the money view – Page 3

Video: Monetary Policy since the Crisis

On May 30, I did a “webinar” with INET’s Young Scholar’s Intiative. The subject was central banking since the financial crisis of a decade ago, and how it forces us to rethink some long-held ideas about money and the real economy — the dstinction between a demand-determined short run and a supply-determined long run; the neutrality of money in the long run; the absence of tradeoffs between unemployment, inflation and other macroeconomic goals; the reduction of monetary policy choices to setting a single overnight interest rate based on a fixed rule.My argument is that the crisis — or more precisely, central banks’ response to it — creates deep problems for all these ideas.

The full video (about an hour and 15 minus, including Q&A) is on YouTube, and embedded below. It’s part of an ongoing series of YSI webinars on endogenous money, including ones by Daniela Gabor, Jo Mitchella nd Sheila Dow. I encourage you, if you’re interested, to sign up with YSI — anyone can join — and check them out.

I didn’t use slides, but you can read my notes for the talk, if you want to.

“On money, debt, trust and central banking”

The central point of my Jacobin piece on the state of economics was meant to be: Whatever you think about mainstream macroeconomic theory, there is a lot of mainstream empirical and policy work that people on the left can learn from and engage with — much more than there was a decade ago. ¹

Some of the most interesting of that new work is from, and about, central banks. As an example, here is a remarkable speech by BIS economist Claudio Borio. I am not sure when I last saw such a high density of insight-per-word in a discussion of money and finance, let alone in a speech by a central banker. I could just say, Go read it. But instead I’m going to go through it section by section, explaining what I find interesting in it and how it connects up to a larger heterodox vision of money.

From page one:

My focus will be the on the monetary system, defined technically as money plus the transfer mechanisms to execute payments. Logically, it makes little sense to talk about one without the other. But payments have too often been taken for granted in the academic literature, old and new. In the process, we have lost some valuable insights.

… two properties underpin a well functioning monetary system. One, rather technical, is the coincidence of the means of payment with the unit of account. The other, more intangible and fundamental, is trust.

This starting point signals three central insights about money. First, the importance of payments. You shouldn’t fetishize any bit of terminology, but I’ve lately come to feel that the term “payments system” is a fairly reliable marker for something interesting to say about money. We all grow up with an idealized model of exchange, where the giving and receiving just happen, inseparably; but in reality it takes a quite sophisticated infrastructure to ensure that my debit coincides with your credit, and that everyone agrees this is so. Stefano Ugolini’s brilliant book on the prehistory of central banking emphasizes the central importance of finality – a binding determination that payment has taken place. (I suppose this was alsso the point of the essay that inaugurated Bitcoin.) In any case it’s a central aspect of “money” as a social institution that the mental image of one person handing a token to another entirely elides.

Second: the focus on money as unit of account and means of payment. The latter term mean money as the thing that discharges obligations, that cancels debts. It’s not evenb included in many standard lists of the functions of money, but for Marx, among others, it is fundamental. Borio consciously uses this term in preference to the more common medium of exchange, a token that facilitates trade of goods and services. He is clear that discharging debt and equivalent obligations is a more central role of money than exchanging commodities. Trade is a special case of debt, not vice versa. Here, as at other points through the essay, there’s a close parallel to David Graeber’s Debt. Borio doesn’t cite Graeber, but the speech is a clear example of my point in my debate with Mike Beggs years ago: Reading Graeber is good preparation for understanding some of the most interesting conversation in economics.

Third: trust. If you think of money as a social coordination mechanism, rather than a substance or quantity, you could argue that the scarce resource it’s helping to allocate is precisely trust. More on this later.

Borio:

a key concept for understanding how the monetary system works is the “elasticity of credit”, ie the extent to which the system allows credit to expand. A high elasticity is essential for the system’s day-to-day operation, but too high an elasticity (“excess elasticity”) can cause serious economic damage in the longer run.

This is an argument I’ve made before on this blog. Any payments system incorporate some degree of elasticity — some degree to which payments can run ahead of incomes. (As my old teacher David Kotz observes, the expansion of capital would be impossible otherwise.) But the degree of elasticity involves some unresolvable tensions. The logic of the market requires that every economic units expenditure eventually be brought into line with its income. But expansion, investment, innovation, requires eventually to be not just yet. (I talked a bit about this tension here.) Another critical point here is the impossibility of separating payments and credit – a separation that has been the goal of half the monetary reform proposals of the past 250 years.²

Along the way, I will touch on a number of sub-themes. .. whether it is appropriate to think of the price level as the inverse of the price of money, to make a sharp distinction between relative and absolute price changes, and to regard money (or monetary policy) as neutral in the long run.

So much here! The point about the non-equivalence of a rise in the price level and a fall in the value of money has been made eloquently by Merijn Knibbe. I don’t think Borio’s version is better, but again, it comes with the imprimatur of Authority.

The fact that inflation inevitably involves relative as well as absolute price changes is made by Leijonhufvud (who Borio cites) and Minsky (who he surprisingly doesn’t); the non-neutrality of money is the subject (and the title) of what is in my opinion Minsky’s own best short distillation of his thought.

Borio:

Compared with the traditional focus on money as an object, the definition [in terms of means of payment] crucially extends the analysis to the payment mechanisms. In the literature, there has been a tendency to abstract from them and assume they operate smoothly in the background. I believe this is one reason why money is often said to be a convention, much like choosing which hand to shake hands with: why do people coordinate on a particular “object” as money? But money is much more than a convention; it is a social institution. It is far from self-sustaining. Society needs an institutional infrastructure to ensure that money is widely accepted, transactions take place, contracts are fulfilled and, above all, agents can count on that happening.

Again, the payments mechanism is a complex, institutionally heavy social arrangement; there’s a lot that’s missed when we imagine economic transactions as I hand you this, you hand me that. Ignoring this social infrastructure invites the classical idea of money as an arbitrary numeraire, from which its long-run neutrality is one short step.

The last clause introduces a deep new idea. In an important sense, trust is a kind of irrational expectation. Trust means that I am sure (or behave as if I am sure) that you will conform to the relevant rules. Trust means I believe (or behave as if I believe) this 100 percent. Anything less than 100 percent and trust quickly unravels to zero. If there’s a small chance you might try to kill me, I should be prepared to kill you first; you might’ve had no bad intentions, but if I’m thinking of killing you, you should think about killing me first; and soon we’re all sprawled out on the warehouse floor. To exist in a world of strangers we need to believe, contrary to experience, that everyone around us will follow the rules.

a well functioning monetary system … will exploit the benefits of unifying the means of payment with the unit of account. The main benefit of a means of payment is that it allows any economy to function at all. In a decentralised exchange system, it underpins the quid-pro-quo process of exchange. And more specifically, it is a highly efficient means of “erasing” any residual relationship between transacting parties: they can thus get on with their business without concerns about monitoring and managing what would be a long chain of counterparties (and counterparties of counterparties).

Money as an instrument for erasing any relationship between the transacting parties: It could not be said better. And again, this is something someone who has read Graeber’s Debt understands very well, while someone who hasn’t might be a bit baffled by this passage. Graeber could also take you a step farther. Money might relieve you of the responsibility of monitoring your counterparties and their counterparties but somebody still has to. Graeber compellingly links the generalized use of money to strong centralized states. In a Graeberian perspective, money, along with slavery and bureaucracy, is one of the great social technologies for separating economic coordination from the broader network of mutual obligations.

