Robert Solow on 'Why Economies Grow'

As a follow-up and companion piece to my previous post, I decided to publish a transcription of a lecture on economic growth by Robert Solow that I transcribed originally as an aid for friends and colleagues who were studying economics. Although the lecture was given by Prof. Solow a few years ago during the height of the financial crisis, it contains loads of timeless insights, some of which is useful to be reminded of in the current situation, as discussions about the output gap resume in the next few years (see chart).

However, it's extremely important to keep in mind that in our current predicament as a result of covid potential GDP will also likely take a huge hit, as businesses and employees require some catching up in terms of business practices (misaligned with changing consumer preferences) and job training (due to skills entropy from employees being on furlough), to name only a few aspects that are likely to be impacted. In many ways, the post-covid period will bring us back to the type of economic analysis that used to occur a long time ago when natural catastrophes had significant and frequent impacts on economies' productive capacities.

The video of the lecture is included down below, though the sound quality is very bad, which is why I recommend reading the transcription instead (and you'll get through the transcript much faster by reading it).

Key insights are highlighted in bold font. Enjoy!

The business of this course is the long run. What are the sources of economic growth in the national economy or in the larger economy? Where does growth come from? And the policy implication – well, not implication, but policy question – is ‘How do you get an economy to grow rapidly and to have that growth widely shared in the nation?’
But there is a problem – it is a problem that appeared in the slides that Prof Newstone showed. It is a problem about getting there from here. So I’m going to start by talking a little bit about right now – this is not going to be the usual stuff about the financial crisis and all that – I have something else in mind.

There is something very odd about our economic situation in the US today. I read just recently an estimate from the Federal Reserve that about $7 trillion worth of wealth has been destroyed in the last year or year in a half (in 2008-2009). The country, so to speak, is $7 trillion poorer than it was.

When I wasn’t having a conversation with Cathy in the car, I was trying to divide 7 trillion by 300 million--the population of the US--in my head. It comes to about $23,000 for every man, woman and child in the country. Some, of course, have lost more, some have lost less.

What I want to point out is how strange that is: $7 trillion of wealth has gone down the drain but the productive capacity of the US economy – the capacity of our system to produce goods and service for its people – hasn’t diminished at all. In fact, it is undoubtedly higher than it was a year ago or 18 months ago: the labour force is a couple percent larger, the skills and education and training of the population is certainly not deteriorating and have probably gained. The net investment in capital has been positive – it’s been declining – but has been positive.

So we have a bigger stock of productive capital in the economy now than we did a year ago or 18 months ago. So the productive capacity of this economy is bigger than it was, despite of this $7 trillion of disappearance of wealth. If you are thinking of buying the US economy as a gift for your boyfriend or girlfriend, it would be worth just as much as it was worth – you know, like a used car – it would be worth just about as much as it was worth a year ago.

So in that sense we haven’t lost anything at all. But, of course, the point is we are in a recession. It is one year old according to pundits. And according to other pundits, or the same pundits, it’ll continue for at least until the second half of this year and maybe beyond. And the point is we are not using the productive capacity that we have.

You saw the unemployment numbers that Professor Newstone showed you. It is a lot harder to measure excess capacity in industry than it is to measure unemployment, but there are such figures, and they show an increase in unused capacity. So we have this machine for producing the goods and services for the population and we are not making full use of it. And that under-use of economic capacity, of productive capacity will go on for a long time. Even if the economy turns up in the second half of this year we will undoubtedly finish 2010 still with some slack in the economy because the slack disappears only gradually. 

So if you are interested – now, this is the point, this is why I started this way – if we are thinking about the long run growth of the economy (which means the long run growth of its capacity to produce), it’s not a separate but it’s an analytically slightly different problem to make sure that that capacity is used.

As long as we are not using all of the capacity that we have, the economy and the decision-makers in the economy are not likely to be motivated to do the things that increase potential output, that increase the productive capacity very rapidly.

So the short-run order of business – policy business – for us and every other rich country in Europe or Asia right now is to close that gap or narrow that gap between productive capacity and actual output, which means fundamentally trying to increase the demand for goods and services. And to do that in a way that at least doesn’t create obstacles to the long-run growth of the economy once the gap is closed, and maybe does some things that will help it.

So, imagine it is now January 2011 and the American economy and the economies of the other rich countries – developed countries of the world – are prospering reasonably well, are using their capacity, have closed that gap. Then the question is: What makes them grow? What economic activities that take place have the effect of increasing the capacity of the economy to produce useful goods and services? 

Now, you won’t be surprised – in fact, I’m staring at this monitor here and it says: so what determines the rate of economic growth in the economy? And that’s the question that I want to come to now, and it becomes relevant after we have done the short run task of closing that gap. There isn’t any one word or two word answer to that question. 

