The Slack Wire

Are Recessions All About Money?

There is a view that seems to be hegemonic among liberal economists, that recessions are fundamentally about money or finance. Not just causally, not just in general, but always, by definition. In this view, the only sense in which one can speak about aggregate demand as a constraint on output, is if we can identify excess demand for some non-produced financial asset.

In the simplest case, people want to hold a stock of money in some proportion to their total income. Money is produced only by the government. Now suppose people’s demand for money rises, and the government fails to increase supply accordingly. You might expect the price of money to rise — that is, deflation. But deflation doesn’t restore equilibrium, either because prices are sticky (i.e., deflation can’t happen, or not fast enough), or because deflation itself further raises the demand for money. It might do this by raising precautionary demand, since falling prices make it likely that businesses and households won’t be able to meet obligations fixed in money terms and will face bankruptcy (Irving Fisher’s debt-deflation cycle). Or deflation might increase demand for money by because it redistributes income from net borrowers to net savers, and the latter have a higher marginal demand for money holdings. Or there could be other reasons. In any case, the price of money doesn’t adjust, so government has to keep its quantity growing at the appropriate rate instead. From this perspective,  if we ever see an economy operating bellow full capacity, it is true by definition that there is excess demand for some money-like asset.

This sounds like Milton Friedman. It is Milton Friedman! But it also seems to be most of the liberal macroeconomists who are usually called Keynesians. Here’s DeLong:

there was indeed a “general glut” of newly-produced commodities for sale and of workers to hire. But it was also the case that the excess supply of goods, services, and labor was balanced by an excess demand elsewhere in the economy. The excess demand was an excess demand not for any newly-produced commodity, but instead an excess demand for financial assets, for “money”…

How, exactly, should economists characterize the excess demand in financial markets? Where was it, exactly? That became a subject of running dispute, and the dispute has been running for more than 150 years, with different economists placing the cause of the “general glut” that was excess supply of newly-produced goods and of labor at the door of different parts of the financial system.

The contestants are:

Fisher-Friedman: monetarism: a depression is the result of an excess demand for money–for those liquid assets generally accepted as means of payment that people hold in their portfolios to grease their market transactions. You fix a depression by having the central bank boost the money stock…

Wicksell-Keynes (Keynes of the Treatise on Money, that is): a depression happens when there is an excess demand for bonds… You fix a depression by either reducing the market rate of interest (via expansionary monetary policy) or raising the natural rate of interest (via expansionary fiscal policy) in order to bring them back into equality….

Bagehot-Minsky-Kindleberger: a depression happens because of a panic and a flight to quality, as everybody tries to sell their risky assets and cuts back on their spending in order to try to shift their portfolio in the direction of safe, high-quality assets… You fix a depression by restoring market confidence and so shrinking demand for AAA assets and by increasing the supply of AAA assets….

From the perspective of this Malthus-Say-Mill framework Keynes’s General Theory is a not entirely consistent mixture of (1), (2), and (3)…Note that these financial market excess demands can have any of a wide variety of causes: episodes of irrational panic, the restoration of realistic expectations after a period of irrational exuberance, bad news about future profits and technology, bad news about the solvency of government or of private corporations, bad government policy that inappropriately shrinks asset stocks, et cetera. Nevertheless, in this Malthus-Say-Mill framework it seems as if there is always or almost always something that the government can do to affect asset supplies and demands that promises a welfare improvement

That’s an admirably clear statement. But is it right? I mean, first, is it right that demand constraints can always and only be usefully characterized as excess demand for some financial asset? And second, is that really what the General Theory says?

The first answer is No. Or rather, it’s true but misleading. It is hard to talk sensibly about a “general glut” of currently produced goods except in terms of an excess demand for some money-like financial asset. But recessions and depressions are not mainly characterized by a glut of currently produced goods. They are characterized by an excess of productive capacity. Markets for all currently-produced goods may clear. But there is still a demand constraint, in the sense that if desired expenditure were higher, aggregate output would be higher. The simple Keynesian cross we teach in the second week of undergrad macro is a model of just such an economy, which makes sense without money or any other financial asset. (And is probably more useful than most of what gets taught in graduate courses.) Arguably, this is the normal state of modern capitalist economies.