The central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled. The interbank market is a critical component of our two-tier monetary system, where bank customer transactions are settled on the banks’ books and then banks, in turn, finally settle on the central bank’s books. To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real- time gross settlement systems

“Two-tier monetary system” is a compressed version of Mehrling’s hierarchy of money. The second point, which Borio further develops further on, is that credit is integral to the payment system, since the two sides of a transaction never exactly coincide – there’s always one side that fulfills its part first and has to accept, however briefly, a promise in return. This is one reason that the dream of separating credit and payments is unrealizable.

The next point he makes is that a supply and demand framework is useless for thinking about monetary policy:

The central bank … simply sets the desired interest rate by signalling where it would like it to be. And it can do so because it is a monopoly supplier of the means of payment: it can credibly commit to provide funds as needed to clear the market. … there is no such thing as a well behaved demand for bank reserves, which falls gradually as the interest rate increases, ie which is downward-sloping.

An interesting question is how much this is specific to the market for reserves and how much it applies to a range of asset markets. In fact, many markets share the two key features Borio points to here: adjustment via buffers rather than prices, and expected return that is a function of price.

On the first, there are a huge range of markets where there’s someone on one or both sides prepared to passively by or sell at a stated price. Many financial markets function only thanks to the existence of market makers – something Mehrling and his Barnard colleague Rajiv Sethi have written eloquently about. But more generally, most producers with pricing power — which is almost all of them — set a price and then passively meet demand at that price, allowing inventories and/or delivery times to absorb shifts in demand, within some range.

The second feature is specific to long-lived assets. Where there is an expected price different from the current price, holding the asset implies a capital gain or loss when the price adjusts. If expectations are sufficiently widespread and firmly anchored, they will be effectively self-confirming, as the expected valuation changes will lead the asset to be quickly bid back to its expected value. This dynamic in the bond market (and not the zero lower bound) is the authentic Keynesian liquidity trap.

To be clear, Borio isn’t raising here these broader questions about markets in general. But they are a natural extension of his arguments about reserves.

Next come some points that shouldn’t be surprising to to readers of this blog, but which are nice, for me as an economics teacher, to see stated so plainly.

The monetary base – such a common concept in the literature – plays no significant causal role in the determination of the money supply … or bank lending. It is not surprising that … large increases in bank reserves have no stable relationship with the stock of money … The money multiplier – the ratio of money to the monetary base – is not a useful concept. … Bank lending reflects banks’ management of the risk-return tradeoff they face… The ultimate anchor of the monetary system is not the monetary base but the interest rate the central bank sets.

We all know this is true, of course. The mystery is why so many textbooks still talk about the supply of high-powered money, the money multiplier, etc. As the man says, they just aren’t useful concepts.

Next comes the ubiquity of credit, which not only involves explicit loans but also any transaction where delivery and payment don’t coincide in time — which is almost all of them. Borio takes this already-interesting point in an interestingly Graeberian direction:

A high elasticity in the supply of the means of payment does not just apply to bank reserves, it is also essential for bank money. … Credit creation is all around us: some we see, some we don’t. For instance, explicit credit extension is often needed to ensure that two legs of a transaction are executed at the same time so as to reduce counterparty risk… And implicit credit creation takes place when the two legs are not synchronised. ….

In fact, the role of credit in monetary systems is commonly underestimated. Conceptually, exchanging money for a good or service is not the only way of solving the problem of the double coincidence of wants and overcoming barter. An equally, if not more convenient, option is to defer payment (extend credit) and then settle when a mutually agreeable good or service is available. In primitive systems or ancient civilisations as well as during the middle ages, this was quite common. … It is easier to find such examples than cases of true barter.

The historical non-existence of barter is the subject of the first chapter of Debt . Here again, the central banker has more in common with the radical anthropologist than with orthodox textbooks, which usually make barter the starting point for discussions of money.

Borio goes on:

the distinction between money and debt is often overplayed. True, one difference is that money extinguishes obligations, as the ultimate settlement medium. But netting debt contracts is indeed a widespread form of settling transactions.

Yes it is: remember Braudel’s Flanders fairs? “The fairs were effectively a settling of accounts, in which debts met and cancelled each other out, melting like snow in the sun.”

At an even deeper level, money is debt in the form of an implicit contract between the individual and society. The individual provides something of value in return for a token she trusts to be able to use in the future to obtain something else of value. She has a credit vis-à-vis everyone and no one in particular (society owes a debt to her).

In the classroom, one of the ways I suggest students think about money is as a kind of social scorecard. You did something good — made something somebody wanted, let somebody else use something you own, went to work and did everything the boss told you? Good for you, you get a cookie. Or more precisely, you get a credit, in both senses, in the personal record kept for you at a bank. Now you want something for yourself? OK, but that is going to be subtracted from the running total of how much you’ve done for the rest for us.

People get very excited about China’s social credit system, a sort of generalization of the “permanent record” we use to intimidate schoolchildren. And ok, it does sound kind of dystopian. If your rating is too low, you aren’t allowed to fly on a plane. Think about that — a number assigned to every person, adjusted based on somebody’s judgement of your pro-social or anti-social behavior. If your number is too low, you can’t on a plane. If it’s really low, you can’t even get on a bus. Could you imagine a system like that in the US?

Except, of course, that we have exactly this system already. The number is called a bank account. The difference is simply that we have so naturalized the system that “how much money you have” seems like simply a fact about you, rather than a judgement imposed by society.

Back to Borio:

All this also suggests that the role of the state is critical. The state issues laws and is ultimately responsible for formalising society’s implicit contract. All well functioning currencies have ultimately been underpinned by a state … [and] it is surely not by chance that dominant international currencies have represented an extension of powerful states…

Yes. Though I do have to note that it’s at this point that Borio’s fealty to policy orthodoxy — as opposed to academic orthodoxy — comes into view. He follows up the Graeberian point about the link between state authority and money with a very un-Graeberian warning about the state’s “temptation to abuse its power, undermining the monetary system and endangering both price and financial stability.”

Turning now to the policy role of the central bank, Borio starts from by arguing that “the concepts of price and financial stability are joined at the hip. They are simply two ways of ensuring trust in the monetary system…. It is no coincidence that securing both price and financial stability have been two core central bank functions.” He then makes the essential point that what the central bank manages is at heart the elasticity of the credit system.

The process underpinning financial instability hinges on how “elastic” the monetary system is over longer horizons… The challenge is to ensure that the system is not excessively elastic drawing on two monetary system anchors. One operates on prices – the interest rate and the central bank’s reaction function. … The other operates on quantities: bank regulatory requirements, such as those on capital or liquidity, and the supervisory apparatus that enforces them.

This is critical, not just for thinking about monetary policy, but as signpost toward the heart of the Keynesian vision. (Not the bastard — but useful — postwar Keynesianism of IS-LM, but the real thing.) Capitalism is not a system of real exchange — it shouldn’t be imagined as a system in which people exchange pre-existing stuff for other stuff they like better. Rather, it is a system of monetary production — a system in which payments and claims of money, meaningless themselves, are the coordinating mechanism for human being’s collective, productive activity.