And I should make it explicit that I am thinking now about what determines the rate of economic growth in a rich economy, in an advanced industrial economy. I am not thinking about developing economies where the answers are related but the answers are somewhat different.

And the truth is that for an advanced economy the answers to that question – what are the sources of growth of national output, of productive capacity – are really the usual suspects. They are things we have known about now for quite a long time. And basically, what matters is what you might describe as investment in a very broad sense. I have to emphasize “in a very broad sense”.

What increases the productive of an economy like ours is investment in physical capital, in machinery, in computers and all the rest of that, investment in what economists call human capital, meaning skills and capacities of workers and people who work in the economy, and investment in new technology.

And here there is a slight difference between the US and even most of the countries in Europe. Not quite across the board but in most branches of industry the US is the technological leader. The gap was very big at the end of the Second World War and has closed considerably. But still, if you look at sector by sector, with some exceptions, the US is the technological leader.

Other countries of the world, that were even fairly rich countries have the luxury of being able to acquire technology by innovation, essentially by adopting, using what is already known. This country (i.e., the US) is in the position of having – so to speak – to invent its own future.

So basically, if we are looking now at the US, the things we have to look after in order to have a successful fairly high rate of growth (we can talk about the equity issues later) are a high rate of savings and investment in plant and equipment. I’d rather have the saving done here than abroad so that, in effect, the capital equipment that is built by investment in this country is owned in this country, and the returns to it stay in this country. It’s not necessary but it’s probably desirable. 

We need an extraordinary amount of emphasis – and we’ll talk more about this later – on investment in human capital, on producing the labour force that has the skills that are necessary to successfully operate that plant and equipment. And that is especially important because a country like this also has to invest in new technology. There is no place it can copy from – it has to in most cases create it itself.

Now, when I say new technology, the phrase tends to have a “high tech” air about it. But I don’t mean it that way.  New technology needn’t be high tech. It turns out that – in many ways – the most important contributors to productivity in the US over the last decade or two have been the application of information technology to wholesale trade, retail trade and financial services.

In fact, there are studies trying to understand why the major, big European economies, Germany, France, UK and Italy have lagged behind the US in productivity terms, general productivity terms. And the common answer seems to be that they have been slow to adapt the information technology to the service sectors. In manufacturing, there is very little gap, if any. But the gap is in the service sectors. 

So, this is extremely important. And I want to emphasize it, even at the risk of some repetition. One of the standard, valid, almost universal generalizations about the way people behave economically is that technically the income elasticity of the demand for services is high. All over the world, as incomes rise, personal incomes rise, people want to spend, [and] choose to spend a larger fraction of that income on services rather than goods. And you can understand why that should be so.

So this means that most of the rapidly growing advanced economies grow more rapidly in the service-producing sectors than in the goods-producing sector. There are exceptions to that. A country like Germany – to a lesser extent Japan, or formally Japan, not so much anymore – has a strong bias toward trying to make its living from simply exporting high quality manufactured goods. You notice I said exporting because the population of Germany, like the population of anywhere else, wants to consume services as it gets rich, not goods.

So those are the things, the essentially important things that a country like the US needs to do to generate long-run growth of productive capacity. 

I should say, in terms of policy, that you should beware of any universal advice like “well, the market will take care of that”. You know, if the alternative to the free-market economy is some kind of central planning, there is no question to where the advantage lies. But there is absolutely no evidence in the historical record of the advanced economies that zero regulation or weak regulation of industry is somehow conducive to rapid growth, or that minimal involvement of the government in the economy is conducive to rapid growth.

The functions of the government in terms of long run growth are just what you would deduce from what I have already said: promoting research and development, providing incentives for investment when they are lacking, taking care of education, and looking after mobility. By the way, it is probably also true that a country – there is less evidence for this generalization, but it’s probably also true – that business cycle instability is bad for economic growth.

For countries that are given to wide fluctuations like the ones we were looking at a few minutes ago, that’s not helpful for long-run growth because it adds to uncertainty. The likelihood of broad fluctuations adds to uncertainty is bad for all forward looking activities, like investment, like mobility, like education.

I wanted to say one more thing about the issue of mobility. When I say mobility, I mean industrial mobility and occupational mobility. In a rapidly growing, technologically-based economy, people have to change the nature of their jobs frequently and capital has to flow freely from obsolescent industries to new industries.

It is very important when you come in this course to talk about issues of equity. I think it is very important to find ways so that the burdens that are associated with necessary mobility don’t fall on workers and other people who are ill-equipped to prepare them [for that eventuality].

Dislocation and sometimes dislocation is probably an inevitable part of fast, mainly technologically-based growth. But it is the task of economic policy to find ways of combining that with income security, up to now, where it’s mostly below the median for incomes.

