The Slack Wire

Capital Mobility as Trojan Horse

In my Jacobin piece on finance, I observed in passing that financial commitments across borders — what’s sometimes called capital mobility — enforce the logic of markets on national governments. This disciplining role has been on vivid display in the euro area over the past few years. Here, courtesy of yesterday’s Financial Times, is a great example of the obverse: If a state does want to resist liberal “reforms”, it needs to limit financial flows across the border.

The headline in the online edition spells it right out:

Renminbi stalls on road to being a global currency. New capital controls lead to doubt, especially over hopes of forcing economic reform.

The print edition is wordier but even clearer:

Renminbi reaches its high water mark. Fresh capital controls cast doubt over the push to increase the global use of its global currency. But what does that mean for the Chinese policymakers who saw it as a ‘Trojan horse’ to force through economic reform?

The whole article is fascinating. On the substance it’s really quite good — anyone who teaches international finance or open-economy macroeconomics should bookmark it to share with students. Along with the political-economy question I’m interested in here, it touches on almost all the most important points you’d want to make about what determines exchange rates. [1]

The article’s starting point is that for most of the past decade, international use of the Chinese renminbi (Rmb) has been steadily increasing. Some people even saw a future rival to the dollar. For most of the period, the renminbi was appreciating against the dollar, and the Chinese government was loosening restrictions on cross-border financial transactions. But recently those trends have reversed:

The share of China’s foreign trade settled in its own currency has shrunk from 26 per cent to 16 per cent over the past year while renminbi deposits in Hong Kong — the currency’s largest offshore centre — are down 30 per cent from a 2014 peak of Rmb1tn. Foreign ownership of Chinese domestic financial assets peaked at Rmb4.6tn in May 2015; it now stands at just Rmb3.3tn. In terms of turnover on global foreign exchange markets, the renminbi is only the world’s eighth most-traded currency — squeezed between the Swiss franc and Swedish krona — barely changed from ninth position in 2013.

What appeared to be structural drivers supporting greater international use of the Chinese currency now appear more like opportunism and speculation.

Large financial outflows — including capital flight by Chinese wealthholders and currency speculators reversing their bets — have led the renminbi to lose 10 percent of its value against the dollar over the past year or so. The Chinese central bank (the People’s Bank of China, or PBoC) has had to use a substantial part of its dollar reserves to keep the renminbi from depreciating even further.

… the PBoC remains active in the foreign exchange market as buyer and seller. Over the past 18 months, this has mostly meant selling dollars from foreign exchange reserves to counteract the depreciation pressure weighing on the renminbi.

This strategy has been expensive, contributing to a decline in reserves from $4tn in June 2014 to $3.1tn at the end of November. Defenders of the PBoC believe such aggressive action to curb depreciation has been worth the price because it prevented panic selling by global investors. Critics counter that costly forex intervention has merely delayed an inevitable exchange-rate adjustment.

For years, the IMF, US Treasury and other outside experts have urged China to embrace a floating exchange rate. In theory, such a step should eliminate the need to tighten capital controls or to spend precious foreign reserves on propping up the exchange rate. Instead, the currency would weaken until inflows and outflows balance.

In the age of Trump, it’s worth stressing this point: The Chinese central bank has been intervening to make the renminbi stronger, not weaker — to keep Chinese goods relatively expensive, not cheap. This has been true for a while, actually, although you can still find prominent liberals complaining about China boosting its exports through “currency manipulation”.  Also, as the article notes, the Washington Consensus line has been that China should end foreign-exchange interventions and abolish capital controls, allowing the renminbi to depreciate even further.

For most countries, continuing to spend down reserves would be the only alternative to uncontrolled depreciation. But China, unlike most countries, has maintained effective controls over cross-border financial flows, so it has another option: limiting the ability of households and businesses to trade renminbi claims for dollar ones.

The State Administration of Foreign Exchange, the regulator, last week said it would continue to encourage outbound investment deals that support the country’s efforts to transform its economy… But the agency said it would apply tighter scrutiny to acquisitions of real estate, hotels, Hollywood studios and sport teams.

That will probably mean fewer food-additive tycoons buying second-tier UK football clubs. It also suggests a crackdown on fake trade invoices, Hong Kong insurance purchases and gambling losses in Macau — all channels used to spirit money out of China. …

“They are trying to squeeze out all the low quality or suspicious or fraudulent outbound investment. But they have also made it clear they support genuine high-quality investment,” says Mr Qu.

These moves come on top of other limits on financial outflows. This passage highlights a couple additional points. First, effective controls on financial flows require controls on cross-border transactions in general. Second, there’s no sharp line between macro policy aimed at the exchange rate or other monetary aggregates, and micro-interventions aimed at channeling credit in particular directions.

Now to the political economy point:

China’s recent moves to tighten approvals for foreign acquisitions by Chinese companies, as well as other transactions that require selling renminbi for foreign currency, cast further doubt on China’s commitment to currency internationalisation.

“There is a fundamental conflict between preserving stability and allowing the freedom and flexibility required of a global currency,” says Brad Setser, senior fellow at the Council on Foreign Relations and a former US Treasury official. “Now that the cost is becoming clear, Chinese policymakers may be realising they are not willing to do what it takes to maintain a global currency. Capital controls certainly set back the cause of renminbi internationalisation but they may well be the appropriate step given the outflow pressures.”

As a topic for banking conferences and think-tank seminars, renminbi internationalisation could not be beaten. It offered a way to express dissatisfaction with the US dollar-dominated monetary system, as laid bare by the 2008 financial crisis, while signalling an eagerness to do business with China’s large, fast-growing economy.

For China’s reform-minded central bank, however, renminbi internationalisation … offered something else: a Trojan horse that could be used to persuade Communist party leaders in Beijing and financial elites to accept reforms that were, in reality, more important for China’s domestic financial system than for the renminbi’s international status. Since 2010, when the internationalisation drive began, many of those reforms have been adopted…

This is the dynamic we’ve seen over and over. Real or imagined pressure from the outside — from international creditors , institutions like the IMF, “the markets” in general — is needed to push through a liberal agenda that would not be accepted on its own merits. This is true in China, with its multiple competing power centers and effective if disorganized popular protests, just as it is for countries with more formally democratic political systems. What’s unusual about China’s case is that the “reform” side may no longer be winning.

What’s  unusual about this article is that it’s spelled out so clearly. “Trojan horse”: Their words, not mine.

The article continues:

The totem of currency internationalisation also served as justification for China’s moves over the past half-decade to open up its domestic financial markets to foreign investment, a process known as capital account liberalisation, that has been crucial to the global push of the renminbi. If foreign investors are to hold large quantities of China’s currency, they must have access to a deep and diverse pool of renminbi assets — and the peace of mind of knowing that they are free to sell those assets and convert proceeds back into their home currency as needed.

Again, thinking of classroom use, this is a nice illustration of liquidity preference.

Until last week, regulators had also steadily loosened approval requirements for foreign direct investment, in to and out of the country.  But those reforms occurred at a time when capital inflows and outflows were roughly balanced, which meant that liberalisation did not create strong pressure on the exchange rate. Now, the situation is very different. Beijing faces a stark choice. Either row back on freeing up capital flows — as it has already begun to do this year — or relinquish control of the exchange rate and accept a hefty devaluation.

We used to talk about a trilemma: A country cannot simultaneously peg its currency, set interest rates at the level required by the domestic economy, and allow free financial flows across its borders. At most you can manage two of the three. But it’s becoming clear that for most countries it’s  more of a dilemma: If you allow free capital mobility, you can’t control either the exchange rate or domestic credit conditions. International financial shifts are so large, and so unpredictable, that for most central banks they’ll overwhelm anything that can be done with conventional tools.

And when you accept free capital mobility, with its dubious rewards, it’s not just control over interest rates and exchange rates you’re giving up. In the absence of  controls over international financial flows, the whole range of economic policy — of public decisions in general — is potentially subject to the veto of finance. If you need foreign wealth-owners to voluntarily hold your assets, the only way to keep them happy — so goes the approved catechism — is to adopt the full range of market-friendly reforms. The FT again:

Economists argue that the fate of renminbi internationalisation ultimately depends on far-reaching economic reforms rather than short-term responses to rising capital outflows.

The list of course starts with privatization of state-owned companies and continues with deregulating finance.

“When you reimpose capital controls after having rolled them back, it can sometimes have a perverse effect,” says Mr Prasad… “What they need to do is something much harder — actually to get started on the broader reform agenda and show that they are serious about it. Right now the sense is that there is very little happening on other reforms.”

This is what it comes down to: If China is going to reach the grail of international-currency status, it is going to have to focus on the “reform” agenda dictated by financial markets — it’s going to have to earn their trust and prove it is “serious.” What exactly are the benefits of that status for China? It’s far from clear. (Of course it’s an attractive prospect for Chinese individuals who own lots of renminbi-denominated assets.) But it doesn’t matter as long as it serves as a seemingly objective basis for continued liberalization, which otherwise might face serious resistance.

“The question is which is to be the master — that’s all.”

 


 

[1] It doesn’t, of course, mention uncovered interest parity, the idea that interest rate differences between currencies exactly offset expected exchange rate changes. This doctrine dominates textbook discussion of exchange rate movements but plays no role in any real-life discussion of them.

Demand and Productivity

I’m picking up, after some months, the project I was working on over the summer on potential output. Obviously the political context is different now. But the questions of what potential output actually means, how tightly it binds, and how close the economy is to it at any given moment, are not going away. Previous entries: onetwothreefour, and five.

*

You’ve probably heard the story about Ed Rensi, the former McDonald’s CEO who claimed the company’s move to replace cashier’s with self-serve kiosks was a response to minimum wage increases.

“I told you so,” he writes. “In 2013, when the Fight for $15 was still in its growth stage, I and others warned that union demands for a much higher minimum wage would force businesses with small profit margins to replace full-service employees with costly investments in self-service alternatives.”

Is this for real? Maybe not: The shift toward kiosks has been happening for a while, so it’s not just a response to the recent minimum wage hikes; and it may not end up reducing labor costs anyway.

But let’s say the move is as as Rensi claims. Then we should call it what it is: an increase in labor productivity. With fewer workers McDonald’s will produce just as many hamburgers; in other words, production per worker will be higher. [1]

As I’ve suggested, this sort of thing is a real problem for a certain strand of minimum wage advocacy. Advocates like to point to productivity gains in response to higher wages as an argument in their favor. (The gains are usually imagined in terms of loyalty, motivation, lower turnover, etc. rather than machines, but functionally it’s the same.) But productivity gains can only reduce the job losses from a minimum wage increase if those losses are large; they are not consistent with a story in which employment stays the same. [2]

But at the macro level, this dynamic has different implications. If the McDonald’s case is typical — if higher labor costs regularly lead to higher productivity — then we need to rethink our idea of supply constraints. There is more space for expansionary policy than we usually think.

Let’s start at the beginning. Suppose there is some policy change, or some random event, that boosts desired spending in the economy. It could be more government spending, it could be lower interest rates, it could be a rise in exports. What happens then?

In the conventional story, higher spending normally leads to greater production of goods and services, which in turn requires higher employment. This leaves fewer people unemployed. Lower unemployment increases the bargaining power of workers, forcing employers to bid up nominal wages. [3] These higher wages are passed on to prices, leading to higher inflation. When inflation reaches whatever level is considered price stability, then we say the economy is at full employment, or at potential output. (In this story the two are equivalent.) If spending continues to rise past this point, the responsible authorities (normally the central bank) will intervene to bring it back down.

This is the story you’ll find in any good undergraduate macroeconomics textbook. It’s a reasonable story, as far as these things go. In the strong form it’s usually given in, it implies a hard limit to how much demand can increase before inflation starts rising unacceptably. Once the pool of unemployed workers falls to the “full employment” level, any further increase in employment will lead to rapid increases in money wages, which will be passed on one for one to inflation.

One place this chain can break is that new workers are not necessarily drawn from the ranks of the currently unemployed — that is, if the size of the laborforce is endogenous. Insofar as people counted as out of the laborforce are in fact available for employment (or net immigration responds to demand), an increase in output doesn’t have to reduce the ranks of the officially unemployed. In other words, the official unemployment rate may underestimate the space available for raising output via increased employment. This motivates the question of how much the the fall in laborforce participation since 2007 is due to demographics, and how much is due to weak demand.

The conventional story can also break down at two other places if productivity growth is endogenous. First, output can increase without a proportionate increase in employment. And second, wages can rise without a proportionate rise in prices.