This is the broadest sense of the statement that money has to be elastic, but not too elastic. If it is too elastic, money will lose its scarcity value, and hence its power to organize human activity. Money is only an effective coordinating mechanism when its possession allows someone to compel the obedience of others. But it has to be flexible enough to adapt to the concrete needs of production, and of the reproduction of society in general. (This is the big point people take form Polanyi.) “You can’t have the stuff until you give me the money” is the fundamental principle that has allowed capitalism to reorganize vast swathes of our collective existence, for better or worse. But applied literally, it stops too much stuff from getting where it needs to go to to be compatible with the requirements of capitalist production itself. There’s a reason why business transactions are almost always on the basis of trade credit, not cash on the barrelhead. As Borio puts it, “today’s economies are credit hungry.”

The talk next turns to criticism of conventional macroeconomics that will sound familiar to Post Keynesians. The problem of getting the right elasticity in the payments system — neither too much nor too little — is “downplayed in the current vintage of macroeconomic models. One reason is that the models conflate saving and financing.“ In reality,

Saving is just a component of national income – as it were, just a hole in overall expenditures, without a concrete physical representation. Financing is a cash flow and is needed to fund expenditures. In the mainstream models, even when banks are present, they imply endowments or “saving”; they do not create bank deposits and hence purchasing power through the extension of loans or purchase of assets. There is no meaningful monetary system, so that any elasticity is seriously curtailed. Financial factors serve mainly to enhance the persistence of “shocks” rather than resulting in endogenous booms and busts.

This seems right to me. The point that there is no sense in which savings finance or precede or investment is a key one for Keynes, in the General Theory and even more clearly in his subsequent writing.³ I can’t help noting, also, that passages like this are a reminder that criticism of today’s consensus macro does not come only from the professionally marginalized.

The flipside of not seeing money as social coordinating mechanism, a social ledger kept by banks, is that you do see it as a arbitrary token that exists in a particular quantity. This latter vision leads to an idea of inflation as a simple imbalance between the quantity of money and the quantity of stuff. Borio:

The process was described in very simple terms in the old days. An exogenous increase in the money supply would boost inflation. The view that “the price level is the inverse of the price of money” has probably given this purely monetary interpretation of inflation considerable intuitive appeal. Nowadays, the prevailing view is not fundamentally different, except that it is couched in terms of the impact of the interest rate the central bank sets.

This view of the inflation process has gone hand in hand with a stronger proposition: in the long run, money (monetary policy) is neutral, ie it affects only prices and no real variables. Again, in the classical tradition this was couched in terms of the money supply; today, it is in terms of interest rates. … Views about how long it takes for this process to play itself out in calendar time differ. But proponents argue that the length is short enough to be of practical policy relevance.

The idea that inflation can be thought of as a decline in the value of money is effectively criticized by Merijn Knibbe and others. It is a natural idea, almost definitionally true, if you vision starts from a world of exchange of goods and then adds money as facilitator or numeraire. But if you start, as Borio does, and as the heterodox money tradition from Graeber to Minsky to Keynes to Marx and back to Tooke and Thornton does, from the idea of money as entries in a social ledger, then it makes about as much sense as saying that a game was a blowout because the quantity of points was too high.

once we recognise that money is fundamentally endogenous, analytical thought experiments that assume an exogenous change and trace its impact are not that helpful, if not meaningless. They obscure, rather than illuminate, the mechanisms at work. … [And] once we recognise that the price of money in terms of the unit of account is unity, it makes little sense to think of the price level as the inverse of the price of money. … any financial asset fixed in nominal terms has the same property. As a result, thinking of inflation as a purely monetary phenomenon is less compelling.

“Not that helpful”, “makes little sense,” “is less compelling”: Borio is nothing if not diplomatic. But the point gets across.

Once we recognise that the interest rate is the monetary anchor, it becomes harder to argue that monetary policy is neutral… the interest rate is bound to affect different sectors differently, resulting in different rates of capital accumulation and various forms of hysteresis. … it is arguably not that helpful to make a sharp distinction between what affects relative prices and the aggregate price level…., not least because prices move at different speeds and differ in their flexibility… at low inflation rates, the “pure” inflation component, pertaining to a generalised increase in prices, [is] smaller, so that the distinction between relative and general price changes becomes rather porous.

In part, this is a restatement of Minsky’s “two-price” formulation of Keynes. Given that money or liquidity is usefulat all, it is presumably more useful for some things more than for others; and in particular, it is most useful when you have to make long-lived commitments that expose you to vagaries of an unknown future; that is, for investment. Throttling down the supply of liquidity will not just reduce prices and spending across the board, it will reduce them particularly for long-lived capital goods.

The second point, that inflation loses its defintion as a distinct phenomenon at low levels, and fades into the general mix of price changes, is something I’ve thought myself for a while but have never seen someone spell out this way. (I’m sure people have.) It follows directly from the fact that changes in the prices of particualr goods don’t scale proportionately with inflation, so as inflation gets low, the shared component of price changes over time gets smaller and harder to identify. Because the shared component is smaller at low inflation, it is going to be more sensitive to the choice of basket and other measurement issues. 20 percent inflation clearly (it seems to me) represents a genuine phenomenon. But it’s not clear that 2 percent inflation really does – an impression reinforced by the proliferation of alternative measures.

The Minskyan two-price argument also means that credit conditions and monetary policy necessarily affect the directiona s well as the level of economic activity.

financial booms tend to misallocate resources, not least because too many resources go into sectors such as construction… It is hard to imagine that interest rates are simply innocent bystanders. At least for any policy relevant horizon, if not beyond, these observations suggest that monetary policy neutrality is questionable.

This was one of the main points in Mike Konczal’s and my monetary toolkit paper.

In the next section, which deserves a much fuller unpacking, Borio critiques the fashionable idea that central banks cannot control the real rate of interest.

Recent research going back to the 1870s has found a pretty robust link between monetary regimes and the real interest rate over long horizons. By contrast, the “usual suspects” seen as driving saving and investment – all real variables – do not appear to have played any consistent role.

This conflation of the “real” (inflation-adjusted) interest rate with a rate determined by “real” (nonmonetary) factors, and therefore beyond the central bank’s influence, is one of the key fissure-points in economic ideology.⁴ The vision of economics, espcially its normative claims, depend on an idea of ecnomic life as the mutually beneficial exchange of goods. There is an obvious mismatch between this vision and the language we use to talk about banks and market interest rates and central banks — it’s not that they contradict or in conflict as that they don’t make contact at all. The preferred solution, going from today’s New Keynesian consensus back through Friedman to Wicksell, is to argue that the “interest rate” set by the central bank must in some way be the same as the “interest rate” arrived at by agents exchanging goods today for goods later. Since the terms of these trades depend only on the non-monetary fundamentals of preferences and technology, the same must in the long run be true of the interest rate set by the financial system and/or the central bank. The money interest rate cannot persistently diverge from the interest rate that would obtain in a nonmonetary exchange economy that in some sense corresponds to the actual one.

