The Slack Wire

A Response to Tom Palley

Tom Palley wrote a strongly worded critique of Modern Monetary Theory last year, which got a lot of attention int he world of heterodox economics. He has just put up a second piece, MMT: The Emperor Still Has No Clothes, reiterating and extending his criticisms.

Palley is a smart guy who I’ve learned a lot from over the years. But this is not his best work.

By way of preliminaries: MMT consists of three distinct arguments. First is chartalism, the claim that the value of money depends on its acceptability to settle tax obligations. This goes back to G. F. Knapp. Second is functional finance, the claim that government (conceived of as a consolidated budget and monetary authority) seeks to adjust the budget balance to achieve full employment, it can never be prevented from doing so by a financing constraint. This goes back to Abba Lerner and Evsey Domar. And third is the employer of last resort (ELR), a proposal for a specific form of spending to be adjusted under the functional finance rule. This seems to be an original contribution of Warren Mosler goes back to Hyman Minsky.

Personally, I find it useful to set aside the first and third of these arguments and focus on the second, functional finance. My own attempt to restate the functional finance claim in the language of contemporary textbooks is here. In my view, the essential difference between functional finance and orthodoxy is that the assignments of the interest rate and budget instruments are flipped. Instead of setting the interest rate to keep output at potential and setting the budget balance to keep the debt on a sustainable path, we assign the budget balance to keeping output at potential and the interest rate to debt sustainability.

Palley wants to knock down all three planks of MMT. What are his objections to functional finance?

(1) In the absence of economic growth, government deficits will lead to inflation regardless of the output gap. This claim is asserted rather than argued for. [1] It’s not clear what the relevance of this point is, since he agrees that deficits are not inherently inflationary when there is positive growth. Perhaps more importantly, this is a rejection not just as of MMT but of almost all policy-oriented macroeconomics, mainstream and heterodox. Whether you’re reading David Romer or Wendy Carlin or Lance Taylor, you’re going to find a Phillips curve that relates inflation to current output. There are plenty of disagreements about how expected inflation comes in, but nobody is going to include the budget balance as an independent term. In his eagerness to debunk MMT, Palley here finds himself reasserting Milton Friedman-style monetarism.

(2) If we assume an arbitrary floor on spending and an arbitrary ceiling on taxes, then it may be impossible to achieve both full employment/price stability and a sustainable debt path with interest rates fixed at zero. Yes, this is true. But it proves too much: If we impose arbitrary constraints on tax and spending levels then there is no guarantee that we can achieve debt sustainability and price stability with ANY interest rate. At any given interest rate, there is minimum primary balance that must be achieved to keep output at potential. There is also a minimum primary balance that must be achieved to keep the debt-GDP ratio constant. There is no a priori reason to think the first balance is higher than the second. So Palley’s argument here could just as well be a proof that there is nothing government can do to prevent public debt from rising without limit. In any case, these arbitrary limits on taxes and spending are not a feature of standard macro models (including Palley’s own models elsewhere), so it’s hard to justify bringing them in here.

(3) MMT lacks a theory of inflation. On the contrary, MMT has exactly the same theory of inflation as orthodox macro: High or rising inflation is the result of output above potential, disinflation or deflation the result of output below potential. In other words, MMT is consistent with a standard Phillips curve of the same kind Palley (and almost everybody else) uses. To be fair, the Wray and Tymoigne piece Palley is responding to is not as clear as it might be on this point. But Palley is supposed to be writing a critique of MMT, not just of one particular article. And people like Stephanie Kelton state unambiguously that MMT shares the orthodox output-gap story of inflation; see for instance slide 13 here.

(4) MMT doesn’t work in open economies because it requires persistent interest rate differentials between countries. Palley claims that the idea that you can hold interest rates in a given country at zero indefinitely is inconsistent with covered interest parity, a “well-established empirical regularity” that “states there is no room for systematic arbitrage of cross-country interest rates.” It seems that Palley has confused covered and uncovered interest parity. CIP is indeed well established empirically, but it only says that there is no arbitrage possible between the spot and forward markets for a given exchange rate. It does not rule out interest-rate arbitrage in the form of the carry trade, and so does not have any implications for the viability of MMT. If UIP held, that would indeed rule out a persistent zero interest policy in the absence of an equally persistent currency appreciation. But UIP, unlike CIP, gets no empirical support in the literature. Japan has sustained the near-zero interest rates that Palley says are unsustainable for 15 years now, and in general, persistent interest rate differentials without any offsetting exchange rate movements are ubiquitous. Furthermore, if financial openness rules out a policy of i=0, then it equally rules out the use of interest rates as a tool for demand management. The best thing you can say about Palley here is that he is parroting orthodoxy; otherwise he is thoroughly confused.

There is one thing that Palley is right about, which is that substantially all of MMT can be found in the old Keynesian literature. This isn’t news — in the same Stephanie Kelton slideshow linked above, she goes out of her way to say that there is nothing “modern” about MMT. And so what? There’s nothing wrong with updating insights from the past. In my opinion, most useful work in economics is about pouring old wine in new bottles.

I don’t write this from a position within MMT. I tend to feel that the genuine insights of Lernerian functional finance are obscured rather than strengthened by basing them in a chartalist theory of money. It’s fine if Tom Palley disagrees with our friends at UMKC and the Levy Institute. But he needs to put down the blunderbuss.

[1] In fact it’s a bit hard to understand what Palley is claiming here. First he says that “money financed deficits” must lead to inflation in a static economy, even with a zero output gap. He adds in a footnote that money-financed are not inflationary in a growing economy; in that case, for price stability “the high-powered money stock must grow at the rate of growth.” Then when he writes down a model, this has become the condition that government budget must be balanced, which is something different again. Also, I must say I can’t help wrinkling my nose a little, when I read about the “stock of high-powered money,” at the smell of a musty antique.

EDIT: Thanks to Daniele Santolamazza for correcting me on the origins of the ELR proposal.

Don’t Start from the Coin

Schumpeter:

Even today, textbooks on Money, Currency, and Banking are more likely than not to begin with an analysis of a state of things in which legal-tender ‘money’ is the only means of paying and lending. The huge system of credits and debits, of claims and debts, by which capitalist society carries on its daily business of production and consumption is then built up step by step by introducing claims to money or credit instruments that act as substitutes for legal tender… Even when there is very little left of [money’s] fundamental role in practice, everything that happens in the sphere of currency, credit, and banking is construed from it, just as the case of money itself is construed from barter. 

Historically, this method of building up the analysis of money, currency, and banking is readily understandable… Legal constructions, too, … were geared to a sharp distinction between money as the only genuine and ultimate means of payment and the credit instrument that embodied a claim to money. But logically, it is by no means clear that the most useful method is to start from the coin—even if, making a concession to realism, we add inconvertible government paper—in order to proceed to the credit transactions of reality. It may be more useful to start from these in the first place, to look upon capitalist finance as a clearing system that cancels claims and debts and carries forward the differences—so that ‘money’ payments come in only as a special case without any particularly fundamental importance. In other words: practically and analytically, a credit theory of money is possibly preferable to a monetary theory of credit.

Perry Mehrling quotes this passage at the start of his essay Modern Money: Credit or Fiat. If you’re someone who worries about the vexed question of what is money anyway, you will benefit from the sustained intelligence Perry brings to bear on it.

Readers of this blog may not be familiar with Perry’s work, so let me suggest a few things. The Credit or Fiat essay is a review of one of Randy Wray’s books, but it makes important positive arguments along with the negative criticism of MMT. [1] A good recent statement of Mehrling’s own views on the monetary system is The Inherent Hierarchy of Money. Two superb essays on monetary thought in the postwar neoclassical synthesis are The Money Muddle and MIT and Money. [2] The former of these coins the term “monetary Walrasianism.” This refers to  the idea that the way to think of a monetary economy is a barter system where, for whatever reason, the nth good serves as unit of account and must be on one side of all trades.  This way of thinking about money is so ingrained that I suspect that many economists would be puzzled by the suggestion that there is any other way of thinking about money. But as Perry shows, this is a specific idea with its own history, to which we can and should imagine alternatives. Finally, The Vision of Hyman Minsky is one of the two best essays I know giving a systematic account of Minsky’s, well, vision. (The other is Minsky as Hedgehog by Dymski and Pollin.) Anyone interested in what money is, what “money” means, and what’s wrong with economists’ answers, could save themselves a lot of trouble and wrong turns by reading those essays. [3]

But let’s talk about the Schumpeter quote.  I think it is right. To understand the monetary nature of modern economies, you need to begin with the credit system, that is, the network of money obligations. Where we want to start from is a world of IOUs. Suppose the only means of payment is a promise to pay. Suppose it’s not only possible for me to tell the bartender at the end of the night, I’ll pay you later, suppose there’s nothing else I can tell him — there’s no cash register at the bar, just a box where my tab goes. Money still exists in this system, but it is only a money of account — concretely we can imagine either an arbitrary unit of value, or some notional commodity that does not circulate, or even exist. (Historical example: non-circulating gold in medieval Europe.) If you give something to me, or do something for me, the only thing I can pay you with now is a promise to pay you later.

