...against fictions and other tall tales

Sunday, 17 January 2016

Stiglitz on credit creation by banks

For those who think that Joseph Stiglitz doesn't know that banks actually create credit:

"We are not in a corn economy where banks serve as an intermediary between farmers who have excess seed and farmers who want more seed. We are in an economy where banks actually create credit. And that makes a very big difference."

h/t: wonkmonk

Saturday, 19 December 2015

Loanable Funds Theories: Classical vs Keynesian

It's been an embarrassingly long time since my last post. It's not due to a shortage of good topics to write about. Rather, I've been caught up in a number of projects at work and been busy on the home front. Hopefully, this post, which was inspired by ongoing conversations I've been having offline with friends and colleagues will partly make up for the radio silence.

One of the biggest fallacies in macroeconomics and macro policy is the idea that the interest rate is determined by the intersection of the upward sloping supply curve of (desired) savings and downward sloping curve of (desired) investment.

According to this traditional, credit-based approach to interest rate determination (as opposed to a "money-based" one à la Keynes's Liquidity Preference Theory in which the interest rate is determined by the supply of and demand for money), savings consist of the supply of loanable funds (i.e., funds that are not spent on consumption), assumed to be positively related to the interest rate, while investment is the demand for loanable funds and assumed to be negatively related to the interest rate.

As far as simple theories go, the old (classical) loanable funds theory is of very little or no use for making sense of the real world and in terms of providing prescriptive insight to policymakers. For one, there's very little evidence that the real rate of interest has significant impact on business investment.

But more importantly, the problem with the traditional loanable funds theory is its public policy implications: it assigns no role to government as a stabilizing feature of the economy during a recession, which is a ludicrous proposition given what we know now about the Great Depression, the Japanese Lost Decade(s) and the Great Recession (the lesson being that government has a role to support recovery, as market mechanisms won't be sufficient, or at the very least, will take too long).

Consistent with the classical origins of this approach, the traditional loanable funds model holds that government intervention to stabilize the economy is not needed because, as the economy falls into recession, there is an automatic stabilizing force clearing the loans market, enabling the supply of and demand for funds to adjust, shifting to the left, reaching a new equilibrium, as in the diagram below.

The self-adjusting mechanism works as follows: first, as the shift in demand for funds is assumed to be greater than the shift in the supply of loans during a downturn, the result is a decrease in the (real) rate of interest, which subsequently causes investment to recover, thus helping to restore economic activity and growth.

In his General Theory, J.M. Keynes illustrated how widespread the belief in traditional loanable funds theory was during his time:
Certainly the ordinary man — banker, civil servant or politician — brought up on the traditional theory, and the trained economist also, has carried away with him the idea that whenever an individual performs an act of saving he has done something which automatically brings down the rate of interest, that this automatically stimulates the output of capital, and that the fall in the rate of interest is just so much as is necessary to stimulate the output of capital to an extent which is equal to the increment of saving; and, further, that this is a self-regulatory process of adjustment which takes place without the necessity for any special intervention or grandmotherly care on the part of the monetary authority. Similarly — and this is an even more general belief, even today — each additional act of investment will necessarily raise the rate of interest, if it is not offset by a change in the readiness to save.  
In a recent post, Paul Krugman dismissed the relevance of the traditional loanable funds model for the real world, pointing out the basic Keynesian insight that the theory is only relevant if the level of income in the economy is fixed. In reality, as Krugman correctly argues, given that income is not fixed, all the traditional loanable funds theory does is "define a relationship between interest rates and income, the IS curve of the conventional Keynesian IS-LM model".

Also, in his post Krugman showed how misleading the model can be for explaining the determination of the rate of interest in a world where the central bank sets the short term interest rate as a way to achieve its policy objective (i.e., hit its inflation target):
The Fed sets interest rates, whether it wants to or not — even a supposed hands-off policy has to involve choosing the level of the monetary base somehow, which means that it’s a monetary policy choice.

Keynesian Credit-based Loanable Funds Theory (credit view) vs Classic Loanable Funds Theory (money view)

So it needs to be repeated: the old loanable funds theory is irrelevant for understanding how the economic activity resumes after a downturn. That said, the basic insight that "credit matters" and that credit fluctuations have significant effects on the real economy should not be rejected out of hand.