But you can’t square the circle this way. A fundamental Keynesian insight is that economic relations between the past and the future don’t take the form of trades of goods now for goods later, but of promises to make money payments at some future date or state of the world. Your ability to make money promises, and your willingness to accept them from others, depends not on any physical scarcity, but on your confidence in your counterparties doing what they promised, and in your ability to meet your own commitments if some expected payment doesn’t come through. In short, as Borio says, it depends on trust. In other words, the fundamental problem for which interest is a signal is not allocation but coordination. When interest rates are high, that reflects not a scarcity of goods in the present relative to the future, but a relative lack of trust within the financial system. Corporate bond rates did not spike in 2008 because decisionmakers suddenly wished to spend more in the present relative to the future, but because the promises embodied in the bonds were no longer trusted.

Here’s another way of looking at it: Money is valuable. The precursor of today’s “real interest rate” talk was the idea of money as neutral in the long run, in the sense that a change in the supply of money would eventually lead only to a proportionate change in the price level.⁵ This story somehow assumes on the one hand that money is useful, in the sense that it makes transactions possible that wouldn’t be otherwise. Or as Kocherlakota puts it: “At its heart, economic thinking about fiat money is paradoxical. On the one hand, such money is viewed as being inherently useless… But at the same time, these barren tokens… allow society to implement allocations that would not otherwise be achievable.” If money is both useful and neutral, evidently it must be equally useful for all transactions, and its usefulness must drop suddenly to zero once a fixed set of transactions have been made. Either there is money or there isn’t. But if additional money does not allow any desirable transaction to be carried out that right now cannot be, then shouldn’t the price of money already be zero?

Similarly: The services provided by private banks, and by the central bank, are valuable. This is the central point of Borio’s talk. The central bank’s explicit guarantee of certain money commitments, and its open ended readiness to ensure that others are fulfilled in a crisis, makes a great many promises acceptable that otherwise wouldn’t be. And like the provider of anything of value, the central bank — and financial system more broadly — can affect its price by supplying more or less of it. It makes about as much sense to say that central banks can influence the interest rate only in the short run as to say that public utilities can only influence the price of electricity in the short run, or that transit systems can only influence the price of transportation in the short run. The activities of the central bank allow a greater degree of trust in the financial system, and therefore a lesser required payment to its professional promise-accepters.⁶ Or less trust and higher payments, as the case may be. This is true in the short run, in the medium run, in the long run. And because of the role money payments play in organizing productive activity, this also means a greater or lesser increase in our collective powers over nature and ability to satisfy our material wants.

Decarbonization: A Keynesian View

The International Economy has asked me to take part in a couple of their recent roundtables on economic policy. My first contribution, on productivity growth, is here (scroll down). My second one, on green investment, is below. But first, I want to explain a little more what I was trying to do with it.

I am not trying to minimize that challenge of dealing with the climate change. But I do want to reject one common way of thinking about those challenges — as a “cost”, as some quantity of other needs that will have to go unmet. I reject it because output isn’t fixed — a serious effort to deal with climate change will presumably lead to a boom with much higher levels of employment and investment. And more broadly I reject it because it’s profoundly wrong to think of the complex activities of production as being equivalent to a certain quantity of “stuff”.

There’s a Marxist version of this, which I also reject — that the reproduction of capitalism requires an ever-increasing flow of material inputs and outputs, which rules out any kind of environmental sustainability. I think this mistakenly equates the situation facing the individual capitalist — the need to maximize money sales relative to money outlays — with the logic of the system as a whole. There is no necessary link between endless accumulation of money and any particular transformation of the material world. To me the real reason capitalism makes it so hard to address climate change isn’t any objective need to dump carbon into the atmosphere. It’s the obstacles that private property and the pursuit of profit — and their supporting ideologies — create for any kind of conscious reorganization of productive activity.

The question was, who will be the winners and losers from the transition away from carbon? Here’s what I wrote:

The response to climate change is often conceived as a form of austerity—how much consumption must we give up today to avoid the costs of an uninhabitable planet tomorrow? This way of thinking is natural for economists, brought up to think in terms of the allocation of scarce means among competing ends. By some means or other—prices, permits, or plans—part of our fixed stock of resources must, in this view, be used to prevent (or cope with) climate change, reducing the resources available to meet other needs.

The economics of climate change look quite different from a Keynesian perspective, in which demand constraints are pervasive and the fundamental economic problem is not scarcity but coordination. In this view, the real resources for decarbonization will not have to be with- drawn from other uses. They can come from an expansion of society’s productive capabilities, thanks to the demand created by clean-energy investment itself. Addressing climate change need not imply a lower standard of living—if it boosts employment and steps up the pace of technological change, it may well lead to a higher one.

People rightly compare the scale of the transition to clean technologies to the mobilization for World War II. Often forgotten, though, is that in countries spared the direct destruction of the fighting, like the United States, wartime mobilization did not crowd out civilian production. Instead, it led to a remarkable acceleration of employment and productivity growth. Production of a liberty ship required 1,200 man hours in 1941, only 500 by 1944. These rapid productivity gains, spurred by the high-pressure economy of the war, meant there was no overall tradeoff between more guns and more butter.

At the same time, the degree to which all wartime economies—even the United States—were centrally planned, reinforces a lesson that economic historians such as Alexander Gerschenkron and Alice Amsden have drawn from the experience of late industrializers: however effective decentralized markets may be at allocating resources at the margin, there is a limit to the speed and scale on which they can operate. The larger and faster the redirection of production, the more it requires conscious direction—though not necessarily by the state.

In a world where output is fundamentally limited by demand, action to deal with climate change doesn’t require sacrifice. Do we really live in such a world? Think back a few years, when macroeconomic discussions were all about secular stagnation and savings gluts. The headlines may have faded, but the conditions that prompted them have not. There’s good reason to think that the main limit to capital spending still is not scarce savings, but limited outlets for profitable investment, and that the key obstacle to faster growth is not technology or “structural” constraints, but the willingness of people to spend money. Bringing clean energy to scale will call forth new spending, both public and private, in abundance.

Of course, not everyone will benefit from the clean energy boom. The problem of stranded assets is real— any effective response to climate change will mean that much of the world’s coal and oil never comes out of the ground. But it’s not clear how far this problem extends beyond the fossil fuel sector. For manufacturers, even in the most carbon-intensive industries, only a small part of their value as enterprises comes from the capital equipment they own. More important is their role in coordinating production—a role that conventional economic models, myopically focused on coordination through markets, have largely ignored. organizing complex production processes, and maintaining trust and cooperation among the various participants in them, are difficult problems, solved not by markets but by the firm as an ongoing social organism. This coordination function will retain its value even as production itself is transformed.

UPDATE: Followup post on the World War II experience here.

The Wit and Wisdom of Trygve Haavelmo

I was talking some time ago with my friend Enno about Merijn Knibbe’s series of articles on the disconnect between the variables used in economic models and the corresponding variables in the national accounts.⁷ Enno mentioned Trygve Haavelmo’s 1944 article The Probability Approach in Econometrics; he thought Haavelmo’s distinction between “theroetical variables,” “true variables,” and “observable variables” could be a useful way of thinking about the slippages between economic reality, economic data and economic theory.

