Links for March 25

Some links, on short-termism, trade, the Fed and other things.

Senators Tammy Baldwin and Jeff Merkley have introduced a bill to limit activist investors’ ability to push for higher payouts. The bill, which is cosponsored by Bernie Sanders and Elizabeth Warren, would strengthen the 13D disclosure requirements for hedge funds and others acquiring large positions in a corporation. This is obviously just one piece of a larger agenda, but it’s good to see the “short-termism’ conversation leading to concrete proposals.

I’m pleased to be listed as one of the supporters of the bill, but I think the strongest endorsement is this furious reaction from a couple of hedge fund dudes. It’s funny how they take it for granted that shareholder democracy is on the same plane as democracy democracy, but my favorite bit is, “Shareholders do not cause bad management, just as voters do not cause bad politicians.” This sounds to me like an admission that shareholders are functionless parasites — if they aren’t responsible for the quality of management, what are we paying them all those dividends for?

I wrote a twitter essay on why the US shouldn’t seek a more favorable trade balance.

Jordan Weissman thinks I was “a bit ungenerous” to Trump.

My Roosevelt Institute colleague Carola Blinder testified recently on reform of the Fed, making the critical point that we need to take monetary policy seriously as a political question. “Contrary to conventional thinking, the rules of central banking are not neutral: Both monetary policy and financial supervision have profound effects on income and wealth inequality … [and] are the product of political contestation and compromise.” Relatedly, Mark Thoma suggests that the Fed “cares more about the interests of the rich and powerful than it does the working class”; his solution, as far as I can tell, is to hope that it doesn’t.

Matt Bruenig has a useful post on employment by age group in the US v the Nordic countries. As he shows, the fraction of people 25-60 working there is much higher than the fraction here (though workers here put in more hours). This has obvious relevance for the arguments of the No We Can’t caucus that there’s no room for more stimulus, because demographics.

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A reminder: “Ricardian equivalence” (debt and tax finance of government spending have identical effects on private behavior) was explicitly denied by David Ricardo, and the “Fisher effect” (persistent changes in inflation lead to equal movements of nominal interest rates, leaving real rates unchanged) was explicitly denied by Irving Fisher. One nice thing about this piece is it looks at how textbooks describe the relationship between the idea and its namesake. Interesting, Mankiw gets Fisher right, while Delong and Olney get him wrong: They falsely attribute to him the orthodox view that nominal interest rates track inflation one for one, when in fact he argued that even persistent changes in inflation are mostly not passed on to nominal rates.

Here is a fascinating review of some recent books on the Cold War conflicts in Angola. One thing the review brings out was how critical the support of Cuba was to South Africa’s defeat there, and how critical that defeat in turn was to the end of apartheid. We tend to take it for granted that history had to turn out as it did, but it’s worth asking if, in the absence of Castro’s commitment to Angola, white rule in South Africa might have ended much later, or not at all.


“Brazil in Drag”: Hyman Minsky on Donald Trump

Via Nathan Cedric Tankus, here is a recent JPKE article by Kevin Capehart on a 1990 lecture by Minsky that uses Trump as a case study of asset market bubbles in the 1980s. The lecture is fascinating, and not just as an odd historical artifact.

Here is what Minsky says about Trump:

One of the puzzles of the 1980s was the rapid rise in the financial wealth of Donald Trump, author of The Art of the Deal… Trump’s fortune was made in real estate. Many large fortunes have been made in real estate, since real estate is highly leveraged. Two factors made Trump somewhat unique — one was the he developed a fortune in the period of high real interest rates, and the second was that the cash flows on most of Trump’s properties were negative.

Trump’s wealth surged because the market value of his properties — or at least the appraised value — was increasing faster than the interest rate. Trump obtained the funds to pay the interest on his outstanding loans by increasing the draw under what in effect was a home equity credit line. The efficiency with which Trump managed these properties was more or less irrelevant — hence Trump could acquire the Taj Mahal in Atlantic City without much concern about the impacts on the profits of the two casinos he already owned. Trump was golden — he had a magic touch — as long as property prices were increasing at a more rapid rate than the interest rate on the borrowed funds.