The macroeconomics of Robert Solow: A partial view

During a hearing before a Congressional Committee on Science and Technology, Robert Solow (MIT) described himself as a "generally quite traditional, mainstream economist".

In my view, either Prof. Solow is unaware of who qualifies as a "traditional, mainstream economist" these days or the definitions of the words "traditional" and "mainstream" need to be completely changed!

Consider, for instance, his views on the notion of "expansionary fiscal consolidation":

[H]ow does a human race with limited intelligence...deal with situations in which the short run need for policy are quite different from the long run need for policy? The feeble-minded, it seems to me, attempt to solve this problem [by asserting] that fiscal consolidation is really expansionary in the short run. I have never been able to understand the mental processes that underlie that statement. But I will take it seriously only -- only -- when its protagonists faced with a situation of clear excess demand propose fiscal expansion. Because if fiscal consolidation is expansionary then fiscal expansion must be contractionary. I don't believe that would happen. So I don't take that argument seriously at all. I think it's cooked up to make a real difficulty go away. (The Feasibility of European Monetary and Fiscal Policies: Rethinking Policy from a Transatlantic Perspective)

...on the supposed lack of microfoundations in Keynesian economics:

You know, there is something a little ludicrous in the belief that microfoundations for macroeconomics were invented some time in the 1970s. If you read Keynes's General Theory or Pigou's Employment and Equilibrium (or many lesser works) you will see that they are full of informal microfoundations. Every author tries to make his behavioral assumptions plausible by talking about the way that groups or ordinary economic agents might be expected to act...But you can recall Keynes's argument that the marginal propensity to consume should be between zero and one, or his discussion about whether the marginal efficiency of investment should be sensitive to current output or should depend primarily on "the state of long-term expectations". Those are microfoundations. (2004, p. 659)

...on the claim there is a connection between the money supply and price level:

[T]he financial press sometimes writes as though there is some special direct connection between the money supply and price level. So far as fundamentals are concerned, monetary policy works through its effects on aggregate nominal demand, just like fiscal policy, in the long run, too. The only direct connection I can think of is itself the creation of pop economics. If business people and others become convinced that there is some causal immaculate connection from the money supply to the price level, completely bypassing the real economy, then the news of a monetary-policy action will generate inflationary or disinflationary expectations and induce the sorts of actions that will tend to bring about the expected outcome and thus confirm the expectations and strengthen the underlying beliefs. (1998:4)

...on the problem with Milton Friedman's reliance on correlations between and M and other variables to infer policy conclusions and the assumption of an exogenous money supply (with John Kareken):

The unreliability of this line of argument is suggested by the following reducto 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, 1963, p. 16)

...on choosing the right model in macroeconomics:

[I] believe rather strongly that the "right" model for an occasion depends on the context --  the institutional context, of course -- but also on the current mix of beliefs, attitudes, norms, and "theories" that inhabits the minds of businessmen, bankers, consumers, and savers. (2004, p.xi)

...on the problems with the DSGE model:

I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way. I do not think that this picture passes the smell test. The protagonists of this idea make a claim to respectability by asserting that it is founded on what we know about microeconomic behavior, but I think that this claim is generally phony. The advocates no doubt believe what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether. (For more, see here and here)

...on the difference between budgetary and real resources costs:

The trouble is that the great world -- including a large part of the intellectual world -- has lost sight of the fundamental difference between budgetary costs and real resource costs. An unemployed worker and an underutilized or idle plant is not something we're saving up for the future. Today's labor can't be used next year or the year after. And the machine time in a plant that's down can't be redone two years from now or three years from now. Three years from now we hope that the plant will be running for current uses. So there's that important sense in which idle resources are almost - and maybe literally - free to the economy. The problem is to get them used in a reasonable way. (see 22:00 here):

...on the importance of fiscal policy for stabilization purposes:

I start from the belief that non-trivial imbalances of aggregate supply and demand do occur in modern industrial capitalist economies, and last long enough that public policy should not ignore them...When such imbalances occur, fiscal policy is a useful tool. The single instrument of monetary policy can not do justice to the multiplicity of policy objectives; and the Ricardian equivalence claim is in practice not nearly enough to convince a realist of the ineffectiveness of fiscal policy. The real obstacles to the rational conduct of fiscal policy are the uncertainties about the proper target for real output and employment, and the tendency for stabilization goals to become inextricably tangled in and distracted by distributional and allocational controversy. (Is fiscal policy possible? Is it desirable?, p. 23)

...on the long run potency of deficit spending financed by bonds vs. deficits financed by money creation, and on the contractionary nature of open market purchases of government bonds (with Alan Blinder):

[N]ot only is deficit spending financed by bonds expansionary in the long run, it is even more expansionary than the same spending financed by the creation of money. [Foonote: An interesting corollary of this is that an open-market purchase, i.e. a swap of B for M by the government with G unchanged, will be contractionary!] (Blinder and Solow: Does Fiscal Policy Matter? 1973)

...on how statements by a central bank can influence how the public translates relative price changes into expectations about the consumer price index:

There are various interest groups in the economy: bankers, investors, savers, lenders, borrowers, buyers and sellers and what not. There is no reason for them to react in the same way. How does one aggregate expectations?