Such was the thinking in the 1970s and 1980s when a few Keynesian economists, including Andrew Weiss, Joseph Stiglitz, Bruce Greenwald, Benjamin Friedman, Alan Blinder and others (including, to some extent, Ben Bernanke) set out to devise Keynesian-inspired credit-based models as alternatives to the conventional and popular Keynesian and monetarist "money-based" models that dominated macroeconomics at the time (all of which assumed a special role for money in the determination of aggregate demand).

The result was a set of economic models highlighting the importance of credit in the economy and the critical role of commercial banks in affecting real output. Though they were labelled "new and improved" versions of loanable funds theory because they emphasized credit rather than money, these models were nothing like their classical predecessor, as the new models assigned no special role to the supply of savings and recognized the critical role of government regulation and macroeconomic stabilization to improve economic outcomes.

At the heart of these new models is the idea that, unlike the traditional loanable funds model, credit is not allocated in an auction process, with the loan going to whoever is willing to pay the highest interest rate. Rather, in these models banks understand that increasing interest rates can in some instances (especially when economic activity is weak or slowing) increase the probability of borrowers to default, as increased lending rates can lead to adverse effects on the incentives of borrowers to undertake activities that are increasingly risky.

Default and bankruptcy are therefore possible in these models -- unlike in the traditional loanable funds model -- because lenders are often unable to properly assess the risk profile of potential borrowers due to a lack of information or the high cost of adequately assessing the default risk of potential borrowers.

So, rather than being determined by the forces of supply and demand, the interest rate in these Keynesian credit-based models is determined by the maximum expected return to banks, that is, the rate with which profits are maximized and risks (e.g., probability of loans not being repaid that can lead to an increase risk of bankruptcy) to the bank are minimized.

In other words, the interest rate is a variable determined by banks themselves as a way to remain profitable. In these models, there is no presumption that increases in the interest rate will boost bank profits given that higher interest rates can increase the probability that borrowers will not pay back their loan, which could result in profit losses for the bank and, in some cases, could lead to bankruptcy.

Nor is there is any presumption in these models that the market for loans is perfect and clears. The market mechanism in these models does not lead credit supply to equal demand because, in their attempt to maximize profits and minimize risks in a context where information about borrower risk is scarce and/or costly to uncover, banks will not supply the amount of credit necessary to meet the demand at the lending rate. In other words, the result is an excess demand for funds (i.e., credit rationing).

Perhaps the simplest and most revealing of these Keynesian loanable funds models is the model by Joseph Stiglitz and Bruce Greenwald (2003)*. In this model, unlike in the traditional loanable funds model, the supply of loans (regardless of whether those loans are supplied via traditional financial intermediation or credit creation**) is not depicted as an upward sloping curve, as in traditional credit-based (loanable funds) models. Rather, banks' supply of loans is represented by a backwards bending curve (see chart below). The reason the curve bends backward in this model is because a rise in the interest rate increases average borrower risk. Also, the model assumes banks scale back the amount of loans supplied as the rate of interest increases to avoid borrower default and, by consequence, profit losses. (In a recent talk, Stiglitz referred to this model as a modern, Keynesian version of Irvin Fisher's debt-deflation theory. The similarities aren't obvious, but they are there.)

When combining the backwards sloping supply curve with a conventional demand curve for loans (where the demand for loans increases as the interest rate falls), the result is a credit market that is not perfect in the sense that the market mechanism (supply and demand for credit) does not provide a market-clearing interest rate, where the demand exceeds the supply for credit.

Ideally, in this model banks should be lending at point L* and setting the lending rate at r* where expected returns are maximized and where credit rationing (CR in the diagram) occurs. However, screening loan applications and paying interest on deposits imply costs to banks, therefore, typically the lending rate will be set a little lower, at point e. At point e, however, there is even more credit rationing because there is less lending.

From a macroeconomic perspective, credit rationing can lead to reduced economic activity by limiting aggregate demand, investment, employment and output. When credit is not available, firms involved in production cut employment and investment, thus lowering national income, output and the general level of employment. In some instances, as Alan Blinder argues, credit rationing can even lead to a Keynesian shortage of effective supply, that is, a shortage of produced goods and services to meet current demand, which in some situations could have the effect of increasing prices.