This might seem paradoxical — jam tomorrow but never jam today — but it’s not. Debts in this system are eventually settled. As Schumpeter says, they’re settled by netting my IOUs to you from your IOUs to me. An important question then becomes, how big is the universe across which we can cancel out debts? If A owes B, B owes C, and C owes A, it’s not hard to settle everyone up. But suppose A owes B who owes C who owes …. who owes M who owes … who owes Z, who owes A. It’s not so easy now for the dbets to be transferred back along the chain for settlement. In any case, though, my willingness to accept your IOUs depends on my belief that I will want to make some payment to you in the future, or that I’ll want to make some payment to someone who will want to make a payment to someone …. who will eventually want to make a payment to you. The longer the chain, the more important it is for their to be some setting where all the various debts are toted up and canceled out.

The great fairs of medieval Europe were exactly this. During their normal dealings, merchants paid each other with bills of exchange, essentially IOUs that could be transferred to third parties. Merchants would pay suppliers by transferring (with their own endorsement) bills from their customers. Then periodically, merchant houses would send representatives to Champagne or wherever, where the various bills could be presented for payment. Almost all the obligations would end up being offsetting. From Braudel, Capitalism and Civilization Vol. 2:

… the real business of the fairs, economically speaking, was the activity of the great merchant houses. … No fair failed to end with a ‘payment session’ as at Linz, the great fair in Austria; at Leipzig, from its early days of prosperity, the last week was for settling up, the Zahlwoche. Even at Lanciano, a little town in the Papal States which was regularly submerged by its fair (though the latter was only of modest dimensions), handfuls of bills of exchange converged on the fair. The same was true of Pezenas or Montagnac, whose fairs relayed those of Beaucaire and were of similar quality: a whole series of bills of exchange on Paris or Lyons travelled to them. 

The fairs were effectively a settling of accounts, in which debts met and cancelled each other out, melting like snow in the sun: such were the miracles of scontro, compensation. A hundred thousand or so “ecus d’or en or” – that is real coins – might at the clearing-house of Lyons settle business worth millions; all the more so as a good part of the remaining debts would be settled either by a promise of payment on another exchange (a bill of exchange) or by carrying over payment until the next fair: this was the deposito which was usually paid for at 10% a year (2.5% for three months). 

This was not a pure credit-money system, since coin could be used to settle obligations for which there was no offsetting bill. But note that a “good part” of the net obligations remaining at the end of the fair were simply carried over to the next fair.

I think it would be helpful if we replaced truck-and-barter with something like these medieval fairs, when we imagine the original economic situation. [4] Starting from a credit view of money modifies our intuitions in several, as I see it, helpful ways.

1. Your budget constraint is always a matter of how much people will lend you, or how safe you feel borrowing. Conversely, the consequences of failing to pay your debts is a fundamental parameter. We can’t push bankruptcy onto the back burner as a tricky but secondary question to be dealt with later.

2. The extension of credit goes with an extension of the realm of the market. The more things you might be willing to do to settle your debts, the more willing I am to lend to you. And conversely, the further what you owe runs beyond your normal income, the more the question of what you won’t do for money comes up for negotiation.

3. Liquidity, money, demand, depend ultimately on people’s willingness to trust each other, to accept promises, to have confidence in things working out according to plan. Liquidity exists on the liability side of balance sheets as much as on the asset side.

4. When we speak of more or less liquidity, we don’t mean a greater or lesser quantity of some commodity designated “money,” but a greater or lesser degree of willingness to extend credit. So at bottom, conventional monetary policy, quantitative easing, lender of last resort operations, bank regulations — they’re all the same thing.

When Minsky says that the fundamental function of banks is “acceptance,” this is what he means. The fundamental question faced by the financial system is, whose promises are good?

[1] I don’t want to get into Perry criticisms of MMT here. Anyone interested should read the article, it’s not long.

[2] MIT and Money also makes it clear that I was wrong to pick Samuelson’s famous consumption-loan essay as an illustration of the neoclassical position on interest rates. The point of that essay, he explains, was not to offer a theory of interest rate determination, but rather to challenge economic conservatives by demonstrating that even in a simple, rigorous model of rational optimization, a public pension system could could be an unambiguous welfare improvement over private retirement saving. My argument wasn’t wrong, but I should have picked a better example of what I was arguing against.

[3] Perry has also written three books. The only one I’ve read is The New Lombard Street. I can’t recommend it as a starting point for someone new to his work: It’s too focused on the specific circumstances of the financial crisis of 2008, and assumes too much familiarity with his larger perspective.

EDIT: I removed some overly belligerent language from the first footnote.

On Other Blogs, Other Wonders

Some things worth reading:

1. Ozgur Orhangazi on the coming balance of payments crisis in Turkey:

Since the late 1970s, “developing and emerging economies” (DEEs) have experienced boom-bust cycles of private capital flows… The latest boom began in the aftermath of the 2008 U.S. financial crisis, fed by the quantitative easing policies of the Federal Reserve and the European Central Bank (ECB). Much of Fed’s injections of credit into the system ended up in the stock markets of advanced economies and even more in the DEEs.
This latest wave of capital flows into DEEs led to currency appreciations, growing current account deficits, credit expansions and asset bubbles. …  

Turkey is a case in point. While in the last decade it gained praise for its strong growth performance, now it is considered to be among the “fragile five”, together with Brazil, India, Indonesia, and South Africa. The biggest concern is the large current account deficit (reaching as much as 7.5 percent of the GDP by the end of November 2013) that is being financed mostly by short-term volatile capital inflows. … 

Starting right after the Fed’s announcement in May 2013, the Turkish lira began losing its value. … From May to the beginning of this week, the lira lost about 30 percent of its value, forcing the Central Bank, which so far has been resistant to increasing interest rates, to sharply increase interest rates at midnight after an emergency meeting on January 28. 

What is next? While the Central Bank’s sharp interest rate hike has, at least for now, stopped the free fall of the lira, the future does not seem very rosy… the depreciation of the lira will create serious problems for the firms that have borrowed in foreign currencies. … This is likely to lead to, at the very least, payment problems; and most probably to many bankruptcies…

There’s been a lot of discussion of whether low interest rates in the US and other developed countries contribute to excessive credit expansion and asset bubbles here. But it’s worth remembering that these problems are much worse for developing countries, which — in a world of free financial flows — share in the credit conditions of the rich countries whether they want to or not. One can be skeptical of particular forms of the “far too low for far too long” argument and still recognize that if aggregate expenditure is to be stabilized solely through conventional monetary policy, the shifts in interest rates  required may be big enough to be destabilizing on other dimensions.
2. Martin Rapetti on the coming balance of payments crisis in Argentina: 

In July 2011, the stock of FX reserves was around U$ 52 billions. The exchange rate was 4.1 pesos per dollar… In August 2011 —three months before the presidential election— the Central Bank started losing reserves. In November 2011, just a few weeks after Cristina Kirchner was re-elected, FX reserves were U$ 46 billions. Since the depletion of FX reserves showed no sign of stopping, the authorities started to implement a series of measures to limit the demand for foreign currency. The controls triggered the blossoming of black markets. FX reserves kept falling, very rapidly since early 2013. In November 2013, after a poor mid-term election, the president fired the governor of the Central Bank and put in charge a new economic team. FX reserves were U$ 33 billions and the exchange rate had reached 6 pesos per dollar…. a week ago, the price of US dollar jumped to 8 pesos. FX reserves are now close to U$ 28 billions. The Central Bank has managed to keep the exchange rate at 8 pesos at the cost of loosing U$ 150/200 millions of reserves per day. There are still widespread expectations of further devaluation and few believe that authorities can sustain the exchange rate at the new level, especially because the rate of inflation has accelerated above 30% annually. In short, FX reserves have so far fallen by 46% and the exchange rate has risen by 95%. If it looks like a dog, walks like a dog and barks like a dog, then… it’s probably a balance of payments crisis.

In Martin’s telling, the root of the problem here is not monetary policy in the developed world, but rather the difficulty of using the exchange rate as a nominal anchor to control inflation.
3. Laura Tanenbaum on how nostalgia, real estate and race have shaped the idea of “Brooklyn”:

Brooklyn nostalgia has done more than sell hot dogs and baseball memorabilia. … in the early 1960s a flourishing literature of … “urban pastoralism” challenged developers and urban renewal through nostalgic appeals to the authenticity of “urban villages” and daily street life. These writings by artists, activists, and academics, most famously Jane Jacobs’s The Death and Life of Great American Cities, inspired and shaped the views of “brownstoners,” homeowners who sought to resist the tide of suburbanization and white flight. But by the 1970s, … coalitions between brownstoners and low-income residents had unraveled; Democratic New York City mayor Ed Koch turned this politics toward conservative ends. Koch “reveled in ethnic kitsch and cultivated a folksy image of a neighborhood New Yorker” while complaining about “poverty pimps.” It was the Southern strategy with an outer-borough accent. 