It’s useful to think about this in terms of a couple of accounting identities, which in my opinion should be part of every macroeconomics textbook. [4] The first is obvious (but worth spelling out), the second a little less so:

(1) growth in demand = percent change in labor productivity + percent change in employment + inflation

(2) percent change in nominal wages = percent change in labor productivity + percent change in labor share + inflation

The standard story is that productivity change on its own due to technology, and the labor shared is fixed and can be ignored in this context. If productivity and labor share can be taken as given, then an increase in demand (money spent on final goods and services) must lead to higher inflation if either employment fails to rise, or if it rises only with higher wages. In this story, if nominal wages rise thanks to a lower unemployment rats, that will pass on one for one to inflation. Pick up an advanced undergraduate textbook like Blanchard or Krugman or Carlin and Soskice, and you will find a Phillips curve of exactly this form, with exactly this story behind it. [5] Policy discussions at central banks conducted in same terms.

This is what underlies idea of hard supply constraints. Output growth is dictated by the fixed, exogenous growth of the laborforce and of productivity. If changes in demand push the economy off that fixed trajectory, all you’ll get is higher or lower inflation. Concretely: To keep inflation at 2 percent, unemployment must be such as to generate nominal wage growth 2 points above the technologically-determined growth of productivity.

But an alternative story is that variation in demand can lead to adjustment in one of the other terms. One possibility is that the laborforce adjusts, as participation rates vary in response to demand conditions. This is what is most often meant by hysteresis: persistent deviations in unemployment from the “natural” level lead to people entering or exiting the laborforce. That implies that even when headline unemployment rates are fairly low, further increases in employment may be possible without a rise in wages. Another possibility is that while higher employment will lead to (or require) higher wages, the wage increase is not passed on to prices but comes at the expense of profits instead. This is Anwar Shaikh’s classical Phillips curve; I’ve written about it here before.

A third possibility is that higher wages are accompanied by higher productivity. Again, this appears as a problem when we are talking about wage increases from legislation, union contracts, or similar developments. But it’s not a problem if the wage increases are thanks to low unemployment. In this case, the joint movement of wages and productivity just means that output can rise higher — that supply constraints are softer. That’s what I want to focus on now.

There are a number of reasons why productivity might rise with wages. Some of them simply amount to mismeasurement of employment — it appears that output per worker is rising but really the effective number of workers is. Others are more fundamental. If productivity responds strongly and persistently to demand, it blurs the distinction between aggregate supply and aggregate demand, to the point that it’s not clear what “potential output” even means.

*

Suppose we do find a consistent pattern where, if demand is strong, unemployment is low, and wages are rising rapidly, then productivity growth is high. What could be happening?

1. Increased hours. If we measure productivity as output per worker, as we usually do, then an increase in average hours worked will show up as an increase in productivity. There is a cyclical component to this — in recessions, employers reduce hours as well as laying off workers. According to the BLS, seasonally adjusted weekly hours fell from 34.4 prior to the recession to a low of 33.7 in summer 2009. While a 2 percent fall in hours might seem small, it’s a big change in less than two years, especially when you consider that real output per worker normally rises by less than 2 percent a year.

2. Workers moving into real jobs from pseudo-employment or disguised unemployment. In any economy there are activities that are formally classified as jobs but are not employment in any substantive sense — you can take these “jobs” without anyone making a decision to hire you, and they don’t come with a wage or any similar claim on any established production process. Joan Robinson’s examples were someone who gathers firewood in a poor country, or sells pencils on streetcorners in a richer one. You could add work in family businesses and various kinds of self-employment and commission-based work to this category. In countries with traditional rural sectors — not the US — work on a family farm is the big item here. These activities absorb people who are unable to find formal jobs; the marginal product of additional workers here is normally very low. So if higher demand draws people from this kind of disguised unemployment back into regular jobs, measured productivity will rise.

3. Workers may be more fully utilized at their existing jobs. Because hiring and firing is costly, business don’t immediately adjust staffing in response to changes in sales. when demand falls, businesses will initially keep some redundant workers because paying them is cheaper than laying them off and replacing them later; and when demand rises, businesses will first try to get more work out of existing employees rather than paying the costs of hiring more. Some of this takes the form of the hours adjustment above, but some of it simply takes the form of hiring “too little” or “too much” labor for the current level of production. These changes in the utilization of existing labor will show up as changes in labor productivity.

4. Higher wages may lead to more capital-intensive production. This is the McDonald’s story: When labor gets more expensive (or scarcer), businesses use more capital instead. This is presumably what people mean when they say “Econ 101” shows that rising wages lead to less employment (assuming they mean anything at all). This may be seen as a negative when it’s a question of raising wages through legislation or unions, but it shouldn’t be when it’s a question of rising wages due to labor scarcity. Insofar as businesses can substitute machines for labor, rising wages will not be passed on to prices, so there is more space to push unemployment down.

5. Productivity-boosting innovations may be more likely when demand is strong and wages rise. This is a variant of the previous story. Now instead of high wage leading business to adopt more capital-intensive techniques from those already available, they redirect innovation toward developing new labor-saving techniques. Conceptually this is not a big difference, but it implies a different signal in the data. In the previous case we would expect  the productivity improvements to be associated with higher investment and to be concentrated at the firms actually experiencing higher wages costs; in this case they might not be.

6. The composition of employment may shift toward higher-productivity sectors. This might happen for either of two reasons. First, higher wages will disproportionately raise costs for more labor-intensive sectors; these higher costs may be absorbed by profits or by prices, but either way they will presumably depress growth in those sectors to the benefit of less labor-intensive, more productive ones. Second, it may so happen that the more income-elastic sectors are also higher-productivity ones. In the short run this is presumably true since durables and investment goods are both capital-intensive and income-elastic. Over the longer run, the opposite is more likely — the composition of demand slowly but steadily shifts toward lower-productivity sectors.

7. The composition of employment may shift toward higher-productivity firms. This sounds similar but it’s a different story. Technical change isn’t an ineffable output-raising essence diffusing across society, it’s embodied in specific new production processes and new businesses — Schumpeter’s new plant, new firms, new men. This means that productivity increases often require new or growing firms to attract workers away from established ones. Given the “frictions” in the labor market, this will require offering a wage significantly above the going rate. And on the other side the fact that the least productive firms can’t afford to pay higher wages will cause them to decline or exit, which also raises average productivity. When wages are flat, on the other hand, low-productivity firms can continue operating. In this sense, higher wages are an integral part of productivity growth. [6]

8. There may be increasing returns in production. It may literally be the case that output per worker rises — at the firm, industry or economy-wide level — when the number of workers rises. Or this may be a more abstract version of some of the stories above. It’s worth noting that increasing returns is an area where the intuitions of people with economics training diverge sharply from people who look at the economy through other lenses. To almost anyone except an economist, it’s obvious that  costs normally fall as more of something is produced. [7]

All of these stories imply that higher demand should lead to higher measured labor productivity. But to figure out how strong this relationship is in reality, we’ll look at different data depending on which of these stories we think it works through.

Another important difference between the stories is they imply different domains over which the relationship should operate. The first three suggest a more or less immediate response of productivity to changes in demand, but also one that cannot continue indefinitely. There’s limits to how much hours per worker can rise and how much additional effort can be extracted from the existing workforce, and a limited pool of disguised unemployment to draw from. (The last is not true in developing countries, where the “latent reserve army” in subsistence agriculture may be effectively unlimited.) The other mechanisms are presumably slower, requiring a sustained “high-pressure economy.”  With these stories, increased demand may push the economy up against supply constraints, with rising inflation, bottlenecks, and so on; but if it keeps pushing against them, eventually they’ll give. In this case, potential output is a medium-term constraint — over longer periods it can adjust to actual output, rather than the reverse.  So in the opposite of conventional story, a temporary increase in inflation can lead to a permanent increase in output. People like Laurence Ball say exactly this about hysteresis, but they are usually thinking of the longer-run adjustment coming on the laborforce side.

If we follow this a step further, we could even say that in the long run, the big problem isn’t that excessively high wages do lead to the substitution of capital for labor but that excessively low wages don’t. People like Arthur Lewis argue that it’s the low wages of poor countries that have led to low productivity there, and not vice versa; there’s a well-known argument that the reason the industrial revolution happened first in Britain rather than in China or India (or Italy or France) is not that that the necessary technical innovations were present only in Britain. They were present many places; it was the uniquely high cost of British labor that made them profitable to adopt for production.

*

I think that productivity does respond to demand. I think this is a good reason to doubt whether the US economy close to “potential output” today, and to doubt what, if anything, this concept actually means. But I also think we need to be clearer about how they are linked concretely. If we want to tell a story about productivity responding to demand, it makes a difference which of the stories above we have in mind. Heterodox people, it seems to me, are too quick to just invoke Verdoorn’s law (productivity rises with output), and justify it with some vague comments about how labor is used more efficiently when it is scarce. [8] Does this apparent law work via substitution of machines for labor, or through fuller utilization of existing employees’ times, or through reallocation of labor to more productive firms and/or industries, or through a labor-saving-bias in technical change, or pure increasing returns, or what? If you’re just making a formal model it may not matter. But if we want to connect the model to concrete historical developments, it certainly does.

Personally, I am most interested in the reallocation stories. They shift our idea of the fundamental constraint on capitalist economies from biophysical resources, to coordination. The great difficulty for any program of raise or transform production —  industrialization, wartime mobilization, decarbonization — isn’t the limited supply of “real” resources, but the speed at which people’s productive activity can be redirected in a coordinated way. This connects with the historical fact that the more rapid and the larger scale is economic development, the more it requires some form of central planning. And it implies that at the most basic level, what the capitalist provides is not money or means of production, but cooperation.

To tell this story, it would be nice if big shifts in productivity growth took the form of changes in the composition of employment, rather than higher output per worker in given jobs. That may or may not be there in the data. For the more immediate question of how much space there is in the US for further expansion, it doesn’t matter as much which of these stories is at work, as long as we can show that at least some of them are. [9]

In the next post or two — which I hope to write in the next week, but we’ll see — I will ask what we can say about the link between demand and productivity based on historical US data. In particular, it’s fairly straightforward to decompose changes in output per worker into three components: within-industry output per hour, within-industry hours per worker, and shifts in the employment between industries. Splitting up productivity growth this way cannot, of course, directly establish a causal link with demand. but it can help clarify which stories are plausible and which are not.

 


 

[1] Throughout this discussion, I use “productivity” to mean labor productivity — output per worker or per hour. There is also “total factor productivity,” which purports to be a measure of output for a given input of labor and capital. This concept, which IMF chief economist Paul Romer memorably called “phlogiston,” is measured as the residual from a production function — the output growth the function does not explain. Since construction of the production function requires several unobseravable parameters, total factor productivity cannot be derived even in principle from economic data. It’s a fun toy for economic theory but useless for describing the behavior of actual economies.

Nonetheless it is widely used — for instance by the CBO as discussed here. As Nathan Tankus pointed out to me the other day, under the ARRA Medicare payments to hospitals are reduced each year based on an estimate of TFP growth for the economy as a whole. It’s a great example of the crackpot wonkery of the law’s authors.

[2] Unless productivity improvements all take the form of higher quality, rather than higher output per worker.

[3] This unemployment-money wages relationship was the original Phillips curve, but it’s better now to refer to it as a wage curve.

[4] It’s a topic for another time, but I think it would be very natural to replace the “aggregate supply” framework of the textbooks with these two identities.

[5] Other textbooks, like Mankiw, base the wage-unemployment relationship on a labor-supply curve rather than a bargaining relationship. Graduate textbooks, of course, replace the institutional detail of workers and employers with a single representative agent, in order to make more space for playing with math.

[6]  Andrew Glyn and his coauthors have a good discussion of this in the context of the postwar boom in  Capitalism Since 1945 (p. 122-123).

[7] For example, here’s Laurie Winkless in Science and the City, which happens to be sitting nearby:

Bessemer’s system rapidly began to change the world of steel manufacturing, and by 1875, costs had dropped to $32 (£23) per tonne. as always, in the supply-and-demand equation, the availability of cheap, high-quality steel made it immensely popular, leading to another huge drop in the price per tonne.

Winkless has made the mistake of studying the actual history of the steel history. If she were an economist, she would know that in the world of supply and demand, immense popularity makes prices rise, not fall!

[8] In Shaikh’s Capitalism, for example, there are a number of models that rely on the claim that productivity rises with output. It’s a big book and I may well have missed a part where he explains more fully why this is true. But as far as I can tell, all he says is that higher unit labor costs “provide a strong incentive for firms to raise productivity.”