The impact of credit rationing on output will depend on whether the firms are dependent on bank loans. Firms that rely on bank financing will cut spending while businesses using bank loans for working capital will stop operating.

The table below provides a comparison between the traditional (classical) loanable funds theory and the modern Keynesian version.

Monetary Policy...

So what are the implications of this model for monetary policy? The conventional story holds that central banks reduce interest rates and investment increases as a result. In the Keynesian loanable funds models, the central bank may succeed in driving down the rate of interest on government securities (Treasury bills), however, it may not get banks to reduce their lending rate if banks perceive an increased risk of default on the part of households and firms due to a worsening economy, or if banks believe economic conditions are not likely to improve. Instead of increasing their loan portfolio, banks could simply choose to purchase safe government securities, as was done during the Great Depression, an outcome that does nothing to support recovery unless it prompts government to implement a fiscal stimulus by making public sector borrowing more attractive.

One doesn't have to think too much to see the relevance of these models to the period since the onset of the Great Recession.

As for contractionary monetary policy, the outcome is similar to the mainstream story in that investment can be curtailed as a result of the increased rate on government securities. However, as Stiglitz and Weiss, argue, "banks will often be unwilling to raise interest rates because of a fear that higher rates will have the adverse effect of chasing away credit-worthy borrowers and adverse incentive effect [of] inducing them to undertake greater risks". Instead, banks may opt to restrict the supply of loans, as in the diagram below.

So the point here is...

A basic principle in Keynesian economics is that no matter how dedicated unemployed workers are in their search for employment or how low the unemployed are willing to bid wages down, there are times when these actions are futile because jobs just are not available to meet the demand. The key insight of Keynesian credit models is similar, except that the crucial element is the insufficient supply of credit. In other words, this 'credit view' can be summarized as follows: often times the amount of loans is not sufficient to meet the demand for credit, regardless of the rate of interest.

To conclude, the main take away from this post is that the influence of interest rates (including the natural rate of interest) is often oversold, as the rate of interest may not be as important as it's often made out to be in the determination of aggregate demand.

The innovative aspect of credit-based Keynesian models was to shift the focus from money (as emphasized in monetarist models) and interest rates (as emphasized in traditional, old Keynesian models) towards elements such as the general degree of risk perceived by banks, both with regard to the default risk of potential borrowers and banks' expectations about future economic conditions. These are the key factors that influence the amount of credit supplied in the economy in credit-based Keynesian models.

* This blog post is dedicated to Joseph Stiglitz and Bruce Greenwald.

** Joseph Stiglitz & Bruce Greenwald (2003): "When a bank extends a loan, it creates a deposit account, increasing the supply of money."


Blinder, Alan. "Credit Rationing and Effective Supply Failures" in Macroecomics Under Debate, Ann Arbor, University o Michigan Press, 1992

Stiglitz, Joseph. and Bruce Greenwald, Toward a New Paradigm in Monetary Economics, 2003.

Monday, 30 March 2015

Ben Bernanke and the natural rate of interest

From Professor Bernanke to Governor Bernanke to Chairman Bernanke to Ben Bernanke, Blogger. Quite the progression!

I enjoyed reading Ben Bernanke's blog post today. But it doesn't appear everyone thinks like me. I noticed some have criticized Bernanke for using the concept of the equilibrium (or natural) rate of interest, or the real rate of interest consistent with output at its potential level and with stable prices.

Now, I realize that the equilibrium real rate is unobservable and varies through time, which means it's subject to uncertainty. However, we could say the same thing about the concept of potential output, yet few would deny it is a useful concept.

In fact, most people are aware of the concept of "output gap", the difference between potential output and actual output. The corollary concept for the real interest rate is the "interest rate gap", the deviation of the actual policy rate from the real equilibrium rate.

This is essentially what Bernanke was driving at in his post today. Simply, the interest rate gap is a measure of the stance of monetary policy: a large (small) gap means monetary policy is loose (tight).