...on the use of "expectations" to explain macro policy outcomes:

[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 data. (1998:93)

...on the claim of self-correcting markets and the role of aggregate demand in causing output fluctuations:

Capitalist economies do not behave like well-oiled equilibrium machines. For all sorts of reasons they can stray above or below potential output for meaningful periods of time, though apparently they are sightly more likely to stray below than above. Even apart from considerations of growth, macro policy should lean in the general direction that will nudge aggregate demand toward potential, whenever a noticeable gap occurs. The relevant point is that this strategy is also growth-promoting. Whatever the level of real interest rates, excessively weak aggregate demand -- and the prospect of weak and fluctuating aggregate demand -- works against investment. Few things are as bad for expected return on investment as weak and uncertain future sales...Successful stabilization contributes to growth too. (Role of macroeconomic policy, p. 301)

...on the need for public policy to address the unemployment of unskilled labor:

It needs to be insisted that the root of the problem lies in the enormous range of earning capacities generated by the interaction of modern technology (and other influences on the demand for unskilled labor) with the demographic and educational outcomes on the supply side of the labor market. There is no really good way for a market economy to deal humanely with that spread. (Too Optimistic)

...on the fallacy of self-correcting markets and the limits of monetary policy during deep recessions:

One important lesson that I hope we have learned from the crisis and the deep recession still going on is that economies like ours can experience uncomfortably long intervals of general excess supply or excess demand. Of course, we -- economists and interested civilians -- used to know that. But it was widely forgotten during the Great Moderation and the accompanying optimism among economists and civilians about smoothly self-correcting markets. The general belief than was that monetary policy was an adequate tool for taking care of any minor blip. During long and deep recessions, however, it has become evident that monetary policy may reach its limits without being able to generate enough aggregate demand to close the excess supply gap. (IMF Talk: Macro and Growth Policies)

...on the problems with Ricardian equivalence:

What might interfere with [the claim that it is optimal for households to save a tax reduction]? Any number of things: if households had been unable to consume as much as their optimal plan required because they lacked liquid assets and could not borrow freely, then the added liquidity provided by the tax reduction would enable them to consumer more now. If the Treasury were a more efficient, less risky, borrower than many households, then the appearance of some new public debt would also affect real behavior. And, of course, if consumers do not look ahead very far or very carefully, if they give little weight to the interests of descendants, or if they tend to ignore or underestimate the future implications of current budgetary actions, then Ricardian equivalence will fail, and tax reduction financed by borrowing will indeed be expansionary. All those "if" clauses strike me as very likely to be real and quantitatively important, and that suggests that Ricardian equivalence is not a practically significant limitation on fiscal policy. (Is fiscal policy possible? Is it desirable?, p. 12)

...on the problem with the natural rate of unemployment hypothesis:

Let me try to explain what nags at me in all this...We are left here with a theory whose two central concepts, the natural rate of unemployment or output and the expected rate of inflation have three suspicious characteristics in common. They are not directly observable. They are not very well defined. And, so far as we can tell, they move around too much for comfort -- they are not stable. I suspect this is an intrinsic difficulty. I have no wish to minimize the importance of, say, inflationary expectations. But we are faced with a real problem: here is a concept that seems in our minds to play an important role in macro behavior, and yet it's very difficult to deal with because it escapes observation and it even escapes clear definition. 

On the natural rate of unemployment, I think the behavior of the profession exhibits problems. In order to make sensible use of this kind of theory, you want the natural rate of unemployment to be a fairly stable quantity. It won't do its job if it jumps around violently from one year to the next. But that's what seems to happen. We, the profession, are driven to explaining events by inventing movements of the natural rate, which we have not observed and have not very well defined. The issue came up first in the passage of the big European economies from 2 percent unemployment, on average, to 8 or 9 percent unemployment, on average, within a few years. The only way to explain that within the standard model is to say that the natural rate of unemployment must have increased from something like 2 percent to something like 8 or 9 percent. The actual facts that could account for any such dynamics never seemed to me or to any critical person to be capable of explaining so big a change. So we are left with inventing changes in the natural rate of unemployment to explain the facts, and it is all done in our heads, not in any tested model. I regret to say that you often find this kind of reasoning: the inflation rate is increasing because the unemployment rate is below the natural rate. How do you know that the unemployment rate is below the natural rate? Because the inflation rate is increasing. I think we are all good enough logicians to realize that this is exactly equivalent to saying that the rate of inflation is increasing, and nothing more. 