[9] The politics of this question under Trump are for another time. But certainly Jeff Spross is right that we don’t want to oppose Trump’s (dubious) plans for a big stimulus by embracing the politics of austerity. We should not respond to Trump by reflexively insisting that the US is already at full employment, and by mocking “vulgar Keynesians” who think there might still be problems for macro policy to solve.

 

EDIT: Fixed the footnote numbering, which was garbled before.

Blogging in the Age of Trump

I haven’t written anything for this blog in the past month. Or rather, I’ve written quite a bit, but nothing I’ve felt comfortable posting. No surprise why.

On the one hand, I have — like everyone — opinions about the election, and the coming Trump presidency and broader Republican ascendancy. But none of those opinions seem especially insightful or original or coherent, and most of them I don’t hold with great confidence. I’m also not sure that this space is the right one for discussions of political strategy: Readers of this blog don’t constitute the kind of community for which the question “what should we do?” makes sense.

But on the other hand, it doesn’t feel right — it doesn’t feel possible — to just go on posting about the same economic questions as before, as if nothing has changed. Even if, in important ways, nothing has. And it still seems too soon to know where the terrains of struggle will be under the new administration, or to guess how the economic debates will reorient themselves along the new political field lines.

I’ve felt stuck. I know I’m not the only one who feels like they have nothing useful to say.

But you still have to get up in the morning, you still have to go to your job, you have to teach your classes, you have to write blog posts. So, back to work.

At Jacobin: Socializing Finance

(Cross-posted from Jacobin. A shorter version appears in the Fall 2016 print issue.)

 

At its most basic level, finance is simply bookkeeping — a record of money obligations and commitments. But finance is also a form of planning – a set of institutions for allocating claims on the social product.

The fusion of these two logically distinct functions – bookkeeping and planning – is as old as capitalism, and has troubled the bourgeois conscience for almost as long. The creation of purchasing power through bank loans is hard to square with the central ideological claim about capitalism, that market prices offer a neutral measure of some preexisting material reality. The manifest failure of capitalism to conform to ideas of how this natural system should behave, is blamed on the ability of banks (abetted by the state) to drive market prices away from their true values. Somehow separating these two functions of the banking system –  bookkeeping and planning –  is the central thread running through 250 years of monetary reform proposals by bourgeois economists, populists and cranks. We can trace it from David Hume, who believed a “perfect circulation” was one where gold alone were used for payments, and who doubted whether bank loans should be permitted at all; to the 19th century advocates of a strict gold standard or the real bills doctrine, two competing rules that were supposed to restore automaticity to the creation of bank credit; to Proudhon’s proposals for giving money an objective basis in labor time; to Wicksell’s prescient fears of the instability of an unregulated system of bank money; to the oft-revived proposals for 100%-reserve banking; to Milton Friedman’s proposals for a strict money-supply growth rule; to today’s orthodoxy that dreams of a central bank following an inviolable “policy rule” that reproduces the “natural interest rate.” What these all have in common is that they seek to restore objectivity to the money system, to legislate into existence the real values that are supposed to lie behind money prices. They seek to compel money to actually be what it is imagined to be in ideology: an objective measure of value that reflects the real value of commodities, free of the human judgements of bankers and politicians.

*

Socialists reject this fantasy. We know that the development of capitalism has from the beginning been a process of “financialization” – of extension of money claims on human activity, and of representation of the social world in terms of money payments and commitments. We know that there was no precapitalist world of production and exchange on which money and then credit were later superimposed: Networks of money claims are the substrate on which commodity production has grown and been organized.  And we know that the social surplus under capitalism is not allocated by “markets,” despite the fairy tales of economists.  It is allocated by banks and other financial institutions, whose activities are not ultimately coordinated by markets either, but by planners of one sort or another.

However decentralized in theory, market production is in fact organized through a highly centralized financial system. And where something like competitive markets do exist, it is usually thanks to extensive state management, from anti-trust laws to all the elaborate machinery set up by the ACA to prop up a rickety market for private health insurance. As both Marx and Keynes recognized, the tendency of capitalism is to develop more social, collective forms of production, enlarging the domain of conscious planning and diminishing the zone of the market. (A point also understood by some smarter, more historically minded liberal economists today.) The preservation of the form of markets becomes an increasingly utopian project, requiring more and more active intervention by government. Think of the enormous public financing, investment, regulation required for our “private” provision of housing, education, transportation, etc.

In  world where production is guided by conscious planning — public or private — it makes no sense to think of  money values as reflecting the objective outcome of markets, or of financial claims as simply a record of “real’’ flows of income and expenditure. But the “illusion of the real,” as Perry Mehrling somewhere calls it, is very hard to resist. We must constantly remind ourselves that market values have never been, and can never be, an objective measure of human needs and possibilities. We must remember that values measured in money – prices and quantities, production and consumption – have no existence independent of the market transactions that give them quantitative form. We must recognize the truth that Keynes – unlike so many bourgeois economists – clearly stated: a quantitative comparison between disparate use-values is possible only when they actually come into market exchange, and only on the terms given by the concrete form of that exchange. It is meaningless to compare  economic quantities over widely separated periods of time, or in countries at very different levels of development. On such questions only qualitative, more or less subjective judgements can be made.

It follows that socialism cannot be described in terms of the quantity of commodities produced, or the distribution of them. Socialism is liberation from the commodity form. It is defined not by the disposition of things but by the condition of human beings. It is the progressive extension of the domain of human freedom, of that part of our lives governed by love and reason.

There are many critics of finance who see it as the enemy of a more humane or authentic capitalism. They may be managerial reformers (Veblen’s “Soviet of engineers”) who oppose finance as a parasite on productive enterprises; populists who hate finance as the destroyer of their own small capitals; or sincere believers in market competition who see finance as a collector of illegitimate rents. On a practical level there is much common ground between these positions and a socialist program. But we can’t accept the idea of finance as a distortion of some true market values that are natural, objective, or fair.

Finance should be seen as a moment in the capitalist process, integral to it but with two contradictory faces. On the one hand, it is finance (as a concrete institution) that generates and enforces the money claims against social persons of all kinds — human beings, firms, nations — that extend and maintain the logic of commodity production. (Student loans reinforce the discipline of wage labor, sovereign debt upholds the international division of labor.)

Yet on the other hand, the financial system is also where conscious planning takes its most fully developed form under capitalism. Banks are, in Schumpeter’s phrase, the private equivalent of Gosplan, the Soviet planning agency. Their lending decisions determine what new projects will get a share of society’s resources, and suspend — or enforce — the “judgement of the market” on money-losing enterprises. A socialist program must respond to both these faces of finance.  We oppose the power of finance if we want to progressively reduce the extent to which human life is organized around the accumulation of money. We embrace the planning already inherent in finance because we want to expand the domain of conscious choice, and reduce the domain of blind necessity. “It is a work of culture — not unlike the draining of the Zuider Zee.”

*

The development of finance reveals the progressive displacement of market coordination by planning. Capitalism means production for profit; but in concrete reality profit criteria are always subordinate to financial criteria. The judgement of the market has force only insofar as it is executed by finance. The world is full of businesses whose revenues exceed their costs, but are forced to scale back or shut down because of the financial claims against them. The world is full of businesses that operate for years, or indefinitely, with costs in excess of their revenues, thanks to their access to finance. And the institutions that make these financing decisions do so based on their own subjective judgement, constrained ultimately not by some objective criteria of value, but by the terms set by the central bank.

There is a basic contradiction between the principles of competition and finance. Competition is imagined as a form of natural selection: Firms that make profits reinvest them and thus grow, while firms that make losses can’t invest and must shrink and eventually disappear. This is supposed to be a great advantage of markets.

But the whole point of finance is to break this link between profits yesterday and investment today. The surplus paid out as dividends and interest is available for investment anywhere in the economy, not just where it was generated. Conversely, entrepreneurs can undertake new projects that have never been profitable in the past, if they can convince someone to bankroll them. Competition looks backward: The resources you have today depend on how you’ve performed in the past. Finance looks forward: The resources you have today depend on how you’re expect (by someone!) to perform in the future. So, contrary to the idea of firms rising and falling through natural selection, finance’s darlings — from Amazon to Uber and the whole unicorn herd — can invest and grow indefinitely without ever showing a profit. This is also supposed to be a great advantage of markets.

In the frictionless world imagined by economists, the supercession of markets by finance is already carried to its limit. Firms do not control or depend on their own surplus. All surplus is allocated centrally, by financial markets. All funds for investment comes from financial markets and all profits immediately return in money form to these markets. This has two contradictory implications. On the one hand, it eliminates  any awareness of the firm as a social organism, of the activity the firm carries out to reproduce itself, of its pursuit of ends other than maximum profit for its “owners”. The firm, in effect, is born new each day by the grace of those financing it.

But by the same token, the logic of profit maximization loses its objective basis. The quasi-evolutionary process of competition – in which successful firms grow and unsuccessful ones decline and die  – ceases to operate if the firm’s own profits are no longer its source of investment finance, but both instead flow into a common pool. In this world, which firms grow and which shrink depends on the decisions of the financial planners who allocate capital between them. Needless to say it makes no difference if we move competition “one level up” – money managers also borrow and issue shares.

The contradiction between market production and socialized finance becomes more acute as the pools of finance themselves combine or become more homogenous. This was a key point for turn-of-the-last-century Marxists like Hilferding (and Lenin), but it’s also behind the recent fuss in the business press over the rise of index funds. These funds hold all shares of all corporations listed on a given stock index; unlike actively managed funds they make no effort to pick winners, but hold shares in multiple competing firms. Per one recent study, “The probability that two randomly selected firms in the same industry from the S&P 1500 have a common shareholder with at least 5% stakes in both firms increased from less than 20% in 1999 to around 90% in 2014.”

The problem is obvious: If corporations work for their shareholders, then why would they compete against each other if their shares are held by the same funds? Naturally, one proposed solution is more state intervention to preserve the form of markets, by limiting or disfavoring stock ownership via broad funds. Another, and perhaps more logical, response is: If we are already trusting corporate managers to be faithful agents of the rentier class as a whole, why not take the next step and make them agents of society in general?

And in any case the terms on which the financial system directs capital are ultimately set by the central bank. Its decisions — monetary policy in the narrow sense, but also the terms on which financial institutions are regulated, and rescued in crises – determine not only the overall pace of credit expansion but the criteria of profitability itself. This is acutely evident in crises, but it’s implicit in routine monetary policy as well. Unless lower interest rates turn some previously unprofitable projects into profitable ones, how are they supposed to work?

At the same time, the legitimacy of the capitalist system — the ideological justification of its obvious injustice and waste —  comes from the idea that economic outcomes are determined by “the market,” not by anyone’s choice. So the planning has to be kept out of site. Central bankers themselves are quite aware of this aspect of their role. In the early 1980s, when the Fed was changing the main instrument it used for monetary policy, officials there were concerned that their choice preserve the fiction that interest rates were being set by the markets. As Fed Governor Wayne Angell put it, it was essential to choose a technique that would “have the camouflage of market forces at work.”

Mainstream economics textbooks explicitly describe the long-term trajectory of capitalist economies in terms of an ideal planner, who is setting output and prices for all eternity in order to maximize the general wellbeing. The contradiction between this macro vision and the ideology of market competition is papered over by the assumption that over the long run this path is the same as the “natural” one that would obtain in a perfect competitive market system without money or banks. Outside of the academy, it’s harder to sustain faith that the planners at the central bank are infallibly picking the outcomes the market should have arrived at on its own. Central banks’ critics on the right — and many on the left — understand clearly that central banks are engaged in active planning, but see it as inherently illegitimate. Their belief in “natural” market outcomes goes with fantasies of a return to some monetary standard independent of human judgement – gold or bitcoin.

Socialists, who see through central bankers’ facade of neutral expertise and recognize their close association with private finance, may be tempted by similar ideas. But the path toward socialism runs the other way. We don’t seek to organize human life on an objective grid of market values, free of the distorting influence of finance and central banks. We seek rather to bring this already-existing conscious planning into the light, to make it into a terrain of politics, and to direct it toward meeting human needs rather than reinforcing relations of domination. In short: the socialization of finance.

*

in the U.S. context, this analysis suggests a transitional program perhaps along the following lines.

