...against fictions and other tall tales

Thursday, 29 March 2012

Steve Keen, terminology and the Walras-Schumpeter-Minsky Law

A quick post. Steve Keen believes that aggregate demand is income plus change in debt, and that this demand is spent not just on goods and services but also on buying financial assets.  For Keen, this view of aggregate demand is at the heart of what he calls the Walras-Schumpeter-Minsky Law.

Now, although I find much insight from Keen's work (especially his belief that the main source of struggle in the economy is between financial and industrial capital), I simply do not understand why he has to re-invent terminology this way.  Also, there are problems with looking at aggregate demand in this fashion.  Economist Marc Lavoie expressed caution with Keen's definition of aggregate demand last year in a commentary on the (always relevant) Relentlessly Progressive Economics Blog.  Lavoie summarized his thoughts on Keen's view that aggregate demand is equal to GDP plus the change in credit as follows:
This does not make much sense to me.  There is also a certain amount of double-counting since investment is often financed by credit.  Furthermore, if I get one million dollars in loans to purchase a house, credit goes up by one million; and if the seller of the house puts the proceeds in a bank account, this will have no effect whatsoever on GDP or economic activity. It may only have an impact on the price of houses.
But, for me, the problem with Keen's definition really remains one of terminology. In economics, practitioners should really strive to use commonly used terminology.  If not, then discussions on important policy issues become impossible since the focus tends to get bogged down on unimportant and time-consuming language concerns rather than on the issues that really matter.

Monday, 26 March 2012

Careful with the saving terminology: a reply to JKH

By Joseph Laliberté and circuit. The authors reside in Canada and come from two different heterodox backgrounds, namely, MMT and the post-Keynesian/circuitist tradition.


Much discussion took place lately regarding the proper meaning of the term “saving”. The issue surfaced when supporters of “Modern Monetary Realism” (a MMT offshoot) called out supporters of Modern Monetary Theory over the confusion they sometimes entertain when defining this term. Specifically, MMR contends that some MMTers often confuse “saving” with “saving minus investment” or “S-I”. The MMRers stress, correctly in our view, that “S” corresponds to “saving” rather than “S-I”. The anonymous blogger JKH has written extensively about this aspect and has even authored a detailed paper on this issue. We highly recommend this paper, as it provides an in-depth analysis and summary of this whole issue.

That being said, we wish to start off by saying that, while one could blame MMTers for putting too strong an emphasis on “S-I” rather than “S” in their analytical framework, it would be wrong to suggest that MMT’s lead proponents (i.e., Fullwiler, Mosler, Wray, etc) are not aware of the intricacies of the “saving” definition. Also, although it is true that some MMTers may have been sloppy at times in their use of terminology (for instance, we know of examples where MMTers have incorrectly referred to “S-I” as “saving” or “net losses”), it is unfair to characterize MMTers as being the only ones who get the terminology wrong. As Scott Fullwiler repeatedly and correctly pointed out, most of us at one time or another are guilty of using unclear or incorrect terminology, especially when commenting on blogs.

The objective of this post is to clarify terminology and demonstrate that JKH’s own choice of words regarding the notion of “saving” is not entirely without fault and could, as a result, mislead some readers. But before doing so, we wish to stress that we fully support the goal of both MMT and MMR (and JKH) in trying to put forth a more technically-sound approach to macroeconomics and economic policymaking. Indeed, it is our hope that all commentators would settle on a standard set of terminology moving forward.

Net Saving or Net Lending?

It is well-known that MMR and MMT have more or less officially adopted Wynne Godley’s terminology. Accordingly, both MMT and MMR would contend that “S-I” should be identified as “net saving” (of which the origin is most likely shorthand for “saving net of investment”). However, in our view, this terminology is not the most appropriate and could result in significant confusion for readers given that the term “net saving” in the OECD’s System of National Accounts refers to something entirely different from “S-I”. The correct terminology for (S-I) is in fact “net lending” (or “net borrowing”). Blogger Neil Wilson has been explicit on this point in the context of the aforementioned debate. In our view, “net lending/net borrowing” of the private domestic economy could also be appropriately described as the “sector surplus/deficit” of the domestic private economy.

