The Slack Wire

Credit Cards and the Corridor

I don’t know if most people realize how much credit card debt fell during and after the Great Recession. It fell by a lot! Credit card debt outstanding today is about $180 billion, or 21 percent, lower than it was at the end of 2007. This is a 50 percent larger fall than in mortgage debt in percentage terms — though the fall in mortgages is of course much bigger in absolute dollars.
This fall in credit card debt is entirely explained by the drop in the number of credit card accounts, from about 500 million to 380 million. The average balance on open credit card accounts is about the same today as it was when the recession began.

The obvious question is, is this fall in consumer credit due to supply, or demand? Are banks less willing to lend, or are households less eager to borrow?

Here’s some interesting data that helps shed light on this question, from the Fed’s most recent Quarterly Report on Household Credit and Finance.

The red line shows the number of credit card accounts closed over the preceding 12 months, while the blue line shows the number opened. So the gap between the blue and red lines equals the change in the number of accounts. The spike in the red line is mostly write-offs, or defaults. I’ll return to those in a subsequent post; for now let’s look at the blue and green lines. The green line shows the number of inquiries, that is, applications for new cards by consumers. The blue line, again, shows the number issued. As we can see, the number of new accounts tracks the number of inquiries almost exactly. [1] What do we conclude from this? That the fall in the rate at which new credit cards are issued is entirely a matter of reduced demand, not supply. And given that balances on outstanding credit cards have not fallen, it’s hard to avoid the conclusion that banks’ reduced willingness to lend played little or no role in the fall in consumer credit.

Of course one figure isn’t dispositive, and mortgage debt is much more important quantitatively than credit card debt. But Dean Baker has been making a similar argument about mortgages for several years now:

the ratio of applications to [home] sales has not risen notably in this slump, indicating that the inability of potential homebuyers to get mortgages has not been a big factor in the housing downturn.

As a matter of fact, after reading that post (or one of Dean’s many others making the same point), I tried to construct a similar ratio for credit cards, but I wasn’t able to find the data. I didn’t realize then that the Fed publishes it regularly in the household credit report.

Needless to say, the ratio of applications to contracts is hardly the last word on this question, and needless to say there are plenty of more sophisticated attempts out there to disentangle the roles of supply and demand in the fall in borrowing. Rather than get into the data issues in more detail right now, I want to talk about what is at stake. Does it matter whether a fall in borrowing is more driven by the supply of credit or the demand for it? I think it does, both for theory and for policy.

One important question, of course, is the historical one: Did the financial crisis straightforwardly cause the recession by cutting off the supply of credit for nonfinancial borrowers, or were other factors more important? I admit to being agnostic on this question — I do think that credit constraints were dragging down fixed investment in the year or so before the recession officially began, but I’m not sure how important this was quantitatively. But setting aside the historical question, we also need to ask, is the availability of credit the binding constraint on real activity today?

For monetarists and New Keynesians, the answer has to be Yes almost by definition. Here’s DeLong:

There is indeed a “fundamental” configuration of asset prices–one that produces full employment, the optimal level of investment given the time preference of economic agents and the expected future growth of the economy, and the optimal division of investment between safe, moderately risky, and blue-sky projects. 

However, right now the private market cannot deliver this “fundamental” configuration of asset prices. The aftermath of the financial crisis has left us without sufficient trusted financial intermediaries … no private-sector agent can create the safe securities that patient and prudent investors wish to hold. The overleverage left in the aftermath of the financial crisis has left a good many investors and financial intermediaries petrified of losing all their money and being forced to exit the game–hence the risk tolerance of the private sector is depressed far below levels that are appropriate given the fundamentals… Until this overleverage is worked off, the private marketplace left to its own will deliver a price of safe assets far above fundamentals  … and a level of investment and thus of employment far below the economy’s sustainable and optimal equilibrium.

In such a situation, by issuing safe assets–and thus raising their supply–the government pushes the price of safe assets down and thus closer to its proper fundamental equilibrium value.

In other words, there is a unique, stable, optimal equilibrium for the macroeconomy. All agents know their expected lifetime income and preferred expenditures in that equilibrium. The only reason we are not there, is if some market fails to clear. If there is a shortfall of demand for currently produced output, then there must be excess demand for some asset the private sector cannot produce. In the monetarist version of the story, that asset is money. [2] In DeLong’s version, it’s “safe assets” more generally. But the logic is the same.

This is why DeLong is so confident that continued zero interest rates and QE must work — that it is literally impossible for output to remain below potential if the Fed follows its stated policy for the next three years. If the only reason for the economy to be off its unique, optimal growth path is excess demand for safe assets, then a sufficient increase in the supply of safe assets has to be able to get us back onto it.

But is this right?

Note that in the passage above, DeLong refers to a depressed “level of investment and thus of employment.” That’s how we’re accustomed to think about demand shortfalls, and most of the time it’s a reasonable shorthand — investment (business and residential) generally does drive fluctuations in demand. But it’s not so clear that this is true of the current situation. Here, check this out:

We’re looking at output relative to potential for GDP and its components; I’ve defined potential as 2.5 percent real annual growth from the 2007Q4 peak. [3] What we see here is investment and consumption both fell during the recession proper, but since 2010, investment has recovered strongly and is almost back to trend. The continued output gap is mainly accounted for by the failure of consumption to show any signs of returning to trend — if anything, consumption growth has decelerated further in the recovery.

You can’t explain low household consumption demand in terms of a shortage of safe assets. The safest, most liquid asset available to households is bank deposits, and the supply of these is perfectly elastic. I should note that it is possible (though not necessarily correct) to explain falling consumption this way for the early 1930s, when people were trying to withdraw their savings from banks and convert them into cash. The private sector cannot print bills or mint coins. But classical bank runs are no longer a thing; people are not trying to literally hoard cash; it is impossible that a lack of safe savings vehicles for households is what’s holding down consumption today.

So if we are going to explain the continued consumption shortfall in DeLong’s preferred terms, households must be credit-constrained. It is not plausible that households are restricting consumption in order to bid up the price of some money-like asset in fixed supply. But it is plausible that the lack of trusted financial intermediaries makes investors less willing to hold households’ debt, and that this is limiting some households’ ability to borrow and thus their consumption. In that case, it could be that increasing the supply of safe assets will provide enough of a cushion that investors are again willing to hold risky assets like household debt, and this will allow households to return to their optimal consumption path. That’s the only way DeLong’s story works.