Decommodify money. While there is no way to separate money and markets from finance, that does not mean that the routine functions of the monetary system must be a source of private profit. Shifting responsibility for the basic monetary plumbing of the system to public or quasi-public bodies is a non-reformist reform – it addresses some of the directly visible abuse and instability of the existing monetary system while pointing the way toward more profound transformations. In particular, this could involve:

 1. A public payments system. In the not too distant past, if I wanted to give you some money and you wanted to give me a good or service, we didn’t have to pay a third party for permission to make the trade. But as electronic payments have replaced cash, routine payments have become a source of profit. Interchanges and the rest of the routine plumbing of the payments system should be a public monopoly, just as currency is.

 2. Postal banking. Banking services should similarly be provided through post offices, as in many other countries. Routine transactions accounts (check and saving) are a service that can be straightforwardly provided by the state.

 3. Public credit ratings, both for bonds and for individuals. As information that, to perform its function, must be widely available, credit ratings are a natural object for public provision even within the overarching logic of capitalism. This is also a challenge to the coercive, disciplinary function increasingly performed by private credit ratings in the US.

 4. Public housing finance. Mortgages for owner-occupied housing are another area where a patina of market transactions is laid over a system that is already substantively public. The 30-year mortgage market is entirely a creation of regulation, it is maintained by public market-makers, and public bodies are largely and increasingly the ultimate lenders. Socialists have no interest in the cultivation of a hothouse petty bourgeoisie through home ownership; but as long as the state does so, we demand that it be openly and directly rather than disguised as private transactions.

 5. Public retirement insurance. Providing for old age is the other area, along with housing, where the state does the most to foster what Gerald Davis calls the “capital fiction” – the conception of one’s relationship to society in terms of asset ownership. But here, unlike home ownership, social provision in the guise of financial claims has failed even on its own narrow terms. Many working-class households in the US and other rich countries do own their own houses, but only a tiny fraction can meet their subsistence needs in old age out of private saving. At the same time, public retirement systems are much more fully developed than public provision of housing. This suggests a program of eliminating existing programs to encourage private retirement saving, and greatly expanding Social Security and similar social insurance systems.

Repress finance. It’s not the job of socialists to keep the big casino running smoothly. But as long as private financial institutions exist, we cannot avoid the question of how to regulate them. Historically financial regulation has sometimes taken the form of “financial repression,” in which the types of assets held by financial institutions are substantially dictated by the state. This allows credit to be directed more effectively to socially useful investment. It also allows policymakers to hold market interest rates down, which — especially in the context of higher inflation — diminishes both the burden of debt and the power of creditors. The exiting deregulated financial system already has very articulate critics; there’s no need to duplicate their work with a detailed reform proposal. But we can lay out some broad principles:

1. If it isn’t permitted, it’s forbidden. Effective regulation has always depended on enumerating specific functions for specific institutions, and prohibiting anything else. Otherwise it’s too easy to bypass with something that is formally different but substantively equivalent. And whether or not central banks are going to continue with their role as the main managers of aggregate demand —  increasingly questioned by those inside the citadel as well as by outsiders — they also need this kind of regulation to effectively control the flow of credit.

2. Protect functions, not institutions. The political power of finance comes from ability to threaten routine social bookkeeping, and the security of small property owners. (“If we don’t bail out the banks, the ATMs will shut down! What about your 401(k)?”) As long as private financial institutions perform socially necessary functions, policy should focus on preserving those functions themselves, and not the institutions that perform them. This means that interventions should be as close as possible to the nonfinancial end-user, and not on the games banks play among themselves. For example: deposit insurance.

3. Require large holdings of public debt. The threat of the “bond vigilantes” against the US federal government has  been wildly exaggerated, as was demonstrated for instance by the debt-ceiling farce and downgrade of 2012. But for smaller governments – including state and local governments in the US – bond markets are not so easily ignored. And large holdings of pubic debt also reduce the frequency and severity of the periodic financial crises which are, perversely, one of the main ways in which finance’s social power is maintained.

4. Control overall debt levels with lower interest rates and higher inflation. Household leverage in the US has risen dramatically over the past 30 years; some believe that this is because debt was needed to raise living standards of living in the face of stagnant or declining real incomes. But this isn’t the case; slower income growth has simply meant slower growth in consumption. Rather, the main cause of rising household debt over the past 30 years has been the combination of low inflation and continuing high interest rates for households. Conversely, the most effective way to reduce the burden of debt – for households, and also for governments – is to hold interest rates down while allowing inflation to rise.

As a corollary to financial repression, we can reject any moral claims on behalf of interest income as such. There is no right to exercise a claim on the labor of others  through ownership of financial assets. To the extent that the private provision of socially necessary services like insurance and pensions is undermined by low interest rates, that is an argument for moving these services to the public sector, not for increasing the claims of rentiers.

Democratize central banks. Central banks have always been central planners. Choices about interest rates, and the terms on which financial institutions will be regulated and rescued, inevitably condition the profitability and the direction as well as level of productive activity. This role has been concealed behind an ideology that imagines the central bank behaving automatically, according to a rule that somehow reproduces the “natural” behavior of markets.

Central banks’ own actions since 2008 have left this ideology in tatters. The immediate response to the crisis have forced central banks to intervene more directly in credit markets, buying a wider range of assets and even replacing private financial institutions to lend directly to nonfinancial businesses. Since then, the failure of conventional monetary policy has forced central banks to inch unwillingly toward a broader range of interventions, directly channeling credit to selected borrowers. This turn to “credit policy” represents an admission – grudging, but forced by events – that the anarchy of competition is unable to coordinate production. Central banks cannot, as the textbooks imagine, stabilize the capitalists system by turning a single knob labeled “money supply” or “interest rate.” They must substitute their own judgement for market outcomes in a broad and growing range of asset and credit markets.

The challenge now is to politicize central banks — to make them the object of public debate and popular pressure.  In Europe, the national central banks – which still perform their old functions, despite the common misperception that the ECB is now the central bank of Europe – will be a central terrain of struggle for the next left government that seeks to break with austerity and liberalism. In the US, we can dispense for good with the idea that monetary policy is a domain of technocratic expertise, and bring into the open its program of keeping unemployment high in order to restrain wage growth and workers’ power. As a positive program, we might demand that the Fed aggressively using its existing legal authority to purchase municipal debt, depriving rentiers of their power over financially constrained local governments as in Detroit and Puerto Rico, and more broadly blunting the power of “the bond markets” as a constraint on popular politics at the state and local level. More broadly, central banks should be held responsible for actively directing credit to socially useful ends.

Disempower shareholders. Really existing capitalism consists of narrow streams of market transactions flowing between vast regions of non-market coordination. A core function of finance is to act as the weapon in the hands of the capitalist class to enforce the logic of value on these non-market structures. The claims of shareholders over nonfinancial businesses, and bondholders over national governments, ensure that all these domains of human activity remain subordinate to the logic of accumulation. We want to see stronger defenses against these claims – not because we have any faith in productive capitalists or national bourgeoisies, but because they occupy the space in which politics is possible.

Specifically we should stand with corporations against shareholders. The corporation, as Marx long ago noted, is “the abolition of the capitalist mode of production within the capitalist mode of production itself.” Within the corporation, activity is coordinated through plans, not markets; and the orientation of this activity is toward the production of a particular use-value rather than money as such. “The tendency of big enterprise,” Keynes wrote, “is to socialize itself.” The fundamental political function of finance is to keep this tendency in check. Without the threat of takeovers and the pressure of shareholder activists, the corporation becomes a space where workers and other stakeholders can contest control over production and the surplus it generates – a possibility that capitalist never lose sight of.

Needless to say, this does not imply any attachment to the particular individuals at the top of the corporate hierarchy, who today are most often actual or aspiring rentiers  without any organic connection to the production process. Rather, it’s a recognition of the value of the corporation as a social organism; as a space structured by relationships of trust and loyalty, and by intrinsic motivation and “professional conscience”; and as the site of consciously planned production of use-values.

The role of finance with respect to the modern corporation is not to provide it with resources for investment, but to ensure that its conditional orientation toward production as an end in itself is ultimately subordinate to the accumulation of money. Resisting this pressure is no substitute for other struggles, over the labor process and the division of resources and authority within the corporation. (History gives many examples of production of use values as an end in itself, which is carried out under conditions as coercive and alienated as under production for profit.) But resisting the pressure of finance creates more space for those struggles, and for the evolution of socialism within the corporate form.

Close borders to money (and open them to people). Just as shareholder power enforces the logic of accumulation on corporations, capital mobility does the same to states. In the universities, we hear about the supposed efficiency  of unrestrained capital flows, but in the political realm we hear more their power to “discipline” national governments. The threat of capital flight and balance of payments crises protects the logic of accumulation against incursions by national governments.

States can be vehicles for conscious control of the economy only insofar as financial claims across borders are limited. In a world where capital flows are large and unrestricted, the concrete activity of production and reproduction must constantly adjust itself to the changing whims of foreign investors. This is incompatible with any strategy for  development of the forces of production at the national level; every successful case of late industrialization has depended on the conscious direction of credit through the national banking system. More than that, the requirement that real activity accommodate cross-border financial flows is  incompatible even with the stable reproduction of capitalism in the periphery. We have learned this lesson many times in Latin America and elsewhere in the South, and are now learning it again in Europe.

So a socialist program on finance should include support for efforts of national governments to delink from the global economy, and to maintain or regain control over their financial systems. Today, such efforts are often connected to a politics of racism, nativism and xenophobia which we must uncompromisingly reject. But it is possible to move toward a world in which national borders pose no barrier to people and ideas, but limit the movement of goods and are impassible barriers to private financial claims.

In the US and other rich countries, it’s also important to oppose any use of the authority – legal or otherwise – of our own states to enforce financial claims against weaker states. Argentina and Greece, to take two recent examples, were not forced to accept the terms of their creditors by the actions of dispersed private individuals through financial markets, but respectively by the actions of Judge Griesa of the US Second Circuit and Trichet and Draghi of the ECB. For peripheral states to foster development and serve as vehicle for popular politics, they must insulate themselves from international financial markets. But the power of those markets comes ultimately from the gunboats — figurative or literal — by which private financial claims are enforced.

With respect to the strong states themselves, the markets have no hold except over the imagination. As we’ve seen repeatedly in recent years — most dramatically in the debt-limit vaudeville of 2011-2013 — there are no “bond vigilantes”; the terms on which governments borrow are fully determined by their own monetary authority. All that’s needed to break the bond market’s power here is to recognize that it’s already powerless.

In short, we should reject the idea of finance as an intrusion on a preexisting market order. We should resist the power of finance as an enforcer of the logic of accumulation. And we should reclaim as a site of democratic politics the social planning already carried out through finance.

Making Sense of Changes in State-Local Debt

In a previous post, I pointed out that state and local governments in the US have large asset positions — 33 percent of GDP in total, down from nearly 40 percent before the recession. This is close to double state and local debt, which totals 17 percent of GDP. Among other things, this means that a discussion of public balance sheets that looks only at debt is missing at least half the picture.

On the other hand, a bit over half of those assets are in pension funds. Some people would argue that it’s misleading to attribute those holdings to the sponsoring governments, or that if you do you should also include the present value of future pension benefits as a liability. I’m not sure; I think there are interesting questions here.

But there are also interesting questions that don’t depend on how you treat the existing stocks of pension assets and liabilities. Here are a couple. First, how how do changes in state credit-market debt break down between the current fiscal balance and other factors, including pension fund contributions? And second, how much of state and local fiscal imbalances are financed by borrowing, and how much by changes in the asset position?

Most economists faced with questions like these would answer them by running a regression. [1] But as I mentioned in the previous post, I don’t think a regression is the right tool for this job. (If you don’t care about the methods and just want to hear the results, you can skip the next several paragraphs, all the way down to “So what do we find?”)

Think about it: what is a regression doing? Basically, we have a variable a that we think is influenced by some others: b, c, d … Our observations of whatever social process we’re interested in consist of sets of values for a, b, c, d… , all of them different each time. A regression, fundamentally, is an imaginary experiment where we adjusted the value of just one of b, c, d… and observed how a changed as a result. That’s the meaning of the coefficients that are the main outputs of a regression, along with some measure of our confidence in them.

But in the case of state budgets we already know the coefficients! If you increase state spending by one dollar, holding all other variables constant, well then, you increase state debt by one dollar. If you increase revenue by one dollar, again holding everything else constant, you reduce debt by one dollar. Budgets are governed by accounting identities, which means we know all the coefficients — they are one or negative one as the case may be. What we are interested in is not the coefficients in a hypothetical “data generating process” that produces changes in state debt (or whatever). What we’re interested in is how much of the observed historical variation in the variable of interest is explained by the variation in each of the other variables. I’m always puzzled when I see people regressing the change in debt on expenditure and reporting a coefficient — what did they think they were going to find?