More than thirty years later, the crush of development marches forward. Brooklyn is a global brand: overpriced trinkets to be sold at Brooklyn Pizza in Manila, Brooklyn Coffeeshop in Curitiba, Brazil, or one of the other global Brooklyns featured in New York magazine’s retrospective of the Bloomberg era. But hip culture in the United States has long had a deep romantic and nostalgic streak, and the hipster’s most recent incarnation, central to the current branding of Brooklyn, has been no exception. 

The role of artists and hipsters in gentrification — specifically, their degree of complicity in the resulting displacement of low-income residents — has been endlessly debated. Were they the developers’ dupes, their victims, or their willing accomplices? Less often commented upon is the implicit equation behind these questions: associating artists with gentrification suggests that an artist has to be white. This is a particularly bitter irony for a borough and a city that has historically been and remains home to some of the most important African-American artists, musicians, filmmakers, writers, and intellectuals in the country. Looking at hipster culture in relationship to their work offers alternative ways of thinking about how the city changes, how we remember it, and what it might mean to oppose the march of neoliberal development without relying on a nostalgia that reflects our memories and desires more than our actual history.

It’s a great piece. Read the whole thing, as they say.

What Do People Need to Know About International Trade?

On the first day of my trade class, we read Paul Krugman’s article “What Do Undergrads Need to Know About Trade?” In an admirably succinct four pages, it captures all the important things that orthodox trade theory claims to tell us about trade policy. I don’t think orthodox views on trade policy have changed at all in the 20 years since it was written. [1]

So what’s Krugman’s answer? What undergrads need to know, he says, is just what Hume and Ricardo were saying, 200 years ago: If relative costs of production are different in two countries, then total world output, and consumption in each individual country, will always be greater with trade than without, and prices will adjust so that trade is balanced. Free trade is always beneficial for all countries involved.

Krugman’s additions to this Ricardo-Hume catechism are mostly negative — a list of things we don’t need to talk about when talk about trade.

Don’t worry about development. The idea that a country can benefit from changing the sectors or industries it specializes in is, he says “a silly concept.” Yes, we look around the world and see workers in rich countries producing things like airplanes and software, which are worth a lot, and workers in poor countries putting the same effort into producing agricultural goods and textiles, which are worth much less. But

Does this mean the rich country’s high standard of living the result of being in the right sector, or that the poorer country would be richer if it tried to emulate the other’s pattern of specialization? Of course not.

Of course not. This blanket dismissal is rather odd, since the work Krugman won the Nobel for explicitly supports an affirmative answer to both questions. [2] It’s a case of esoteric versus exoteric knowledge, I guess — some truths are not meant for everyone. Or as Krugman delicately puts it, “the innovative stuff is not a priority for undergrads.”

Don’t worry about demand. In debates over policy, “the central issue is employment” in the arguments on both sides. But this is wrong, he says:

The level of employment is a macroeconomic issue, depending in the short run on aggregate demand and depending in the long run on the natural rate of unemployment, with policies like tariffs having little net effect. Trade policy should be debated in terms of its impact on efficiency…

It’s not immediately obvious why the claim that employment depends on aggregate demand is inconsistent with the claim that trade flows have important employment effects. After all, net exports are a component of demand. The implicit assumption is evidently that the central bank (or some other domestic policymaker) is maintaining the level of demand at the full-employment level, and will offset any effects from trade. [3]

Don’t worry about trade deficits, and the financing they require. “The essential things to teach students are still the insights of Ricardo and Hume. That is, trade deficits are self-correcting…”

The whole piece is frankly polemical — it’s clear that the goal is not to educate in the normal sense, but to equip students to take a particular side in public debates. This is not specific to Krugman, of course. If anything, most contemporary textbooks are even worse. [4] One  reason I am using Caves and Frankel in my class is that it has less obnoxious editorializing than other texts I looked at. But less is still a lot.

Enough Krugman-bashing. What’s the alternative? What should people know about international trade? Matias Vernengo has one good alternative list. Here is mine.

There are three frameworks or perspectives in which we can productively think about international trade. The questions we ask in each case will depend on whether we are thinking of trade flows as the adjusting variable, or as reflecting an exogenous change to which some other variable(s) must adjust.

1. Trade flows are part of aggregate expenditure. On the one hand, a good way to predict trade flows is to assume that a fixed fraction of each dollar of spending goes to imported goods. As Joan Robinson and others have stressed, in the short run at least, adjustment of trade balances comes mainly or entirely through income changes. (This is also the perspective developed in Enno Schroeder’s work, which I’ve discussed here before.) On the other hand, if we can’t assume there is some level of full employment or potential output to which to which the economy always returns, then we have to be concerned with trade flows as one factor determining the level of aggregate income. This might be only a short-run phenomenon, as in mainstream Keynesian analysis, or it might be important to economic growth rates over the long run, as in models of balance of payments constrained growth.

2. Trade flows are part of the balance of payments. In a capitalist world economy, there are many different money payments and obligations between countries, of which trade flows are just part. In a world of liquidity constraints, certain configurations of money payments or money commitments are costly, or cannot be achieved at all. That is, a country in the aggregate cannot in general borrow unlimited amounts at “the” world interest rate. The tighter the constraints on a country’s financial position, the more positive a trade balance it must somehow achieve. On the other hand, for a given level of financing constraint, a more positive trade balance allows for more freedom on other dimensions. This interaction between trade flows and financial constraints is central to the balance of payments crises that are such a prominent feature of the modern world economy.

3. Trade flows involve specialization. Thinking now in terms of baskets of goods rather than money flows, the essential thing about international trade is that it allows a country’s consumption and production decisions to be made independently. Given that productive capacities vary more between countries than the mix of consumption goods chosen at a given income and prices, in practice this means that trade allows for specialization in production. If we take productive capacities as given, it follows that trade raises world output and income by allowing countries to specialize according to comparative costs. This is the essential (and genuine) insight of Ricardo. On the other hand, if we think that inherent differences between countries are small and that differences in productive capacity arise mainly through production itself, then international trade will lead to a historically contingent pattern of international specialization in which some positions are more advantageous than others. If causality runs from trade patterns to productive capacities and not just vice versa, then there is a case for including activity trade policy in any development strategy.

The orthodox trade theory has legitimate value and deserves a place in the curriculum. As we’ll discuss in the next post, simple textbook models of the Ricardo-Mill type can be used to tell stories with more interesting political implications than the usual free-trade morality tales. But they are only part of the picture. Much of what matters about trade depends on the fact that it involves flows of money and not just exchanges of goods.

[1] Have Krugman’s views changed since he wrote this? As reflected in his textbooks, no they have not. As reflected in his blog, seems like sometimes yes, sometimes no. Someone should ask him.

[2] For example, one of Krugman’s more widely cited articles is this one, which develops a model in which an innovating region (“the North”) develops new products, which it exports to a non-innovating region (“The South”). In the model,

Higher Northern per capita income depends on the quasi-rents from the Northern monopoly of new products, so the North must continually innovate not only to maintain its relative position but even to maintain its real income in absolute terms. 

This is hard to distinguish from the arguments for industrial policy that Krugman dismisses as silly.

[3] What’s especially odd here is that orthodox theory says that in a world of mobile capital, the only tool the central bank has to maintain full employment is changes in the exchange rate. In standard textbooks (including Krugman’s own), it is impossible for monetary policy to boost employment unless it improves the trade balance.

[4] For example, David Colander’s generally undogmatic intro textbook includes a section titled “If trade is so good, why do so many people oppose it?”The answer turns out to be, they’re just confused.

International Trade: What Are the Questions?

This semester, I’m teaching an upper-level class at Roosevelt on international trade. Trade is an interest of mine, but not something I’ve ever taught. So it will be a learning experience for me at least as much as for the students.

One way to organize a class like this is to start with the orthodox approach and then present the various heterodox alternatives. I don’t know if that’s the best way to do things; but it is what I am doing. So we divide things up:

1. Orthodox trade theory. Orthodox approaches to trade (the first half of any standard textbook; we are using Caves and Frankel) treat trade as an exchange of goods for goods. We assume that trade is always balanced and that all resources are fully employed, and show how specialization by different countries in their preferred activities leaves everyone better off. We can divide this approach into Ricardian models, which treats countries preferred activities as dictated by inherent differences in productive capacities, on the one hand; and on the other, the Heckscher-Ohlin models that regard countries as having the same productive technology but different “endowments” of (a relatively small number of) “factors of production.” As far as I can tell, these two kinds of models are not associated with distinct schools of thought in any larger sense; but it seems to me that the tension between them is one of the more interesting things in the orthodox theory.