I’ll come back to this in a future post, hopefully. But it’s important to stress that the notion of aggregate demand limiting output, does not imply that any currently-produced good is in excess supply. [1]

Meanwhile, how about the second question — in the General Theory, did Keynes see demand constraints as being fundamentally about excess demand for money or some other financial asset, with the solution being to change the relative price of currently produced goods, and that asset? Again, the answer is No.

In his explanation of the instability of capitalist economies, Keynes always emphasizes the fluctuations in investment demand (or in his terms, the marginal efficiency of capital schedule). Investment demand is based on the expected returns of new capital goods over their lifetime. But the distribution of future states of the world relevant to those returns is not just stochastic but fundamentally unknown, so expectations about profits on long-lived fixed capital are essentially conventional and unanchored. It is these fluctuations in expectations, and not the demand for financial assets as expressed in liquidity preference, that drives booms and slumps. Keynes:

The fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the rate of interest may seriously aggravate the decline in investment. But the essence of the situation is to be found, nevertheless, in the collapse of the marginal efficiency of capital… Liquidity preference, except those manifestations which are associated with increasing trade and speculation, does not increase until after the collapse in the marginal efficiency of capital.  

It is this, indeed, which renders the slump so intractable. Later on, a decline in the rate of interest will be a great aid to recovery and probably a necessary condition of it. But for the moment, the collapse in the marginal efficiency of capital may be so complete that no practicable reduction in the rate of interest will be enough [to offset it]. If the reduction in the rate of interest was capable of proving an effective remedy by itself, it might be possible to achieve a recovery without the elapse of any considerable interval of time and by means more or less directly under the control of the monetary authority. But in fact, this is not usually the case.

In this sense, Keynes agrees with the Real Business Cycle theorists that the cause of a decline in output is not fundamentally located in the financial system, but a fall in the expected profitability of new investment. The difference is that RBC thinks a decline in expected profitability must be due to genuine new information about the true value of future profits. Keynes on the other hand thinks there is no true expected value in that sense, and that our belief about the future are basically irrational. (“Enterprise only pretends to itself to be actuated by the statements in its prospectus … only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come.”) This is an important difference. But the key point here is the bolded sentences. Keynes considers DeLong’s view that the fundamental cause of a downturn is an autonomous increase in demand for safe or liquid assets, and explicitly rejects it.

The other thing to recognize is that Keynes never mentions the zero lower bound. He describes the liquidity trap as theoretical floor of the interest rate, which is above zero, but nothing in his argument depends on it. Rather, he says,

The most stable, and least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in the future, the minimum rate of interest acceptable to the generality of wealthowners. (Cf. the nineteenth-century saying quoted by Bagehot, that “John Bull can stand many things, but he cannot stand 2 percent.”) 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.

This is an important part of the argument, but it tends to get ignored by mainstream Keynesians, who assume that monetary authority can reliably set “the” interest rate. But as we see clearly today, this is not a good assumption to make. Well before the policy rate reached zero, it had become effectively disconnected from the rates facing business borrowers. And of course the hurdle rate from the point of view of the decisionmakers at a firm considering new investment isn’t just the market interest rate, but that rate plus some additional premium reflecting what Keynes (and later Minsky) calls borrower’s risk.

So, Keynes thought that investment demand was subject to wide, unpredictable fluctuations, and probably also a secular downward trend. He doubted that very large movements in the interest rate could be achieved by monetary policy. And he didn’t think that the moderate movements that could be achieved, would have much effect on investment. [2] Where did that leave him? “Somewhat skeptical of the success of a merely monetary policy directed toward influencing the rate of interest” at stabilizing output and employment; instead, the government must “take an ever greater responsibility for directly organizing investment.”

Of course, DeLong could be misrepresenting Keynes and still be right about economic reality. But we need to at least recognize that aggregate demand is logically separate from the idea of a general glut; that the former, unlike the latter, does not necessarily involve excess demand for any financial asset; and that in practice supply and demand conditions in financial markets are not always the most important or reliable influences on aggregate demand. Keynes, at least, didn’t think so. And he was a smart guy.