For the question we’re interested in, I think the right tool is a covariance matrix. (Covariance is the basic measure of the variation that is shared between two variables.) Here we are taking advantage of the fact that covariance is linear: cov(x, y + z) = cov(x, y) + cov(x, z). Variance, meanwhile, is just a variable’s covariance with itself. So if we know that a = b + c + d, then we know that the variance of a is equal to the sum of its covariances with each of the others. In other words, if y = Σ xn then:

(1) var(y) = Σ cov(y, xn)

So for example: If the budget balance is defined as revenue – spending, then the variance of some observed budget balances must be equal to the covariance of the balance with revenue, minus the covariance of the balance with spending.

This makes a covariance matrix an obvious tool to use when we want to allocate the observed variation in a variable among various known causes. But for whatever reason, economists turn to variance decompositions only in few specific contexts. It’s common, for instance, to see a variance decomposition of this kind used to distinguish between-group from within-group inequality in a discussion of income distribution. But the same approach can be used any time we have a set of variables linked by accounting identities (or other known relationships) and we want to assess their relative importance in explaining some concrete variation.

In the case of state and local budgets, we can start with the identity that sources of funds = uses of funds. (Of course this is true of any economic unit.) Breaking things up a bit more, we can write:

revenues + borrowing = expenditure + net acquisition of financial assets (NAFA).

Since we are interested in borrowing, we rearrange this to:

(2) net borrowing = expenditure – revenue + NAFA = fiscal balance – NAFA

But we are not simply interested in borrowing,w e are interested in the change in the debt-GDP ratio (or debt-GSP ratio, in the case of individual states.) And this has a denominator as well as a numerator. So we write:

(3) change in debt ratio = net borrowing – nominal growth rate

This is also an accounting identity, but not an exact one; it’s a linear approximation of the true relationship, which is nonlinear. But with annual debt and income growth rates in the single digits, the approximation is very close.

So we have:

(4) change in debt ratio = expenditure – revenue + NAFA – nominal growth rate * current debt ratio

It follows from equation (1) that  the variance of change in the debt ratio is equal to the sum of the covariances of the change with each of the right-side variables. In other words, if we are interested in understanding why debt-GDP ratios have risen in some years and fallen in others, it’s straightforward to decompose this variation into the contributions of variation in each of the other variables. There’s no reason to do a regression here. [2]

So what do we find?

Here’s the covariance matrix for combined state and local debt for 1955 to 2013.  “Growth contrib.” refers to the last term in Equation (4). To make reading the table easier, I’ve reversed the sign of the growth contribution, fiscal balance and revenue; that means that positive values in the table all refer to factors that increase the variance of debt-ratio growth and negative values are factors that reduce it. [3]

Debt Ratio Growth Growth Contrib. Fiscal Balance Revenue Expenditure NAFA & Trusts
Debt Ratio Growth 0.18
Growth Contrib. (-) 0.10 0.11
Fiscal Balance (-) 0.03 0.04 0.13
Revenue (-) 0.08 0.24 0.12 5.98
Expenditure 0.11 0.28 -0.01 5.86 5.87
NAFA & Trusts 0.06 -0.05 0.13 -0.01 -0.14 0.23

How do we read this? First of all, note the bolded terms along the main diagonal — those are the covariance of each variable with itself, that is, its variance.  It is a measure of how much individual observations of this variable differ from each other. The off-diagonal terms, then, show how much of this variation is shared between two variables. Again, we know that if one variable is the sum of several others, then its variance will be the sum of its covariances with each of the others.

So for example, total variance of debt ratio growth is 0.18. (That means that the debt ratio growth  in a given year is, on average, about 0.4 percentage points above or below the average growth rate for the full period.) The covariance of debt-ratio growth and (negative) growth contribution is 0.10. So a bit over half the debt-ratio variance is attributable to nominal GDP growth. In other words, if we are looking at why the debt-GDP ratio rises more in some years than in others, more of the variation is going to be explained by the denominator of the ratio than the numerator. Next, we see that the covariance of debt growth with the (negative) fiscal balance is 0.03. In other words, about one-sixth of the variation in annual debt ratio growth is explained by fiscal deficits or surpluses.

This is important, because most discussions of state and local debt implicitly assume that all change in the debt ratio is explained this way. But in fact, while the fiscal balance does play some role in changes in the debt ratio — the covariance is greater than zero — it’s a distinctly secondary role.  Finally, the last variable, “NAFA & Trusts,” explains about a third of variation in debt ratio growth. In other words, years when state and local government debt is rising more rapidly relative to GDP, are also years in which those governments are adding more rapidly to their holdings of financial assets. And this source of variation explains about twice as much of the historical pattern of debt ratio changes, as the fiscal balance does.

Since this is probably still a bit confusing, the next table presents the same information in a hopefully clearer way. Here see only the covariances with debt ratio growth — the first column of the previous table — and they are normalized by the variance of debt ratio growth. Again, I’ve flipped the sign of variables that reduce debt-ratio growth. So each value of the table shows the share of variation in the growth of state-local growth ratios that is explained by that component. There is also a second column, showing the same thing for state governments only.  

Component State + Local State Only
Nominal Growth (-) 0.52 0.30
Fiscal Balance (-) 0.17 0.31
Revenue (-) -0.41 0.07
Expenditure 0.58 0.24
… of which: Interest 0.06 0.03
Trust Contrib. and NAFA 0.33 0.37
… of which: Pensions 0.01 0.02

I’ve added a couple variables here — interest payments under expenditure and pension contributions under NAFA and Trusts. Note in particular the small value of the latter. Pension contributions are quite stable from year to year. (The standard deviation of state/local pension contributions as a percent of GDP is just 0.07, versus around 0.5 for nontrust NAFA.)  This says that even though most state and local assets are in pension funds, pension contributions contribute only a little to the variation in asset acquisition. Most of the year to year variability is in governments’ acquisition of assets on their own behalf. This is helpful: It means that if we are interested in understanding variation in the growth of debt over time, or the role of assets vs. liabilities in accommodating fiscal imbalances, we don’t need to worry too much about how to think about pension funds. (If we want to focus on the total increase in state debt, as opposed to the variation over time, then pensions are still very important.)

If we compare the overall state-local sector with state governments only, the picture is broadly similar, but there are some interesting differences. First of all, nominal growth rates are somewhat less important, and the fiscal balance more important, for state government debt ratio. This isn’t surprising. State governments have more flexibility than local ones to independently adjust their spending and revenue; and state debt ratios are lower, so the effect on the ratio from a given change in growth rates is proportionately smaller. For the same reason, the effect of interest rate changes on the debt ratio, while small in both cases, is even smaller for the lower-debt state governments. [4]

So now we have shown more rigorously what we suggested in the previous post: While the fiscal balance plays some role in explaining why state and local debt ratios rise at some times and fall at others, it is not the main factor. Nominal growth rates and asset acquisition both play larger roles.

Let’s turn to the next question: How do state and local government balance sheets adjust to fiscal imbalances? Again, this is just a re-presentation of the data in the first table, this time focusing on the third column/row. Again, we’re also doing the decomposition for states in isolation, and adding a couple more items — in this case, the taxes and intergovernmental assistance components of revenue, and the pension contribution component of NAFA. The values are normalized here by the variance of the fiscal balance. The first four lines sum to 1, as do the last three. In effect, the first four rows of the table tells us where fiscal imbalances come from; the final three tell us where they go.


Component State + Local State Only
Revenue, of which: 0.94 1.01
… Taxes 0.50 0.93
… Intergovernmental 0.18 -0.04
Expenditure (-) 0.06 -0.01
Trust Contrib. and NAFA, of which: 1.04 0.92
… Pensions 0.10 -0.49
Borrowing (-) -0.04 0.08

So what do we see? Looking at the first set of lines, we see that state-local fiscal imbalances are entirely expenditure-driven. Surprisingly, revenues are no lower in deficit years than in surplus ones. Note that this is true of total revenues, but not of taxes. Deficit years are indeed associated with lower tax revenue and surplus years with higher taxes, as we would expect. (That’s what the positive values in the “taxes” row mean.) But this is fully offset by the opposite variation in payments from the federal government, which are lower in surplus years and higher in deficit years. During the most recent recession, for example, aggregate state and local taxes declined by about 0.4 percent of GDP. But federal assistance to state and local governments increased by 0.9 percent of GDP. This was unexpected to me: I had expected most of the variation in state budget balances to come from the revenue side. But evidently it doesn’t. The covariance matrix is confirming, and quantifying, what you can see in the figure below: Deficit years for the state-local sector are associated with peaks in spending, not troughs in revenue.

muni-budgets
Aggregate State-Local Revenue and Expenditure, 1953-2013

Turning to the question of how imbalances are accommodated, we find a similarly one-sided story. None of the changes in state-local budget balances result in changes in borrowing; all of them go to changes in fund contributions and direct asset purchases. [5] For the sector as a whole, in fact, asset purchases absorb more than all the variation in fiscal imbalances; borrowing is lower in deficit years than in surplus years. (For state governments, borrowing does absorb about ten percent of variation in the fiscal balance.) Note that very little of this is accounted for by pensions — less than none in the case of state governments, which see lower overall asset accumulation but higher pension fund contributions in deficit years. Again, even though pension funds account for most state-local assets, they account for very little of the year to year variation in asset purchases.

So the data tells a very clear story: Variation in state-local budget balances is driven entirely by the expenditure side; cyclical changes in their own revenue are entirely offset by changes in federal aid. And state budget imbalances are accommodated entirely by changes in the rate at which governments buy or sell assets. Over the postwar period, the state-local government sector has not used borrowing to smooth over imbalances between revenue and spending.

 

[1] The interesting historical meta-question, to which I have no idea of the answer, when and why regression analysis came to so completely dominate empirical work in economics. I suspect there are some deep reasons why economists are more attracted to methodologies that treat observed data as a sample or “draw” from a universal set of rules, rather than methodologies that focus on the observed data as the object of inquiry in itself.

[2] I confess I only realized recently that variance decompositions can be used this way. In retrospect, we should have done this in our papers in household debt.

[3] Revenue and expenditure here include everything except trust fund income and payments. In other words, unlike in the previous post, I am following the standard practice of treating state and local budgets separate from pension funds and other trust funds. The last line, “NAFA and Trusts”, includes both contributions to trust funds and acquisition of financial assets by the local government itself. But income generated by trust fund assets, and employee contributions to pension funds, are not included in revenue, and benefits paid are not included in expenditure. So the “fiscal balance” term here is basically the same as that reported by the NIPAs and other standard sources.

[4] This is different from households and the federal government, where higher debt and, in the case of households, more variable interest rates, mean that interest rates are of first-order importance in explaining the evolution of debt ratios over time.

[5] It might seem contradictory to say that a third of the variation in changes in the debt ratio is due to the fiscal balance, even though none of the variation in the fiscal balance is passed through to changes in borrowing. The reason this is possible is that those periods when there are both deficits and higher borrowing, also are periods of slower nominal income growth. This implies additional variance in debt growth, which is attributed to both growth and the fiscal balance. There’s some helpful discussion here.

 

(This post is based on a paper in process. I probably will not post any more material from this project for the next month or so, since I need to return to the question of potential output.)

 

Lost in Fiscal Space

Arjun and Jayadev and I have a working paper up at the Washington Center for Equitable Growth on the conflict between conventional macroeconomic policy and Lerner-style functional finance. Here’s the accompanying blogpost, cross-posted from the WCEG blog.

 

One pole of current debates about U.S. fiscal policy is occupied by the “functional finance” position—the view usually traced back to the late economist Abba Lerner—that a government’s budget balance can be set at whatever level is needed to stabilize aggregate demand, without worrying about the level of government debt. At the other pole is the conventional view that a government’s budget balance must be set to keep debt on a sustainable trajectory while leaving the management of aggregate demand to the central bank. Both sides tend to assume that these different policy views come from fundamentally different ideas about how the economy works.

A new working paper, “Lost in Fiscal Space,” coauthored by myself and Arjun Jayadev, suggests that, on the contrary, the functional finance and the conventional approaches can be understood in terms of the same analytic framework. The claim that fiscal policy can be used to stabilize the economy without ever worrying about debt sustainability sounds radical. But we argue that it follows directly from the standard macroeconomic models that are taught to undergraduates and used by policymakers.