2. Keynesian approaches. Here the important thing is the systematic relationship between income-expenditure and trade flows. On the one hand, we think a predictable fraction of incremental expenditure will fall on imports, and on the other, net exports are a form of autonomous demand boosting income. The short-run version of this approach used to be fully respectable; one very good presentation is Dornbusch’s 1980 textbook, Open Economy Macroeconomics. [1] The long-run version of the Keynesian approach is Thirlwall’s model of balance-of-payments constrained growth. I don’t know that this has ever been respectable but I think it’s useful and sensible and, I hope, teachable.

3. New trade theory. The starting point here is that while orthodox theory says that the biggest gains come from trade between countries that are most different (in terms of productive capacities or factor endowments), what we see in the real world is that most trade is between basically similar industrialized countries. The explanation, according to this approach, is that most trade is not in fact driven by comparative advantage, but by increasing returns, which reward specialization even in the absence of any inherent differences between countries or regions. This is the stuff Paul Krugman got his prize for. One puzzle about the new trade theory is that its practitioners almost all endorse the same free-trade policy orthodoxy underwritten by the old trade theory, even though the substantive content would seem to undermine it. What the new theory says is, first, that the pattern of specialization between countries is in some important respect arbitrary and at least potentially shaped by choices; and second, that the global distribution of income is a function of who ends up with which specialty. in this sense, there is some affinity between the new trade theory and Marxist theories of imperialism, dependency and unequal exchange. I’d wondered for a while if anyone had written about this connection. The answer turns out to be yes: Krugman himself. He even cites Lenin!

4. Development, dependency and unequal exchange. There is a large body of radical theory here, which I admit I have not quite got my arms around. For current purposes, let’s think in terms of two strands of analysis — or at least two sets of questions, which may or may not correspond to different schools or bodies of theory. First, there is the relationship between trade and economic development. Historically, we could put this at the very beginning of the list, since it seems that many of the earliest writers on what we now call economics were centrally concerned with this question. But for our purposes, we are interested in the tradition that runs from Hamilton to Friedrich List to Gerschenkron to Dani Rodrik and Ha-Joon Chang. These mostly pragmatic analyses, associated politically with rising rivals to the current hegemon, include a mix of infant industry/”import protection as export promotion” arguments, and trade restrictions as devices to expand the domestic policy space (the positive side of mercantilism emphasized by Keynes.) Second, there are the various theories that go under the names of dependency and unequal exchange. The key claim here is that there is a systematic movement of prices that favors the North and disfavors the South. We may further subdivide these theories into Prebisch-Singer and related approaches, and more Marxist analyses from Hobson, Lenin and Luxembourg through Baran to Frank, Wallerstein, Amin and Emmanuel.

Another way of looking at this: Among the assumptions of the orthodox theory are that all resources are fully employed, that prices always adjust so as to balance trade (or equivalently, that goods trade directly for goods), and that countries’ productive capacities can be taken as exogenous and determine the pattern of trade. Keynesian approaches reject the first two of these assumptions, the new trade theory rejects the third; the various development/dependency approaches also reject the third assumption and in some versions the first two as well.

There reason I’m posting this here is I’d like to integrate my teaching more with this blog. So the hope is to have a bunch of posts about all this over the next few months. I’m sure I’ll get a lot of things wrong; maybe the readers of the blog can correct some of them.

[1] On the other hand, this contemporary (and very admiring) review of the Dornbusch book does chide him for starting with 

a nonmonetary “Keynesian” model with rigid prices, fixed exchange rates, and unemployment … The basic consideration is short-run full employment; long-run problems of allocation and prices are left in the background. Economists with a more “classical” turn of mind may be a little disconcerted to find tariffs introduced as instruments to raise employment and to see real wages explained by the “claims” of trade unions. They would probably prefer to start out with the long-run picture, linking monetary aspects firmly to the pure theory of international trade. 

So maybe it wasn’t ever fully respectable. One thing I’d like to understand better is exactly when and to what extent “Keynsian” theory was accepted among academic economists.

2013 Books

[List only – partial]

Munro – Too Much Happiness; Something I’ve Been Meaning to Tell You; others

Ishiguro – Remains of the Day

Ulinich – Petropolis

McGuane – Gallatin Canyon

Bolano – Last Evenings on Earth

Valles – The Child

Minsky – John Maynard Keynes

Russell – New Deal Banking Reforms and Keynesian Welfare State Capitalism

Hobsbawm – Nations and Nationalism since 1870; Uncommon People

Cumings – The Korean War

Dobb – Theories of Value and Distribution since Adam Smith

Krippner – Capitalizing on Crisis

Leijonhufvud – Keynesian Economics and the Economics of Keynes

Faber and Mazlish – How To Talk So Kids Will Listen & Listen So Kids Will Talk

Davis – Managed by the Markets

Jellinek – The Paris Commune of 1871

Debt and Demand

One interesting issue in the ongoing secular stagnation debate is the relationship between debt and aggregate demand. In particular, there’s been a revival of the claim that there is something like a one to one relationship between changes in the ratio of debt to income, and final demand for goods and services.

I would like to reframe this claim a bit, drawing on my recent work with Arjun Jayadev. [1] In a nutshell: Changes in debt-income ratios reflect a number of macroeconomic variables, and until you have a specific story about which of those variables is driving the debt-income ratio, you can’t say what relationship to expect between that ratio and demand. We show in our paper that the entire post-1980 rise in household debt ratios can be explained, in an accounting sense, by higher real interest rates. Conversely, if the interest rates faced by households are lower in the future, debt-income ratios will decline without any fall in demand for real goods and services.

You might not know it from the current discussion, but there is an existing literature on these questions. The relationship between leverage — especially household debt — and aggregate demand was explored in a number of papers around the time of the last US credit crisis, in the late 1980s. Perhaps I’ll write a proper review of this material at some point; a short list would include Benjamin Friedman (1984 and 1986), Caskey and Fazzari (1991), Alfred Eichner (1991) and Tom Palley (1994 and 1997). It’s unfortunate that these earlier papers don’t get referred to in today’s discussion of debt and demand, by either mainstream or heterodox writers. [2]

For most of these writers, the important point was that the effect of debt on demand is two-faced: new borrowing can finance additional expenditure on real goods and services, but on the other hand debt service payments (in the presence of credit constraints) subtract from the funds available for current expenditure. Eichner, for instance, uses the equation E = F + delta-D – DS, or aggregate expenditure equals cashflow plus debt growth minus debt service payments.

More generally, to think systematically about the relationship between debt and household expenditure, we need to start from a consistent set of accounts. The first principle of financial accounting is that, for any economic unit, total sources of funds must equal total uses of funds. There are many ways of organizing accounts, at the level of the individual household or firm, at the level of the sector, or at the level of the nation, but this equality must always hold. You can slice up sources and uses of funds however you like, but total money coming in must equal total money going out.

The standard financial accounts for the United States are the Flow of Funds, maintained by the Federal Reserve. A number of alternative accounting frameworks are reflected in the social accounting matrixes developed by the late Wynne Godley and Lance Taylor and their students and collaborators.

Here’s one natural way of organizing sources and uses of funds for the household sector:

compensation of employees
+
capital income
+
transfer receipts
+
net borrowing 
=
consumption (including consumer durables)
+
residential investment
+ 
tax payments
+
interest payments
+ 
net acquisition of financial assets

The items before the equal sign are sources of funds; the items after are uses. [3] The first two uses of funds are included in GDP measured as income, while the latter two are not. Similarly, the first two uses of funds are included in GDP measured as expenditure, while the latter three are not.

When we look at the whole balance sheet, it is clear that borrowing cannot change in isolation. An increase in one source of funds must be accompanied by some mix of increase in some use(s) of funds, and decrease in other sources of funds. So if we want to talk about the relationship between borrowing and GDP, we need a story about what other items on the balance sheet are changing along with it. One possible story is that changes in borrowing are normally matched by changes in consumption, or in residential investment. This is the implicit story behind the suggestion that lower household borrowing will reduce final demand dollar for dollar. But there is no reason in principle why that has to be the main margin that household borrowing adjusts on, and as we’ll see, historically it often has not been.

So far we have been talking about the absolute levels of borrowing and other flows. But in general, we are not interested in the absolute level of borrowing, but on the ratio of debt to income. It’s common to speak about changes in borrowing and changes in debt-income ratios as if they were synonyms. [4]  But they are not. The debt-income ratio has a denominator as well as a numerator. The denominator is nominal income, so the evolution of the ratio depends  not only on household borrowing, but on real income growth and inflation. Faster growth of nominal income — whether due to real income growth or inflation — reduces the debt-income ratio, just as much as lower borrowing does.

In short: For changes in the debt-income ratio to be reflected one for one in aggregate demand, two things must be true. First, changes in the ratio must be due mainly to variation in the numerator, rather than the denominator. And second, changes in the numerator must be due mainly to variation in consumption and residential investment, rather than variation in other balance sheet items. How true are these things with respect to the rise in debt-income ratios over the past 30 years?