[1] The other point, to anticipate a possible objection, is that the investment decision does not involve allocation of a fixed stock of savings between capital goods and financial assets.

[2] The undoubted effectiveness of monetary policy in the postwar decades might seem to argue against this point. But it’s important to recognize — though Keynes himself didn’t anticipate this — that in practice monetary policy has operated largely though its effect on the housing market, not on investment.

Don’t Let Nobody Walk All Over You

Here’s a heartening story from the old neighborhood:

An 82-year-old great-grandmother cried tears of joy Friday as nearly 200 neighbors rallied in her support on the day she was to be evicted. Mary Lee Ward was granted a reprieve when the owner of the Brooklyn house where she lives agreed to continue meeting with her lawyers next week. “You have to stick with it when you know your right,” Ward told the cheering crowd. “Don’t let nobody walk all over you.” 

Ward, who fell victim in 1995 to a predatory subprime mortgage lender that went under in 2007, has been battling to stay in the Tompkins Avenue home for more than a decade. A city marshal was supposed to boot Ward from the one-family frame house Friday, but didn’t show as her lawyers sat down with an assemblywoman and the home’s owner. … “I hope they realize that they can never really win,” Ward said. “I will not compromise.”

Why don’t we see more of this kind of thing? There are millions of families with homes in foreclosure, and millions more heading that way. Being forcibly evicted from your home has got to be one of the most wrenching experiences there is. And yet as long as you’re in the house, you have some real power. And the moral and emotional claims of someone like Ward to her home are clear, regardless of who holds the title. Someone just has to organize it. Here, I think, is where we are really suffering from the loss of ACORN — these situations are tailor-made for them.

Still, there is some good work going on. I was at a meeting recently of No One Leaves, a bank tenant organization in Springfield, MA. Modeled on Boston’s City Life/Vida Urbana, this is a project to mobilize people whose homes have been foreclosed but are still living in them. Homeowners who still have title have a lot to lose and are understandably anxious to meet whatever conditions the lender or servicer sets. But once the foreclosure has happened, the homeowner, paradoxically, is in a stronger negotiating position; if they’re going to have to leave anyway, they have nothing to lose by dragging the process out, while for the bank, delay and bad publicity can be costly. So the idea is to help people in this situation organize to put pressure — both in court and through protest or civil disobedience — on the banks to agree to let them stay on as tenants more or less permanently, at a market rent. In the longer run, this will discourage foreclosures too.

It’s a great campaign, exactly what we need more of.

But there’s another important thing about No One Leaves: They’re angry. The focus isn’t just on the legal rights of people facing foreclosure, or their real chance to stay in their homes if they organize and stick together, it’s on fighting the banks. There’s a very clear sense that this is not just a problem to be solved, but that the banks are the enemy. I was especially struck by one middle-aged guy who’d lost the home he’d lived in for some 20 years to foreclosure. “At this point, I don’t even care if I get to stay,” he said. “Look, I know I’m probably going to have to leave eventually. I just want to make this as slow, and expensive, and painful, for Bank of America as I can.” Everyone in the room cheered.

Liberals hate this sort of thing. But it seems to be central to successful organizing. Back when I was at the Working Families Party, one of the things the professional organizers always talked about was the importance of polarizing — getting people to articulate who was responsible for their problems, who’s the other side. It was a central step in any house visit, any meeting. And from what I could tell, it worked. I mean, it’s foolish of someone like Mary Lee Ward to say, “I will not compromise,” isn’t it? Objectively, compromise is how most problems get solved. But if she didn’t have a clear sense of being on the side of right against wrong, how would she have the energy to keep up what, objectively, was very likely to be a losing fight, or convince her neighbors to join her? Somebody or other said there are always three questions in politics. You have to know what is to be done — the favorite topic of intellectuals. But that’s not enough. You also have to know which side you are on, but that’s not enough either. Before you devote your time and energy to a political cause, you have to know who is to blame.