Here’s the idea. There are two instruments: first, the interest rate set by the central bank; and second, the fiscal balance—the budget surplus or deficit. And there are two targets: the level of aggregate demand consistent with acceptable levels of inflation and unemployment; and a stable debt-to-GDP ratio. Each instrument affects both targets—output depends on both the interest rate set by monetary authorities and on the fiscal balance (as well as a host of other factors) while the change in the debt depends on both new borrowing and the interest paid on existing debt. Conventional policy and functional finance represent two different choices about which instrument to assign to which target. The former says the interest rate instrument should focus on demand and the fiscal-balance instrument should focus on the debt-ratio target, the latter has them the other way around.

Does it matter? Not necessarily. There is always one unique combination of interest rate and budget balance that delivers both stable debt and price stability. If policy is carried out perfectly then that’s where you will end up, regardless of which instrument is assigned to which target. In this sense, the functional finance position is less radical than either its supporters or its opponents believe.

In reality, of course, policies are not followed perfectly. One common source of problems is when decisions about each instrument are made looking only at the effects on its assigned target, ignoring the effects on the other one. A government, for example, may adopt fiscal austerity to bring down the debt ratio, ignoring the effects this will have on aggregate demand. Or a central bank may raise the interest rate to curb inflation, ignoring the effects this will have on the sustainability of the public debt. (The rise in the U.S. debt-to-GDP ratio in the 1980s owes more to Federal Reserve chairman Paul Volcker’s interest rate hikes than to President Reagan’s budget deficits.) One natural approach, then, is to assign each target to the instrument that affects it more powerfully, so that these cross-effects are minimized.

So far this is just common sense; but when you apply it more systematically, as we do in our working paper, it has some surprising implications. In particular, it means that the metaphor of “fiscal space” is backward. When government debt is large, it makes more sense, not less, to use active fiscal policy to stabilize demand—and leave the management of the public debt ratio to the central bank. The reason is simple: The larger the debt-to-GDP ratio, the more that changes in the ratio depend on the difference in between the interest rate and the growth rate of GDP, and the less those changes depend on current spending and revenue (a point that has been forcefully made by Council of Economic Advisers Chair Jason Furman). This is what we see historically: When the public debt is very large, as in the United States during and immediately after the Second World War, the central bank focused on stabilizing the public debt rather than on stabilizing demand, which means responsibility for aggregate demand fell to the budget authorities.

We hope this paper will help clarify what’s at stake in current debates about U.S. fiscal policy. The question is not whether it’s economically feasible to use fiscal policy as our primary instrument to manage aggregate demand. Any central bank that is able to achieve its price stability and full employment mandates is equally able to keep the debt-to-GDP ratio constant while the budget authorities manage demand. The latter task may even be easier, especially when debt is already high. The real question is who we, as a democratic society, trust to make decisions about the direction of the economy as a whole.

UPDATE: Nick Rowe has an interesting response here. (And an older one here, with a great comments thread following it.)

The Action Is on the Asset Side

Let’s talk about state and local government balance sheets.

Like most sectors of the US economy, state and local governments have seen a long-term increase in credit-market debt, from about 8 percent of GDP in 1950 to 19 percent of GDP in 2010, before falling back a bit to 17 percent in 2013. [1] While this is modest compared with federal-government and household debt, it is not trivial. Municipal bonds are important assets in financial markets. On the liability side, state and local debt operates as a political constraint at the state level and often plays a prominent role in public discussions of state budgets. Cuts to state services and public employee wages and pensions are often justified by the problem of public debt, municipal bond offerings are a focal point for local politics, and you don’t have to look far to find scare stories about an approaching state  or local debt crisis.

muni-debt
State and Local Government Debt, 1953-2013

 

My interest in state and local debt is an extension of my work (with Arjun Jayadev) on household debt and on sovereign debt. The question is: To what extent to historical changes in debt ratios reflect the balance between revenue and expenditure, and to what extent do they represent monetary-financial factors like inflation and interest rates? The exact balance of course depends on the sector and period; what we want to steer people away from is the habit of assuming that balance sheet changes are a straightforward record of real income and spending flows. [2]

The first thing to note about state and local debt is that, as the first figure shows, only about 40 percent of it is owed by state governments, with the majority is owed by the thousands of local governments of various types. Of the 10 percent of GDP or so owed by local governments, about half is owed by general-purpose governments (cities, counties and towns, in that order), and half by special purpose districts, with school districts accounting for about half of this (or a bit over 2 percent of GDP). This is interesting because, as the  figure below shows, the majority of state and local spending is at the state level.

muni-spending
State and Local Government Spending, 1953-2013

 

This imbalance goes back to at least the 1950s and 1960s, when local governments accounted for just over half of combined state and local spending, but more than three-quarters of combined state and local government debt. The explanation for the different distributions of spending and debt over different levels of government is simple: While state governments account for a larger share of total state and local spending, local governments account for about two-thirds of state and local capital spending. In the US, most infrastructure spending is the responsibility of local governments; direct service provision, which requires buildings and other fixed assets, is also disproportionately local. State government budgets, on the other hand, include a large proportion of transfer spending, which is negligible at the local level. Since debt is mainly used to finance capital spending, it’s no surprise that the distribution of debt looks more like the distribution of capital spending than like the distribution of spending in general.

This is an interesting fact in itself, but it also is a good illustration of an important larger point that should be obvious but is often ignored: The main use of debt is to finance assets. This simple point is for some reason almost always ignored by economists — both mainstream and heterodox economists regard the paradigmatic loan as a consumption loan. [3] Among other things, this leads to the mistaken idea that credit-market debt reflects — or at least is somehow related to — dissaving. When in fact there’s no connection.

For households and businesses, just as for state and local governments, the majority of debt finances investment. [4] This means that additions to the liability side of the balance sheet are normally simultaneous with additions to the asset side, with no effect on saving. If anything, since most assets are not financed entirely with debt, most transactions that increase debt require saving to increase also. (Homebuyers normally get a mortgage and make a downpayment.) Sovereign governments are the only economic units whose borrowing mainly finances gaps between current revenue and current expenditure. Again, this point is missed as much by heterodoxy as by the mainstream. Just flipping over to the next tab in my browser, I find a Marxist writing that “Debt has become so high that the personal savings rate in the United States actually became negative.” Which is a non sequitur.

The fact that most state-local debt is at the local level, while most spending is at the state level, is a reflection of the fact that debt is used to finance capital spending and not spending in general. But in and of itself this fact doesn’t tell us anything about how much changes in the state-local debt ratio reflect fiscal deficits or dissaving. It still could be true that state and local debt mainly reflects accumulated fiscal deficits.

As it turns out, though, it isn’t true at all. As the next figure shows, historically there is no relationship between changes in the state-local debt ratio and the state-local fiscal balance.

muni-debtyears

Here, the vertical axis shows the change in the ratio of aggregate state and local debt to GDP over the year. The horizontal axis shows the aggregate fiscal balance, with surpluses positive and deficits negative. So for instance, in 2009 the debt ratio increased by about one point, while state and local governments ran an aggregate budget deficit of close to 6 percent of GDP. [5] If changes in the debt ratio mainly reflected fiscal deficits, we would expect most of the points to fall along a line sloping down from upper left to lower right. They really don’t. Yes, 2009 has both very large deficits and a large rise in the debt ratio; but 2007 has the largest aggregate surpluses, and the debt ratio rose by almost as much. Eyeballing the figure you might see a weak negative relationship; but in this case your eyeballs are fooling you. In fact, the correlation is positive. A regression of the change in on debt on the fiscal balance yields a coefficient of positive 0.11, significant at the 5 percent level. As I’ll discuss later, I’m not sure a regression is a good tool for this job. But it is good enough to answer the question, “Is state and local debt mainly the result of past deficits?” with a definite No.

How can state and local fiscal balances vary without changing the sector’s debt? The key thing to recognize about state and local government balance sheets is that they also have large financial asset positions. In the aggregate, the sector’s net financial wealth is positive; unlike the federal government, state and local governments are net creditors, not net borrowers, in financial markets. As of 2013, the sector as a whole had total debt of 18 percent of GDP, and financial assets of 34 percent of GDP. As the following figures show, the long-term rise in state and local assets is much bigger than the rise in debt. Now it is true that most of these assets are held in pension funds, rather than directly. But a lot of them are not. In fact, for state governments — though not for the state-local sector as a whole — even nontrust assets exceed total debt. And whether or not you want to attribute pension assets to the sponsoring government, contributions to pension funds are important margin on which state budgets adjust.

State and Local Financial Assets, 1953-2013
State and Local Financial Assets, 1953-2013

 

Combined State-Local Financial Net Wealth

 

As the final figure shows, since the mid 1990s the aggregate financial assets of state-local government have exceeded aggregate debt in every single state. (Alaska, with government net financial wealth in excess of 100 percent of gross state product, is off the top of the chart, as is Wyoming.) This is a change from the 1950s and 1960s, when positive and negative net positions were about equally common. Nationally, the net credit position of state and local governments was equal to 16 percent of GDP in 2013, down from over 20 percent in 2007.

These large asset positions have a number of important implications:

1. To the extent that state and local governments run deficits in recessions, they are can be financed by reducing net acquisition of assets rather than by issuing more debt. And historically it seems that this is how they mostly are financed, especially in recent cycles. So if we are interested in whether state and local budgets behave procyclically or anticyclically, the degree of flexibility these governments have on the asset side is going to be a key factor.

2. Some large part of the long-term increase in state and local debt can be attributed to increased net acquisition of assets. This is especially notable in the 1980s, when there were simultaneous rises in both state debt and state financial assets. And changes in assets are strongly correlated across states. I.e. the states that increase their debt the most in a given year, tend to also be the ones that increased their assets the most — in some periods, higher debt is actually associated with a shift toward a net creditor position.

3. Low interest rates are not so clear an argument for increased infrastructure spending as people often assume, given that little of this spending currently happens at the federal level. Yes, an individual project may still look more cost-effective, but set against that is the pressure to increase trust fund contributions.

4. If state and local governments face financial constraints on current spending, these are at least as likely to reflect the terms on which they must prefund future expenses as the terms on which they can borrow.

The second point is the key one for my larger argument. Debt is part of a financial system that evolves independently of the system comprising “real” income and expenditure. They connect with each other, but they don’t correspond to each other. The case of state and local governments is somewhat different from households and the federal government — for the latter two, changes in interest rates play a major role in the evolution of debt ratios (along with changing default rates for households), while net acquisition of financial assets is not important for the federal government. But in all cases, purely financial factors play a major role in the evolution of debt ratios, along with changes in nominal income growth rates, which explain about a third of the variation in state-local debt ratios over time. And in all cases the divergence between the real and financial variables is especially visible in the 1980s.

With respect to state and local governments specifically, point 4 may be the most interesting one. Why do state and local governments hold so much bigger asset positions than they used to? What is the argument for prefunding pension benefits and similar future expenses, rather than meeting them on a pay-as-you-go basis? And how do those arguments change if we think the current regime of low interest rates is likely to persist indefinitely? It’s not obvious to me that either public employees or public employers are better off with funded pensions. Unlike in the private sector, public employees don’t need insurance against outliving their employer. It’s not obvious why governments should hold reserves against future pension payments but not against other equally large, equally predictable future payments. Nor is it obvious how much protection funded pensions offer against benefit cuts. And if interest rates remain lower than growth rates, prefunding pensions is actually more expensive than treating them as a current expense. I see lots of discussion about how state and local government funds should be managed, but does anyone ask whether they should hold these big funds at all?

In any case, given the very large asset positions of state and local governments, and the large cyclical and secular variation in net acquisition of assets, it’s clear that we shouldn’t imagine there’s any connection between sate and local debt and state and local fiscal positions. And we shouldn’t assume that the main financial problem faced by state and local governments is the terms they can borrow on. Most of the action is on the asset side.

 

[1] My critique of Piketty comes from the same place.

[2] All data in this post comes from the Census of Governments.

[3] This is true of economic theory obviously, but it’s also true of a lot of empirical work. When Gabriel Chodorow-Reich was hired at Harvard a few years ago, for instance, his job market paper was an empirical study of credit constraints on business borrowers that ignored investment and treated credit as an input into current production.

[4] For households, nearly 70 percent of debt is accounted for by mortgages, with auto loans and student debt accounting for another 10 percent each. (Admittedly, spending in the latter two categories is counted as consumption the national accounts; but functionally, cars and diplomas are assets.) Less than 10 percent of household debt looks like consumption loans.