It’s plausible, yes; but is it true? The credit card data is evidence that, no, it is not. If you believe the evidence of that first figure, the fall in consumer borrowing is driven by demand, not supply; continued weakness in consumption is not the result of unwillingness of investors to hold household debt due to excess demand for safe assets. If you believe the figure, investors are no less willing to hold consumer debt than they were before the recession; it’s households that are less willing to borrow.

Again, one figure isn’t dispositive. But what I really want to establish is the logical point: The shortage-of-safe-assets explanation of the continued output gap, and the corollary belief in the efficacy of monetary policy, only makes sense if the weakness in nonfinancial units’ expenditure is due to continued tightness of credit constraints. So every additional piece of evidence that low consumption (and investment, though again investment is not especially low) is not due to credit constraints, is another nail in the coffin of the shortage-of-safe-assets story.

So what’s the alternative? Well, that’s beyond the scope of this post. But basically, it’s this. Rather than assume there is a unique, stable, optimal equilibrium, we say that the macroeconomy has multiple equilibria and/or divergent adjustment dynamics. More specifically, we emphasize the positive feedback between current income and expenditure. For small deviations in income, people and businesses don’t adjust their expenditure, but use credit and and/or liquid assets to maintain it at its normal level. But for large deviations, this buffering no longer takes place, both because of financing constraints and because true lifetime income is uncertain, so people’s beliefs about it change in response to changes in current income.

In other word’s Axel Leijonhufvud’s “corridor of stability”. Within certain bounds (the corridor), the economy experiences stabilizing feedback, based on relative prices; beyond them, it experiences destabilizing feedback based on the income-expenditure link. Within these bounds, the multiplier is weak; outside them, it is “strong enough for effects of shocks to be endogenously amplified. Within the corridor, the prescription is in favor of ‘monetarist,’ outside in favor of ‘fiscalist’, policy prescriptions.”
I’m going to break that thought off here. The important point for now is that if you think that the continued depressed level of real economic activity is due to excess demand for safe assets, you really need evidence that the expenditure of households and businesses is limited by the unwillingness of investors to hold their liabilities, i.e. that they face credit constraints. And this credit card data is one more piece of evidence that they don’t. Which, among other things, makes it less likely that central bank interventions to remove risk from the balance sheets of the financial system will meaningfully boost  output and employment.

[1] For some reason, inquiries are given over the past six months while the other two series are given over the past year. This implies that about half of all inquiries result in a new account being opened. The important point for our purposes is that this fraction did not change at all during the financial crisis and recession.

[2] To be fair, you can also find this story in the General Theory — “unemployment develops because people want the moon,” etc. But it’s not the only story you can find there. And, I would argue, Keynes really intends this as a story of how downturns begin, and not why they persist.

[3] Yes, it would be more “correct” to use the BEA’s measure of potential output. But the results would be qualitatively very similar, and I don’t think there’s nearly enough precision in measures of potential output to make the few tenths of a point difference meaningful.

LATE UPDATE: Here is a similar graph for the previous recession & recovery.

IMF: Abolish the Debt!

Not exactly; you have to read between the lines a little.

People are talking about this new thing from the IMF, reviving the 1930s-era “Chicago plan” for 100% reserve banking. Red meat for the end-the-Fed crowd. The paper shares a coauthor, Michael Kumhof, with that other notable recent piece of IMF rabble-rousing, on how inequality is responsible for financial crises. Anyway, the Chicago plan. It was the brainchild of Herbert Simon Henry Simons and Irving Fisher:

The key feature of this plan was that it called for the separation of the monetary and credit functions of the banking system, first by requiring 100% backing of deposits by government-issued money, and second by ensuring that the financing of new bank credit can only take place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks, but not through the creation of new deposits, ex nihilo, by banks.  

Fisher (1936) claimed four major advantages for this plan. First, preventing banks from creating their own funds during credit booms, and then destroying these funds during subsequent contractions, would allow for a much better control of credit cycles, which were perceived to be the major source of business cycle fluctuations. Second, 100% reserve backing would completely eliminate bank runs. Third, allowing the government to issue money directly at zero interest, rather than borrowing that same money from banks at interest, would lead to a reduction in the interest burden on government finances and to a dramatic reduction of (net) government debt, given that irredeemable government-issued money represents equity in the commonwealth rather than debt. Fourth, given that money creation would no longer require the simultaneous creation of mostly private debts on bank balance sheets, the economy could see a dramatic reduction not only of government debt but also of private debt levels.

Kumhof and his coauthor Jaromir Benes run through how such a thing would be implemented today, and then estimate its effects on output and prices in a DSGE model. (I don’t care about that second part.) My opinion: I don’t think this makes sense practically as a practical policy proposal or strategically as a political focal point. But it’s not crazy. I think it’s a useful thought experiment to clarify what we do and don’t need banks for, and I’m glad that some people around Occupy seem to be noticing and talking about it.

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Though Kumhof and Benes don’t quite say so, this proposal should really be understood as addressing two distinct and separate problems:

1. Stabilization via monetary policy is constrained by the fact that its traditional tools have less purchase on private credit creation than they are imagined to or they used to, and not just at the ZLB. (As discussed repeatedly on this blog, e.g. these posts and this one.) So if the state wants to continue relying on monetary policy as its main countercyclical tool, we need to think about institutional changes that would strengthen the transmission mechanism.

2. If government liabilities are more liquid than the liabilities of even the biggest banks, as they certainly seem to be, then the banking system plays no function with respect to federal borrowing. The banks that hold federal debt are providing “anti-intermediation” — they are replacing more liquid assets with less liquid ones. In this sense, whatever income banks get from holding federal debt and providing means of payment are pure rents – it would be more efficient for federal liabilities to serve as means of payment directly.

The Chicago plan is the stone that is supposed to kill both these birds. I think it misses both, but in an intellectually productive way. In other words, it’s fun to think about.