A while back I had a conversation with a friend who’s worked for the labor movement for many years, one campaign after another. If you know anyone like that, or have been part of an organizing drive yourself, you know that in the period before a union representation vote, an American workplace is a little totalitarian state. (Well, even more than usual.) Spies reporting on private conversations, mandatory mass meetings, veiled and open threats, punishment on the mere suspicion of holding the wrong views, no due process. And yet people do still vote for unions and support unionization campaigns, even when being fired would be a a personal catastrophe. Why, I asked my friend. I mean, union jobs do have better pay, benefits, job security —  but are they that much better, that people think they’re worth the risk? “Oh, it’s not about that,” he said. “It’s about the one chance to say Fuck You to your boss.”

Hardt and Negri have a line somewhere in Empire about how, until we can overcome our fear of death, it will be “carried like a weapon against the hope of liberation.” When I first read the book, I thought that was pretty strange. But now I think there’s something important there. Self interest, even enlightened, only takes you so far, because when you’re weak, your self-interest is very often going to be in accomodation to power. I’m not sure I’d go as far as Hardt and Negri, that we have to lose our fear of death to be free moral agents. But it is true that we can’t organize collectively to assert our rights in our homes and our jobs as long as we’re dominated individually by our fear of losing them. Some other motivation — dignity,  pride, anger or even hatred — is needed to say, instead, that nobody is going to walk all over you.

A History of Debt/GDP

“Probably more uninformed statements have been made on public-sector debt and deficits,” says Willem Buiter, “than on any other subject in macroeconomics. Proof by repeated assertion has frequently appeared to be an acceptable substitute for proof by deduction or proof by induction.”

It’s hard to disagree. 
But at least we know where an informed discussion starts. It starts from the least controversial equation of macroeconomics, the law of motion of public debt:
b is the ratio of public debt to GDP, d is the ratio of primary deficit to GDP, i is the nominal interest rate, g is the real growth rate of GDP, and pi is inflation. In principle this is true by definition. (In practice things aren’t alway so simple.) The first thing you realize, looking at this equation, is that contrary to the slack-jawed bleating of conventional opinion, there’s no necessary connection between the evolution of public debt and government spending and taxes. Interest rates, growth rates and inflation are, in principle, just as important as the primary balance. Which naturally invites the question, which have been more important in practice?
There have been various efforts to answer this question for different countries in different periods, but until recently there wasn’t any systematic effort to answer it for a broad sample of countries over a long period. I was thinking of trying to do such an exercise myself. But it looks like that’s not necessary. As Tom M. points out in comments,  the IMF has just undertaken such an exercise. Using the new Historical Public Debt Database, they’ve decomposed the debt-GDP ratios of 174 countries, from 1880 to the present, into the four components of the law of motion. (Plus a fifth, discussed below.) It’s an impressive project. Ands far as one can tell from this brief presentation, they did it right. Admittedly it’s a laconic 25-page powerpoint, but there’s not even the hint of a suggestion that microfoundations or welfare analysis would contribute anything. The question is just, how much has each of the components contributed to shifts in debt-GDP ratios historically?
As I’ve noted here before, the critical issue is the relationship between g and i, or (g + pi) and i as I’ve written it here. On this point, the IMF study gives ammunition to both sides.
From roughly 1895 to 1920, and from 1935 to 1980, nominal growth rates (g + pi) generally exceeded nominal interest rates. From 1880 to 1895, from 1920 to 1935, and from 1980 to the present, interest mostly exceeded growth. It’s impossible, looking at this picture, to say one relationship or the other is normal. Lernerian-Keynesians will say, why can’t the conditions of the postwar decades be reproduced by any government that chooses to; while the orthodox (Marxists and neoclassicals equally) will say the postwar decades were anomalous for various reasons — financial repression, limited international mobility of capital, exceptionally strong growth. The historical evidence doesn’t clearly resolve the question either way.

Given the unstable relationship between g and i, it’s not surprising there’s no consistent pattern in episodes of long-term reduction in debt-GDP ratios. I had hoped such episodes would turn out to be always, or almost always, the result of faster growth, lower interest rates, and higher inflation. This is basically true for the postwar decades, when the biggest debt reductions happened. Since 1980, though, it seems that countries that have reduced their debt-GDP ratios have done it the hard way, by taxing more than they spent. Over the whole period since 1880, periods of major (at least 10 percent of GDP) debt reduction has involved primary surpluses and g > r in about equal measure.