It seems to me that we ought to be thinking much more about the determinants of whatever you choose to call it. I hate to use the phrase "natural rate" but of course I do. It was a masterpiece of persuasive definition by Milton. Who could ever want an unnatural rate of unemployment? (Fifty years of the Phillips Curve: A Dialogue on what we have learned, p.84)

...and more on the natural rate of unemployment:

There is nothing like an adjustable, unobservable parameter to keep a theory afloat in rough seas...I think the doctrine [of the natural rate of unemployment] to be theoretically and empirically as soft as a grape. To say that in the long run the unemployment rate tends to return to the natural rate of unemployment is to say almost nothing. In the long run the unemployment rate goes where it goes. You can call where it goes the natural rate; but unless you have a more convincing story than I have seen about the length of the long run and the location of the natural rate, you are only giving a tendentious name to a vague concept (1998, pp. 9, 91)

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.

References

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.

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.

Reference 

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

Deficit spending got the US out of the Great Depression: Paul Samuelson on helicopter money

Paul Samuelson, circa 2008 (see here at 1:31):

I'm full of sensible heresies. How do you think we got out -- in Roosevelt's time -- got out of that depression? How do you think the pernicious Adolf Hitler -- inheriting about the same, at least one third unemployment -- got out of it? And both of us got out of it in about the same number of years as you are getting to 1939. If you look at Mrs Schwartz's analysis of that, it's completely remote from the truth. 

This is not how it happened, but this is equivalent to how it happened: somebody invented helicopters. And somebody went to the printing press and printed-off millions and billions of legal tender. And then those helicopters flew over the poorer rural regions and the slums of the city. And it wasn't a problem of whether the money was going to be saved or wasn't going to be spent. It had nothing to do with pump-priming...It had nothing to do with jump-starting. [...] It was not a Federal Reserve operation.[...] 

Now, Mrs Schwartz and her collaborator, who's name I forgot at this moment [laughter], would say "well that helped to keep the M up". That's a joke! [The banker] didn't go out and start making new loans. He acquired more Treasury certificates, which had a yield of essentially zero. 

So we never got out of the Great Depression? Yes, we did. We did it essentially by deficit spending [...] 

The rest of this excellent discussion is well worth a careful listen.

Addendum : An ingenious reader has created a direct link to this excerpt on You Tube (see here). 2013-11-07

The Old Keynesian prescription to get out of a deep recession

In my previous post, I highlighted an article that shows the most promising unconventional monetary policies for boosting ailing economies right now are overt monetary financing and the policy measures advocated by neo-chartalists.

It's worth mentioning that, from a practical standpoint, this is essentially what the traditional, Keynesian IS-LM model would prescribe in a context of high public debt combined with nominal interest rates at the zero lower bound.

A good example of the application of IS-LM toward this end is Robert Gordon's analysis of the difficulties facing Japanese policymakers in the 1990s:

If monetary policy is impotent because it cannot reduce the interest rate any further, a fiscal stimulus is required to end the slump and bring back the output ratio back to its desired level [...]

The low level of the Japanese interest rate created a policy dilemma in Japan. Monetary policy could not push interest rates appreciably lower, yet fiscal policymakers felt constrained in achieving a large fiscal stimulus by the high existing level of the fiscal deficit in Japan and by the fact that the public debt in Japan had reached 100 percent of real GDP. 

However, the IS-LM model suggests a way out of the Japanese policy dilemma... [:] a combined monetary and fiscal policy stimulus that shifts the LM and IS curves rightward by the same amount can boost real GDP without any need for a decline in interest rates [...]

Also, with such a combined policy there is no need for a further increase in the national debt held by the public, since to achieve its monetary expansion, the central bank can buy the government bonds issued as a result of the increased fiscal deficit [...]

Why did the Bank of Japan resist what seemed to be the obvious solution, which was that the Bank buy up the government bonds issued as a result of the fiscal stimulus? This solution, sometimes called "monetizing the debt", would be the real-world equivalent of shifting the LM curve rightward along with the IS curve, in contrast to the increased interest rates that would result if the IS curve were pushed rightward without a corresponding rightward LM movement. Bank of Japan policymakers retreated into the traditional fear of central bankers that monetizing the debt would undermine the Bank's independence and credibility, two goals that are embedded in the structure of beliefs of central bankers. In fact, as a result of rapid inflation after World War II, the Bank is legally banned from buying bonds directly from government, although it is still able to purchase government bonds indirectly through financial markets. 