The goal of the plan is to, in effect, collapse the categories of inside money, outside money and government debt by eliminating the first and turning the third into the second. Equivalently, it’s an attempt to legislate the economy into functioning the way monetarists (and some MMTers) say it already does, with a fixed money supply set by policy. You could think of it as another intervention in the centuries-old Currency School vs. Banking School debate — except that unlike most Currency School advocates over the past two centuries, Kumhof and Benes acknowledge that the Banking School is right about how existing financial systems operate, and that 100% reserves is not a return to some “natural” arrangement but a radical and far-reaching reform.

Why wouldn’t it work?

On the first goal, improving the reliability of stabilization policy, it’s important to recognize that deposits are not where the action is, and haven’t been for a long time. So 100% reserve backing of deposits is really the smallest piece of this thing. In effect, it’s a proposal to tighten the Fed’s handle on the narrow money supply — M1, in the jargon. but most means of payment in the economy aren’t captured by M1 — they don’t take the form of deposits, and haven’t for a long time. (In this respect things have really changed since 1936.) So it wouldn’t be enough to tighten the rules on deposit creation; you’d have to abolish (or impose the same reserve requirements on) all the other assets that serve as means of payment (and are more or less captured in M2 and formerly in M3), and prevent the financial system from developing new ones.

The proposal does do this, but it’s pretty draconian — under Kumhof and Benes’ plan “there is no lending at all between private agents.” As soon as you relax that restriction, the plan’s advantages in terms of stabilization go away. An absolute legal prohibition on IOUs might please Ezra Pound, but it’s hard to see it playing well among any of the IMF’s other constituencies. And the reality is if anything worse than that, because, as the Islamic world has been finding for 1,400 years now, it is very hard to legally distinguish debt contracts from other kinds of private contracts. So in practice you’d need an almost Soviet level of control over economic activity to realize something like this.

Perhaps I’m exaggerating the practical difficulties faced by the plan, but even if you could overcome them, it would only solve half the problem. The proposal only strengthens contractionary policy, not expansionary policy. It might have prevented the acceleration in credit creation in the 1980s and 1990s, but wouldn’t have done anything to boost credit creation and real activity in the past few years. It’s true that it would prevent the specific dynamic that Fisher (and later Friedman) blamed for the Depression, a positive feedback in a downturn between bank failures and a falling money supply. But that dynamic no longer exists, given deposit insurance and active countercyclical monetary policy, altho I suppose one could imagine it reappearing again in the future…

Part of the issue is whether you think lack of effective demand = lack of nominal effective demand = excess demand for money, by definition. This is the standard New Keynesian view, borrowed from monetarism. In this view a recession necessarily involves an insufficient money supply. But I don’t accept this. And once you accept that recessions involve multiple equilibria or coordination failures, there is no reason to think that increasing the supply of money must logically be a reliable way to get out of one, and lots of empirical evidence that it isn’t.

But even if the “Chicago plan” is not a workable solution to the breakdown of the monetary policy transmission mechanism, it’s a useful exercise. At the least, it calls attention to the fact that there is a breakdown — in a monetarist world, reforming the financial system to allow the central bank to control the money supply would be like legislating the law of gravity. Kumhof and Benes are clear that this proposal is only meaningful because under current arrangements, money is fully endogenous:

The critical feature of our theoretical model is that it exhibits the key function of banks in modern economies, which is not their largely incidental function as financial intermediaries between depositors and borrowers, but rather their central function as creators and destroyers of money. A realistic model needs to reflect the fact that under the present system banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending. This fact can be verified in the description of the money creation system in many central bank statements, and it is obvious to anybody who has ever lent money and created the resulting book entries.

(As a footnote tartly notes, that includes Kumhof, a former banker.)

So while the proposal doesn’t describe something you could actually do, it does help illuminate the current system of credit creation, via a sharply contrasting ideal alternative.

How about the second goal, eliminating the value-subtracting activity of banks “financing” government debt? Here I think they are onto something important. Interest is a payment for liquidity, as we’ve known since Keynes. So there is no economic reason for the government to pay interest to financial intermediaries when its own liabilities are the most liquid there are.

The problem here is, it’s not clear why, once you recognize this, you would stop at splitting of the payment system from credit creation. Why doesn’t the state provide means of payment directly? Whatever arguments there were for a state monopoly on money issue presumably don’t go away when money becomes electronic, so why isn’t there a public debit card just like there is federal currency? (This becomes really obvious when you look at the outright scams that happen when private businesses manage EBT cards, etc.) Of course there are people who want private currencies, but they are crazy libertarians. And yet without anyone accepting their arguments, we’ve implicitly gone along with them as the economy has moved toward electronic means of payment — every time you pay with a debit or credit card, some financial parasite takes their cut. The obvious solution is to end the private monopoly on means of payment. (What do want? Postal savings and a public payment system! When do we want them? Now!) Benes and Kumhof don’t go all the way there, but their plan is at least a step in that direction.

There’s a broader point here. Axel Leijonhufvud (among others) suggests that the fundamental reason there is a term premium (and at least part of the reason there is a liquidity premium) is that there is a chronic excess of long-term, illiquid assets in the form of physical capital, because of the technical superiority of roundabout production processes. That is, the time to maturity of the representative asset is longer than the horizon of the typical asset-holder. Thus the “constitutional weakness” (Hicks) at the long end of the credit market.

But if a larger proportion of the private economy’s outside assets are made up of government debt rather than physical capital, (and if a larger proportion of saving is done by institutions rather than households, tho that’s iffier) then this constitutional weakness goes away, and there’s no reason to have anyone collecting a fee for maturity transformation. Ashwin at Macroeconomic Resilience has written some very smart stuff about this.

Banks came into existence, in other words, in a world where most savers had a very high demand for liquidity, and most liabilities were risky and illiquid. So you needed someone to stand between, to intermediate. But today most saving is via institutional investors with long horizons — pensions etc. — or internal to the firm, while a very large proportion of borrowing is by sovereign governments, and so less risky/more liquid than anything banks can issue. In this world there’s no need for intermediaries in the old sense; they’re just rent-collecting parasites. This is not the way the “Chicago plan” is motivated but it seems like a not-bad way of making the point.