The puzzle is that the lenders failed to recognize that the arithmetic of his cash flows was virtually identical with that of the developing countries [discussed earlier in the lecture]; in effect Trump was Brazil in drag. In the short run Trump could make his interest payments with funds from new loans — but when the increase in property prices declined to a value below the interest rate, Trump would become short of the cash necessary to pay the interest on the outstanding loans.

The increase in U.S. real estate prices in the 1980s was regional, and concentrated in the Northeast and in coastal California. … Real estate prices dipped in the oil patch, climbed modestly in the rust belt, and surged in those areas that benefitted from the rapid increases in incomes in banking and financial services — sort of a derived demand from the financial success of Drexel Burnham. In effect, those individuals with high incomes in financial services — and with the prospect of sharp increase in incomes — set the pace for increases in real estate prices.

Trump’s cousins were alive and well and flourishing in Tokyo, Taipei and Seoul especially in the second half of the 1980s. The prices of equities and real estate were increasing because they were increasing…

In any market economy the price of real estate will tend to reflect both its rental return and the rate of return on the riskless bond. … The price of land rises and the price of land sometimes falls — the relevant question is whether the anticipated increase in the price of land is sufficiently higher than the interest rate on bonds to justify a riskier investment.


The key question is why so many varied bubbles developed in the last several decades. The most general answer is that sharp changes in inflation rates and interest rates led to extremely volatile movement in asset prices. And once these price movements begin, then on occasion momentum may develop and feed on itself — at least for a while.

So in Minsky’s version of The Art of the Deal, there are three things you need to get rich like Trump. First, be an investor in NYC and New Jersey real estate in a period when land prices are rising rapidly there relative to the rest of the country. Second, be highly leveraged. And third — and this is critical — convert your equity to cash as quickly as possible to protect yourself from the post-bubble fall in prices. Picking the right individual properties doesn’t matter so much, and managing the properties well doesn’t matter at all.

In this analysis, the repeated bankruptcies of Trump-controlled properties don’t undermine his claims of business success, nor are they just an incidental footnote to it; they are an integral part of how he got so rich. Because the flipside of extracting cash from his properties through “what was in effect a home equity credit line” is that there was less equity left for the entity that actually owned them.

The trick to making money in an asset bubble is to cash out before it pops. Doing this by selling at the peak is hard; you have to time it just right. It’s easier and much more reliable to cash out the capital gains as they accrue; that just requires some way of moving them to a different legal entity. The precedent for Trump, in this reading, would be the utility holding companies that played such a big part in the stock market boom of the 1920s and were such a big target for regulation in the 1930s. Another parallel would be today’s private equity funds. To the extent that the funds cash out via so-called “dividend recapitalization” (special dividends paid by the acquired company to the PE fund) rather than eventual resale, an acquired company that doesn’t end in bankruptcy is money left on the table. It’s interesting, in this context, to think about Romney and Trump as successive Republican nominees: They may embody different cultural stereotypes (prissy Mormon patriarch vs womanizing New York vulgarian) but fundamentally they are in the same business of financial value extraction.

Links for March 14

A few things elsewhere on the web, relevant to recent conversations here.

1. Michael Reich and his colleagues at the Berkeley Center for Labor Research have a new report out on the impacts of a $15 minimum wage in New York. It does something I wish all studies of the minimum wage and employment would do: It explicitly decomposes the employment impact into labor productivity, price, demand and labor share effects. Besides being useful for policy, this links nicely to the macro discussion of alternative Phillips curves.

2. I like Susan Schroeder’s idea of creating a public credit-rating agency. It’s always interesting how the need to deal with immediate crises and dysfunctions creates pressure to socialize various aspects of the financial system. The most dramatic recent example was back in the fall of 2008, when the Fed began lending directly to anyone who needed to roll over commercial paper; but you can think of lots of examples, including QE itself, which involves the central bank taking over part of banks’ core function of maturity transformation.