I finally picked up the Haavelmo article, and it turns out to be a deep and insightful piece — for the reason Enno mentioned, but also more broadly on how to think about empirical economics. It’s especially interesting coming from soeone who won the Nobel Prize for his foundational work in econometrics. Another piece of evidence that orthodox economists in the mid-20th century thought more deeply and critically about the nature of their project than their successors do today.

It’s a long piece, with a lot of mathematical illustrations that someone reading it today can safely skip. The central argument comes down to three overlapping points. First, economic models are tools, developed to solve specific problems. Second, economic theories have content only insofar as they’re associated with specific procedures for measurement. Third, we have positive economic knowledge only insofar as we can make unconditional predictions about the distribution of observable variables.

The first point: We study economics in order to “become master of the happenings of real life.” This is on some level obvious, or vacuous, but it'[s important; it functions as a kind of “he who has ears, let him hear.” It marks the line between those who come to economics as a means to some other end — a political commitment, for many of us; but it could just as well come from a role in business or policy — and those for whom economic theory is an end in itself. Economics education must, obviously, be organized on the latter principle. As soon as you walk into an economics classroom, the purpose of your being there is to learn economics. But you can’t, from within the classroom, make any judgement about what is useful or interesting for the world outside. Or as Hayek put it, “One who is only an economist, cannot be a good economist.”⁸

Here is what Haavelmo says:

Theoretical models are necessary tools in our attempts to understand and explain events in real life. … Whatever be the “explanations” we prefer, it is not to be forgotten that they are all our own artificial inventions in a search for an understanding of real life; they are not hidden truths to be “discovered.”

It’s an interesting question, which we don’t have to answer here, whether or to what extent this applies to the physical sciences as well. Haavelmo thinks this pragmatic view of scientific laws applies across the board:

The phrase “In the natural sciences we have laws” means not much more and not much less than this: The natural sciences have chosen fruitful ways of looking upon physical reality.

We don’t need to decide here whether we want to apply this pragmatic view to the physical sciences. It is certainly the right way to look at economic models, in particular the models we construct in econometrics. The “data generating process” is not an object existing out in the world. It is a construct you have created for one or both of these reasons: It is an efficient description of the structure of a specific matrix of observed data; it allows you to make predictions about some specific yet-to-be-observed outcome. The idea of a data-generating process is obviously very useful in thinking about the logic of different statistical techniques. It may be useful to do econometrics as if there were a certain data generating process. It is dangerously wrong to believe there really is one.

Speaking of observation brings us to Haavelmo’s second theme: the meaningless of economic theory except in the context of a specific procedure for observation. It might naively seem, he says, that

since the facts we want to study present themselves in the form of numerical measurement, we shall have to choose our models from … the field of mathematics. But the concepts of mathematics obtain their quantitative meaning implicitly through the system of logical operations we impose. In pure mathematics there really is no such problem as quantitative definition of a concept per se …

When economists talk about the problem of quantitative definitions of economic variables, they must have something in mind which has to do with real economic phenomena. More precisely, they want to give exact rules how to measure certain phenomena of real life.

Anyone who got a B+ in real analysis will have no problem with the first part of this statement. For the rest, this is the point: economic quantities come into existence only through some concrete human activity that involves someone writing down a number. You can ignore this, most of the time; but you should not ignore it all of the time. Because without that concrete activity there’s no link between economic theory and the social reality it hopes to help us master or make sense of.

Haavelmo has some sharp observations on the kind of economics that ignores the concrete activity that generates its data, which seem just as relevant to economic practice today:

Does a system of questions become less mathematical and more economic in character just by calling x “consumption,” y “price,” etc.? There are certainly many examples of studies to be found that do not go very much further than this, as far as economic significance is concerned.

There certainly are!

An equation, Haavelmo continues,

does not become an economic theory just by using economic terminology to name the variables invovled. It becomes an economic theory when associated with the rule of actual measurement of economic variables.

I’ve seen plenty of papers where the thought process seems to have been somthing like, “I think this phenomenaon is cyclical. Here is a set of difference equations that produce a cycle. I’ll label the variables with names of parts of the phenomenon. Now I have a theory of it!” With no discussion of how to measure the variables or in what sense the objects they describe exist in the external world.

What makes a piece of mathematical economics not only mathematics but also economics is this: When we set up a system of theoretical relationships and use economic names for the otherwise purely theoretical variables involved, we have in mind some actual experiment, or some design of an experiment, which we could at least imagine arranging, in order to measure those quantities in real economic life that we think might obey the laws imposed on their theoretical namesakes.

Right. A model has positive content only insofar as we can describe the concrete set of procedures that gets us from the directly accessible evidence of our senses. In my experience this comes through very clearly if you talk to someone who actually works in the physical sciences. A large part of their time is spent close to the interface with concrete reality — capturing that lizard, calibrating that laser. The practice of science isn’t simply constructing a formal analog of physical reality, a model trainset. It’s actively pushing against unknown reality and seeing how it pushes back.

Haavelmo:

When considering a theoretical setup … it is common to ask about the actual meaning of this or that variable. But this question has no sense within the theoretical model. And if the question applies to reality it has no precise answer … we will always need some willingness among our fellow research workers to agree “for practical purposes” on questions of definitions and measurement …A design of experiments … is an essential appendix to any quantitative theory.

With respect to macroeconomics, the “design of experiments” means, in the first instance, the design of the national accounts. Needless to say, national accounting concepts cannot be treated as direct observations of the corresponding terms in economic theory, even if they have been reconstructed with that theory in mind. Cynamon and Fazzari’s paper on the measurement of household spending gives some perfect examples of this. There can’t be many contexts in which Medicare payments to hospitals, for example, are what people have in mind when they construct models of household consumption. But nonetheless that’s what they’re measuring, when they use consumption data from the national accounts.

I think there’s an important sense in which the actual question of any empirical macroeconomics work has to be: What concrete social process led the people working at the statistics office to enter these particular values in the accounts?

Or as Haavelmo puts it:

There is hardly an economist who feels really happy about identifying the current series of “national income, “consumptions,” etc. with the variables by those names in his theories. Or, conversely, he would think it too complicated or perhaps uninteresting to try to build models … [whose] variables would correspond to those actually given by current economic statistics. … The practical conclusion… is the advice that economists hardly ever fail to give, but that few actually follow, that one should study very carefully the actual series considered and the conditions under which they were produced, before identifying them with the variables of a particular theoretical model.

Good advice! And, as he says, hardly ever followed.

I want to go back to the question of the “meaning” of a variable, because this point is so easy to miss. Within a model, the variables have no meaning, we simply have a set of mathematical relationships that are either tautologous, arbitrary, or false. The variables only acquire meaning insofar as we can connect them to concrete social phenomena. It may be unclear to you, as a blog reader, why I’m banging on this point so insistently. Go to an economics conference and you’ll see.

The third central point of the piece is that meaningful explanation requires being able to identify a few causal links as decisive, so that all the other possible ones can be ignored.