To frame the question in a tractable way, we need to simplify the balance sheet, combining some items to focus on the ones we care about. In our paper, Arjun and I were interested in debt ratios, not aggregate demand, so we grouped together all the non-credit flows into a single variable, which we called the household primary deficit. We defined this as all uses of funds except interest payments, minus all sources of funds except borrowing.

Here, I do things slightly differently. I divide changes in debt into those due to nominal income growth, those due to expenditures that contribute to aggregate demand (consumption and residential investment), and those due to non-demand expenditure (interest payments and net acquisition of financial assets.) For 1985 and later years, I also include the change in debt-income ratios attributable to default. (We were unable to find good data on household level defaults for earlier years, but there is good reason to think that household defaults did not occur at a macroeconomically significant level between the Depression and the Great Recession.) This lets us answer the question directly: historically, how closely have changes in household debt-income ratios been linked to changes in aggregate demand?

Figure 1 shows the trajectory of household debt for the US since 1929, along with federal debt and non financial business debt. (All are given as fractions of GDP.) As we can see, there have been three distinct episodes of rising household debt ratios since World War II: one in the decade or so immediately following the war, one in the mid-1980s, and one in the first half of the 2000s.

Figure 1: US debt-GDP ratios, 1929-2011

Figure 2 shows the annual change in the debt ratio, along with the decomposition described above. All variables are expressed as deviations from the 1950-2010 average. The heavy black line is the change in the debt-income ratio. The solid red line is final-demand expenditure, i.e. non-interest consumption plus residential investment. The dashed and dotted blue lines show the contributions of nominal income growth and non-demand expenditure, respectively. And the purple line with diamonds shows the contribution of defaults. (Defaults are measured relative to the 1985-2010 average.)

Figure 2: Decomposition of changes in the household debt-income ratio, 1949-2011

It’s clear from this figure that there is an important element of truth to the Keen-Krugman view that there is a tight link between the debt-incoem ratio and demand. There is evidently a close relationship between household demand and changes in the debt ratio, especially with respect to short-term variation. But that view is also missing something important. In some periods, there are substantial divergences between final demand from household and changes in the debt ratio. In particular, the increase in the household debt ratio in the 1980s (by about 20 points of GDP) took place during a period when consumption and residential investment by households were near their lowest levels since World War II. The increase in household debt after 1980 has often been described as some kind of “consumption binge”; this is the opposite of the truth.

The ambiguous relationship between household debt and aggregate demand can be seen in Table 1, which compares the periods of rising household debt with the intervening periods of stable or falling debt. The numbers are annual averages; to facilitate comparisons between periods, the averages for sub periods are again expressed as deviations from the 1950-2010 mean. (Or from the 1985-2010 mean, in the case of defaults.) The numbers are the contributions to the change i the debt-income ratio, so a positive value for nominal income growth indicates lower inflation and/or growth than the postwar average.

Table 1: Decomposition of changes in the household debt-income ratio, selected periods

Change in debt-income ratio Contribution of nominal income growth Aggregate-demand expenditure Non-demand   expenditure Defaults
1950-2010 mean 1.5 -4.9 89.1 17.7 -0.9
Difference from mean:
1949-1963 1.3 2.3 2.9 -4.3 N/A
1964-1983 -1.6 -1.4 -1.8 1.1 N/A
1984-1989 1.4 -0.3 -2.1 3.8 0.4
1990-1998 -0.5 0.3 -0.8 0.3 0.2
1999-2006 3.2 -1.2 3.1 1.7 0.1
2007-2010 -3.5 1.7 -1.4 -2.0 -1.3

What we see here is that while the first and third episodes of rising debt are indeed associated with higher than average household expenditure on real goods and services, the 1980s episode is not. The rise in debt in the 1980s is explained by a rise in non-demand expenditures. Specifically, it is entirely due to the rise in interest payments, which doubled from 3-4 percent of household income in the 1950s and 1960s to over 8 percent in the late 1980s. (Interest payments continued around this level up to the Great Recession, falling somewhat only in the past few years. The reason “non-demand expenditures” is lower after 1990 is because the household sector sharply reduced net acquisition of financial assets.) Also, note that while the housing booms of 1949-1963 and 1999-2006 saw almost identical levels of household expenditure on real goods and services, the household debt ratio rose nearly twice as fast in the more recent episode. The reason, again, is because of much higher interest payments in the 2000s compared with the immediate postwar period. Finally, as I’ve pointed out on this blog before, the deleveraging since 2008 would have been impossible without elevated household defaults, which approached 4 percent of outstanding household debt in 2009-2010 — partly offset by the sharp fall in household income in 2009, which raised the debt-income ratio.

Figure 3, from our paper, offers another way of looking at this. The heavy black line is the actual trajectory of the household debt-income ratio. The other lines show counterfactual scenarios in which non-interest household expenditures are at their historical levels, but growth, inflation and/or interest rates are held constant at their 1946-1980 average levels.

Figure 3: Counterfactual scenarios for the evolution of household-debt income ratios, 1946-2010

All these counterfactual scenarios show a spike in the 2000s: People really did borrow to pay for new houses! But the counterfactual scenarios also show lower overall trends of household debt, indicating that slower income growth, lower inflation and higher interest rates all contributed to the rise of household debt post-1980, independent of changes in borrowing behavior. Most interestingly, the red line shows that new borrowing after 1980 was lower than new borrowing in the 1950s, 60s and 70s; if households had engaged in the exact same spending on consumption, residential investment and financial assets as they actually did, but inflation, growth and interest rates had remained at their pre-1980 levels, the household debt-income ratio would have trended gradually downward.

To the extent that rising debt-income ratios after 1980 were the result of higher interest rates and disinflation, they were not contributing to aggregate demand. And if lower interest rates and and, perhaps, higher inflation and/or higher default rates bring down debt ratios in the future, deleveraging will not be a headwind for demand. 

It is customary to see rising debt as the result of private choices to finance higher expenditures by issuing new credit-market liabilities. But historically, it is equally correct to see rising debt as the result of political choices that increase the real value of existing liabilities.

[1] I’m pleased to report that a version of this paper has been accepted for publication by American Economic Journal: Macroeconomics. This has caused some adjustment in my view of the permeability of the “mainstream-heterodox” divide.

[2] This neglect of the earlier literature is especially puzzling since several of the protagonists of the 1990-era discussion are active in the sequel today. Steve Fazzari, for instance, in his several superb recent papers (with Barry Cynamon) on household debt, does not refer to his own 1991 paper, tho it is dealing with substantially the same questions. 

[3] Only a few minor items are left out. This grouping of sources and uses of funds essentially follows Lance Taylor’s social accounting matrices, as presented in Reconstructing Macroeconomics and elsewhere. Neither the NIPAs nor the Flow of Funds present household accounts in exactly this way. The Flow of Funds groups all three sources of household income together, treats consumer durables as a separate category of household investment, and treats interest payments as consumption. The NIPAs treat residential investment and mortgage interest payments as their own sector, separate from the household sector, and omits borrowing and net acquisition of financial assets. The NIPAs also include a number of noncash items, of which the most important is the imputed flow of housing services from the owner-occupied housing sector to the household sector and the corresponding imputed rental payments from the household sector to the owner-occupied residential sector.

[4] For example, a recent paper on the causes of “The Rise in U.S. Household Indebtedness” begins with the sentence, “During the past several decades in the United States, signi ficant changes have occurred in household saving and borrowing behavior,” with no sign of realizing that this is a different question than the one posed by the title.

The Interest Rate, the Interest Rate, and Secular Stagnation

In the previous post, I argued that the term “interest rate” is used to refer to two basically unrelated prices: The exchange rate between similar goods at different periods, and the yield on a credit-market instrument. Why does this distinction matter for secular stagnation?

Because if you think the “natural rate of interest,” in the sense of the credit-market rate that brings aggregate expenditure to a desired level in some real-world economic situation, should be the time-substitution rate that would exist in a model that somehow corresponds to that situation, when the two are in fact unrelated — well then, you are going to end up with a lot of irrelevant and misleading intuitions about what that rate should be.

In general, I do think the secular stagnation conversation is a real step forward. So it’s a bit frustrating, in this context, to see Krugman speculating about the “natural rate” in terms of a Samuelson-consumption loan model, without realizing that the “interest rate” in that model is the intertemporal substitution rate, and has nothing to do with the Wicksellian natural rate. This was the exact confusion introduced by Hayek, which Sraffa tore to pieces in his review, and which Keynes went to great efforts to avoid in General Theory. It would be one thing if Krugman said, “OK, in this case Hayek was right and Keynes was wrong.” But in fact, I am sure, he has no idea that he is just reinventing the anti-Keynesian position in the debates of 75 years ago.

The Wicksellian natural rate is the credit-market rate that, in current conditions, would bring aggregate expenditure to the level desired by whoever is setting monetary policy. Whether or not there is a level of expenditure that we can reliably associate with “full employment” or “potential output” is a question for another day. The important point for now is “in current conditions.” The level of interest-sensitive expenditure that will bring GDP to the level desired by policymakers depends on everything else that affects desired expenditure — the government fiscal position, the distribution of income, trade propensities — and, importantly, the current level of income itself. Once the positive feedback between income and expenditure has been allowed to take hold, it will take a larger change in the interest rate to return the economy to its former position than it would have taken to keep it there in the first place.