Back in the Keynesian era, policymakers used the concept of the "full employment surplus" (FES), or the budgetary surplus consistent with full employment, as a way to illustrate how the actual budget deficit wasn't being caused by a lack of tax revenue or out of control government spending but rather was caused by the weakness of the economy and the lack of output due to unemployed and idle resources. I view the interest rate gap in a similar way. Whereas the FES provided a useful measure of the stance of fiscal policy by highlighting the difference between the actual "surplus" (or negative surplus in the case of a deficit) and the FES, the interest rate gap provides a useful measure of the stance of monetary policy.

But don't get me wrong. In no way does any of this mean that central banks should be rigid in adjusting their policy rate to track the estimated equilibrium real rate.

As far as I'm concerned, central bankers should use their judgement and consider all information, not just their estimates of the real equilibrium rate and interest rate gap. For instance, if a central bank's estimate of the real equilibrium rate shows it is rising, yet inflation isn't, it may not be the right time to increase the policy rate.

Similarly, if a central bank's estimate of the equilibrium rate shows it is remaining stable, yet unemployment is rising, it may be entirely justified for the central bank to keep its policy rate at the same level or even to reduce it. I'm of the same view when it comes to the concept of the natural rate of unemployment: using it properly requires good judgement.

A final note on Bernanke's comment about how large deficits tend to increase the equilibrium real rate given that government borrowing diverts savings away from private investment. One thing I noticed is that Bernanke carefully added that this would occur "if everything else stays equal". In other words, this means he's not denying that a different (or even, opposite) effect could occur if other forces are at work.

For instance, the opposite effect could occur if budget deficits, by sustaining business activity, reduce default risk on corporate bonds and subsequently narrow the spread between the yields on corporate and government bonds, thus helping to reduce the cost of capital to the private sector. In such a scenario, budget deficits have effectively "crowded-in" private sector spending. I doubt Bernanke would deny that budget deficits could have such an effect.

Friday, 20 March 2015

The Federal Reserve Bored

Paul Krugman points out possibly the biggest challenge to sensible, rational policy making and debating these days:
The Times has an interesting headline here: Richard Fisher, Often Wrong but Seldom Boring, Leaves the Fed. Because entertainment value is what we want from central bankers, right? I mean, Janet Yellen is such a drag — she just keeps being right about the economy, and that gets old really fast, you know?
It really is too bad that it's these 'entertainers' -- they range from the likes of Rick Santelli and Larry Kudlow to the establishment types like Fisher -- get such media attention. I mean, it's not like decent analysis doesn't exist, especially since the appearance of websites like Vox and the increased popularity of economics blogs.

Anyway, in other news, I've had very little time to blog these last few months but I intend to get back into it in earnest fairly shortly so stay tuned.

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

Sunday, 23 November 2014

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

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

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

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

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

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

The logic in Prof. Krugman's paper can be summarized as follows:
  • households and firms will borrow and spend if they expect higher inflation in the future;
  • borrowing and spending is influenced by the real interest rate (i.e., the nominal rate of interest less the expected rate of inflation); and 
  • a rise in expected inflation is for all intents and purposes equivalent to (i.e., has the same effect as) a fall in the real interest rate.
In other words, Prof. Krugman is saying that an increase in expected inflation of, say, three percent will have the same expansionary effect as a three percent cut in interest rates.

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

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

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

Prof. Krugman is aware of this criticism. Economists Robert Gordon, Alan Blinder and Martin Neil Baily all raised this point during the discussion that took place following the presentation of his paper. Here are the minutes that were recorded from that discussion:
Robert Gordon...criticized the assumption in Krugman's models that the monetary authorities can easily change inflationary expectations for the future -- that the announcement of a policy will change expectations despite present slack in the economy. He believed that agents' expectations depend largely on actual experience, and that they will experience increased inflation only when there is pressure in the markets for goods, services, and labor. Alan Blinder agreed. He thought that Krugman's inflationary policy would work if it could be implemented; but that would require the Bank of Japan to create expected inflation, which, in turn, would require persuading people that the future was going to be fundamentally different from the past. Japan had zero inflation in the past six years, and the average in the previous decade was 1.8 percent per year. Thus to create expected inflation of 4 percent, with actual inflation lagging behind, would be difficult.[Martin] Baily concurred, observing that it would be easy for Russia to be credible in announcing inflationary policy but hard for Japan. (Krugman, 1998:201)
True believers in the power of central banks will respond to this line of criticism by reverting to this old saw: a credible central bank would not have let inflation get too low in the first place, thus people's expectations would never had been unhinged as a consequence. To this, I say: wishful thinking!