Think back to that Paul Romer piece on what’s wrong with modern macroeconomics. One of the most interesting parts of it, to me, was its insistent Humean skepticism about the possibility of a purely inductive economics, or for that matter science of any kind. Paraphrasing Romer: suppose we have n variables, any of which may potentially influence the others. Well then, we have n equations, one for each variable, and n² parameters (counting intercepts). In general, we are not going to be able to estimate this system based on data alone. We have to restrict the possible parameter space either on the basis of theory, or by “experiments” (natural or otherwise) that let us set most of the parameters to zero on the grounds that there is no independent variation in those variables between observations. I’m not sure that Romer fully engages with this point, whose implications go well beyond the failings of real business cycle theory. But it’s a central concern for Haavelmo:

A theoretical model may be said to be simply a restriction upon the joint variations of a system of quantities … which otherwise might have any value. … Our hope in economic theory and research is that it may be possible to establish contant and relatively simple relations between dependent variables … and a realtively small number of independent variables. … We hope that for each variable y to be explained, there is a realtively small number of explaining factors the variations of which are practically decisive in determining the variations of y. … If we are trying to explain a certain observable varaible, y, by a system of causal factors, there is, in general, no limit to the number of such factors that might have a potential influence upon y. But Nature may limit the number of fctors that have a nonneglible factual influence to a relatively small number. Our hope for simple laws in economics rests upon the assumption that we may proceed as if such natural limitations of the number of relevant factors exist.

One way or another, to do empirical economic, we have to ignore mst of the logically possible relationships between our variables. Our goal, after all, is to explain variation in the dependent variable. Meaningful explanation is possible only if the number of relevant causal factors is small. If someone asks “why is unemployment high”, a meaningful answer is going to involve at most two or three causes. If you say, “I have no idea, but all else equal wage regulations are making it higher,” then you haven’t given an answer at all. To be masters of the hapennings of real life, we need to focus on causes of effects, not effects of causes.

In other words, ceteris paribus knowledge isn’t knowledge at all. Only unconditional claims count — but they don’t have to be predictions of a single variable, they can be claims about the joint distribution of several. But in any case we have positive knowledge only to the extent we can unconditionally say that future observations will fall entirely in a certain part of the state space. This fails if we have a ceteris paribus condition, or if our empirical works “corrects” for factors whose distribution and the nature of whose influence we have not invstigated.⁹ Applied science is useful because it gives us knowledge of the kind, “If I don’t turn the key, the car will not start, if I do turn the key, it will — or if it doesn’t there is a short list of possible reasons why not.” It doesn’t give us knowledge like “All else equal, the car is more likely to start when the key is turned than when it isn’t.”¹⁰

If probability distributions are simply tools for making unconditional claims about specific events, then it doesn’t make sense to think of them as existing out in the world. They are, as Keynes also emphasized, simply ways of describing our own subjective state of belief:

We might interpret “probability” simply as a measure of our a priori confidence in the occurrence of a certain event. Then the theoretical notion of a probability distribution serves us chiefly as a tool for deriving statements that have a very high probability of being true.

Another way of looking at this. Research in economics is generally framed in terms of uncovering universal laws, for which the particular phenomenon being studied merely serves as a case study.¹¹ But in the real world, it’s more oftne the other way: We are interested in some specific case, often the outcome of some specific action we are considering. Or as Haavelmo puts it,

As a rule we are not particularly interested in making statements about a large number of observations. Usually, we are interested in a relatively small number of observations points; or perhaps even more frequently, we are interested in a practical statement about just one single new observation.

We want economics to answer questions like, “what will happen if US imposes tariffs on China”? The question of what effects tariffs have on trade in the abstract is, itself, uninteresting and unanswerable.

What do we take from this? How, according to Haavelmo, should empirical economics be?

First, the goal of empirical work is to explain concrete phenomena — what happened, or will happen, in some particular case.

Second, the content of a theory is inseparable from the procedures for measuring the variables in it.

Third, empirical work requires restrictions on the logically possible space of parameters, some of which have to be imposed a priori.

Finally, prediction (the goal) means making unconditional claims about the joint distribution of one or more variables. “Everything else equal” means “I don’t know.”

All of this based on the idea that we study economics not as an end in itself, but in response to the problems forced on us by the world.

Saving and Borrowing: A Response to Klein

Matthew Klein has a characteristically thoughtful post disagreeing with my new paper on income distribution and debt. I think his post has some valid arguments, but also, from my point of view, some misunderstandings. In any case, this is the conversation we should be having.

I want to respond on the specific points Klein raises. But first, in this post, I want to clarify some background conceptual issues. In particular, I want to explain why I think it’s unhelpful to think about the issues of debt and demand in terms of saving.

Klein talks a great deal about saving in his post. Like most people writing on these issues, he treats the concepts of rising debt-income ratios, higher borrowing and lower saving as if they were interchangeable. In common parlance, the question “why have households borrowed more?” is equivalent to “why have households saved less?” And either way, the spending that raises debt and reduces saving, is also understood to contribute to aggregate demand.

This conception is laid out in Figure 1 below. These are accounting rather than causal relationships. A minus sign in the link means the relationship is negative.

We start with households’ decision to consume more or less out of their income. Implicitly, all household outlays are for consumption, or at least, this is the only flow of household spending that varies significantly. An additional dollar of household consumption spending means an additional dollar of demand for goods and services; it also means a dollar less of savings. A dollar less of savings equals a dollar more of borrowing. More borrowing obviously means higher debt, or — equivalently in this view — a higher debt-GDP ratio.

There’s nothing particularly orthodox or heterodox about this way of looking at things. You can hear the claim that a rise in the household debt-income ratio contributes more or less one for one to aggregate demand as easily from Paul Krugman as from Steve Keen. Similarly, the idea that a decline in savings rates is equivalent to an increase in borrowing is used by Marxists as well as by mainstream economists, not to mention eclectic business journalists like Klein. Of course no one actually says “we assume that household assets are fixed or nonexistent.” But implicitly that’s what you’re doing when you treat the question of what has happened to household borrowing as if it were the equivalent of what has happened to household saving.

There is nothing wrong, in principle, with thinking in terms of the logic of Figure 1, or constructing models on that basis. Social science is impossible without abstraction. It’s often useful, even necessary, to think through the implications of a small subset of the relationships between economic variables, while ignoring the rest. But when we turn to the concrete historical changes in macroeconomic quantities like household debt and aggregate demand in the US, the ceteris paribus condition is no longer available. We can’t reason in terms of the hypothetical case where all else was equal. We have to take into account all the factors that actually did contribute to those changes.

This is one of the main points of the debt-inequality paper, and of my work with Arjun Jayadev on household debt. In reality, much of the historical variation in debt-income ratios and related variables cannot be explained in terms of the factors in Figure 1. You need something more like Figure 2.

Figure 2 shows a broader set of factors that we need to include in a historical account of household sector balances. I should emphasize, again, that this is not about cause and effect. The links shown in the diagram are accounting relationships. You cannot explain the outcomes at the bottom without the factors shown here. [1] I realize it looks like a lot of detail. But this is not complexity for complexity’s sake. All the links shown in Figure 2 are quantitatively important.

The dark black links are the same as in the previous diagram. It is still true that higher household consumption spending reduces saving and raises aggregate demand, and contributes to lower saving and higher borrowing, which in turn contributes to lower net wealth and an increase in the debt ratio. Note, though, that I’ve separated saving from balance sheet improvement. The economic saving used in the national accounts is quite different from the financial saving that results in changes in the household balance sheet.