The traditional reason for the historic reluctance of central bankers to monetize the debt and conduct a simultaneous monetary and fiscal expansion has been fear of inflation. Yet Japan's problem in the late 1990s was deflation, not inflation [...]

While the prescription of the IS-LM model in favor of a combined monetary-fiscal expansion seemed clear, implementing this policy recommendation was blocked by the reluctance of the Bank of Japan's to give up its historic commitment to price stability. (137-138) (emphasis added)

One final word. This type of policy solution goes back a long way. A variant of this mechanism -- minus the IS-LM language -- is even found in (Keynesian) Lorie Tarshis's textbook published in 1947.

Reference

Gordon, R., Macroeconomics, Eighth Edition, 2000.

Which unconventional monetary policies hold most promise?

Kudos to Biagio Bossone, Chairman of the Group of Lecce and former central banker (and circuit theorist par excellence), for his first-rate analysis (see here: part 1 and part 2) of the different types of unconventional monetary policy measures that have been implemented and proposed in the last few years!

Bossone's piece does a fantastic job of presenting the different policy proposals into six distinct categories based on their implied transmission channel and the degree of cooperation between the fiscal and monetary authorities that is required in order to implement the proposed measures.

The main take-away from the analysis is that Bossone finds the proposals that aim to boost aggregate demand via fiscal actions are the most promising. According to Bossone, the benefits of fiscal measures (with or without actions by the monetary authority) are that their effect is more direct than policy measures such as quantitative easing (which works indirectly via its impact on interest rates) or forward guidance (which works indirectly via its effect on the public's expectations on future interest rates).

In the concluding paragraph, Bossone writes,

...this result vindicates the proposed measures to expand the money supply via overt monetary financing or neo-chartalism, which aims to inject new money independently of central banks' interest-rate policies, especially if these are limited by the zero lower bound.

Reference

Bossone, B., Unconventional monetary policies revisited, Part 1 and Part 2, Vox, October 2013

Impact of the US Payroll tax cut...and tax hike

This is a very informative (and short) piece by economists at the NY Fed on the effect of the 2011 US payroll tax cut and its recent expiration.

Here's a good summary:

Overall, our analysis suggests that the payroll tax cut during 2011-12 led to a substantial increase in consumer spending and facilitated the consumer deleveraging process. Based on consumers’ responses to our recent survey, expiration of the tax cuts is likely to lead to a substantial reduction in spending as well as contribute to a slowdown or possibly a reversal in the paydown of consumer debt. These effects are also likely to be heterogeneous, with groups that are more credit and liquidity constrained more likely to be adversely affected. Such nuances may be lost in the aggregate macroeconomic statistics, but they’re important for policymakers to consider as they debate fiscal policy.

Reference

Zafar, B., van der Klaauw, W., My Two (Per)cents: How are American Workers dealing with the Payroll Tax Hike, Federal Bank of New Work, Liberty Street Blog.

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.

Public investment and productivity growth: How to provide properly for the future

Just as I was thinking about the moral aspects of economic policy, here comes Paul Krugman with a fantastic commentary on how governments today are shortchanging future generations by not taking advantage of record low interest rates and not spending on productivity-enhancing public investments:

Fiscal policy is, indeed, a moral issue, and we should be ashamed of what we’re doing to the next generation’s economic prospects. But our sin involves investing too little, not borrowing too much — and the deficit scolds, for all their claims to have our children’s interests at heart, are actually the bad guys in this story. 

So true. This reminds me of something the late economist Robert Eisner wrote:

...balancing the budget at the expense of our public investment in the future is one way that we really borrow from our children - and never pay them back. (1996)

The reason for this is that the "deficit equals bad" crowd is completely oblivious to the fact that public investment adds to the stock of productive assets that help to enhance private sector productivity in the long run. And public spending on infrastructure, education, basic research and the development of new technology is essential to achieve the level of productivity necessary to improve our standard of living in the future.

And at a time when we are facing an aging population, increasing our future productivity growth should be a (if not the number one) priority.

A good explanation for this is provided by Francis Cavanaugh, former senior US Treasury Department economist and former CEO of the Federal Retirement Thrift Investment Board, who argues that

Significant productivity increases will be necessary as a diminished labor force is called on to support an expanded group of retirees. Without such increased production per worker, a shortage of goods will lead to price increases, and it is likely that the baby boomers will suffer a significant decline in the purchasing power of their retirement dollars. Inflation could soon decimate their retirement savings. That's the economic reality; if you're not working, you're dependent on the productivity of those who are. (1996)

In other words, the best protection against the potential losses that come with an aging population is to take measures today aimed at increasing the productivity growth of tomorrow. This should be the long term goal of policymakers right now.

So Prof. Krugman is right: contrary to what most politicians and commentators believe about how to improve our long-run prospect, slashing government spending is exactly the wrong thing to do at this time. 