3. On the subject of big business’s tendency to socialize itself, I should have linked earlier to Noah Smith’s discussion of “new industrialism” (including my work for the Roosevelt Institute) as the next big thing in economic policy. Eric Ries’ proposal for creating a new, nontransferable form of stock ownership reminded me of this bit from Keynes: “The spectacle of modern investment markets has sometimes moved me towards the conclusion that  the purchase of an investment [should be] permanent and indissoluble, like marriage, except by reason of death or other grave cause… For this would force the investor to direct his mind to the long-term prospects and to those only.”

4. In comments to my recent post on the balance of payments, Ramanan points to a post of his, making the same point, more clearly than I managed to. Also worth reading is the old BIS report he links to, which explicitly distinguishes between autonomous and accommodative financial flows. Kostas Kalaveras also had a very nice post on this topic a while ago, noting that in Europe TARGET2 balances function as a buffer allowing private financial flows and current account balances to move independently from each other.

5. I’m teaching intermediate macroeconomics here at John Jay, as I do most semesters, and I’ve put some new notes I’m using up on the teaching page of this website. It’s probably mostly of interest to people who teach this stuff themselves, but I did want to call attention to the varieties of business cycles handout, which is somewhat relevant to current debates. It’s also an example of how I try to teach macro — focus on causal relationships between observable aggregates, rather than formal models based on equilibrium conditions.

How to Think about the Balance of Payments: The US Position 2012-2013

In the previous post, I suggested that we should think of the various trade and financial flows in the balance of payments as evolving more or less independently, with imbalances between them normally accommodated by passive buffers rather than being closed by any kind of price adjustment. In that post I focused on the prewar gold standard. Here is a more recent example of what I’m talking about.

From 2012 to 2013 there was a general “risk on” shift in financial markets, with fears of a new crisis receding and investors focusing more on yield and less on safety and liquidity. In a risk-off environment investors prefer the safety of US assets even if yields are very low; in a risk-on environment, as we were moving toward in 2013, they prefer higher-yielding non-US assets.

Now, how was this shift in asset demand accommodated in the balance of payments? Orthodox theory suggests that there should be some offsetting change in interest rates and/or exchange rate expectations to keep demand for US and non-US assets balanced. But this didn’t happen — interest rate differentials didn’t close, and “risk-on” is associated with a falling rather than a rising dollar. And in fact, there was a large net outflow of portfolio investment: Net acquisition of foreign assets was $250 billion higher in 2013 than 2012, and net foreign acquisition of US assets by foreigners was $250 billion lower. Orthodox theory also says that if there is a net shift in investment flows, there should be an offsetting change in the current account. But the US current account shifted only $60 billion toward surplus, compared with the $500 billion net shift in portfolio flows. In a country with a fixed exchange rate, we would expect the remaining portfolio outflow to be accommodated by a fall in foreign exchange reserves. but of course the dollar floats, and the Fed does not hold significant reserves.

In fact, the entire shift was accommodated within the US banking system, most importantly by a rise in foreign-held deposits of $400 billion. Now this is an increase in US foreign liabilities, but it does not reflect a decision by anyone to borrow from abroad. It simply reflects the mechanics of international financial transactions. When an American spends money to purchase a foreign asset, the “money” they are using is a deposit at an American bank. When the asset is purchased, that deposit is transferred to the foreign asset-seller (or some intermediary), turning the deposit into a foreign liability of the bank. So the shift of portfolio investment out of the US does not require any change in prices (or incomes) to generate an offsetting flow into the US. The foreign liabilities that finance the purchase of foreign assets are generated mechanically in the course of the transaction itself.