Another interesting point is how much the law of motion turns out to have exceptions. The IMF’s version of the equation above includes an additional term on the right side: SFA, or stock-flow adjustment, meaning the discrepancy between the flow of debt implied by the other terms of the equation and the stock of debt actually observed. This discrepancy turns out to be often quite large. This could reflect a lot of factors; but for recent episodes of rising debt-GDP ratios (in which SFA seems to play a central role) the obvious interpretation is that it reflects the assumption by the government of the banking system’s debts, which is often not reflected in official deficit statistics but may be large relative to the stock of debt. The extreme case is Ireland, where the government guarantee of the financial system resulted in the government assuming bank liabilities equal to 45 percent of GDP. To the extent this is an important factor in rising public debt generally — and again, the IMF study supports it — it suggests another reason why concern with balancing the long-term budget by “reforming” Medicare, etc., is misplaced. One financial crisis can cancel out decades of fiscal rectitude; so if you’re concerned about what the debt-GDP ratio will be in 2075, you should spend less time thinking about public spending and taxes, and much more time thinking about effective regulation of the financial sector.
The bottom line is, the dynamics of public debt are complicated. But as always, intractable theoretical controversies become more manageable, or at least more meaningful, when they’re posed as concrete historical questions. Good on the IMF for doing this.

A History of Catastrophes

Schumpeter says:

Even if he confines himself to the most regular of commodity bills and looks with aversion on any paper that displays a suspiciously round figure,the banker must not only know what the transaction is which he is asked to finance and how it is likely to turn out, but he must also know the customer, his business, and even his private habits, and get, by frequently “talking things over with him,” a clear picture of his situation. … However, this is not only highly skilled work, proficiency in which cannot be acquired in any school except that of experience, but also work which requires intellectual and moral qualities not present in all people who take to the banking profession. 

… In the case of bankers, however, failure to be up to what is a very high mark interferes with the working of the system as a whole. Moreover, bankers may, at some times and in some countries, fail to be up to the mark corporatively: that is to say, tradition and standards may be absent to such a degree that practically anyone, however lacking in aptitude and training, can drift into the banking business, find customers, and deal with them according to his own ideas. In such countries or times, wildcat banking develops. This in itself is sufficient to turn the history of capitalist evolution into a history of catastrophes.

From Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process.

What a magnificent book! Leaving my heavily-annotated copy on the NYC subway is one of my great regrets in life, bookwise. It doesn’t seem to be in print now. Does anybody still read it?

We Are All Austerians Now

Mark Thoma:

we must cut spending and raise taxes to get the debt under control

I’m sorry, but This. Is. Not. True.

If you look at future debt-GDP ratios and think they are too high, how can you reduce them?

1. You can improve the primary balance by raising taxes and/or reducing spending.

2. You can raise the growth rate.

3. You can lower the real interest rate on government debt.

4. You can raise inflation. (This may also help with 3, depending what we think of Fisher’s law.)

EDIT: 5. You can default. (Thanks, Bruce Wilder.)

One is not the only choice. We can, of course, debate which of these choices offers the best tradeoff between feasibility and desirability. But it is not true that reducing the long-run debt-GDP ratio necessarily involves reducing spending or raising taxes. And anyone who want a rational discussion of fiscal issues, needs to stop lying to people that it is.

How bad things are, can be seen by the fact that someone as smart as Barkely Rosser has been convinced that a reluctance to raise taxes is the problem for aggregate demand. When the debate comes down or whether we should raise taxes or cut spending, the real question has been answered, and answered wrong. At that point it’s just a question of what flavor of austerity we want. Thank god at least there’s still Daniel Davis.

If we wanted to move this debate forward, the next step would be to look at periods when the long term debt-GDP ratio was reduced in rich countries. How much was due to the primary balance that Thoma takes for granted is the only solution, how much was due to faster growth, how much to lower interst rates and how much to higher inflation?