References

Cavanaugh, F., The truth about the national debt, Boston: HBSP, 1996

Eisner, R., "The balanced budget crusade", The Public Interest, Winter 1996

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

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

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

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

As household net borrowing increases, the rate of unemployment declines

A closer view of recent years

Is there a moral aspect to economic policy?

From Ed Luce of the Financial Times (a good article):

Mr Bernanke’s grounding has given him the authority to dismiss those who view the meltdown through a moral lens and want to purge society for its excesses. Had he embraced this popular intuition, the US would now be following the UK into triple-dip recession. As Mr Bernanke noted in Texas shortly after Rick Perry, its governor, had all but threatened him with a lynch mob: “I am not a believer in the Old Testament theory of the business cycle.”

As a general rule, any argument pushing for less government intervention on moral grounds in a weak economy should be viewed with suspicion. "Less is more" can be an acceptable rule for making decisions of a personal nature but in the realm of economic policy, it's often just bad advice. This is largely because of the two-sided nature of any monetary transaction: your spending is my income, public sector spending is private sector income.

A few years ago, economist Ben Friedman examined how morality intersects with economics and public policy. His view is that government intervention, in terms of its impact on the lives of citizens through its role in fostering economic growth, 'less' is definitely 'less':

A commonly held view is that government policy should try, insofar as it can, to avoid interfering with private economic initiative: the expectation of greater profits is ample incentive for a firm to expand production, or build a new factory, while the prospect of higher wages is likewise sufficient to encourage workers to seek out training or invest in their own education...The best that government can do (so the story goes) is minimize taxes, or safety regulations...The "right" pace of economic growth is whatever the market - that is, the aggregate of all private decisions - would deliver on its own.

But this familiar view too is seriously incomplete. To the extent that economic growth brings not only higher private incomes but also greater openness, tolerance, and democracy -- benefits we value but that the market does not price -- and to the extent that these unpriced benefits outweigh any unpriced harm that might ensue, market forces alone will systematically provide too little growth. Calling for government to stand aside while the market determines our economic growth ignores the vital role of public policy: the right rate of economic growth is greater than the purely market-determined rate, and the role of government policy is to foster it. (2005:14)

The point here is that public policy positively influences a society's moral character when it helps to raise living standards, which in turn affect the attitude of people toward themselves and encourages greater openness and tolerance.

Also, on a separate yet related point, it's really hard to believe there's any good to be found in the popular view that government action should be avoided because it (allegedly) stifles private sector initiative. On this point, I think Bill White of the Bank for International Settlements makes a good point:

...faced with serious deflationary tendencies, all of the weapons in the macroeconomic arsenal should be used to their full effect to ensure that aggregate demand is maintained. The concept of "creative destruction" has a certain intuitive appeal, but it should be remembered that the phrase was coined well before the onset of the Great Depression.

Reference

Friedman, B., The moral consequences of economic growth, 2005, New York, Knopf

Helicopter money: an operational view

Much has been written about Adair's Turner suggestion that central banks should consider financing public spending but I thought this short exchange between Adair Turner and economist Mario Seccareccia at an INET conference in 2011 is worth pointing out.

Here's Adair Turner's question:

[About Japan]...why wouldn't it been better still to do what Friedman said was the correct policy post facto in the 1930s, which is "helicopter money". Why wouldn't a better policy had been for the Japanese government to simply run fully, overtly, monetized deficits so that the last [inaudible] percent of GDP was not in the form of a debt contract held by the Japanese private sector but was in the form of absolute, categoric fiat money? (at 2:30 here)

This is Mario Seccareccia's response:

[About the] issue which had been raised about fiscal policy and the "helicopter drop" [vs conventional deficit spending]. That's a false dichotomy. I mean, deficit spending is -- in a sense -- monetization all the time. [Bond issuance is] how the central bank then behaves to clear or sterilize -- so to speak -- those reserves in the system in order to meet its interest rate policy. Period. There is no such thing as a "helicopter" doing this. It's always done through deficit spending fundamentally, I would argue. (at 9:00 here)

The point to remember when thinking about a central bank's ability to inject exogenous increases in reserve balances is that in a monetary regime such as Japan (and the UK for that matter) where the central bank targets an interest rate and the remuneration rate on reserves balances isn't set at the same level as its target interest rate, the central bank can't conduct offensive open market operations aimed at increasing the amount of reserve balances without simultaneously frustrating its goal of keeping its benchmark interest rate on target. Under such a regime the central bank's ability to control money growth is essentially limited to conducting defensive open market operations aimed at keeping its interest rate on target.