There’s no harm in the term “natural rate of interest” if you understand it to mean “the credit market interest rate that policymakers should target to get the economy to the state they think it should be in, from the state it in now.”And in fact, that is how working central bankers do understand it. But if you understand “natural rate” to refer to some fundamental parameter of the economy, you will end up hopelessly confused. It is nonsense to say that “We need more government spending because the natural rate is low,” or “we have high unemployment because the natural rate is low.” If G were bigger, or if unemployment weren’t high, there would be a different natural rate. But when you don’t distinguish between the credit-market rate and time-substitution rate, this confusion is unavoidable.

Keynes understood clearly that it makes no sense to speak of the “natural rate of interest” as a fundamental characteristic of an economy, independent of the current state of aggregate demand:

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest”, which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level. 

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment. 

I am now no longer of the opinion that the concept of a “natural” rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.

EDIT: In response to Nick Edmonds in comments, I’ve tried to restate the argument of these posts in simpler and hopefully clearer terms:

Step 1 is to recognize that in a model like Samuelson’s, “interest rate” just means any contract that allows you to make a payment today and receive a flow of income in the future. It would be the exact same model, capturing the exact same features of the economy, if we wrote “profit rate” or “house price-to-rent ratio” instead of “interest rate.” Any valid intuition the model gives us, applies to ALL asset yields, not just to the the credit-instrument yields that we call “interest rates” in every day life.

Step 2 is to think about the other factors that enter into real-world asset yields, besides the intertemporal exchange rate Samuelson is interested in — risk, liquidity, carrying costs and depreciation, and expected capital gains. Since all real-world asset yields incorporate at least one of these factors, none correspond exactly to Samuelson’s intertemporal interest rate.

Step 3 is to realize that not only are credit-instrument yields not exactly the Samuelson “interest rate,” they aren’t even approximately it. The great majority of credit market transactions we see in real economies are not exchanges of present income for future income, but exchanges of two different claims on future income. So the intertemporal interest rate enters on both sides and cancels out.

At that point, we have established that the “interest rate” the monetary authority is targeting is not the “interest rate” Samuelson is writing about.

Step 4 is then to ask, what does it mean to say that some particular credit-market interest rate is the “natural” one? That is where the dependence on fiscal policy, income distribution, etc. come in. But those factors are not part of the argument for why the credit-market rate is not even approximately the intertemporal rate.

The Interest Rate and the Interest Rate

We will return to secular stagnation. But we need to clear some ground first. What is an interest rate?

Imagine you are in a position to acquire a claim on a series of payments  in the future. Since an asset is just anything that promises a stream of payments in the future, we will say you are thinking of buying of an asset. What will you look at to make your decision?

First is the size of the payments you will receive, as a fraction of what you pay today. We will call that the yield of the asset, or y. Against that we have to set the risk that the payments may be different from expected or not occur at all; we will call the amount you reduce your expected yield to account for this risk r. If you have to make regular payments beyond the purchase of the asset to receive income from it (perhaps taxes, or the costs of operating the asset if it is a capital good) then we also must subtract these carrying costs c. In addition, the asset may lose value over time, in which case we have to subtract the depreciation rate d. (In the case of an asset that only lasts one period — a loan to be paid back in full the next period, say — d will be equal to one.) On the other hand, owning an asset can have benefits beyond the yield. In particular, an asset can be sold or used as collateral. If this is easy to do, ownership of the asset allows you to make payments now, without having to waiting for its yield in the future. We call the value of the asset for making unexpected payments its liquidity premium, l. The market value of long-lasting assets may also change over time; assuming resale is possible, these market value changes will produce a capital gain g (positive or negative), which must be added to the return. Finally, you may place a lower value on the payments from the asset simply because they take place in the future; this might be because your needs now are more urgent than you expect them to be then, or simply because you prefer income in the present to income in the future. Either way, we have to subtract this pure time-substitution rate i.

So the value of an asset costing one unit (of whatever numeraire) will be 1 + y – r – c – d + l + g – i.

(EDIT: On rereading, this could use some clarification:

Of course all the terms can take on different (expected) values in different time periods, so they are vectors, not scalars. But if we assume they are constant, and that the asset lasts forever (i.e. a perpetuity), then we should write its equilibrium value as: V = Y/i, where Y is the total return in units of the numeraire, i.e. Y = V(y – r – c + l + g) and i is the discount rate. Divide through both sides by V and we have i = y – r – c + l + g. We can now proceed as below.)

In equilibrium, you should be just indifferent between purchasing and not purchasing this asset, so we can write:

y – r – c – d + l + g – i = 0, or

(1) y = r + c + d – l – g + i

So far, there is nothing controversial.

In formal economics, from Bohm-Bawerk through Cassel, Fisher and Samuelson to today’s standard models, the practice is to simplify this relationship by assuming that we can safely ignore most of these terms. Risk, carrying costs and depreciation can be netted out of yields, capital gains must be zero on average, and liquidity is assumed not to matter or just ignored. So then we have:

(2) y = i

In these models, it doesn’t matter if we use the term “interest rate” to mean y or to mean i, since they are always the same.

This assumption is appropriate for a world where there is only one kind of asset — a risk-free contract that exchanges one good in the present for 1 + i goods in the future. There’s nothing wrong with exploring what the value of i would be in such a world under various assumptions.

The problem arises when we carry equation (2) over to the real world and apply it to the yield of some particular asset. On the one hand, the yield of every existing asset reflects some or all of the other terms. And on the other hand, every contract that involves payments in more than one period — which is to say, every asset — equally incorporates i. If we are looking for the “interest rate” of economic theory in the economic world we observe around us, we could just as well pick the rent-price ratio for houses, or the profit rate, or the deflation rate, or the ratio of the college wage premium to tuition costs. These are just the yields of a house, of a share of the capital stock, of cash and of a college degree respectively. All of these are a ratio of expected future payments to present cost, and should reflect i to exactly the same extent as the yield of a bond does. Yet in everyday language, it is the yield of the bond that we call “interest”, even though it has no closer connection to the interest rate of theory than any of these other yields do.

This point was first made, as far as I know, by Sraffa in his review of Hayek’s Prices and Production. It was developed by Keynes, and stated clearly in chapters 13 and 17 of the General Theory.

For Keynes, there is an additional problem. The price we observe as an “interest rate” in credit markets is not even the y of the bond, which would be i modified by risk, expected capital gains and liquidity. That is because bonds do not trade against baskets of goods. They trade against money. When we see a bond being sold with a particular yield, we are not observing the exchange rate between a basket of goods equivalent to the bond’s value today and baskets of goods equivalent to its yield in the future. We are observing the exchange rate between the bond today and a quantity of money today. That’s what actually gets exchanged. So in equilibrium the price of the bond is what equates the expected returns on the two assets:

(3) y_B – r_B + l_B + g_B – i = l_M – i

(Neither bonds nor money depreciate or have carrying costs, and money has no risk. If our numeraire is money then money also cannot experience capital gains. If our numeraire was a basket of goods instead, then -g would be expected inflation, which would appear on both sides and cancel out.)

What we see is that i appears on both sides, so it cancels out. The yield of the bond is given by:

(4) y_B  = r_B – g_B + (l_M – l_B)

The yield of the bond — the thing that in conventional usage we call the “interest rate” — depends on the risk of the bond, the expected price change of the bond, and the liquidity premium of money compared with the bond. Holding money today, and holding a bond today, are both means to enable you to make purchases in the future. So the intertemporal substitution rate i does not affect the bond yield.

(We might ask whether the arbitrage exists that would allow us to speak of a general rate of time-substitution i in real economies at all. But for present purposes we can ignore that question and focus on the fact that even if there is such a rate, it does not show up in the yields we normally call “interest rates”.)

This is the argument as Keynes makes it. It might seem decisive. But monetarists would reject it on the grounds that nobody in fact holds money as a store of value, so equation (3) does not apply. The bond-money market is not in equilibrium, because there is zero demand for money beyond that needed for current transactions at any price. (The corollary of this is the familiar monetarist claim that any change in the stock of  money must result in a proportionate change in the value of transactions, which at full employment means a proportionate rise in the price level.) From the other side, endogenous money theorists might assert that the money supply is infinitely elastic for any credit-market interest rate, so l_M is endogenous and equation (4) is underdetermined.

As criticisms of the specific form of Keynes’ argument, these are valid objections. But if we take a more realistic view of credit markets, we come to the same conclusion: the yield on a credit instrument (call this the “credit interest rate”) has no relationship to the intertemporal substitution rate of theory (call this the “intertemporal interest rate.”)