How the Other Side Thinks

At least someone is happy about the debt-ceiling deal:

Low government debt yields may reflect concern about the health of the economy and the drag spending cuts would have on gross domestic product.

Reductions are “going to be good for Treasuries, ironically, because it’s bad for the economy,” Tad Rivelle, the head of fixed-income investment at Los Angeles-based TCW Group Inc., which manages about $115 billion, said in an interview last week. “It ought to further restrain economic growth by in effect withdrawing a good deal of fiscal stimulus.” 

By “good for Treasuries,” he means good for people who own Treasuries.

This brings out a point I’ve been thinking about for a while. Marxist  and mainstream economists don’t agree on much, but one view they do generally share is that under capitalism, growth is the central objective pursued by the state. Maybe we should not take that for granted.

For individual capitals, growth, endless accumulation, is a necessity imposed by the pressure of competition. And when the individual capitalist tries to influence the state they are generally looking for measures to help them grow faster. They have to, it’s a condition of their survival. But insofar as the capitalist class as a whole (or some substantial fraction of it) exercises political agency, they’re not subject to competition. An individual capital needs to grow as fast as possible so as not to be overtaken by its rivals; but for capital as a whole, there is no equivalent pressure. What capital as a whole needs from the state is to maintain its basic conditions of existence and secure its political dominance. And that may well be as well achieved through slower growth, as through faster. Directly, because the labor supply is liable to be dangerously depleted by rapid growth. More broadly, because growth is inherently chaotic, unpredictable and destabilizing. This isn’t in the textbooks but you can learn it from Schumpeter just as well as from Marx. Or from just from looking around.

There’s a long line of arguments, going back to Marx’s reserve army of the unemployed, via Kalecki’s “Political Aspects of Full Employment,” formalized in the postwar period as Goodwin cycles or Crotty and Boddy’s political business cycles, and most fully developed in Glyn et al.’s Capitalism Since 1945, that periods of low unemployment can’t be sustained under capitalism, because they put upward pressure on wages and more broadly leave workers overly confident and politically empowered. Greenspan, bless his shriveled soul, was onto something important when he insisted in the late 1990s that the Fed could tolerate low unemployment without raising interest rates only because workers were intimidated by downsizing and the loss of job security.

Now, these are cyclical arguments. And the US hasn’t had a cycle of this kind since the 1980s. The last couple of downturns haven’t been about wages, at least overtly, but about asset bubbles and oil prices. But even if this recession wasn’t caused by the Fed raising interest rates to choke off wage growth (and clearly it wasn’t) capital and its political representatives could take advantage of it opportunistically to force down the wage share. One wouldn’t deliberately provoke a deep recession just to reduce wages, because of the political risks; but if one stumbles into it and the politics turn out to be manageable, why let a good crisis go to waste?

More broadly, if high growth rates are risky for capital, and if they were only politically necessary thanks to competition with the Soviet Union (this is an important argument that’s not quite spelled out in the Glyn book), then we shouldn’t be shocked if the post-Cold War state ends up preferring growth-reducing policies. Brad DeLong has been complaining lately about the failure, as he sees it, of the state to live up to its role as the committee to manage the collective affairs of the bourgeoisie. But maybe he just hasn’t been invited to the meetings.

UPDATE: Yglesias makes a similar argument in a less provocative way. Before the 1980s, we had episodes of high inflation, and no episodes of sustained high unemployment. Since the 1980s, we’ve had no episodes of high inflation, but we’ve had repeated episodes of sustained high unemployment. The obvious interpretation, which I share with Ygelsias, is that the Phillips Curve is not vertical even over the long run — there is a secular tradeoff between employment and price stability, and since Volcker the Fed’s preferences have shifted toward the price-stability side. Why this is the case is a different question, but it seems safe to say it has to do with the diverging interests of workers and owners and their respective political strength.

It’s Not About the Deficits

I was going to write something about tonight’s debt-celing deal. “Reduces Domestic Discretionary Spending to the Lowest Level Since Eisenhower,” says the White House in triumphant title case. Yay! No more EPA, no more civil rights enforcement, no more federal spending on housing or child care or clean energy. They didn’t need them in the Eisenhower era, so why should we?