In addition to the factors the debt-demand story of Figure 1 focuses on, we also have to consider: various actual and imputed payment flows that the national accounts attribute to the household sector, but which do not involve any money payments to or fro households (blue); the asset side of household balance sheets (gray); factors other than current spending that contribute to changes in debt-income ratios (red); and change in value of existing assets (cyan).

The blue factors are discussed in Section 5 of the debt-distribution paper. There is a much fuller discussion in a superb paper by Barry Cynamon and Steve Fazzari, which should be read by anyone who uses macroeconomic data on household income and consumption. Saving, remember, is defined as the difference between income and consumption. But as Cynamon and Fazzari point out, on the order of a quarter of both household income and consumption spending in the national accounts is accounted for by items that involve no actual money income or payments for households, and thus cannot affect household balance sheets.

These transactions include, first, payments by third parties for services used by households, mainly employer-paid premiums for health insurance and payments to healthcare providers by Medicaid and Medicare. These payments are counted as both income and consumption spending for households, exactly as if Medicare were a cash transfer program that recipients then chose to use to purchase healthcare. If we are interested in changes in household balance sheets, we must exclude these payments, since they do not involve any actual outlays by households; but they still do contribute to aggregate demand. Second, there are imputed purchases where no money really changes hands at all. The most important of these are owners’ equivalent rent that homeowners are imputed to pay to themselves, and the imputed financial services that households are supposed to purchase (paid for with imputed interest income) when they hold bank deposits and similar assets paying less than the market interest rate. Like the third party payments, these imputed interest payments are counted as both income and expenditure for households. Owners’ equivalent rent is also added to household income, but net of mortgage interest, property taxes and maintenance costs. Finally, the national accounts treat the assets of pension and similar trust funds as if they were directly owned by households. This means that employer contributions and asset income for these funds are counted as household income (and therefore add to measured saving) while benefit payments are not.

These items make up a substantial part of household payments as recorded in the national accounts – Medicare, Medicaid and employer-paid health premiums together account for 14 percent of official household consumption; owners’ equivalent rent accounts for another 10 percent; and imputed financial services for 4 percent; while consolidating pension funds with households adds about 2 percent to household income (down from 5 percent in the 1980s). More importantly, the relative size of these components has changed substantially in the past generation, enough to substantially change the picture of household consumption and income.

Incidentally, Klein says I exclude all healthcare spending in my adjusted consumption series. This is a misunderstanding on his part. I exclude only third-party health care spending — healthcare spending by employers and the federal government. I’m not surprised he missed this point, given how counterintuitive it is that Medicare is counted as household consumption spending in the first place.

This is all shown in Figure 3 below (an improved version of the paper’s Figure 1):

The two dotted lines remove public and employer payments for healthcare, respectively, from household consumption. As you can see, the bulk of the reported increase in household consumption as a share of GDP is accounted for by healthcare spending by units other than households. The gray line then removes owners’ equivalent rent. The final, heavy black line removes imputed financial services, pension income net of benefits payments, and a few other, much smaller imputed items. What we are left with is monetary expenditure for consumption by households. The trend here is essentially flat since 1980; it is simply not the case that household consumption spending has increased as a share of GDP.

So Figure 3 is showing the contributions of the blue factors in Figure 2. Note that while these do not involve any monetary outlay by households and thus cannot affect household balance sheets or debt, they do all contribute to measured household saving.

The gray factors involve household assets. No one denies, in principle, that balance sheets have both an asset side and a liability side; but it’s striking how much this is ignored in practice, with net and gross measures used interchangeably. In the first place, we have to take into account residential investment. Purchase of new housing is considered investment, and does not reduce measured saving; but it does of course involve monetary outlay and affects household balance sheets just as consumption spending does. [2] We also have take into account net acquisition of financial assets. An increase in spending relative to income moves household balance sheets toward deficit; this may be accommodated by increased borrowing, but it can just as well be accommodated by lower net purchases of financial assets. In some cases, higher desired accumulation of financial asset can also be an autonomous factor requiring balance sheet adjustment. (This is probably more important for other sectors, especially state and local governments, than for households.) The fact that adjustment can take place on the asset as well as the liability side is another reason there is no necessary connection between saving and debt growth.

Net accumulation of financial assets affects household borrowing, but not saving or aggregate demand. Residential investment also does not reduce measured saving, but it does increase aggregate demand as well as borrowing. The red line in Figure 3 adds residential investment by households to adjusted consumption spending. Now we can see that household spending on goods and services did indeed increase during the housing bubble period – conventional wisdom is right on that point. But this was a spike of limited duration, not the secular increase that the standard consumption figures suggest.

Again, this is not just an issue in principle; historical variation in net acquisition of assets by the household sector is comparable to variation in borrowing. The decline in observed savings rates in the 1980s, in particular, was much more reflected in slower acquisition of assets than faster growth of debt. And the sharp fall in saving immediately prior to the great recession in part reflects the decline in residential investment, which peaked in 2005 and fell rapidly thereafter.

The cyan item is capital gains, the other factor, along with net accumulation, in growth of assets and net wealth. For the debt-demand story this is not important. But in other contexts it is. As I pointed out in my Crooked Timber post on Piketty, the growth in capital relative to GDP in the US is entirely explained by capital gains on existing assets, not by the accumulation dynamics described by his formula “r > g”.

Finally, the red items in Figure 2 are factors other than current spending and income that affect the debt-income ratio. Arjun Jayadev and I call this set of factors “Fisher dynamics,” after Irving Fisher’s discussion of them in his famous paper on the Great Depression. Interest payments reduce measured saving and shift balance sheets toward deficit, just like consumption; but they don’t contribute to aggregate demand. Defaults or charge-offs reduce the outstanding stock of debt, without affecting demand or measured savings. Like capital gains, they are a change in a stock without any corresponding flow. [3] Finally, the debt-income ratio has a denominator as well as a numerator; it can be raised just as well by slower nominal income growth as by higher borrowing.

These factors are the subject of two papers you can find here and here. The bottom line is that a large part of historical changes in debt ratios — including the entire long-term increase since 1980 — are the result of the items shown in red here.

So what’s the point of all this?

First, borrowing is not the opposite of saving. Not even roughly. Matthew Klein, like most people, immediately translates rising debt into declining saving. The first half of his post is all about that. But saving and debt are very different things. True, increased consumption spending does reduce saving and increase debt, all else equal. But saving also depends on third party spending and imputed spending and income that has no effect on household balance sheets. While debt growth depends, in addition to saving, on residential investment, net acquisition of financial assets, and the rate of chargeoffs; if we are talking about the debt-income ratio, as we usually are, then it also depends on nominal income growth. And these differences matter, historically. If you are interested in debt and household expenditure, you have to look at debt and expenditure. Not saving.

Second, when we do look at expenditure by households, there is no long-term increase in consumption. Consumption spending is flat since 1980. Housing investment – which does involve outlays by households and may require debt financing – does increase in the late 1990s and early 2000s, before falling back. Yes, this investment was associated with a big rise in borrowing, and yes, this borrowing did come significantly lower in the income distribution that borrowing in most periods. (Though still almost all in the upper half.) There was a debt-financed housing bubble. But we need to be careful to distinguish this episode from the longer-term rise in household debt, which has different roots.