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Third piece, the transition. How do you go to a 100%-reserve world without a huge contraction of credit and activity? Here their solution is kind of clever. If you look at US nonfinancial debt, they observe, total business and home mortgage debt together come to about $20 trillion, and total government and non-mortgage household debt also come to about $20 trillion. Only the former, which finances investment, is socially productive, they figure. Under the Chicago Plan, banks would need $20 trillion in new reserves to avoid reducing the investment-financing part of their lending. Where do those new reserves come from? By the central bank buying up and extinguishing the other, non-productive half of the debt. It’s the best-credentialed jubilee proposal you’re likely to see.

Of course banks are worse off because half their interest-earning assets are replaced with sterile reserves. But in the logic of the proposal, there’s no social cost to that, since the lost interest income was for value-substracting “anti-intermediation” (my phrase, not theirs) activity; it was the banks’ fee for substituting less liquid for more liquid assets. Strictly speaking,though, this only applies to government debt. It’s not clear what’s supposed to happen with the stuff the non-mortgage household debt was paying for. Some of it, like credit card debt, was incurred just incidentally to making payments, and would no longer be needed in a world with separate payment and credit systems. As for the rest, they don’t say. It would be logical to see it as mostly for essentials that are better provide publicly, financed by continued reserve issuance. But that would be, as somebody said, not just reading between the lines, but off the edge of the page.

Overall, I like it. A lot. Not because I think it’s a good policy proposal or even (probably) a useful focal point for political mobilization. In general, I think that one should avoid, even for rhetorical purposes, the presumption that economic policy is set by a benevolent philosopher-king (an assumption baked into standard macro models). Agreeing on how the banking system “should” function under some more or less implicit set of constraints will not get us a bit closer to a society fit for human beings. But politically, having paper from the IMF suggesting, even in this rather artificial way, that the simplest solution to excessive debt is just to abolish it, has got to be useful in the coming rising of the debtors. Intellectually, meanwhile, what I like about this is that it puts in sharp relief how little the existing financial system can be explained, as it usually is, as the solution to the economic problems of intermediation and liquidity provision. If the functions banks are supposedly performing could be performed much more efficiently and easily without them, then banks must really be for something else.

EDIT: Oh and also, I’ve got to quote this bit:

Any debate on the origins of money is not of merely academic interest, because it leads directly to a debate on the nature of money, which in turn has a critical bearing on arguments as to who should control the issuance of money. … Since the thirteenth century [the] precious-metals-based system has, in Europe, been accompanied, and increasingly supplanted, by the private issuance of bank money, more properly called credit. On the other hand, the historically and anthropologically correct state/institutional story for the origins of money is one of the arguments supporting the government issuance and control of money under the rule of law. In practice this has mainly taken the form of interest-free issuance of notes or coins, although it could equally take the form of electronic deposits. 

There is another issue that tends to get confused with the much more fundamental debate concerning the control over the issuance of money, namely the debate over “real” precious-metals-backed money versus fiat money. … this debate is mostly a diversion, because even during historical regimes based on precious metals the main reason for the high relative value of precious metals was … government fiat and not the intrinsic qualities of the metals.These matters are especially confused in Smith (1776), who takes a primitive commodity view of money… 

The historical debate concerning the nature and control of money is the subject of Zarlenga (2002), a masterful work that traces this debate back to ancient Mesopotamia, Greece and Rome. Like Graeber (2011), he shows that private issuance of money has repeatedly led to major societal problems throughout recorded history, due to usury associated with private debts. Zarlenga does not adopt the common but simplistic definition of usury as the charging of “excessive interest”, but rather as “taking something for nothing” through the calculated misuse of a nation’s money system for private gain.

This is a really smart passage for a bunch of reasons. But what I really like about it is that it vindicates my position in the great Graeber debate on about three different levels. Take that, Mike Beggs!

Demand and Competitiveness: Germany and the EU

I put up a post the other day about Enno Schroder’s excellent work on accounting for changes in trade flows. Based on the comments, there’s some confusion about the methodology. That’s not surprising: It’s not complicated, but it’s also not a familiar way of looking at this stuff, either within or outside the economics profession. Maybe a numerical example will help?

Let’s consider two trading partners, in this case Germany and the rest of the EU. (Among other things, having just two partners avoids the whole weighting issue.) The first line of the table below shows total demand in each — that is, all private consumption, government consumption, and investment — in billions of euros. (As usual, this is final demand — transfers and intermediate goods are excluded.) So, for instance, in the year 2000 all spending by households, firms and governments in Germany totaled 2.04 trillion euros. The next two lines show the part of that expenditure that went to imports — from the rest of the EU for Germany, from Germany for the rest of the EU, and from the rest of the world for both. The final two lines of each panel then show the share of total expenditure in each place that went to German and rest-of-EU goods respectively. The table looks at 2000 and 2009, a period of growing surpluses for Germany.

2000 2009
Germany Demand 2,041 2,258
Imports from EU 340 429
Imports from Rest of World 198 235
Germany Share 74% 71%
EU ex-Germany Share 17% 19%
EU ex-Germany Demand 9,179 11,633
Imports from Germany 387 501
Imports from Rest of World 795 998
Germany Share 4% 4%
EU ex-Germany Share 87% 87%
Ratio, Germany-EU Exports to Imports 1.14 1.17
EU Surplus, Percent of German GDP 2.27 3.02

So what do we see? In 2000, 74 cents out of every euro spent in Germany went for German goods and services, and 17 cents for goods and services from the rest of the EU. Nine years later, 71 cents out of each German euro went to German stuff, and 19 cents to stuff from the rest of the EU. German households, businesses and government agencies were buying more from the rest of Europe, and less from their own country. Meanwhile, the rest of Europe was spending 4 cents out of every euro on goods and services from Germany — exactly the same fraction in 2009 as in 2000.

If Germans were buying more from the rest of the EU, and non-German Europeans were buying the same amount from Germany, how could it be that the German trade surplus with the rest of Europe increased? And by nearly one percent of German GDP, a significant amount? The answer is that total expenditure was rising much faster in the rest of Europe — by 2.7 percent a year, compared with 1.1 percent a year in Germany. This is what it means to say that the growing German surplus is entirely accounted for by demand, and that Germany actually lost competitiveness over this period.