It makes me mad. And it’s not good to write when you’re mad. As the man says,

Hatred, even of baseness,
Distorts the features.
Anger, even against injustice,
Makes the voice grow hoarse.

So instead of this appalling deal, let’s talk about the trajectory of the debt historically. Specifically, this very interesting take from the always-interesting Willem Buiter:

The last time the US sovereign radically lowered the ratio of public debt to GDP was between 1946 (the all-time high for the Federal debt burden at 121.20 percent) and 1974 (its post-World War II low at 31.67 percent). Arithmetically, of the 89.53 percentage points reduction in the Federal debt burden, inflation accounted for 52.63pp and real GDP growth accounted for 55.86 pp. Federal surpluses accounted for minus 20.51pp. …

Longer average maturity and occasionally sharp bursts of inflation helped erode the real burden of the Federal debt between 1946 and 1974, but so did financial repression – ceilings on nominal interest rates. … Until the Treasury-Federal Reserve Accord of March 1951, the Federal Reserve System was formally committed to maintaining a low interest rate peg on Treasury bonds – a practice introduced in 1942 when the Fed pegged the interest rate on Treasury bills at 0.375 percent. This practice was continued after the war despite a 14 percent rate of CPI inflation in 1947 and an 8 percent rate in 1948. The rate on 3-month Treasury Bills remained at 0.375 percent until June 1947 and did not reach 1.40 percent until March 1951.

Even after the Treasury-Federal Reserve Accord, there remained financial repression in the form of ceilings on bank lending and borrowing rates like Regulation Q, which prohibited the payment of interest on demand deposits. Without financial repression and with a relatively short average debt maturity, it would take high US rates of (unanticipated) inflation to bring down the burden of the debt appreciably.

This is the key point that comes out of the relationships that govern the evolution of the federal debt: Deficits/surpluses are just one factor, along with growth rates, interest rates, and inflation, that determine the trajectory of the debt. There’s no a priori reason to think that long-term shifts in the debt-GDP ratio are more likely to come about through changes in the government’s fiscal stance rather than one of the other three variables; and there’s historical evidence that in practice growth, inflation and interest rates usually matter more. At some point I’ll do an exercise similar to Buiter’s. But in the meantime, I’m happy to take it from him — the dude is the chief economist at Citibank — that, in the the postwar decades, growth and inflation contributed about equally to the very large reduction in the US debt-GDP ratio, while fiscal discipline contributed less than nothing.

So if you wanted to follow the postwar US in reducing the debt-GDP ratio over a long period — it’s not entirely clear why you would want to do this — you should be thinking about faster growth, higher inflation and policies to hold down interest rates (aka “financial repression”), not higher taxes and lower spending. Anyone who says, “The growth of the debt is unsustainable, therefore we need to move the federal budget toward balance” doesn’t know what they’re talking about.

Or, they’re talking about something else.

You can interpret Obama’s relentless pursuit of defeat in the budget-ceiling fight in psychological terms. But it seems more parsimonious to at least consider that he’s simply an honest servant of the country’s owners, who see the crisis as a once-in-a-lifetime chance to roll back the social wage. Raising the Medicare eligibility age wouldn’t have done anything much to reduce the long-term debt-GDP ratio. But it definitely would reduce the number of people with Medicare.

UPDATE: This post is evidently the kind of thing Matt Yglesias has in mind when he says he’s

frustrated by lefties who seem to see the unprecedented Republican obstruction the President is dealing with as part of an 11-dimensional chess game through which Obama “really” wants his progressive initiatives to be frustrated at every term. 

 But this gets the n-dimensional chess metaphor backward, I think. The whole reason people claim Obama is playing a deeper or more complex game is to argue that even when his actions don’t seem to get him closer to his supposed goals, he really is getting there but by some devious route. But if your theory, as here, is that the actual outcome was the intended outcome, you don’t need to assume any deviousness. If I sacrifice my knight for no apparent gain, then maybe I have some complex plan you don’t see — that’s the extra dimensions. But if I’m playing to lose, no extra dimensions are needed to explain my bad move. Yglesias’s frustration here would apply to lefties who argued that Obama’s big progressive victories were really serving a conservative agenda. And there are certainly people who would argue that — if there were any big progressive victories to argue about.

