" view of deficit spending

In this presentation, post-Keynesian economist Mario Seccareccia of the University of Ottawa applies the sectoral flows approach to macroeconomics to discuss the importance of fiscal policy. Some of the issues covered in the presentation were discussed in two of my earlier posts (here and here). The presentation was given last week in Bretton Woods, NH, at a conference organized by the Institute for New Economic Thinking. It's well worth the 15 minutes.

The paper submitted by Prof. Seccareccia can be found on the conference website here.

As mentioned in my earlier posts, the sectoral flows view of the economy facilitates macroeconomic analysis by showing how the receipts and outlays of each sector of the economy create a corresponding rise or fall in the sectors' net acquisition of financial assets. In the presentation, Prof. Seccareccia uses the example of the Canadian economy to show how the government surpluses of the late 1990s and early 2000s corresponded with a decrease in savings by the household sector.

h/t: Cullen Roche

The economy's financial flows are a closed system

In the previous post, I mentioned that the sectoral balance approach is based on the premise that the government deficit is equal to the private sector's surplus, and vice versa. Just to be clear, this does not mean that we must disregard the inflow and outflow of funds to and from the foreign sector. Quite the contrary, the foreign sector plays a key part in Canada's economy. Take, for instance, the chart below depicting net lending for each sector of the economy since 1990 (double-click on chart to expand). In the chart you can see that the foreign sector supplied significant funds for investment to the Canadian economy in the early 1990s, in 1998, and again starting in 2008. During most of the period between 1996 and 2007 (1998 being the only exception), it was Canadian savings (i.e. government surpluses and corporate savings) that contributed to financing foreign borrowing.

In the chart you can also see the deterioration in the financial position of the household sector since 1992. In the decades prior to 2000, the traditional role of the household sector was to lend funds to the rest of the economy. However, since 2002 the role of primary lender has now been taken over by the corporate sector. The chart also shows that the deterioration in the household sector and the rise in the corporate sector's financial position coincided with the rapid reduction in the government sector's deficit position.

The chart is also useful for showing how the deficit (surplus) of one sector is always offset by at least one other sector's surplus (deficit). Take, for instance, the year 2001. In that year, foreign sector borrowing (net lending deficit) equaled the sum of the government and corporate sector surpluses. A similar situation also occurred in 2003 when the only sector with a surplus (corporate sector) equaled the sum of the net lending deficits of the household and foreign sectors. This also occurred earlier in 1994 and 1995 when government sector borrowing equaled the sum of the net lending surpluses of all the other three sectors. As Statistics Canada explains in this study,

Surplus sectors net lend to other sectors, and deficit sectors net borrow from other sectors...At the economy-wide level, the sectors' net lending or borrowing positions sum to zero - such that all aggregate saving has been allocated to aggregate investment. (p. 6)

So what does this all mean? Well, for starters, it means that government deficits are not always harmful. On the contrary, government deficits can be essential for a healthy economy. In the early 1990s, it was the large government deficits that enabled the household sector to stay in a surplus position while Canada was a net borrower to the foreign sector. Since 2009, Canada has witnessed a similar dynamic: the large government deficit is helping the household sector improve its financial position in the context of an economy facing a massive combined foreign sector and corporate sector surplus.

Provinces with lowest debt-to-GDP ratios have the most vulnerable household sector

TD Bank recently released an interesting report identifying British Columbia and Alberta as the regions with the most financially vulnerable household sectors in Canada. The assessment is based on a comparison of the household sector in each province or region using standard financial indicators, including the debt-to-income ratio, share of households with a high debt-service ratio, personal savings rate, debt-to-asset ratio and home price-to-income ratio. Among other things, the report highlights that BC and Alberta have household sectors with the highest average debt-to-income and debt-service ratios.

But does TD's assessment give us the full picture? And is it a coincidence that out of the four regions deemed to be most vulnerable in the report, three of these regions also happen to be the provinces with the lowest government net debt in Canada? Probably not. This is especially apparent when you look at the financial situation in each province using a stock-flow consistent approach to macroeconomics.

The sectoral balance approach is useful in this regard because it takes into account the financial status of the various sectors of the economy at the macro level. Based on the insights of economists John Maynard Keynes, Hyman Minsky and Wynne Godley, this approach provides a useful lense for understanding why households in BC and Alberta are now in a precarious financial state.

The sectoral balance approach is based on a simple premise derived from standard double-entry accounting: the government deficit equals the non-government surplus and vice-versa. This means that, assuming no changes in the trade account, government deficits add funds to the private sector (household and corporate sectors combined) while government surpluses do the opposite by removing funds from the private sector.

In the case of BC and Alberta, years of government surpluses have led these provinces to reduce their net debt down to 14.7 and -9.6 percent of GDP respectively (Alberta has a negative net debt or surplus). Given the average provincial net debt currently is over 25 percent, it is clear that, from a sectoral balance standpoint, BC and Alberta are the provinces where government surpluses have gone the furthest in diverting funds away from the private sector.

Also, given that a large portion of the provincial debt is held by foreign investors, the strict policy of retiring public debt has resulted in a significant outflow of funds away from the government sector and the provincial economy as a whole. This outflow of funds means less investment, less public services and reduced purchasing power for households in the face of rising housing costs and decreased lending activity by banks. Considering also that the corporate sector balance in Canada is currently very high, it is easy to understand why the household sector in these provinces are facing difficult times.

The sectoral balance approach also takes into account financial flows entering or leaving the economy. This means that, assuming no changes in the public sector balance, trade deficits decrease the private sector balance while trade surpluses increase it. In the case of Canada, the recent current account deficit has affected the provincial economies in more or less the same way, and the result has been an overall weakening in the financial position of both households and businesses in each province.

To sum up, although there are many factors that affect households' financial position, it is clear that the weakness currently affecting the household sectors in BC and Alberta is in part a consequence of the debt reduction efforts of the BC and Alberta governments in years past. The financial outflows caused by Canada's recent trade deficits and the huge funneling of funds away from households toward Canada's corporate sector have only worsened the situation.*

In a way, it is ironic that the report points to the two provinces Canadians have always been told are models of "sound" public finance (i.e. low government debt). But then again, we should have known better given that double-entry accounting is several hundred years old...

*For more on the sectoral balance approach in the Canadian context, see this excellent article by Marshall Auerback.