When it comes to the role of expectations in explaining macroeconomic outcomes, Robert Solow warned that it should be used with caution (though Solow said this in a different context):
...[T]o rest the whole argument on expectations -- that all-purpose unobservable -- just stops rational discussion in its tracks. I agree that the expectations, beliefs, theories, and prejudices of market participants are all important determinants of what happens. The trouble is that there is no outcome or behavior pattern that cannot be explained by one or another drama starring expectations. Since none of us can measure expectations (whose?) we have a lot of freedom to write the scenario we happen to like today. Should I respond...by writing a different play, starring somewhat different expectations? No thanks, I'd rather look at the data. (Solow and Taylor, 1998:93)
The problem with economics and economic policymaking these days is that too much of it relies on monetary policy and the role of the central bank. There are limits to what central banks can do because people do not believe central banks are omnipotent and have the ability to control inflation expectations on demand. For this reason, Old Keynesians had it rightfiscal policy must be resorted to bring about normal economic activity.

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

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

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

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


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

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

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

Monday, 27 October 2014

Secular stagnation, secular exhilaration and fiscal policy

Paul Krugman is right: secular stagnation has historically always referred to a situation of persistent low demand, which, according to my old 1971 Samuelson and Scott textbook, renders it inappropriate for governments to attempt to balance the budget over the business cycle (as per the principle of countercyclical compensation).

While in a secular stagnation (Is the shorthand 'SecStag' catching on?), Samuelson and Scott suggest that constant or near-constant government budget deficits are needed to sustain an adequate level of demand to achieve full employment, as shown here:

Samuelson and Scott (1971:437)

The policy stance required during secular stagnation contrasts with the stance needed during periods of so-called "secular exhilaration" (with high demand), during which the right policy is running budget surpluses as a way to avoid overheating the economy and reduce inflationary pressures.

It's true that sustained deficits will increase public debt; however, the low cost of borrowing that usually comes with secular stagnation should help to ensure public debt levels won't get out of hand.

But hasn't the experience of Japan in the 1990s taught us that big deficits don't work to stimulate a stagnant economy, you might ask?

The answer is no. Kenneth Kuttner and Adam Posen demonstrated in "Passive Savers and Policy Effectiveness in Japan" that low tax revenues caused by a weak economy were to blame for the rising debt levels, not expansionary fiscal policy.

Of course, it's important that the spending be directed toward productive use.

I can think of two ways to achieve this goal. First, governments should invest in early childhood learning, an investment that's well known to pay-off in the long-run. Second, investing in infrastructure is also a good bet, as demonstrated several years ago by David Aschauer and Alicia Munnell, and as recently recommended by the IMF.


Aschauer, D., 1989, "Is Public Expenditure Productive", Journal of Monetary Economics, Vol. 23, pp. 177-200.

IMF, "Is it time for an infrastructure push? The macroeconomic effects of public investments", Chapter 3, October 2014.

Kuttner, K. and A. Posen, "Passive Savers and Policy Effectiveness in Japan", Institute for International Economics, 2001.

Munnell, A., 1990, "Why has productivity declined? Productivity and Public Investment" New England Economic Review, Federal Reserve Bank of Boston, January/February issue, pp. 3-22.

Samuelson and Scott, Economics, 3rd Canadian Edition, McGraw-Hill, 1971.

Tuesday, 14 October 2014

Deficit, Deficit, Who's got the Deficit? (Secular stagnation edition)

Over 50 years ago, James Tobin wrote an article for the New Republic entitled "Deficit, Deficit, Who's got the Deficit" (1963) that explains why the US federal government almost always needs to run a budget deficit.

The article is a gem. It has everything a good macroeconomics article should have: lots of debunking, all the relevant data, and a good dose of policy recommendations.

Unfortunately, the article is nowhere to be found on the internet. This post seeks to fix that by providing some key excerpts. Another purpose of this post is to use Tobin's analytical framework in that article and apply it to today's economic environment in the US.