Again, these are not estimates, they are the actual numbers as reported by EuroStat. It is simply a matter of historical fact that Germans spent more of their income on goods from the rest of the EU, and less on German goods, in 2009 than in 2000, and that the rest of the EU spent the same fraction of its income on German goods in the two years. Obviously, this does not rule out the possibility that German goods were becoming cheaper relative to the rest of Europe’s, if you postulate some other factor that would have reduced Germany’s exports without a growing cost advantage. (This is not so easy, since Germany’s exports are the sort of high-end manufactures which usually have a high income elasticity, i.e. for which demand is expected to rise over time.) And it is also compatible with a story where German export prices fell, but export demand is price-inelastic, so that lower prices did nothing to raise export earnings. But it is absolutely not compatible with a simple story where the most important driver of German trade imbalances is changing relative prices. For that story to work, the main factor in Germany’s growing surpluses would have to have been expenditure switching from other countries’ goods to Germany’s. And that didn’t happen.

NOTE: This my table, not Enno’s. The data is from Eurostat, while he uses the Penn World Tables, and he does not look at intra-European trade specifically.

UPDATE: There’s another question, which no one asked but which you should always try to answer: Why does it matter? The truth is, a big reason I care about this is that I’m curious how capitalist economies work, and this stuff seems to shed some light on that, in terms of both the specific content  and the methodology. But more specifically:

First, seeing trade flows as driven by income as well as price fits better with a vision of economy that has many different possible states of rest. It fits better with a vision of economies evolving in historical time, rather than gravitating toward an equilibrium which is both natural and optimal. In this particular case, there is no reason to suppose that the relative growth rates consistent with full employment in each country are also the relative growth rates consistent with balanced trade. A world in which trade flows respond mainly to relative prices is a world where macropolicy doesn’t pose any fundamentally different challenges in an open economy than in a closed one. Whatever mechanisms operated to ensure full employment continue to do so, and then the exchange rate adjusts to keep trade flows balanced (or appropriately unbalanced, for a country with a good reason to export or import capital.) Whereas when the main relationship is between income and trade, they cannot vary independently.

Second, there are important implications for policy. Krugman keeps saying that Germany needs higher relative prices, i.e., higher inflation. Even leaving aside the political difficulties with such a program, it makes sense on its own terms only if there is a fixed pool of European demand. To say that the only way you can have an adequate level of demand in Greece is for prices to fall relative to Germany, is to accept, on a European or global level, the structural theory of unemployment that Krugman rejects so firmly (and rightly) for the US. By contrast if competitiveness didn’t cause the problem, we shouldn’t assume competitiveness is involved in the solution. The historical evidence suggests that more rapid income growth in Germany will be sufficient to move its current account back to balance. The implications for domestic demand in Germany are the opposite in this case as in the relative-prices case: Fixing the current account problem means more jobs and orders for German workers and firms, not  higher inflation in Germany. [1]

So if you buy this story, you should be more pessimistic about a Greek exit from the euro — since there’s less reason to think that flexible exchange rates will lead to balanced trade — but more optimistic about a solution within the euro.

I don’t understand why, for economists like Krugman and Dean Baker, Keynesianism always seems to stop at the water’s edge. Why does their analysis of international trade always implicitly [2] assume a world economy continually at full capacity, where a demand shortfall in one country or region implies excess demand somewhere else? They know perfectly well that the question of unemployment in one country cannot be reduced to the question of who is getting paid too much; why do they forget it as soon as exchange rates come into the picture? Perhaps it’s for the same reasons — whatever they are — that so many economists who support all kinds of domestic regulation are ardent supporters of free trade, even though that’s just laissez-faire at the global level. In the particular case of Krugman, I think part of the problem is that his own scholarly work is in trade. So when the conversation turns to trade he loses one of the biggest assets he brings to discussions of domestic policy — a willingness to forget all the “progress” in economic theory over the past 30 or 40 years.

[1] A more reasonable version of the higher-prices-in-Germany claim is that Germany must be willing to accept higher inflation in order to raise demand. In some times and places this could certainly be true. But I don’t think it is for Germany, given the evident slack in labor markets implied by stagnant wages. And in any case that’s not what Krugman is saying — for him, higher inflation is the solution, not an unfortunate side effect.

[2] Or sometimes explicitly — e.g. this post has Germany sitting on a vertical aggregate supply curve.

What Drives Trade Flows? Mostly Demand, Not Prices

I just participated (for the last time, thank god) in the UMass-New School economics graduate student conference, which left me feeling pretty good about the next generation of heterodox economists. [1] A bunch of good stuff was presented, but for my money, the best and most important work was Enno Schröder’s: “Aggregate Demand (Not Competitiveness) Caused the German Trade Surplus and the U.S. Deficit.” Unfortunately, the paper is not yet online — I’ll link to it the moment it is — but here are his slides.

The starting point of his analysis is that, as a matter of accounting, we can write the ratio of a county’s exports to imports as :

X/M = (m*/m) (D*/D)

where X and M are export and import volumes, m* is the fraction of foreign expenditure spent on the home country’s goods, m is the fraction of the home expenditure spent on foreign goods, and D* and D are total foreign and home expenditure.

This is true by definition. But the advantage of thinking of trade flows this way, is that it allows us to separate the changes in trade attributable to expenditure switching (including, of course, the effect of relative price changes) and the changes attributable to different growth rates of expenditure. In other words, it lets us distinguish the changes in trade flows that are due to changes in how each dollar is spent in a given country, from changes in trade flows that are due to changes in the distribution of dollars across countries.

(These look similar to price and income elasticities, but they are not the same. Elasticities are estimated, while this is an accounting decomposition. And changes in m and m*, in this framework, capture all factors that lead to a shift in the import share of expenditure, not just relative prices.)

The heart of the paper is an exercise in historical accounting, decomposing changes in trade ratios into m*/m and D*/D. We can think of these as counterfactual exercises: How would trade look if growth rates were all equal, and each county’s distribution of spending across countries evolved as it did historically; and how would trade look if each country had had a constant distribution of spending across countries, and growth rates were what they were historically? The second question is roughly equivalent to: How much of the change in trade flows could we predict if we knew expenditure growth rates for each country and nothing else?