Suppose you are buying a house, which you will pay for by taking out a mortgage equal to the value of the house. For simplicity we will assume an amortizing mortgage, so you make the same payment each period. We can also assume the value of housing services you receive from the house will also be the same each period. (In reality it might rise or fall, but an expectation that the house will get better over time is obviously not required for the transaction to take place.) So if the purchase is worth making at all, then it will result in a positive income to you in every period. There is no intertemporal substitution on your side. From the bank’s point of view, extending the mortgage means simultaneously creating an asset — their loan to you — and a liability — the newly created deposit you use to pay for the house. If the loan is worth making at all, then the expected payments from the mortgage exceed the expected default losses and other costs in every period. And the deposits are newly created, so no one associated with the bank has to forego any other expenditure in the present. There is no intertemporal substitution on the bank’s side either.

(It is worth noting that there are no net lenders or net borrowers in this scenario. Both sides have added an asset and a liability of equal value. The language of net lenders and net borrowers is carried over from models with consumption loans at the intertemporal interest rate. It is not relevant to the credit interest rate.)

If these transactions are income-positive for all periods for both sides, why aren’t they carried to infinity? One reason is that the yields for the home purchaser fall as more homes are purchased. In general, you will not value the housing services from a second home, or the additional housing services of a home that costs twice as much, as much as you value the housing services of the home you are buying now. But this only tells us that for any given interest rate there is a volume of mortgages at which the market will clear. It doesn’t tell us which of those mortgage volume-interest rate pairs we will actually see.

The answer is on the liquidity side. Buying a house makes you less liquid — it means you have less flexibility if you decide you’d like to move elsewhere, or if you need to reduce your housing costs because of unexpected fall in income or rise in other expenses. You also have a higher debt-income ratio, which may make it harder for you to borrow in the future. The loan also makes the bank less liquid — since its asset-capital ratio is now higher, there are more states of the world in which a fall in income would require it to sell assets or issue new liabilities to meet its scheduled commitments, which might be costly or, in a crisis, impossible. So the volume of mortgages rises until the excess of housing service value over debt service costs make taking out a mortgage just worth the incremental illiquidity for the marginal household, and where the excess of mortgage yield over funding costs makes issuing a new mortgage just worth the incremental illiquidity for the marginal bank. (Incremental illiquidity in the interbank market may — or may not — mean that funding costs rise with the volume of loans, but this is not necessary to the argument.)

Monetary policy affects the volume of these kinds of transactions by operating on the l terms. Normally, it does so by changing the quantity of liquid assets available to the financial system (and perhaps directly to the nonfinancial private sector as well). In this way the central bank makes banks (and perhaps households and businesses) more or less willing to accept the incremental illiquidity of a new loan contract. Monetary policy has nothing to do with substitution between expenditure in the present period and expenditure in some future period. Rather, it affects the terms of substitution between more and less liquid claims on income in the same future period.

Note that changing the quantity of liquid assets is not the only way the central bank can affect the liquidity premium. Banking regulation, lender of last resort operations and bailouts also change the liquidity premium, by chaining the subjective costs of bank balance sheet expansion. An expansion of the reserves available to the banking system makes it cheaper for banks to acquire a cushion to protect themselves against the possibility of an unexpected fall in income. This will make them more willing to hold relatively illiquid assets like mortgages. But a belief that the Fed will take emergency action prevent a bank from failing in the event of an unexpected fall in income also increases its willingness to hold assets like mortgages. And it does so by the same channel — reducing the liquidity premium. In this sense, there is no difference in principle between monetary policy and the central bank’s role as bank supervisor and lender of last resort. This is easy to understand once you think of “the interest rate” as the price of liquidity, but impossible to see when you think of “the interest rate” as the price of time substitution.

It is not only the central bank that changes the liquidity premium. If mortgages become more liquid — for instance through the development of a regular market in securitized mortgages — that reduces the liquidity cost of mortgage lending, exactly as looser monetary policy would.

The irrelevance of the time-substitution rate i to the credit-market interest rate y_B becomes clear when you compare observed interest rates with other prices that also should incorporate i. Courtesy of commenter rsj at Worthwhile Canadian Initiative, here’s one example: the Baa bond rate vs. the land price-rent ratio for residential property.

Both of these series are the ratio of one year’s payment from an asset, to the present value of all future payments. So they have an equal claim to be the “interest rate” of theory. But as we can see, none of the variation in credit-market interest rates (y_B, in my terms) show up in the price-rent ratio. Since variation in the time-substituion rate i should affect both ratios equally, this implies that none of the variation in credit-market interest rates is driven by changes in the time-substitution interest rate. The two “interest rates” have nothing to do with each other.

(Continued here.)

EDIT: Doesn’t it seem strange that I first assert that mortgages do not incorporate the intertemporal interest rate, then use the house price-rent ratio as an example of a price that should incorporate that rate? One reason to do this is to test the counterfactual claim that interest rates do, after all, incorporate Samuelson’s interest rate i. If i were important in both series, they should move together; if they don’t, it might be important in one, or in neither.

But beyond that, I think housing purchases do have an important intertemporal component, in a way that loan contracts do not. That’s because (with certain important exceptions we are all aware of) houses are not normally purchased entirely on credit. A substantial fraction of the price is paid is upfront. In effect, most house purchases are two separate transactions bundled together: A credit transaction (for, say, 80 percent of the house value) in which both parties expect positive income in all periods, at the cost of less liquid balance sheets; and a conceptually separate cash transaction (for, say, 20 percent) in which the buyer foregoes present expenditure in return for a stream of housing services in the future. Because house purchases must clear both of these markets, they incorporate i in way that loans do not. But note, i enters into house prices only to the extent that the credit-market interest rate does not. The more important the credit-market interest rate is in a given housing purchase, the less important the intertemporal interest rate is.

This is true in general, I think. Credit markets are not a means of trading off the present against the future. They are a means of avoiding tradeoffs between the present and the future.

Secular Stagnation, Progress in Economics

It’s the topic of the moment. Our starting point is this Paul Krugman post, occasioned by this talk by Lawrence Summers.

There are two ways to understand “secular stagnation.” One is that the growth rate of income and output will be slower in the future. The other is that there will be a systematic tendency for aggregate demand to fall short of the economy’s potential output. It’s the second claim that we are interested in.

For Krugman, the decisive fact about secular stagnation is that it implies a need for persistently negative interest rates. That achieved, there is no implication that growth rates or employment need to be lower in the future than in the past. He  is imagining a situation where current levels of employment and growth rates are maintained, but with permanently lower interest rates.

We could also imagine a situation where full employment was maintained by permanently higher public spending, rather than lower interest rates. Or we could imagine a situation where nothing closed the gap and output fell consistently short of potential. What matters is that aggregate expenditure by the private sector tends to fall short of the economy’s potential output, by a growing margin. For reasons I will explain down the road, I think this is a better way of stating the position than a negative “natural rate” of interest.

I think this conversation is a step forward for mainstream macroeconomic thought. There are further steps still to take. In this post I describe what, for me, are the positive elements of this new conversation. In subsequent posts, I will talk about the right way of analyzing these questions more systematically — in terms of a Harrod-type growth model — and  about the wrong way — in terms of the natural rate of interest.

The positive content of “secular stagnation”

1. Output is determined by demand.

The determination of total output by total expenditure is such a familiar part of the macroeconomics curriculum that we forget how subversive it is. It denies the logic of scarcity that is the basis of economic analysis and economic morality. Since Mandeville’s Fable of the Bees, it’s been recognized that if aggregate expenditure determines aggregate income, then, as Krugman says, “vice is virtue and virtue is vice.”

A great deal of the history of macroeconomics over the past 75 years can be thought of as various efforts to expunge, exorcize or neutralize the idea of demand-determined income, or at least to safely quarantine it form the rest of economic theory. One of the most successful quarantine strategies was to recast demand constraints on aggregate output as excess demand for money, or equivalently as the wrong interest rate. What distinguished real economies from the competitive equilibrium of Jevons or Walras was the lack of a reliable aggregate demand “thermostat”. But if a central bank or other authority set that one price or that one quantity correctly, economic questions could again be reduced to allocation of scarce means to alternative ends, via markets. Both Hayek and Friedman explicitly defined the “natural rate” of interest, which monetary policy should maintain, as the rate that would exist in a Walrasian barter economy. In postwar and modern New Keynesian mainstream economics, the natural rate is defined as the market interest rate that produces full employment and stable prices, without (I think) explicit reference to the intertemporal exchange rate that is called the interest rate in models of barter economies. But he equivalence is still there implicitly, and is the source of a great deal of confusion.

I will return to the question of what connection there is, if any, between the interest rates we observe in the world around us, and what a paper like Samuelson 1958 refers to as the “interest rate.” The important thing for present purposes is:

Mainstream economic theory deals with the problems raised when expenditure determines output, by assuming that the monetary authority sets an interest rate such that expenditure just equals potential output. If such a policy is followed successfully, the economy behaves as if it were productive capacity that determined output. Then, specifically Keynesian problems can be ignored by everyone except the monetary-policy technicians. One of the positive things about the secular stagnation conversation, from my point of view, is that it lets Keynes back out of this box.