Eventually, the effort to close out this residual long dollar position might produce downward pressure on the value of the dollar. And if the dollar does depreciate, that may increase demand for other US assets or for US exports sufficient to absorb the deposits. But there is no guarantee that either of these things will happen. And certainly they will not happen quickly. What we know for sure is that buffering within the banking system can offset quite large flows for substantial periods of time — in this case, a shift in portfolio flows of a couple percent of GDP sustained over a year. It might be that, with sufficient time, net sales of US assets might be large enough to push their price down, raising the yield enough to compensate for the lower safety premium. Or it might be that the downward pressure on the dollar will eventually lead to a big enough depreciation to raise US net exports enough to balance the portfolio outflow — but this will be a very long process, if it happens at all. It’s quite likely the portfolio will reverse for its own reasons (like a shift back toward “risk off”) before these adjustments even get started. Alternatively, liquidity constraints within the banking system may exhaust its buffering capacity before any other adjustment mechanism comes into play, requiring active intervention by the state or a catastrophic adjustment of the current account. (Presumably not in the case of the US, but often enough elsewhere.)

In practice, where we see payments balance maintained smoothly, it’s more likely because the underlying patterns of trade and investment are balanced and stable enough to not strain the buffering capacity of the banking system, rather than thanks to the operation of any adjustment mechanism.


How to Think about the Balance of Payments

There are many payments between countries — trade in goods and services, profits and interest paid to foreign capitalists, portfolio investment, FDI and bank lending, transactions between governments. All of these payments must balance out one way or another.

International-finance orthodoxy since David Hume has been about identifying an automatic mechanism that ensures that all these flows balance. This mechanism should take the form of a price adjustment, whether of the price level, the exchange rate, or the interest rate.

An alternative Keynesian approach is to make aggregate income the adjusting variable that maintains the balance of payments equality, just as it is in maintaining the domestic savings-investment balance. This is the idea behind balance of payments constrained growth.

Balance of payments constrained growth is certainly an improvement on the price adjustment mechanisms of orthodoxy. But I think it would be even better to consider both as items on a menu of things that may happen when a payments imbalance develops. The beginning of wisdom here is to recognize that there is no general mechanism that maintains payments balance. Changes in relative prices, exchange rates, interest rates or incomes may all play a role, depending on the timeframe we are considering and on the countries involved and the source of the imbalance.

Our theory of balance of payments adjustments should not begin with the universal logic of either orthodox or b.o.p.-constrained growth models, but with a concrete historical enumeration of the various sources of payments imbalance and the various kinds of adjustment in response to them.

We also need to consider other kinds of adjustment mechanisms, in particular, accommodation by buffers. This will always be the dominant mechanism if we are considering a short enough period. In the first instance, payments balance is maintained because there are some actors in the system who will passively take the other side of any open foreign exchange positions. The familiar example of this is a central bank that holds foreign exchange reserves: When it intervenes in the foreign exchange market, it passively allows its reserve position to adjust to accommodate whatever net demand there is for foreign currency. But there are also private buffers. In particular, there’s not nearly enough recognition of the special role of banks in the payments system, which requires them to take open foreign exchange positions when other units engage in cross-border transactions. An inflow of foreign investment, for instance, will in the first instance always result in a an increase in foreign assets in the banking system of the receiving country and foreign liabilities in the banking system of the investing country. How large are the imbalances that can be buffered in this way, and how long the banking system will passively maintain its open position without some other adjustment mechanism coming into play, are open questions. But there is no question that in the short run, the balance of payments is maintained through this sort of passive buffering, and not through any adjustment of either prices or incomes.

We also need to recognize the role of active policy in maintaining payments balance. We tend to think of policy “interventions” as modifications or “shocks” to an underlying structure of payments, but official actions may be an important adjustment mechanism by which that structure is maintained in the first place. This includes both bilateral or multilateral actions that generate offsetting official financial flows in the face of imbalances (important even in the19th century, in the form of central bank cooperation) and unilateral actions to limit outflows, including capital controls, import restrictions and so on.