The key results are in the figure below. Look particularly at Germany,  in the middle right of the first panel:

The dotted line is the actual ratio of exports to imports. Since Germany has recently had a trade surplus, the line lies above one — over the past decade, German exports have exceed German imports by about 10 percent. The dark black line is the counterfactual ratio if the division of each county’s expenditures among various countries’ goods had remained fixed at their average level over the whole period. When the dark black line is falling, that indicates a country growing more rapidly than the countries it exports to; with the share of expenditure on imports fixed, higher income means more imports and a trade balance moving toward deficit. Similarly, when the black line is rising, that indicates a country’s total expenditure growing more slowly than expenditure its export markets, as was the case for Germany from the early 1990s until 2008. The light gray line is the other counterfactual — the path trade would have followed if all countries had grown at an equal rate, so that trade depended only on changes in competitiveness. When the dotted line and the heavy black line move more or less together, we can say that shifts in trade are mostly a matter of aggregate demand; when the dotted line and the gray line move together, mostly a matter of competitiveness (which, again, includes all factors that cause people to shift expenditure between different countries’ goods, including but not limited to exchange rates.)
The point here is that if you only knew the growth of income in Germany and its trade partners, and nothing at all about German wages or productivity, you could fully explain the German trade surplus of the past decade. In fact, based on income growth alone you would predict an even larger surplus; the fraction of the world’s dollars falling on German goods actually fell. Or as Enno puts it: During the period of the German export boom, Germany became less, not more, competitive. [2] The cases of Spain, Portugal and Greece (tho not Italy) are symmetrical: Despite the supposed loss of price competitiveness they experienced under the euro, the share of expenditure falling on these countries’ goods and services actually rose during the periods when their trade balances worsened; their growing deficits were entirely a product of income growth more rapid than their trade partners’.
These are tremendously important results. In my opinion, they are fatal to the claim (advanced by Krugman among others) that the root of the European crisis is the inability to adjust exchange rates, and that a devaluation in the periphery would be sufficient to restore balanced trade. (It is important to remember, in this context, that southern Europe was running trade deficits for many years before the establishment of the euro.) They also imply a strong criticism of free trade. If trade flows depend mostly or entirely on relative income, and if large trade imbalances are unsustainable for most countries, then relative growth rates are going to be constrained by import shares, which means that most countries are going to grow below their potential. (This is similar to the old balance-of-payments constrained growth argument.) But the key point, as Enno stresses, is that both the “left” argument about low German wage growth and the “right” argument about high German productivity growth are irrelevant to the historical development of German export surpluses. Slower income growth in Germany than its trade partners explains the whole story.
I really like the substantive argument of this paper. But I love the methodology. There is an econometrics section, which is interesting (among other things, he finds that the Marshall-Lerner condition is not satisfied for Germany, another blow to the relative-prices story of the euro crisis.) But the main conclusions of the paper don’t depend in any way on it. In fact, the thing can be seen as an example of an alternative methodology to econometrics for empirical economics, historical accounting or decomposition analysis. This is the same basic approach that Arjun Jayadev and I take in our paper on household debt, and which has long been used to analyze the historical evolution of public debt. Another interesting application of this kind of historical accounting: the decomposition of changes in the profit rate into the effects of the profit share, the utilization rate, and the technologically-determined capital-output ratio, an approach pioneered by Thomas Weisskopf, and developed by others, including Ed Wolff, Erdogan Bakir, and my teacher David Kotz.
People often say that these accounting exercises can’t be used to establish claims about causality. And strictly speaking this is true, though they certainly can be used to reject certain causal stories. But that’s true of econometrics too. It’s worth taking a step back and remembering that no matter how fancy our econometrics, all we are ever doing with those techniques is describing the characteristics of a matrix. We have the observations we have, and all we can do is try to summarize the relationships between them in some useful way. When we make causal claims using econometrics, it’s by treating the matrix as if it were drawn from some stable underlying probability distribution function (pdf). One of the great things about these decomposition exercises — or about other empirical techniques, like principal component analysis — is that they limit themselves to describing the actual data. In many cases — lots of labor economics, for instance — the fiction of a stable underlying pdf is perfectly reasonable. But in other cases — including, I think, almost all interesting questions in macroeconomics — the conventional econometrics approach is a bit like asking, If a whale were the top of an island, what would the underlying geology look like? It’s certainly possible to come up with a answer to that question. But it is probably not the simplest way of describing the shape of the whale.
[1] A perennial question at these things is whether we should continue identifying ourselves as “heterodox,” or just say we’re doing economics. Personally, I’ll be happy to give up the distinct heterodox identity just as soon as economists are willing to give up their distinct identity and dissolve into the larger population of social scientists, or of guys with opinions.
[2] The results for the US are symmetrical with those for Germany: the growing US trade deficit since 1990 is fully explained by more rapid US income growth relative to its trade partners. But it’s worth noting that China is not: Knowing only China’s relative income growth, which has been of course very high, you would predict that China would be moving toward trade deficits, when in fact it has ben moving toward surplus. This is consistent with a story that explains China’s trade surpluses by an undervalued currency, tho it is consistent with other stories as well.

In Comments: The Lessons of Fukushima

I’d like to promise a more regular posting schedule here. On the other hand, seeing as I’m on the academic job market this fall (anybody want to hire a radical economist?) I really shouldn’t be blogging at all. So on balance we’ll probably just keep staggering along as usual.

But! In lieu of new posts, I really strongly recommend checking out the epic comment thread on Will Boisvert’s recent post on the lessons of Fukushima. It’s well over 100 comments, which while no big deal for real blogs, is off the charts here. But more importantly, they’re almost all serious & thoughtful, and number evidently come from people with real expertise in nuclear and/or alternative energy. Which just goes to show: If you bring data and logic to the conversation, people will respond in kind.

You Eat Mitt Romney’s Salt

Don’t you love the Romney video? I’m not going to deny it, right now I am with Team Dem. It’s true, we usually say “the bosses have two parties”; but it’s not usual for them to run for office personally, themselves. And when they do, wow, what a window onto how they really think.

It’s hard to even imagine the mindset where the person sitting in the back of the town car is the “maker” and the person upfront driving is just lazing around; where the guys maintaining the hedges and manning the security gates at the mansion are idle parasites, while the person living in it, just by virtue of that fact, is working; where the person who owns the dressage horse is the producer and the people who groom it and feed it and muck it are the layabouts. As some on the right have pointed out, it’s weird, also, that “producing” is now equated with paying federal taxes. Isn’t working in the private sector supposed to be productive? Isn’t a successful business contributing something to society besides checks to the IRS?