That said, he is only partway out. Even if it’s acknowledged that setting the right interest rate does not solve the problem of aggregate demand as easily as previously believed, the problem is still framed in terms of the interest rate.

2. Demand normally falls short of potential

Another strategy to limit the subversive impact of Keynes has been to consign him to the sublunary domain of the short run, with the eternal world of long run growth still classical. (It’s a notable — and to me irritating — feature of macroeconomics textbooks that the sections on growth seem to get longer over time, and to move to the front of the book.) But if deviations from full employment are persistent, we can’t assume they cancel out and ignore them when evaluating an economy’s long-run trajectory.

One of the most interesting parts of the Summers talk came when he said, “It is a central pillar of both classical models and Keynesian models, that it is all about fluctuations, fluctuations around a given mean.” (He means New Keynesian models here, not what I would consider the authentic Keynes.) “So what you need to do is have less volatility.” He introduces the idea of secular stagnation explicitly as an alternative to this view that demand matters only for the short run. (And he forthrightly acknowledges that Stanley Fischer, his MIT professor who he is there to praise, taught that demand is strictly a short-run phenomenon.) The real content of secular stagnation, for Summers, is not slower growth itself, but the possibility that the same factors that can cause aggregate expenditure to fall short of the economy’s potential output can matter in the long run as well as in the short run.

Now for Summers and Krugman, there still exists a fundamentals-determined potential growth rate, and historically the level of activity did fluctuate around it in the past. Only in this new era of secular stagnation, do we have to consider the dynamics of an economy where aggregate demand plays a role in long-term growth. From my point of view, it’s less clear that anything has changed in the behavior of the economy. “Secular stagnation” is only acknowledging what has always been true. The notion of potential output was never well defined. Labor supply and technology, the supposed fundamentals, are strongly influenced by the level of capacity utilization. As I’ve discussed before, once you allow for Verdoorn’s Law and hysteresis, it makes no sense to talk about the economy’s “potential growth rate,” even in principle. I hope the conversation may be moving in that direction. Once you’ve acknowledged that the classical allocation-of-scarce-means-to-alternative-ends model of growth doesn’t apply in present circumstances, it’s easier to take the next step and abandon it entirely.

3. Bubbles are functional

One widely-noted claim in the Summers talk is that asset bubbles have been a necessary concomitant of full employment in the US since the 1980s. Before the real estate bubble there was the tech bubble, and before that there was the commercial real estate bubble we remember as the S&L crisis. Without them, the problem of secular stagnation might have posed itself much earlier.

This claim can be understood in several different, but not mutually exclusive, senses. It may be (1) interest rates sufficiently low to produce full employment, are also low enough to provoke a bubble. It may be (2) asset bubbles are an important channel by which monetary policy affects real activity. Or it may be (3) bubbles are a substitute for the required negative interest rates. I am not sure which of these claims Summers intends. All three are plausible, but it is still important to distinguish them. In particular, the first two imply that if interest rates could fall enough to restore full employment, we would have even more bubbles — in the first case, as an unintended side effect of the low rates, in the second, as the channel through which they would work. The third claim implies that if interest rates could fall enough to restore full employment, it would be possible to do more to restrain bubbles.

An important subcase of (1) comes when there is a minimum return that owners of money capital can accept. As Keynes said (in a passage I’m fond of quoting),

The most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners.[2] If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money.  Cf. the nineteenth-century saying, quoted by Bagehot, that “John Bull can stand many things, but he cannot stand 2 per cent.”

If this is true, then asking owners of money wealth to accept rates of 2 percent, or perhaps much less, will face political resistance. More important for our purposes, it will create an inclination to believe the sales pitch for any asset that offers an acceptable return.

Randy Wray says that Summers is carrying water here for his own reputation and his masters in Finance. The case for bubbles as necessary for full employment justifies his past support for financial deregulation, and helps make the case against any new regulation in the future. That may be true. But I still think he is onto something important. There’s a long-standing criticism of market-based finance that it puts an excessive premium on liquidity and discourages investment in long-lived assets. A systematic overestimate of the returns from fixed assets might be needed to offset the systematic overestimate of the costs of illiquidity.

Another reason I like this part of Summers’ talk is that it moves us toward recognizing the fundamental symmetry between between monetary policy conventionally defined, lender of last resort operations and bank regulations. These are different ways of making the balance sheets of the financial sector more or less liquid. The recent shift from talking about monetary policy setting the money stock to talking about setting interest interest rates was in a certain sense a step toward realism, since there is nothing in modern economies that corresponds to a quantity of money. But it was also a step toward greater abstraction, since it leaves it unclear what is the relationship between the central bank and the banking system that allows the central bank to set the terms of private credit transactions. Self-interested as it may be, Summers call for regulatory forbearance here is an intellectual step forward. It moves us toward thinking of what central banks do neither in terms of money, nor in terms of interest rates, but in terms of liquidity.

Finally, note that in Ben Bernanke’s analysis of how monetary policy affects output, asset prices are an important channel. That is an argument for version (2) of the bubbles claim.

4. High interest rates are not coming back

For Summers and Krugman, the problem is still defined in terms of a negative “natural rate” of interest. (To my mind, this is the biggest flaw in their analysis.) So much of the practical discussion comes down to how you convince or compel wealth owners to hold assets with negative yields. One solution is to move to permanently higher inflation rates. (Krugman, to his credit, recognizes that this option will only be available when or if something else raises aggregate demand enough to push against supply constraints.) I am somewhat skeptical that capitalist enterprises in their current form can function well with significantly higher inflation. The entire complex of budget and invoicing practices assumes that over some short period — a month, a quarter, even a year — prices can be treated as constant. Maybe this is an easy problem to solve, but maybe not. Anyway, it would be an interesting experiment to find out!

More directly relevant is the acknowledgement that interest rates below growth rates may be a permanent feature of the economic environment for the foreseeable future. This has important implications for debt dynamics (both public and private), as we’ve discussed extensively on this blog. I give Krugman credit for saying that with i < g, it is impossible for debt to spiral out of control; a deficit of any level, maintained forever, will only ever cause the debt-GDP ratio to converge to some finite level. (I also give him credit for acknowledging that this is a change in his views.) This has the important practical effect of knocking another leg out from the case for austerity. It’s been a source of great frustration for me to see so many liberal, “Keynesian” economists follow every argument for stimulus with a pious invocation of the need for long-term deficit reduction. If people no longer feel compelled to bow before that shrine, that is progress.

On a more abstract level, the possibility of sub-g or sub-zero interest rates helps break down the quarantining of Keynes discussed above. Mainstream economists engage in a kind of doublethink about the interest rate. In the context of short-run stabilization, it is set by the central bank. But in other contexts, it is set by time preferences and technological tradeoff between current and future goods. I don’t think there was ever any coherent way to reconcile these positions. As I will explain in a following post, the term “interest rate” in these two contexts is being used to refer to two distinct and basically unrelated prices. (This was the upshot of the Sraffa-Hayek debate.) But as long as the interest rate observed in the world (call it the “finance” interest rate) behaved similarly enough to the interest rate in the models (the “time-substitution” interest rate), it was possible to ignore this contradiction without too much embarrassment.

There is no plausible way that the “time substitution” interest rate can be negative. So the secular stagnation conversation is helping reestablish the point — made by Keynes in chapter 17 of the General Theory, but largely forgotten — that the interest rates we observe in the world are something different. And in particular, it is no longer defensible to treat the interest rate as somehow exogenous to discussions about aggregate demand and fiscal policy. When I was debating fiscal policy with John Quiggin, he made the case for treating debt sustainability as a binding constraint by noting that there are long periods historically when interest rates were higher than growth rates. It never occurred to him that it makes no sense to talk about the level of interest rates as an objective fact, independent of the demand conditions that make expansionary fiscal policy desirable. I don’t mean to pick on John — at the time it wasn’t clear to me either.

Finally, on the topic of low interest forever, I liked Krugman’s scorn for the rights of interest-recipients:

How dare anyone suggest that virtuous individuals, people who are prudent and save for the future, face expropriation? How can you suggest steadily eroding their savings either through inflation or through negative interest rates? It’s tyranny!
But in a liquidity trap saving may be a personal virtue, but it’s a social vice. And in an economy facing secular stagnation, this isn’t just a temporary state of affairs, it’s the norm. Assuring people that they can get a positive rate of return on safe assets means promising them something the market doesn’t want to deliver – it’s like farm price supports, except for rentiers.

It’s a nice line, only slightly spoiled by the part about “what the market wants to deliver.” The idea that it is immoral to deprive the owners of money wealth of their accustomed returns is widespread and deeply rooted. I think it lies behind many seemingly positive economic claims. If this conversation develops, I expect we will see more open assertions of the moral entitlement of the rentiers.