[1] Think of it this way: If I ask why the return on an investment was 20 percent, there is no end to causal factors you can bring in, from favorable macroeconomic conditions to a sound business plan to your investing savvy or inside knowledge. But in accounting terms, the return is always explained by the income and the capital gains over the period. If you know both those components, you know the return; if you don’t, you don’t. The relationships in the figure are the second kind of explanation.

[2] Improvement of existing housing is also counted as investment, as are brokers’ commissions and other ownership transfer costs. This kind of spending will absorb some part of the flow of mortgage financing to the household sector — including the cash-out refinancing of the bubble period — but I haven’t seen an estimate of how much.

[3] There’s a strand of heterodox macro called “stock-flow consistent modeling.” Insofar as this simply means macroeconomics that takes aggregate accounting relationships seriously, I’m very much in favor of it. Social accounting matrices (SAMs) are an important and underused tool. But it’s important not to take the name too literally — economic reality is not stock-flow consistent!

Two Papers in Progress

There are two new papers on the articles page on this site. Both are work in progress – they haven’t been submitted anywhere yet.

[I’ve taken the debt-distribution paper down. It’s being revised.]

The Evolution of State-Local Balance Sheets in the US, 1953-2013

Slides

The first paper, which I presented in January in Chicago, is a critical assessment of the idea of a close link between income distribution and household debt. The idea is that rising debt is the result of rising inequality as lower-income households borrowed to maintain rising consumption standards in the face of stagnant incomes; this debt-financed consumption was critical to supporting aggregate demand in the period before 2008. This story is often associated with Ragnuram Rajan and Mian and Sufi but is also widely embraced on the left; it’s become almost conventional wisdom among Post Keynesian and Marxist economists. In my paper, I suggest some reasons for skepticism. First, there is not necessarily a close link between rising aggregate debt ratios and higher borrowing, and even less with higher consumption. Debt ratios depend on nominal income growth and interest payments as well as new borrowing, and debt mainly finances asset ownership, not current consumption. Second, aggregate consumption spending has not, contrary to common perceptions, risen as a share of GDP; it’s essentially flat since 1980. The apparent rise in the consumption share is entirely due to the combination of higher imputed noncash expenditure, such as owners’ equivalent rent; and third party health care spending (mostly Medicare). Both of these expenditure flows are treated as household consumption in the national accounts. But neither involves cash outlays by households, so they cannot affect household balance sheets. Third, household debt is concentrated near the top of the income distribution, not the bottom. Debt-income ratios peak between the 85th and 90th percentiles, with very low ratios in the lower half of the distribution. Most household debt is owed by the top 20 percent by income. Finally, most studies of consumption inequality find that it has risen hand-in-hand with income inequality; it appears that stagnant incomes for most households have simply meant stagnant living standards. To the extent demand has been sustained by “excess” consumption, it was more likely by the top 5 percent.

The paper as written is too polemical. I need to make the tone more neutral, tentative, exploratory. But I think the points here are important and have not been sufficiently grappled with by almost anyone claiming a strong link between debt and distribution.

The second paper is on state and local debt – I’ve blogged a bit about it here in the past few months. The paper uses budget and balance sheet data from the census of governments to make two main points. First, rising state and local government debt does not imply state and local government budget deficits. higher debt does not imply higher deficits: Debt ratios can also rise either because nominal income growth slows, or because governments are accumulating assets more rapidly. For the state and local sector as a whole, both these latter factors explain more of the rise in debt ratios than does the fiscal balance. (For variation in debt ratios across state governments, nominal income growth is not important, but asset accumulation is.) Second, despite balanced budget requirements, state and local governments do show substantial variation in fiscal balances, with the sector as a whole showing deficits and surpluses up to almost one percent of GDP. But unlike the federal government, the state and local governments accommodate fiscal imbalances entirely by varying the pace of asset accumulation. Credit-market borrowing does not seem to play any role — either in the aggregate or in individual states — in bridging gaps between current expenditure and revenue.

I will try to blog some more about both these papers in the coming days. Needless to say, comments are very welcome.

How State Budgets Adjust

Here is a figure from the paper I’m presenting at the Eastern Economics Association meetings next weekend, on state and local government balance sheets:

State Government Finances 1999-2013. Source: Census of Governments, author’s analysis

This figure is just for aggregate state governments. It shows total borrowing (red), net acquisition of financial assets (blue), and the overall fiscal balance (black, with surplus as positive). It also shows the year over year change in the ratio of state debt to GDP (the gray dotted line). A number of interesting points come out here:

Despite statutory balanced-budget requirements, state budgets do show significant cyclical movement, from aggregate deficits of around 0.5 percent of GDP in recent recessions to surpluses as high as 0.5 percent of GDP in the expansions of the 1980s and 1990s (not shown here). Individual state governments show larger movements.
Shifts in state government fiscal balances are accommodated almost entirely on the asset side of the balance sheet. When state government revenue exceeds current expenditure, they buy financial assets; when revenue falls or expenditure rises, they sell financial assets (or buy less). State governments borrow in order to finance specific capital projects; unlike the federal government, they do not use credit-market borrowing to close gaps between current expenditure and revenue. (As I show in the paper, this is still true when we look at state governments cross-sectionally rather than aggregate data.) Between 2005 and 2009, state budgets moved from an aggregate surplus of around 0.3 percent of GDP to an aggregate deficit of around 0.5 percent. But borrowing over this period was completely flat – the entire shortfall was made up by reduced acquisition of financial assets.
The ratio of state government debt to GDP rose over the Great Recession period, by a total of about 2 points. While this is small compared with the increase in federal debt over the same period, it is certainly not trivial. Among other things, rising state debt ratios have been used as arguments for austerity and attacks on pubic-sector unions in a number of states. But as we see here, the entire rise in state debt-GDP ratios over this period is explained by slower growth. The ratio rose because of a smaller denominator, not a bigger numerator.
State debt ratios rose around the same time that state budgets moved into deficit. But there is no direct relationship between these two developments. Deficits were financed entirely through a reduction in assets. Simultaneously, the drastic slowdown in growth mean that even though state governments significantly reduced their borrowing, in dollar terms, during the recession, the ratio of debt to income rose. It is true, of course, that both the deficits and the growth slowdown were the result of the recession. But the increase in state debt ratios would have been exactly the same if state budgets had not moved to deficit at all.
Since 2010 there has been a simultaneous fall in state government borrowing and acquisition of assets. When these two variables vary together (as they also do across governments in some periods) it suggests that there is some autonomous balance sheet adjustment going on that can’t be reduced to the net financial position changing to accommodate real flows. (The fact that offsetting financial positions cannot in general be netted out is one of the main planks of Bezemer’s accounting view of economics.)

The pattern is similar in the previous recession. Although there was some increase in borrowing as state governments moved into deficit in 2002-2003, the large majority of the financing was on the asset side.

The larger significance of all this, and the data underlying it, is discussed more in the paper. I will post that here next week. In the meantime, the two big takeaways are, first, that a lot of historical variation in debt ratios are driven by the effect of different nominal growth rates on the existing debt stock rather than by new borrowing; and that state governments don’t finance budget imbalances on the liability side of their balance sheets, but on the asset side.

(Earlier posts based on the same work here and here.)

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.

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.

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**

**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.