It is weird. But as we’re all realizing, the 47 percent/53 percent rhetoric has a long history on the Right. (It would be interesting to explore this via the rounding-up of 46.4 percent to 47, the same way medievalists trace the dissemination of a text by the propagation of copyists’ errors.) Naturally, brother Konczal is on the case, with a great post tracing out four lineages of the 47 percent. His preferred starting point, like others’, is the Wall Street Journal‘s notorious 2002 editorial on the “lucky duckies” who pay no income tax.

That’s a key reference point, for sure. But I think this attitude goes back a bit further. The masters of mankind, it seems to me, have always cultivated a funny kind of solipsism, imagining that the people who fed and clothed and worked and fought for them, were somehow living off of them instead.

Here, as transcribed in Peter Laslett’s The World We Have Lost, is Gregory King’s 1688 “scheme” of the population of England. It’s fascinating to see the careful gradations of status (early-moderns were nothing if not attentive to “degree”); we’ll be pleased to see, for instance, that “persons in liberal arts and sciences,” come above shopkeepers, though below farmers. But look below that to the “general account” at the bottom. We have 2.675 million people “increasing the wealth of the kingdom,” and 2.825 million “decreasing the wealth of the kingdom.” The latter group includes not only the vagrants, gypsies and thieves, but common seamen, soldiers, laborers, and “cottagers,” i.e. landless farmworkers. So in three centuries, the increasers are up from 49 percent to 53 percent, and the lucky duckies are down from 51 percent to 47. That’s progress, I guess.

One can’t help wondering how the wealth of the kingdom would hold up if the eminent traders by sea couldn’t find common seamen, if the farmers had to do without laborers, if there were officers but no common soldiers. 

Young Alexander conquered India.
He alone?
Caesar beat the Gauls.
Was there not even a cook in his army?

Always more where they come from, I suppose Gregory King might say.

Here, also from Laslett, is a similar division from 100 years earlier, by Sir Thomas Smith:

1. ‘The first part of the Gentlemen of England called Nobilitas Major.’ This is the nobility, or aristocracy proper.
2. ‘The second sort of Gentlemen called Nobilitas Minor.’ This is the gentry and Smith further divides it into Knights, Esquires and gentlemen.
3. ‘Citizens, Burgesses and Yeomen.’
4. ‘The fourth sort of men which do not rule.’

Of this last group, Smith explains:

The fourth sort or class amongst us is of those which the old Romans called capite sensu proletarii or operarii, day labourers, poor husbandmen, yea merchants or retailers which have no free land, copyholders, and all artificers, as tailors, shoemakers, carpenters, brick- makers, brick-layers, etc. These have no voice nor authority in our commonwealth and no account is made of them, but only to be ruled and not to rule others.

In other words, Elizabethan Mitt Romney, your job is not to worry about those people.

Smith’s contemporary Shakespeare evidently had distinctions like these in mind when he wrote Coriolanus. (A remarkably radical play; I think it was the only Shakespeare Brecht approved of.) The title chracter’s overriding passion is his contempt for the common people, those “geese that bear the shapes of men,” who “sit by th’ fire and presume to know what’s done i’ the Capitol.” He hates them specifically because they are, as it were, dependent, and think of themselves as victims.

They said they were an-hungry; sigh’d forth proverbs, —
That hunger broke stone walls, that dogs must eat,
That meat was made for mouths, that the gods sent not
Corn for the rich men only: — with these shreds
They vented their complainings…

He has no patience for this idea that people are entitled to enough to to eat:

Would the nobility lay aside their ruth
And let me use my sword, I’d make a quarry
With thousands of these quarter’d slaves, as high
As I could pick my lance.

One more instance. Did everybody read Daniyal Mueenuddin‘s In Other Rooms, Other Wonders?

It’s a magnificent, but also profoundly conservative, work of fiction. In Mueenuddin’s world the social hierarchy is so natural, so unquestioned, that any crossing of its boundaries can only be understood as a personal, moral failing, which of course always comes at a great personal cost. There’s one phrase in particular that occurs repeatedly in the book: “They eat your salt,” “you ate his salt,” etc. The thing about this evidently routine expression is that the eater is always someone of lower status, and the person whose salt is being eaten is always a landlord or aristocrat. “Oh what could be the matter in your service? I’ve eaten your salt all my life,” says the electrician who has, in fact, spent all his life keeping the pumps going on the estates of the man he’s petitioning. Somehow, in this world, the person who sits in a mansion in Lahore or Karachi is entitled as a matter of course to all the salt and all the good things of life, and the person who physically produces the salt should be grateful to get any of it.

Mueenuddin describes this world vividly and convincingly, in part because he is a writer of great talent, but also clearly in part because he shares its essential values. Just in case we haven’t got the point, the collection’s final story, “A Spoiled Man,” is about how an old laborer’s life is ruined when his master’s naive American wife gets the idea he deserves a paycheck and proper place to sleep, giving him the disastrous idea that he has rights. You couldn’t write fiction like that in this country, I don’t think. Hundreds of years of popular struggle have reshaped the culture in ways that no one with the sensitivity to write good fiction could ignore. A Romney is a different story.

UDPATE: Krugman today is superb on this. (Speaking of being on Team Dem.)

Thomas Sargent Abandons Rational Expectations, Converts to Post Keynesianism

From Keynes (1937), “The General Theory of Employment”:

We have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. Sometimes we are not much concerned with their remoter consequences, even though time and chance may make much of them. But sometimes we are intensely concerned with them… The whole object of the accumulation of wealth is to produce results, or potential results, at a comparatively distant, and sometimes indefinitely distant, date. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders wealth a peculiarly unsuitable subject for the methods of the classical economic theory. … 

By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty… Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of an European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.