[5] This is different from the number you will find in the national accounts. The main reasons for the difference are, first, that the Census works on a strict cashflow basis, and, second, that it consolidates pension and other trust funds with the sponsoring government. (See here.) This means that if a pension fund’s benefit payments exceed its income in a given year, that contributes to the deficit of the sponsoring government in the Census data, but not in the national accounts. This is what’s responsible for the very large deficits reported for 2009. If we are interested in credit-market debt the Census approach seems preferable, but there are some tricky questions for sure. All this will be discussed in more detail in the paper I’m writing on state and local balance sheets.

 

EDIT: Followup here.

Thinking about Monetary Policy

There’s been even more ink spilled lately than usual over the reasons monetary policy seems to have lost its mojo, and what it would take to get it back. Admittedly a lot of it is the same dueling pronouncements over whether helicopter money must always or can never work, but with the volume turned up a notch.

From my point of view, the conceptual issues here are simpler than you’d guess from the shouting. It comes down to two questions. First, how much control does the central bank have over the terms on which various economic units can adjust their balance sheets by selling assets or issuing new liabilities? And second, how many units would increase their spending on goods and services if they could more easily make the required balance sheet adjustments? Obviously, these questions are not straightforward. And they have to be answered jointly — to be effective, monetary policy has to reach not just the elasticity of the financial system in general, but its elasticity at the points where it meets financially-constrained units. But in principle, it’s simple enough.

The whole question, it seems to me, is made more confusing than it needs to be by two bad habits of economists. First is the tendency to think of the economy as a tightly articulated system, with just a few degrees of freedom. (This is one way of describing the focus on equilibrium.) To an economist, the economy is like a pool of water, where a disturbance to any part of it leads to a rapid adjustment of the whole system to a final state that can be described on the basis of a few parameters, without any information about specific components. What’s the alternative? The economy is like a pile of rocks: Disturbances may remain local rather than being transmitted to the whole system; less information about the structure can be derived from a few global parameters and more depends on the contingent states of the individual components; and stability is the result not of rapid adjustment, but rather of buffers that make adjustment unnecessary. Economists’ fixation on tightly-articulated systems tempts us to think about a single parameter (the interest rate, the money supply) changing uniformly through the economy (and often over all of time), and economic units fully adjusting their behavior in response.  It leads to a focus on the ultimate endpoint of an adjustment process rather than its next step. This yields stronger, and often paradoxical, conclusions than you would reach if you imagined beliefs and behavior changing locally and incrementally.

The second vice is economists’ incorrigible tendency to mistake the map for the territory. Like the first, this leads us to overvalue formal logical analysis at the expense of the concrete and historical. It also leads us to take an abstract representation that was adopted to clarify a particular question in a particular context, and treat it as an object in itself, as if it descried a self-contained world. Anyone who’s spent time around economists will have noticed their habit of regarding any label on a variable in an equation, as a physical object out there in the world. There’s nothing wrong — it should go without saying — with formal, logical analysis; as Marx said, abstraction is the social scientist’s equivalent of the microscope or telescope. The difference is that economists treat models as toy train sets rather than as tools. In the case of monetary policy, it works like this. The central bank adopts a policy tool which, in the institutional context at the time, gives them adequate control over the overall pace of credit expansion. Economists abstract from the — genuinely, but only for the moment  — irrelevant details of exactly how this instrument works, and postulate a direct connection with the economic outcome it is meant to control. To make communication with other economists easier, they often also construct a model where just exactly the intervention carried out by the central bank is what’s needed to restore the Walrasian optimum. This may be harmless enough as long as the policy framework persists. But the dogmatic insistence that “the central bank sets the money supply” or “the central bank sets the interest rate” is a source of endless confusion when the instrument is changing to something else.

So coming back to the concrete situation, how much can the Fed influence the expansion of bank balance sheets, and how much is expenditure on current production held down by the inelasticity of bank balance sheets? In the idealized financial world of circa 1950, the answer was simple. Commercial bank liabilities were deposits; deposits expanded through investment loans to business and households; and the total volume of deposits was strictly limited by the reserves made available by the Fed. The situation today is more complicated. But we have a better chance of making sense of it if we don’t get distracted by brain teasers about “M”.

 

I wrote this a month or two ago and didn’t post it for some reason. As a critical post, it really ought to have links to examples of the positions being criticized; but at this point it doesn’t seem worth the trouble.

Links for October 14

Now we are making progress. This piece by CEA chair Jason Furman on “the new view” of fiscal policy seems like a big step forward for mainstream policy debate. He goes further than anyone comparably prominent in rejecting the conventional macro-policy wisdom of the past 30 years. From where I’m sitting, the piece advances beyond the left edge of the current mainstream discussion in at least three ways.

First, it abandons the idea of zero interest rates as a special state of exception and accepts the idea of fiscal policy as a routine tool of macroeconomic stabilization. Reading stuff like this, or like SF Fed President John Williams saying that fiscal policy should be “a first responder to recessions,” one suspects that the post-1980s consensus that stabilization should be left to the central banks may be gone for good. Second, it directly takes on the idea that elected governments are inherently biased toward stimulus and have to be institutionally restrained from overexpansionary policy. This idea — back up with some arguments about  the“time-inconsistency” of policy that don’t really make sense — has remained a commonplace no matter how much real-world policy seems to lean the other way. It’s striking, for instance, to see someone like Simon Wren-Lewis rail against “the austerity con” in his public writing, and yet in his academic work take it as an unquestioned premise that elected governments suffer from “deficit bias.” So it’s good to see Furman challenge this assumption head-on.

The third step forward is the recognition that the long-run evolution of the debt ratio depends on GDP growth and interest rates as well as on the fiscal balance. Some on the left will criticize his assumption that the debt ratio is something policy should be worried about at all — here the new view has not yet broken decisively with the old view; I might have some criticisms of him on this point myself. But it’s very important to point out, as he does, that “changes in the debt ratio depend on two factors: the difference between the interest rate and the growth rate… and the primary balance… The larger the debt is, the more changes in r – g dwarf the primary balance in the determination of debt dynamics.” (Emphasis added.) The implication here is that the “fiscal space” metaphor is backward — if the debt ratio is a target for policy, then a higher current ratio means you should focus more on growth, and that responsibility for the “sustainability” of the debt rests more with the monetary authority than the fiscal authority. Admittedly Furman doesn’t follow this logic as far as Arjun and I do in our paper, but it’s significant progress to foreground the fact the debt ratio has both a numerator and a denominator.

If you’re doubting whether there’s anything really new here, just compare this piece with what his CEA chair predecessor Christina Romer was saying a decade ago — you couldn’t ask for a clearer statement of what Furman now rejects as “the old view.” It’s also, incidentally, a sign of how far policy discussions — both new view and old view — are from academic macro. DSGE models and their associated analytic apparatus don’t have even a walk-on part here. I think left critics of economics are too quick to assume that there is a tight link — a link at all, really — between orthodox theory and orthodox policy.

 

Why do stock exchanges exist? I really enjoyed this John Cochrane post on volume and information in financial markets. The puzzle, as he says, is why there is so much trading — indeed, why there is any trading at all. Life cycle and risk preference motivations could support, at best, a minute fraction of the trading we see; but information trading — the overwhelming bulk of actual trading — has winners and losers. As Cochrane puts it:

all trading — any deviation of portfolios from the value-weighted market index — is zero sum. Informed traders do not make money from us passive investors, they make money from other traders. It is not a puzzle that informed traders trade and make money. The deep puzzle is why the uninformed trade, when they could do better by indexing. …

Stock exchanges exist to support information trading. The theory of finance predicts that stock exchanges, the central institution it studies, the central source of our data, should not exist. The tiny amounts of trading you can generate for life cycle or other reasons could all easily be handled at a bank. All of the smart students I sent to Wall Street for 20 years went to participate in something that my theory said should not exist.

At first glance this might seem like one of those “puzzles” beloved of economists, where you describe some real-world phenomena in terms of a toy model of someone maximizing something, and then treat the fact that it doesn’t work very well as a surprising fact about the world rather than an unsurprising fact about your description. But in this case, the puzzle seems real; the relevant assumptions apply in financial markets in a way they don’t elsewhere.

I like that Cochrane makes no claim to have a solution to the puzzle — the choice to accept ignorance rather than grab onto the first plausible answer is, arguably, the starting point for scientific thought and certainly something economists could use more of. (One doesn’t have to accept the suggestion that if we have no idea what social needs, if any, are met by financial markets, or if there is too much trading or too little, that that’s an argument against regulation.) And I like the attention to what actual traders do (and say they do), which is quite different from what’s in the models.

 

Yes, we know it’s not a “real” Nobel. So the Nobel went to Hart and Holmstrom. Useful introductions to their work are here and here. Their work is on contract theory: Why do people make complex ongoing agreements with each other, instead of just buying the things they want? This might seem like one of those pseudo-puzzles — as Sanjay Reddy notes on Twitter, the question only makes sense if you take economists’ ideal world as your starting point. There’s a whole genre of this stuff: Take some phenomenon we are familiar with from everyday life, or that has been described by other social scientists, and show that it can also exist in a world of exchange between rational monads. Even at its best, this can come across like a guy who learns to, I don’t know, play Stairway to Heaven with a set of spoons. Yes, getting the notes out takes real skill, and it doesn’t sound bad, but it’s not clear why you would play it that way if you weren’t for some reason already committed to the gimmick. Or in this case, it’s not clear what we learn from translating a description of actual employment contracts into the language of intertemporal optimization; the process requires as an input all the relevant facts about the phenomenon it claims to explain. What’s the point, unless you are for some already committed to ignoring any facts about the world not expressed in the formalism of economics? This work — I admit I don’t know it well — also makes me uncomfortable with the way it seems to veer opportunistically between descriptive and prescriptive. Is this about how actual contracts really are optimal given information constraints and so on, or is it about how optimal contracts should be written? Anyway, here’s a more positive assessment from Mark Thoma.

 

Still far from full employment. Heres’ a helpful report from the Center for Economics and Policy Research on the state of the labor market. They look at a bunch of alternatives to the conventional unemployment rate and find that all of them show a weaker labor market than in 2006-2007. Hopefully the Clinton administration and/or some Democrats in the Senate will  put some sharp questions to FOMC appointees over the next few years about whether they think the Fed as fulfilled its employmnet mandate, and on what basis. They’ll find some useful ammunition here.

 

Saving, investment and the natural rate. Here’s a new paper from Lance Taylor taking another swipe at the pinata of the “natural rate”. Taylor points out that if the “natural” interest rate simply means the interest rate at which aggregate demand equals potential output (even setting aside questions about how we measure potential), the concept doesn’t make much sense. If we look at the various flows of spending on goods and services by sector and purpose, we can certainly identify flows that are more or less responsive to interest rates; but there is no reason to think that interest rate changes are the main driver of changes in spending, or that “the” interest rate that balances spending and potential at a given moment is particularly stable or represents any kind of fundamental parameters of the economy. Even less can we think of the “natural” rate as balancing saving and investment, because, among other reasons, “saving” is dwarfed by the financial flows between and within sectors. Taylor also takes Keynes to task (rightly, in my view) for setting us on the wrong track with assumption that households save and “entrepreneurs” invest, when in fact most of the saving in the national accounts takes place within the corporate sector.

 

On other blogs, other wonders:

At Vox, another reminder that the rise in wealth relative to income that Piketty documents is mainly about the rising value of existing assets, not the savings-and-accumulation process he talks about in his formal models.

Also at Vox: How much did Germany benefit from debt forgiveness after World War II? (A lot.) EDIT: Also here.

Is there really a “global pivot” toward more expansionary fiscal policy? The IMF and Morgan Stanley both say no.

Another one for the short-termism file: Here’s an empirical paper suggesting that when banks become publicly traded, their management starts responding to short-run movements in their stock, taking on more risk as a result.

Matias Vernengo has a new paper on Raul Prebisch’s thought on business cycles and growth. Prebisch would be near the top of my list of twentieth century economists who deserve more attention than they get.

I was just at Verso for the release party for Peter Frase’s new book Four Futures, based on his widely-read Jacobin piece. I don’t really agree with Peter’s views on this — I don’t see the full replacement of human labor by machines as the logical endpoint of either the historical development of capitalism or a socialist political project — but he makes a strong case. If the robot future is something you’re thinking about, you should definitely buy the book.