The right starting point, I think, is to think of the various financial and trade flows as evolving essentially independently. If they happen to more or less balance, then the available buffers and whatever limited price adjustment is possible will be enough to maintain balance. If they don’t happen to balance, then the expected outcome is a crisis of some sort, ending with state intervention and/or a change in the “fundamental” parameters. There is no automatic mechanism that maintains balance. Where we see smooth payments balance over a long period time, it is probably because international payments are being actively managed by the authorities, or because productive capacities, import demands, asset preferences of foreign investors and so on have evolved to fit the existing pattern of payments, rather than vice versa.

The classic case is the London-centered gold standard system of the 19th century. Despite what someone like Barry Eichengreen will tell you, price flexibility was not an important element in the stability of this system. While prices and wages did rise and especially fall more freely before World War One, they almost always did so in parallel across trading partners, not in the opposite way that would offset trade imbalances. Instead, the system depended on the following institutionally specific features.

1. A large fraction of non-British savings, especially from Latin America and other less-developed countries, were held in London. This meant that many “international” payments simply involved a transfer from one British bank account to another, with no cross-border settlement required.

2. British foreign investment primarily funded purchases of British capital goods, so that financial outflows and exports naturally rose and fell together without the need for price adjustments.

3. The capital goods so purchased (for railroads especially) were largely used to produce exports to Britain, offsetting interest and divided payments back to London.

4. Slower growth in Britain was associated with lower interest rates there. So the slowdown in import payments abroad (due to lower incomes) was offset by an increase in foreign lending, which was quite interest-sensitive.

5. Within Europe central banks actively cooperated to offset any payments imbalances that did occur. On several occasions where there a net flow of gold from London to Paris seemed to be developing, the Bank of France made large loans to the Bank of England so that no actual gold had to move. In addition, the belief that gold convertibility would be maintained, or if suspended soon restored at the old parity, meant if a payments imbalance led to a deviation of the market exchange rate from the official parity, it would generate large speculative flows toward the depreciated currency.

6. Outside of Europe, crises and defaults were integral to the operation of the system. While interest-sensitive foreign lending meant that for England (and to some extent other European countries, and later the US), imports and financial outflows tended to move in opposite directions, higher interest rates could not reliably generate financial inflow for peripheral countries. Instead, the normal adjustment process for large imbalances was a catastrophic one in which large deficits periodically led to suspension of convertibility and default.

7. Over the longer run, the “fundamentals” in the periphery were shaped to produce payments balance at prevailing prices, rather than prices adjusting to fundamentals. Foreign investment financed development of export industries suiting the needs of the investing country, with higher-wage countries specializing in higher-value products. In settler colonies, migrant flows strengthened trade and financial links with the mother country.

Bottom line: there was no adjustment mechanism. Stability depended on the contingent fact that the prevailing “shocks” had roughly balanced effects on payment flows. Small imbalances were absorbed by buffers (which in the pre-WWI system included the cost of transporting gold). Large imbalances were actively managed or else led to the system breaking down, either locally, or globally as with the war.

For the gold standard era, I think the best statement of this perspective is Triffin’s “Myths and Realities of the So-Called ‘Gold Standard’.” Alec Ford’s The Gold Standard 1880-1914: Britain and Argentina is also very good (as is Barry Eichengreen’s discussion of it.) Peter Temin makes essentially this argument in his Lessons from the Great Depression — that the gold standard worked before World War I but broke down in the 1920s not because prices were more flexible before the war, but because in the prewar period it did not have to deal with big imbalances in trade and financial flows as developed after. Keynes makes the same larger point, as well as all seven of the specific points above, but at scattered places in his writing and correspondence rather than — as far as I know — in any single text. This perspective is in the same spirit as the “surplus recycling mechanism” that Varoufakis talks about in The Global Minotaur and elsewhere, the idea that there is no price mechanism that tends to bring about payments balance and so some specific institution is needed to offset persistent surpluses and deficits. (Though of course Varoufakis is focused on the more recent period.) The point that productive capacities are shaped by relative prices, rather than vice versa, was made by development economists like Arthur Lewis — it’s stated very clearly in his Evolution of the World Economic Order.

