A kind word for Paul

Paul Krugman's recent posts on the abuse use by politicians of economic studies as a way to support ideologically-driven fiscal austerity have been right on. Here's from his latest:

...the important story isn’t about the sins of the economists; it’s about our warped economic discourse, in which important people seize on academic work that fits their preconceptions. Even if you don’t think Reinhart-Rogoff made much difference to actual policy, the meteoric rise and catastrophic fall of their reputation speaks volumes about why this slump goes on and on.

I made a similar point in an earlier column when I wrote that 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.

...[F]iscal 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".

This is why I continue to think that the ones who are really responsible for austerity are the politicians who support this view. Economic studies were used to provide cover for these leaders' preferred set of policy choices.

Anyway, there's no matching Prof. Krugman's performance these last few months. Not only have his forecasts been right on, but his retrospective look at why things unfolded the way they did has been downright flawless.

Moving past the 90 percent threshold: Focusing on growth

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

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

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

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

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

Reference

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

Are investors seeing the writing on the wall?

John Carney reports that Wall Street is now showing signs of turning against fiscal austerity.

Apparently, the Reinhart-Rogoff fiasco has something to do with it. Perhaps.

Or is it the realization that the narrowing US federal budget deficit since the start of the sequester in early March may signal the end of bountiful corporate profits?

As I've explained before, contrary to conventional wisdom, business profits are actually positively impacted by government budget deficits. Here is my take from a macro accounting standpoint:

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.

Now, it's true that under normal circumstances other factors such as household consumption and saving behavior and trade flows can significantly affect how these variables interact. However, in the current context where household spending has been largely subdued by deleveraging concerns, and exports weakened by sluggish growth in Europe, the UK and elsewhere around the world, the budget deficit consists of an important source of demand and (from a national accounts perspective) of corporate profits.