Tobin on US Sectoral Financial Balances, circa 1963

The article starts off by describing the fundamental (iron?) law of financial balances:
For every buyer there must be a seller, and for every lender a borrower. One man's expenditure is another's receipt. My debts are your assets, my deficits your surplus. 
If each of us was consistently "neither borrower nor lender," as Polonius advised, no one would ever need to violate the revered wisdom of Mr. Micawber. But if the prudent among us insist on running and lending surpluses, some of the rest of us are willy-nilly going to borrow to finance budget deficits. 
In the United States today one budget that is usually left holding a deficit is that of the federal government. When no one else borrows the surpluses of the thrifty, the Treasury ends up doing so. Since the role of debtor and borrower is thought to be particularly unbecoming to the federal government , the nation feels frustated and guilty. 
Unhappily, crucial decisions of economic policy too often reflect blind reactions to these feelings. The truisms that borrowing is the counterpart of lending and deficits the counterpart of surpluses are overlooked in popular and Congressional discussions of government budgets and taxes. Both guilt feelings and policy are based serious misunderstanding of the origin of federal budget and surpluses. (1963:10)
Tobin then goes on to explain that both the household and financial sectors were running large financial surpluses (worth $20 billion combined in 1963):
American households and financial institutions consistently run financial surpluses. They have money to lend, beyond their own needs to borrow. As a group American households and non-profit institutions have in recent years shown a net financial surplus averaging about $15 billion a year -- that is, households are ready to lend, or to put into equity investments...more than they are ready to borrow. [...] In addition, financial institutions regularly generate a lendable surplus, now of the order of $5 billion a year. For the most part these institutions -- banks, saving and loans associations, insurance companies, pension funds, and like -- are simply intermediaries which borrow and relend the public's money. Their surpluses result from the fact that they earn more their lending operations than they distribute or credit to their depositors, shareowners, and policyholders. [...]
The article goes on to list the sectors of the economy that must borrow the $20 billion in surplus funds available from households and financial institutions:
State and local governments as a group have been averaging $3-4 billion a year of net borrowing...Unincorporated businesses, including farms, absorb another 3-4 billion a year. To the rest of the world we can lend perhaps $2 billion a year. We cannot lend abroad -- net -- more than the surplus of our exports over our imports of goods and services, and some of that surplus we give away in foreign aid. [...]
The remainder -- some $10-12 billion -- must be used either by nonfinancial corporate business or by the federal government. Only if corporations as a group take $10-12 billion of external funds, by borrowing or issuing new equities, can the federal government expect to break even. [...]
Tobin then follows into a discussion about the policy implications of these lending and borrowing dynamics:
The moral is inescapable, if startling. If you would like the federal deficit to be smaller, the deficits of business must be bigger. Would you like the federal government to run a surplus and reduce its debt? Then the business deficits must be big enough to absorb that surplus as well as the funds available from households and financial institutions. 
That does not mean business must run at a loss -- quite the contrary. Sometimes, it is true, unprofitable business are forced to borrow or to spend financial reserves just to stay afloat; this was a major reason for business deficits in the depths of the Great Depression. But normally it is business with good profits and good prospects that borrow and sell new shares of stock, in order to finance expansion and modernization...The incurring of financial deficits by business firms -- or by households and governments for that matter -- does not usually mean that such institutions are living beyond their means and consuming their capital. Financial deficits are typically the means of accumulating nonfinancial assets -- real property in the form of inventories, buildings and equipment. 
When does business run big deficits? When do corporations draw heavily on the capital markets? The record is clear: when business is very good, when sales are pressing hard on capacity, when businessmen see further expansion ahead. Though corporations' internal funds -- depreciation allowances and plowed-back profits -- are large during boom times, their investment programs are even larger. [...]
Recession, idle capacity, unemployment, economic slack -- these are the enemies of the balanced government budget. When the economy is faltering, households have more surpluses available to lend, and business firms are less inclined to borrow them. (1963:11)
The Corporate Sector: From Deficits to Large Surpluses

Of course, at the time Tobin wrote this article, US financial balances weren't exactly the same as they are today. Households as a group were running financial surpluses, the US was mostly a net lendor to the rest of the world, and the corporate sector was a net borrower of funds. Essentially, three things have changed since the mid-1980s with respect to financial balances (see charts below, double-click to enlarge).