Therefore, on the basis of the Statistics Canada glossary (which is in line with OECD terminology), the following terminology will be used in this post when referring to saving and investment:
  •  “S-I” is “net borrowing/net lending” of the domestic private sector (in the three sector model), where “S” is “gross saving” of the domestic private sector and “I” is “gross investment” (or gross fixed capital formation plus investment in inventories) of the domestic private sector. Gross saving does not include a deduction for capital consumption allowance (capital consumption allowance is known at the micro level as “depreciation”). Similarly, gross investment does not include a deduction for capital consumption allowance.
  •  “Net saving” of the domestic private sector, unlike “gross saving”, includes a deduction for capital consumption allowance. “Net saving” for the domestic corporate sector (a subset of the domestic private sector) is approximately equivalent to undistributed corporate earnings.
From the above definition, it is quite clear that households/corporations deploy their gross saving, not their net saving. In fact, it could be said that if gross saving is above zero, then it will be deployed in assets (either actively, as in the case of deployments in equipment, or passively, as when leaving it in a checking account) or deployed to reduce liabilities (e.g., repaying loans). If gross saving is above zero, deployment will occur even if net saving is zero or negative due to deduction of capital consumption allowance (i.e., depreciation). Statistics Canada drives this point home when it describes how gross saving is derived from net saving:
Added to this item [net saving] are capital consumption allowances (CCA). The latter are a cost reflecting the reduction in the value of fixed assets used up in production during the period (i.e., depreciation). Even so, they constitute available resources, since in practice, CCA is merely an accounting entry.
This is consistent with the definitions used by the OECD, and fully consistent with the approach used at the micro (business) level. Indeed, a business could in fact generate significant amount of gross saving and deploy them in various types of assets (real or financial) or to reduce liabilities while simultaneously running down its accumulated net savings (i.e., running down its accumulated retained earnings). This is why we argue that JKH’s flow equation S=I+(S-I) is really about gross saving and gross investment, as he himself mentioned when he described this equation as one of “portfolio balance” in which “the two major categories for the application of saving are investment and net financial assets”.

Gross Saving or Net Saving?

On the basis of the above, we would contend that JKH and other MMRers have themselves entertained some confusion over their interpretation of “saving” in two important ways.

First, JKH rarely specifies whether he talks about gross saving or net saving. Second, and more importantly, JKH at times seems to switch from gross saving to net saving in the same paragraph or in the same text. Nowhere is this confusion more apparent as in the comments by JKH that were published on the CNCB website. In those comments, JKH writes that:
Saving is described in proper accounting terms as funds sourced from income by virtue of being saved from income. The eventual deployment of that source of funds is described properly as a use of funds — whether such deployment and use occurs in the form of a bank deposit, a bond, a stock, newly produced residential real estate, or newly produced plant and equipment. The deployment or use of funds is separate from the act of saving itself.
In the paragraph above, JKH is referring to “deployment” and “use of funds” and, as such, ought to be talking about gross savings. Then, in the subsequent paragraph, he states the following:
In summary, the consolidated private sector account obscures, not only the view of saving as it materializes within a given accounting period in bifurcated fashion across household and corporate sectors separately, but also the view of total private sector saving as it is projected fully into the household balance sheet, when captured as a cumulative measure over a sequence of such accounting periods.
In the paragraph above, JKH should really be talking about net saving given that, after all, it is net savings that could be seen as “being projected fully into the household balance sheet, when captured as a cumulative measure over a sequence of such accounting periods”.  On this point, we think that JKH has unfortunately erred in his flow-stock reconciliation.  Flow is about the deployment (i.e., use of funds) of gross saving, as mentioned above. Stock is about cumulative net saving, as capital consumption allowance (depreciation) is netted out from both the asset side and the equity side when reconciling the flow to a balance sheet.  As you can see from the chart below showing corporate gross saving, net saving and net lending, from an empirical standpoint, this is not a minor point. Indeed, using Canada as an example, there is a very significant difference between the level of corporate gross saving and net saving in the national accounts (click on chart to expand).

Source: Statistics Canada and authors' calculations

Granted, the difference between gross saving and net saving will vary greatly between industries. For instance, in the service industry such as banking, the difference could be relatively small, but in capital intensive industries such as car manufacturing or oil and gas extraction, the difference could be very substantial.

Similarly, JKH repeats this error in his paper by again not specifying whether he refers to net saving or gross saving and by confusing the act of deployment of gross saving with net saving:
In summary, saving is a subset of income. It is a flow, not a stock. It is the residual of after-tax spending on consumption. (In the case of corporations, it is undistributed profit after the payment of all expenses including taxes and depreciation.) Saving is not the actual deployment of funds into asset acquisitions or liability reductions. Those events are defined subsequent to the fact of saving.
In the above paragraph, JKH is referring to the deployment of gross saving (i.e. use of funds) while also referring to “net saving” when he writes that, for a corporation, saving “is undistributed profit after the payment of all expenses including taxes and depreciation”.

Concluding remark 

Is JKH aware of the conceptual shortcuts he has employed when talking about the term “saving”? He is. At least one of the authors of this post has had exchanges with him on blogs about this issue and he has always been gracious and meticulous in his responses. So we are not about to claim that JKH does not know how to do proper stock-flow reconciliation.

Did JKH simplify his savings terminology so that his message about saving versus net lending is easier to assimilate for a general audience? We would say yes. And herein lies the paradox of academic expression. As a general case, we should always strive to be as precise as possible in terms of terminology or expression. But the necessity to get your message across to a general audience is bound to collide with our utopian goal to be perfectly and academically precise in the use of words.

So, in conclusion, we would argue that in trying to convince us that “saving” is different from net lending for the private domestic sector, JKH ended up using arguments that could be viewed as counter-productive in that they blurred the distinction between gross saving as it is deployed (use of funds) and recorded on a cash flow statement, and net saving as it is accumulated (as a stock) and recorded on a balance sheet.