Obviously, the specifics will be different today. But I think the same basic perspective on the balance of payments still applies. Where payments balance exists, it is because of institutional factors that tend to generate offsetting disturbances to trade and financial flows, and because the international structure of production has evolved to generate balance at existing relative prices, rather than because prices have adjusted. And when imbalances do develop, they are accommodated first by passive buffers, and then either actively managed by authorities or else produce a breakdown in the system.


Note: I wrote most of this post in February 2015 and then for some reason never put it up. It really should have links, but given that it’s already sat around for over  year I decided to just put it up as-is. Since the original post was very long, I’ve split it into two parts. The second half is here


We’ve Always Had Free Trade with Eastasia

There’s nothing like trade to provoke full-throated defenses of economic orthodoxy. How many other topics are there where people would even use the phrase to mean what is correct, obvious, not to be questioned? For example,  Binyamin Applebaum in yesterday’s Times: On Trade, Trump Breaks with 200 Years of Economic Orthodoxy.

Donald J. Trump’s blistering critique of American trade policy boils down to a simple equation: Foreigners are “killing us on trade” because Americans spend much more on imports than the rest of the world spends on American exports. …

Add a few “whereins” and “whences” and that sentiment would conform nicely to the worldview of the first Queen Elizabeth of 16th-century England, to the 17th-century court of Louis XIV, or to Prussia’s Iron Chancellor, Otto von Bismarck, in the 19th century. The great powers of bygone centuries subscribed to the economic theory of mercantilism…

Etc. Restrictions on trade aren’t just mistaken, they’re  exotic, primitive, un-American, part of a dusty storybook world of kings and queens and whences.

I admit, this is an issue where I’m a bit of a heterodox bubble. I’ve been reading people like Ha-Joon Chang  so long, I forget how pervasive is the idea that the US has always practiced free trade (except for one terrible mistake in the 1930s.) I forget how unquestioned the myth of free trade is in the larger economic conversation. Because of course it is a myth. Here is Chang:

Between 1816 and the end of the Second World War, the U.S. had one of the highest average tariff rates on manufacturing imports in the world… The Smoot-Hawley Tariff of 1930, which Bhagwati portrays as a radical departure from a historic free-trade stance, only marginally (if at all) increased the degree of protectionism in the U.S. economy…

The following quote from Ulysses Grant, the Civil War hero and president of the United States from 1868 to 1876 clearly shows how the Americans had no illusions about [free trade]. “For centuries England has relied on protection, has carried it to extremes and has obtained satisfactory results from it. There is no doubt that it is to this system that it owes its present strength. After two centuries, England has found it convenient to adopt free trade because it thinks that protection can no longer offer it anything. Very well then, Gentlemen, my knowledge of our country leads me to believe that within 200 years, when America has gotten out of protection all that it can offer, it too will adopt free trade.”

Or here’s Paul Bairoch, whose book remains the esential reference on trade policy historically:

One should not forget that modern protectionism was born in the United States. In 1791, Alexander Hamilton, the first Secretaary of the Treasury, drew up his famous Report on Manufactures, which is considered to be the first formulation of modern protectionist theory. … The major contribution of Hamilton is the idea that industrialization is not possible wothout tariff protection. He was apparently the first to have used the term ‘infant industries.’ …

from 1861 to the end of World War II was [a period] of strict protectionism … the tariff in force from 1866 to 1883 provided for import duties averaging 45% for manufactured goods… When the United States caught up with European industry, … [that] rendered obsolete the ‘infant industries’ agument… The Republican party based its case for introducing the Mckinley Tariff of 1890 on the need to safeguard the wage levels of American workers

The McKinley Tariff, which raised duties to an average of 50 percent, became law, and its sponsor went on to be elected president. Applebaum might have mentioned McKinley. He might have mentioned Grant. He might have mentioned Abraham Lincoln, who as Chang points out, built his early campaigns as much on support for tariffs as on opposition to slavery. He might have mentioned Hamilton — I hear he’s really hot right now. But of course he didn’t: In America we’ve always practiced free trade. So instead we get Queen Elizabeth and Chancellor Bismarck.