First, starting in the mid-1980s, the US has become a net borrower to the rest of the world. Second, since the early 1990s and until the financial crisis, households were net borrowers to other sectors; since 2007, the household sector has returned to its traditional role of being a net lender. Finally, since the 1990s, the corporate sector has been at different times either a net lender or net borrower. However, since 2009, the corporate sector has been running a very large net financial surplus.*

What is the main policy implication to take-away from this state of affairs?

I would venture that the main take-away is that it's unlikely the US federal government will balance its budget any time soon unless households and/or firms start spending again.

In a recent article for an IMF publication entitled "Secular Stagnation: Affluent Economies Stuck in Neutral", economist Robert Solow (MIT) discussed the business sector's net lending position as a possible sign that there may be a "shortage of investment opportunities yielding a rate of return acceptable to investors" or, stated differently, that the "real rate of interest compatible with full utilization is negative, and not consistently achievable", a situation associated with the notion of "secular stagnation":
In the United States, at least, business investment has recovered only partially from the recession, although corporate profits have been very strong. The result, as pointed out in an unpublished paper by Brookings Institution Senior Fellows Martin Baily and Barry Bosworth, is that business saving has exceeded business investment since 2009. The corporate sector, normally a net borrower, became a net lender to the rest of the economy. This does smell rather like a reaction to an expected fall in the rate of return on investment, as the stagnation hypothesis suggests. (see chart below)
Source: Baily and Bosworth, 2013
Secular Stagnation

So what can be done? Paul Samuelson and Anthony Scott asked a similar question in the 1971 Canadian edition of their Economics textbook:
What if our continental economy is in for what Harvard's Alvin Hansen called "secular stagnation"? - which means a long period in which slowing population increase, [...], high corporate saving, the vast piling up of capital goods, and a bias toward capital-saving inventions will imply depressed investment schedules relative to saving schedules? Will not active fiscal policy designed to wipe out such deflationary gaps then result in running a deficit most of the time, leading to a secular growth in the public debt? The modern answer is "Under these conditions, yes; and over the decades the budget should not necessarily be balanced." (1971:436-7)
In my next post, I'll write more about secular stagnation and policy responses to address its possible eventuality.

* This post by Brian Romanchuk contains many useful charts and information on financial balances, as well as discusses secular stagnation from a stock-flow consistent perspective.

Update: I added charts on 2014-10-14, following a comment by Ramanan.


Baily, M. N., B. Bosworth, "The United States Economy: Why such a weak recovery", September 11, 2013, Brookings Institution, Washington DC.

Samuelson and Scott, Economics, 3rd Canadian Edition, McGraw-Hill, 1971

Solow, R., "Secular Stagnation: Affluent Economies Stuck in Neutral", in Looming Ahead, Finance and Development, vol. 51 , no.3. September 2014.

Tobin, J., "Deficit, Deficit, Who's got the Deficit?", New Republic, January 19, 1963

Sunday, 12 October 2014

Paul Krugman on currency independence, circa 1999

If there's one macroeconomic observation that has gone from obscure to remarkably mainstream in recent years, it's that a nation that has given up its currency independence is at a big disadvantage relative to nations with independent, sovereign currencies, especially when it comes to options for addressing economic downturns and overcoming the aftermath of financial crises.

Paul Krugman has been a main proponent of this view. And he's been at it for a while.

Here's an excerpt from a classic piece by Krugman from 1999 on the ills faced by Argentina after it experimented with dollarization in the 90s:
The problem, you see, is that the same rules that prevent Argentina from printing money for bad reasons--to pay for populist schemes or foolish wars--also prevent it from printing money for good reasons such as fighting recessions or rescuing the financial system. [...] 
Now, these problems with a rigidly fixed exchange rate are not news. But for a while, currency-board enthusiasts managed to convince themselves that they weren't significant. They argued that as long as governments themselves followed stable policies--and as long as the economy was sufficiently 'flexible' (the all-purpose answer to economic difficulties)--there would be few serious recessions. 
But it turns out that history does not stop just because the currency is stable. And faced with a politically inconvenient recession, the Peronists find that there is nothing they can do. They cannot print money. They cannot even borrow money for some employment-generating public spending, because fiscal indiscipline would undermine the peso's hard-won credibility.
Read the entire column here.


Krugman, P., Don't laugh at me Argentina, Slate, July 20, 1999