UPDATE: A very detailed look at the "helicopter drop" issue is found in Scott Fullwiler's article "Helicopter drops are fiscal operations" (2010). For a general discussion on offensive vs defensive open market operations, see Lombra, Herendeen and Torto, Money and the Financial System, page 425, 1980.

Fiscal austerity: A solution looking for a problem

Since the release earlier this month of the paper by IMF economists Olivier Blanchard and Daniel Leigh, I've noticed a lot of comments on blogs and news websites suggesting that the IMF economists and their inability to properly measure the size of the fiscal multiplier earlier are to blame for making political leaders believe that fiscal austerity could be expansionary and for misleading them into enacting austerity measures within their respective nations.

That's nonsense.  As if the decision to go down the road of austerity depended on a technical detail such as the potency of the fiscal multiplier.  Such a statement is as implausible as suggesting that some of the ill-advised military interventions in the Middle East during the last decade would have been prevented had those leaders who decided to enter those wars had been provided better intelligence.

Those looking to blame someone for the current disaster created by fiscal austerity should instead turn to the real culprits, the politicians themselves, as well as their horde of political aides who recommended a course of action that flies in the face of both common sense and empirical evidence.

As I discussed in an earlier post, the case against expansionary austerity was well established even before nations decided to enact austerity measures.  And amazingly, the empirical evidence against expansionary fiscal austerity stems from one of the most highly circulated economics papers of 2009, which, ironically, was branded as supporting the case for expansionary fiscal austerity.

This paper is the study by Alberto Alesina and Sylvia Ardagna, which found that the combination of austerity and growth occurred in 25 percent of the relevant episodes recorded by the OECD between 1970 and 2007 (2009, Data Appendix:Table A2).

In other words, the study demonstrated that the odds of successfully reducing public debt levels and achieving increased growth through austerity were 1 in 4.  As far as empirical support in favor of expansionary fiscal austerity goes, that's pretty weak.  With such information available, going ahead with austerity was tantamount to someone deciding to intentionally leave their umbrella at home knowing that there is a 75 percent chance of rain that day.  So much for the theory of the rational decision-maker!

And now economists are to blame?

The bottom line is that the disaster of austerity is not about economists getting it wrong.  Rather, it is a typical example of a policy-making failure: policymakers making decisions without regard for the facts.  But, more importantly, fiscal austerity was a prepackaged "solution to a problem" that fits with today's dominant policy-making ideology, which holds that governments have little or no purpose other than catering to financial interests and leaving the path clear for free-market actors to find solutions to every problem facing society.

To conclude, fiscal austerity is simply another example of a "solution looking for a problem", an empty and empirically ineffectual idea with no clear rationale other than giving the appearance that "something is being done".  In this sense, fiscal austerity joins the list of other well-known solutions looking for problems that have been tried and failed in the last thirty years such as deregulation, privatization, supply-side economics and so on.

References

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

Blanchard, O. and D. Leigh, "Growth Forecast Errors and Fiscal Multiplier", IMF Working Paper WP/13/1, January 2013

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

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

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

E. Domar

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

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

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

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

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

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

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

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

Then, Domar describes the merits of a budget deficit:

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

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

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

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

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

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

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

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

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

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

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

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

References

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

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

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

Behind the deficit: high interest rates and recessions

As a follow-up to my previous article, I thought I would post this chart:

Primary government balance, Source: Statistics Canada

It shows Canada's consolidated government financial balance with and without interest on the debt.  The government's primary budget balance (i.e., current revenue less spending excluding interest on debt) is a good indicator of the magnitude of fiscal policy, declining during downturns and rising when real GDP increases. (Refer to this Statistics Canada table to view the relevant data)

The chart shows a few things.  First, it shows that interest on the debt (and the Bank of Canada's high interest rate policy in the 1980s) was an important contributing factor to the size of the deficit in the 1980s and early 1990s.  Notice how the gap between the two series shrinks as we move towards the 1990s.

Second, it drives home the point that recessions have a significant impact on the size of the government budget deficit by increasing the use of automatic stabilizers (i.e., unemployment benefits and other expenditures) and reducing government tax revenues.  Note that the primary government balance reached a surplus during the late 1980s as a result of the deficit reduction efforts of the federal Tories under Mulroney and of the provinces (see arrow).  The primary government balance only declined again as a result of the recession of the early 1990s.  The end of the recession restored the primary surplus.

Third, it makes it clear (given the above) that the series of government surpluses that Canada witnessed starting in the mid- to late-90s had their roots in the fiscal policy measures of the 1980s (e.g., tax increases and spending cuts) rather than solely in the cutbacks of the 1990s under the federal Liberals and of the provinces.  This is a point that very few commentators in Canada appreciate.

But the main lesson to take away from the above is that the large budget deficit of the early 1990s was caused by the recession. It was not a consequence of 'out of control' government spending, as most are led to believe.

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.