 

EDIT: Two I meant to include, and forgot:

David Glasner has a follow-up post on the inconsistency of rational expectations with the “shocks” and comparative statics they usually share models with. It’s probably not worth beating this particular dead horse too much more, but one more inconsistency. As I can testify first-hand, at most macroeconomic journals, “lacks microfoundations” is sufficient reason to reject a paper. But this requirement is suspended as soon as you call something a “shock,” even though technology, the markup, etc. are forms of behavior just as much as economic quantities or prices are. (This is also one of Paul Romer’s points.)

And speaking of people named Romer, David and and Christina Romer have a new working paper on US monetary policy in the 1950s. It’s a helpful paper — it’s always worthwhile to reframe abstract, universal questions as concrete historical ones — but also very orthodox in its conclusions. The Fed did a good job in the 1950s, in their view, because it focused single-mindedly on price stability, and was willing to raise rates in response to low unemployment even before inflation started rising. This is a good example of the disconnect between the academic mainstream and the policy mainstream that I mentioned above. It’s perfectly possible to defend orthodoxy macroeconomic policy without any commitment to, or use of, orthodox macroeconomic theory.

 

EDIT: Edited to remove embarrassing confusion of Romers.

Links for October 6

More methodenstreit. I finally read the Romer piece on the trouble with macro. Some good stuff in there. I’m glad to see someone of his stature making the  point that the Solow residual is simply the part of output growth that is not explained by a production function. It has no business being dressed up as “total factor productivity” and treated as a real thing in the world. Probably the most interesting part of the piece was the discussion of identification, though I’m not sure how much it supports his larger argument about macro.  The impossibility of extracting causal relationships from statistical data would seem to strengthen the argument for sticking with strong theoretical priors. And I found it a bit odd that his modus ponens for reality-based macro was accepting that the Fed brought down output and (eventually) inflation in the early 1980s by reducing the money supply — the mechanisms and efficacy of conventional monetary policy are not exactly settled questions. (Funnily enough, Krugman’s companion piece makes just the opposite accusation of orthodoxy — that they assumed an increase in the money supply would raise inflation.) Unlike Brian Romanchuk, I think Romer has some real insights into the methodology of economics. There’s also of course some broadsides against the policy  views of various rightwing economists. I’m sympathetic to both parts but not sure they don’t add up to less than their sum.

David Glasner’s interesting comment on Romer makes in passing a point that’s bugged me for years — that you can’t talk about transitions from one intertemporal equilibrium to another, there’s only the one. Or equivalently, you can’t have a model with rational expectations and then talk about what happens if there’s a “shock.” To say there is a shock in one period, is just to say that expectations in the previous period were wrong. Glasner:

the Lucas Critique applies even to micro-founded models, those models being strictly valid only in equilibrium settings and being unable to predict the adjustment of economies in the transition between equilibrium states. All models are subject to the Lucas Critique.

Here’s another take on the state of macro, from the estimable Marc Lavoie. I have to admit, I don’t care for way it’s framed around “the crisis”. It’s not like DSGE models were any more useful before 2008.

Steve Keen has his own view of where macro should go. I almost gave up on reading this piece, given Forbes’ decision to ban on adblockers (Ghostery reports 48 different trackers in their “ad-light” site) and to split the article up over six pages. But I persevered and … I’m afraid I don’t see any value in what Keen proposes. Perhaps I’ll leave it at that. Roger Farmer doesn’t see the value either.

In my opinion, the way forward, certainly for people like me — or, dear reader, like you — who have zero influence on the direction of the economics profession, is to forget about finding the right model for “the economy” in the abstract, and focus more on quantitative description of concrete historical developments. I expressed this opinion in a bunch of tweets, storified here.

 

The Gosplan of capitalism. Schumpeter described banks as capitalism’s equivalent of the Soviet planning agency — a bank loan can be thought of as an order allocating part of society’s collective resources to a particular project.  This applies even more to the central banks that set the overall terms of bank lending, but this conscious direction of the economy has been hidden behind layers of ideological obfuscation about the natural rate, policy rules and so on. As DeLong says, central banks are central planners that dare not speak their name. This silence is getting harder to maintain, though. Every day there seems to be a new news story about central banks intervening in some new credit market or administering some new price. Via Ben Bernanke, here is the Bank of Japan announcing it will start targeting the yield of 10-year Japanese government bonds, instead of limiting itself to the very short end where central banks have traditionally operated. (Although as he notes, they “muddle the message somewhat” by also announcing quantities of bonds to be purchased.)  Bernanke adds:

there is a U.S. precedent for the BOJ’s new strategy: The Federal Reserve targeted long-term yields during and immediately after World War II, in an effort to hold down the costs of war finance.

And in the FT, here is the Bank of England announcing it will begin buying corporate bonds, an unambiguous step toward direct allocation of credit:

The bank will conduct three “reverse auctions” this week, each aimed at buying the bonds from particular sectors. Tuesday’s auction focuses on utilities and industries. Individual companies include automaker Rolls-Royce, oil major Royal Dutch Shell and utilities such as Thames Water.

 

Inflation or socialism. That interventions taken in the heat of a crisis to stabilize financial markets can end up being steps toward “a more or less comprehensive socialization of investment,” may be more visible to libertarians, who are inclined to see central banks as a kind of socialism already. At any rate, Scott Sumner has been making some provocative posts lately about a choice between “inflation or socialism”. Personally I don’t have much use for NGDP targeting — Sumner’s idée fixe — or the analysis that underlies it, but I do think he is onto something important here. To translate the argument into Keynes’ terms, the problem is that the minimum return acceptable to wealth owners may be, under current conditions, too high to justify the level of investment consistent with the minimum level of growth and employment acceptable to the rest of society. Bridging this gap requires the state to increasingly take responsibility for investment, either directly or via credit policy. That’s the socialism horn of the dilemma. Or you can get inflation, which, in effect, forces wealthholders to accept a lower return; or put it more positively, as Sumner does, makes it more attractive to hold wealth in forms that finance productive investment.  The only hitch is that the wealthy — or at least their political representatives — seem to hate inflation even more than they hate socialism.

 

The corporate superorganism.  One more for the “finance-as-socialism” files. Here’s an interesting working paper from Jose Azar on the rise of cross-ownership of US corporations, thanks in part to index funds and other passive investment vehicles.

The probability that two randomly selected firms in the same industry from the S&P 1500 have a common shareholder with at least 5% stakes in both firms increased from less than 20% in 1999Q4 to around 90% in 2014Q4 (Figure 1).1 Thus, while there has been some degree of overlap for many decades, and overlap started increasing around 2000, the ubiquity of common ownership of large blocks of stock is a relatively recent phenomenon. The increase in common ownership coincided with the period of fastest growth in corporate profits and the fastest decline in the labor share since the end of World War II…

A common element of theories of the firm boundaries is that … either firms are separately owned, or they combine. In stock market economies, however, the forces of portfolio diversification lead to … blurring firm boundaries… In the limit, when all shareholders hold market portfolios, the ownership of the firms becomes exactly identical. From the point of view of the shareholders, these firms should act “in unison” to maximize the same objective function… In this situation the firms have in some sense become branches of a larger corporate superorganism.

The same assumptions that generate the “efficiency” of market outcomes imply that public ownership could be just as efficient — or more so in the case of monopolies.

The present paper provides a precise efficiency rationale for … consumer and employee representation at firms… Consumer and employee representation can reduce the markdown of wages relative to the marginal product of labor and therefore bring the economy closer to a competitive outcome. Moreover, this provides an efficiency rationale for wealth inequality reduction –reducing inequality makes control, ownership, consumption, and labor supply more aligned… In the limit, when agents are homogeneous and all firms are commonly owned, … stakeholder representation leads to a Pareto efficient outcome … even though there is no competition in the economy.

As Azar notes, cross-ownership of firms was a major concern for progressives in the early 20th century, expressed through things like the Pujo committee. But cross-ownership also has been a central theme of Marxists like Hilferding and Lenin. Azar’s “corporate superorganism” is basically Hilferding’s finance capital, with index funds playing the role of big banks. The logic runs the same way today as 100 years ago. If production is already organized as a collective enterprise run by professional managers in the interest of the capitalist class as a whole, why can’t it just as easily be managed in a broader social interest?

 

Global pivot? Gavyn Davies suggests that there has been a global turn toward more expansionary fiscal policy, with the average rich country fiscal balances shifting about 1.5 points toward deficit between 2013 and 2016. As he says,

This seems an obvious path at a time when governments can finance public investment programmes at less than zero real rates of interest. Even those who believe that government programmes tend to be inefficient and wasteful would have a hard time arguing that the real returns on public transport, housing, health and education are actually negative.

I don’t know about that last bit, though — they don’t seem to find it that hard.

 

Taylor rule toy. The Atlanta Fed has a cool new gadget that lets you calculate the interest rate under various versions of the Taylor Rule. It will definitely be useful in the classroom. Besides the obvious pedagogical value, it also dramatizes a larger point — that macroeconomic variables like “inflation” aren’t objects simply existing in the world, but depend on all kinds of non-obvious choices about measurement and definition.

 

The new royalists. DeLong summarizes the current debates about monetary policy:

1. Do we accept economic performance that all of our predecessors would have characterized as grossly subpar—having assigned the Federal Reserve and other independent central banks a mission and then kept from them the policy tools they need to successfully accomplish it?

2. Do we return the task of managing the business cycle to the political branches of government—so that they don’t just occasionally joggle the elbows of the technocratic professionals but actually take on a co-leading or a leading role?

3. Or do we extend the Federal Reserve’s toolkit in a structured way to give it the tools it needs?

This is a useful framework, as is the discussion that precedes it. But what jumped out to me is how he reflexively rejects option two. When it comes to the core questions of economic policy — growth, employment, the competing claims of labor and capital — the democratically accountable, branches of government must play no role. This is all the more striking given his frank assessment of the performance of the technocrats who have been running the show for the past 30 years: “they—or, rather, we, for I am certainly one of the mainstream economists in the roughly consensus—were very, tragically, dismally and grossly wrong.”

I think the idea that monetary policy is a matter of neutral, technical expertise was always a dodge, a cover for class interests. The cover has gotten threadbare in the past decade, as the range and visibility of central bank interventions has grown. But it’s striking how many people still seem to believe in a kind of constitutional monarchy when it comes to central banks. They can see people who call for epistocracy — rule by knowers — rather than democracy as slightly sinister clowns (which they are). And they can simultaneously see central bank independence as essential to good government, without feeling any cognitive dissonance.

 

Did extending unemployment insurance reduce employment? Arin Dube, Ethan Kaplan, Chris Boone and Lucas Goodman have a new paper on “Unemployment Insurance Generosity and Aggregate Employment.” From the abstract:

We estimate the impact of unemployment insurance (UI) extensions on aggregate employment during the Great Recession. Using a border discontinuity design, we compare employment dynamics in border counties of states with longer maximum UI benefit duration to contiguous counties in states with shorter durations between 2007 and 2014. … We find no statistically significant impact of increasing unemployment insurance generosity on aggregate employment. … Our point estimates vary in sign, but are uniformly small in magnitude and most are estimated with sufficient precision to rule out substantial impacts of the policy…. We can reject negative impacts on the employment-to-population ratio … in excess of 0.5 percentage points from the policy expansion.

Media advisory with synopsis is here.

 

On other blogs, other wonders

Larry Summers: Low laborforce participation is mainly about weak demand, not demographics or other supply-side factors.

Nancy Folbre on Greg Mankiw’s claims that the one percent deserves whatever it gets.

At Crooked Timber, John Quiggin makes some familiar — but correct and important! — points about privatization of public services.

In the Baffler, Sam Kriss has some fun with the new atheists. I hadn’t encountered Kierkegaard’s parable of the madman who tells everyone who will listen “the world is round!” but it fits perfectly.

A valuable article in the Washington Post on cobalt mining in Africa. Tracing out commodity chains is something we really need more of.

Buzzfeed on Blue Apron. The reality of the robot future is often, as here, just that production has been reorganized to make workers less visible.

At Vox, Rachelle Sampson has a piece on corporate short-termism. Supports my sense that this is an area where there may be space to move left in a Clinton administration.

Sven Beckert has edited a new collection of essays on the relationship between slavery and the development of American capitalism. Should be worth looking at — his Empire of Cotton is magnificent.

At Dissent, here’s an interesting review of Jefferson Cowie’s and Robert Gordon’s very different but complementary books on the decline of American growth.