Sunday, 18 March 2012

Alexander Field on crowding out and the role of public investment

In this new interview by the Institute for New Economic Thinking (INET), economist Alexander Field explains the role that public investment has in improving the productivity of the private sector during periods of slow economic growth. I thought it would make for a good follow-up to my previous post on the topic of crowding out.

On the issue of whether public expenditures resulted in the crowding out of private spending during the Great Depression, Field argues that:
"There's a clear and compelling argument about crowding out. It's really only relevant either from a theoretical or practical standpoint if the economy is close to potential or natural output. But then, as now, we were not close to full employment so there's no real problem in terms of monetizing government deficits.  It's not going to create an inflationary problem and it's not going to push up real interest rates"
You can find the rest of the interviews in this series on the INET website here.  Also, I previously discussed the productivity-enhancing properties of public investment here and here.

Wednesday, 14 March 2012

Deficit myths (Part 4): A note on crowding out

Maxime Bernier, Canada's federal Minister of State for Small Business and Tourism, wants us to believe that Keynesian policy remedies that aim to increase government spending in the economy have zero effect on aggregate demand.  According to Bernier, every time the government borrows funds from the private sector, the private lenders who lend to the government will have less money to spend or invest elsewhere, or will have less money to lend to other businesses.  Bernier sums up his thoughts as follows:
Government borrowing and spending goes up; private borrowing and spending goes down.  There is no net effect, no increase in overall demand.  It's like taking a bucket of water in the deep end of a swimming pool and emptying it in the shallow end.
In other words, according to Bernier, deficit spending by the government "always and everywhere" (to use Prof. Friedman's words) crowds out private sector spending and investment.

Here's the thing: this is like saying that government deficits fully crowd out private spending all the time, a completely untenable proposition.  The problem with this notion of "100 percent crowding out" is that it defies common sense and is not supported by the facts.  I have always found that the problem with this view of crowding out was best described by Francis Cavanaugh, a long-time career economist and executive with the US Treasury, in his book entitled The Truth about the National Debt.  According to Cavanaugh,
If we were to accept the argument that government deficits crowd out private investment, then we might accept the argument that government surpluses "crowd in" private investment.  By that logic, a tax increase resulting in a surplus would lead to an increase in private investment. The government takes more money from the private sector, and somehow the private sector has more money to save or invest. Nonsense. (p. 45)
Another problem with Bernier's claim that deficit spending by the government fully crowds out private investment is it implies that cuts to government spending must result in an offsetting increase in private sector spending.  That's like saying that public sector austerity leads to greater private sector spending.  However, as many economists would argue, the evidence to support this claim is very weak.

In fact, one of the most influential papers (by Alberto Alesina and Sylvia Ardagna) on the benefits of public sector austerity and the notion of "expansionary fiscal consolidation" is now being criticized on important methodological grounds.  The economist and former Chair of the Council of Economic Advisers, Christina Romer, sums up the criticism as follows:
Unfortunately, there turns out to be a lot of omitted variable bias in Alesina and Ardagna’s empirical analysis.  Some of their fiscal consolidations weren’t deliberate attempts to get the deficit down at all.  Rather, they were times when the budget deficit fell because stock price booms were pushing up tax revenues.  Stock prices were a big omitted variable.  They were driving the deficit reduction and were likely correlated with rapid output growth.  This omitted variable made it look as though deficit reduction was expansionary, when it really wasn’t. (2011:18)
Finally, it should be emphasized that, in the case of Canada, Bernier's claim that government budget deficits inhibit private sector investment is not supported by the facts.  As you can see in the chart below showing the (consolidated) government fiscal position and the total level of business investment in structures, machinery and equipment as a percentage of GDP since 1981, there is no relationship between the fiscal position of the government sector and level of business investment (click on chart to expand).  Indeed, the level of business investment remained within a fairly constant range during the entire period, regardless of whether the government sector was running a deficit or not.

Source: Statistics Canada

Alesina, A and Ardagna, S., "Large Changes in Fiscal Policy: Taxes vs Spending", NBER Working Paper No. 15438, October 2009

Cavanaugh, F. X., The Truth about the National Debt (Boston: HBS Press, 1996)

Romer, C., "What do we know about the effects of fiscal policy: Separating evidence from ideology?", Hamilton College Speech, November 7, 2011.

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

Saturday, 10 March 2012

The federal government: A big spender?

On March 29, Canada's federal minister of finance will table the budget for the upcoming fiscal year.  As always, in the weeks leading to "budget day", Canadians will be bombarded by commentaries from reporters, economists and politicians about the (supposedly) worrisome size of the federal budget deficit.

Just to put things in perspective, I thought it might be useful to include the following chart showing federal income and outlays as a percentage of GDP since 1990.  As you can see, federal government expenditures cannot be characterized as being out of control.  In fact, the chart shows that current federal spending is at one of the lowest levels in decades.

Rather, it would be more accurate to say that the budget deficit is being caused by the considerable decline in government tax revenues and the increase in federal transfers to persons (mostly employment insurance benefits) since the start of the downturn in 2008.  The Harper government's decision to lower the federal sales tax by two percent between mid-2006 and late 2007 is another important cause of the recent decline in federal tax revenues.