Better late than never, I suppose…

UPDATE: OK, ok, Sargent has written a lot about uncertainty and expectations.  Harry Konstantidis points out this 1972 article Rational Expectations and the Term Structure of Interest Rates, which is … really interesting, actually. It’s an empirical test of whether the behavior of interest rates over time is consistent with bond prices being set by a process of rational expectations. The conclusions are surprisingly negative:

The evidence summarized above implies that it is difficult to maintain both that only expectations determine the yield curve and that expectations are rational in the sense of efficiently incorporating available information. The predictions of the random walk version of the model are fairly decisively rejected by the data, particularly for forward rates with less than five years term to maturity. … 

It is clear that our conclusions apply with equal force to the diluted form of the expectations hypothesis that allows forward rates to be determined by expectations plus time-invariant liquidity premiums. … On the other hand, it would clearly be possible to determine a set of time-dependent “liquidity premiums” that could be used to adjust the forward rates so that the required sequences would display “white” spectral densities. … While this procedure has its merits in certain instances, it is essentially arbitrary, there being no adequate way to relate the “liquidity premiums” so derived to objective characteristics of markets… 

An alternative way to “save” the doctrine that expectations alone determine the yield curve in the face of empirical evidence like that presented above is to abandon the hypothesis that expectations are rational. Once that is done, the model becomes much freer, being capable of accommodating all sorts of ad hoc, plausible hypotheses about the formation of expectations. Yet salvaging the expectations theory in that way involves building a model of the term structure that … permits expectations to be formed via a process that could utilize available information more efficiently and so enhance profits. That seems … extremely odd.

In other words: Observed yields are inconsistent with a simple version of rational expectations. They could be made consistent, but only by trvializing the theory by adding ad hoc adjustments that could fit anything. We might conclude that expectations are not rational, but that’s too scary. So … who knows.

One unambiguous point, though, is that under rational expectations interest rates should follow a random walk, and your best prediction of interest rates on a given instrument at some future date should be the rate today. Just saying “I don’t now” is not consistent with rational expectations — for one thing, it gives you no basis for deciding whether a product like the one being advertised here is priced fairly. Sargent’s “No” is consistent, though, with fundamental uncertainty in the Keynes sense. In that case the decision to buy or not buy is based on nonrational behavioral rules — like, say, looking at endorsements of recognized authorities. (Keynes: “Knowing that our individual judgment is worthless, we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed.”) So I stand by my one-liner.

In Defense of Debt

I have a new post up at the Jacobin, responding to Mike Beggs’ critical review of David Graeber’s Debt. It’s a much longer, and hopefully more convincing, version of some arguments I was having with Mike and others over at Crooked Timber last month. Mike things there is no useful economics in Debt; I think that on the contrary, the book fits well with important strands of heterodox economics going back to Marx and Keynes (not to mention Schumpeter and Wicksell).

In particular, I think the historical and anthropological material in Debt helps put concrete social flesh on two key analytic points. First, that we need to think of capitalism primarily organized around the accumulation of money, with economic decision taken in terms of money flows and money commitments; not as a system for the mutually beneficial exchange of goods. And second, within capitalism, we can distinguish between economies where the medium of exchange is primarily commodity or fiat money, and economies where it is primarily bank-created credit money. Textbook economic analysis tends to work strictly in terms of the former, but both kinds of economies have existed historically and they behave quite differently.

(There’s a lot more in the book than this, of course, but what I am trying to do — I don’t know how successfully — is clarify the points where Debt contributes most directly to economics debates about money and credit.)

If this sounds at all interesting, you should first read Mike’s review, if you haven’t, and then read my very long response.

… and then, you should read all the other great stuff at The Jacobin. For my money, it’s the most exciting new political journal to come along in a while.

Bring Back Butlerism

From Eric Foner’s A Short History of Reconstruction:

Even more outrageous than Tweed … was Massachusetts Congressman Benjamin F. Butler, who flamboyantly supported causes that appalled reformers such as the eight-hour day, inflation, and payment of the national debt in greenbacks. He further horrified respectable opinion by embracing women’s suffrage, Irish nationalism, and the Paris Commune.

Or, as a horrified Nation put it, Butlerism was

the embodiment in political organization of a desire for the transfer of power to the ignorant and poor, and the use of government to carry out the poor and ignorant man’s view of the nature of society.

Labor law, inflation, women’s rights, anti-imperialism, and small-c communism, not to mention government by the poor? We could use a little more of that 1870s spirit today. People on the left who want to central banks to do more, in particular, could talk more about loose money’s radical pedigree.

So who was this guy? The internet is mainly interested in his Civil War career. Made a general on the basis of his pro-union, anti-slavery politics, he was, not surprisingly, pretty crap at it; but it does appear that he was the first Union officer to refuse to return fugitive slaves to their masters, and the first to successfully enlist black troops in the South. That was enough for Jefferson Davis to order that if he were captured, he should be executed on the spot. So he didn’t know how to lead a cavalry charge; sounds like a war hero to me.

In the current Jacobin (which everyone should be reading), Seth Ackerman offers emancipation and Reconstruction as a usable past for the Occupy left, unfavorably contrasting “the heavily prefigurative and antipolitical style of activism practiced by William Lloyd Garrison” with the pragmatic abolitionists who

saw that a strategic approach to abolition was required, one in which the “cause of the slave” would be harnessed to a wider set of appeals. At each stage of their project, from the Liberty Party to the Free Soil Party and finally the Republican Party, progressively broader coalitions were formed around an emerging ideology of free labor that merged antislavery principles with the economic interests of ordinary northern whites.

Today’s left, he suggests, could learn from this marriage of radical commitments and practical politics. Absolutely right.

There is, though, a problem: Reconstruction wasn’t just defeated in the South, it was abandoned by the North, largely by these same practical politicians, whose liberalism was transposed in just a few years from the key of anti-slavery to the key of “free trade, the law of supply and demand, the gold standard and limited government” (that’s Foner again), and who turned out to be less frightened by the restoration of white supremacy in the South than by “schemes for interference with property.”

If we must, as we must, “conjure up the spirits of the past …, borrowing from them names, battle slogans, and costumes in order to present this new scene in world history in time-honored disguise and borrowed language,” then certainly, we could do worse than the Civil-War era Republicans who successfully yoked liberalism to the cause of emancipation (though I’m not sure why Seth name-checks Salmon P. Chase, an early opponent of Reconstruction). But personally, I’d prefer to dress up as a populist who continued to support the rights of working people even after liberalism had decisively gone its own way, and who ended up representing “all that the liberals considered unwholesome in American politics.” Anybody for a revival of Butlerism?