Bottom Rail, Moving Up

David Harvey observed recently that this crisis was the first in modern times in which the periphery has not borne a disproportionate share of the costs. Dani Rodrik’s recent posts make a similar point.

And it’s true — over the past 40 years, we’ve seen repeated episodes when growth has slowed in the rich world, and collapsed catastrophically in the South. Neoliberalism has meant the tools the North uses to ameliorate slumps have been forbidden to poor countries. As my friend Doug Henwood says, in each of the crises of the past two decades, “the First World banks got a Minsky bailout while the Third World suffered a Fisher deflation.” But this time really seems to be different.
It’s interesting to compare the last of those episodes, the Asian crisis of 1997, with the most recent crisis.
Whatever you think the underlying causes of the 1997 crisis were (people sure liked saying “crony capitalism”) the basic facts are straightforward. East and Southeast Asia experienced a “sudden stop” of previously large financial inflows, leaving them unable to meet their foreign-currency obligations. As a result they were forced to abandon their currency pegs, abruptly raise interest rates to unheard-of levels, and eliminate their trade deficits with extreme prejudice. The result was severe economic disruption and brutal recessions. Indonesia, for example, didn’t regain its pre-crisis level of output for a full five years.
Fast forward ten years, and the same region is a bright spot in the global growth picture. What people don’t realize, though, is that many Asian countries experienced a sudden stop of financial inflows in 2007-08 even larger than the one that caused so much destruction in 1997. Add to that a collapse in export earnings as demand in the rich countries fell, and Asian countries faced a substantially larger shock to foreign exchange earnings in 2007-2008 than ten years before.
Change in Gross Flows as Percent of Peak GDP
1997Q2-1997Q4 Peak-2008Q4
Portfolio Inflows All Forex Inflows Portfolio Inflows All Forex Inflows
Indonesia -10.6 -18.5 -6.1 -9.7
Korea -5.9 -18.0 -10.1 -29.5
Phillipines -5.4 -15.9 -9.3 -30.1
Thailand -2.5 -12.4 -6.2 -22.4
Source: IMF International Financial Statistics.
Notes: [1]
As the table shows, several of the newly industrializing countries of East Asia experienced a shock to their balance of payments in 2007-08 about double that of 1997. So why did the earlier shock have so much larger effects?
“Floating exchange rates” is the wrong answer. (“Fiscal responsibility” is worse, it’s not even wrong.) As captured in the well-known J-curve, even when exchange rates move in the right direction, they initially have the wrong effects on trade flows. Even in the most optimistic case it takes at least a year before a depreciation begins to improve the trade balance. Anyway, in the crisis this time, Asian exchange rates didn’t fall. 
In the short run at least, trade flows respond to movements in incomes, not relative prices. Replacing the trade-price relationship with a trade-income relationship is probably the key contribution of Post Keynesian analysis to the study of international finance and trade. [2] Combined with the notion of liquidity constraints — despite what the textbook says, the supply of credit is not infinitely elastic at “the” interest rate — this means there are situations where a country needs to rapidly improve its balance of payments and the only tool available (once direct import restrictions are ruled out) is to reduce income, often by some large multiple of the gap to be closed. [3] In a nutshell, that’s what happened in 1997. So why not this time?
The answer is that the Asian countries entered this crisis, unlike the last one, with large current account surpluses and foreign-exchange reserves. Countries that can respond to a negative shock to foreign exchange inflows by reducing their own accumulation of foreign assets or spending down their reserves, don’t have to reduce imports by pushing down income and output. Instead, they could and did raise domestic incomes via stimulus programs and interest-rate cuts, to offset the fall in export demand. And this is not only good news for them, it also dampens the process by which trade-induced contractions would otherwise propagate across borders.
Indeed, it’s probably precisely to be ready for this contingency that Asian countries committed themselves to running surpluses in the first place. There’s an old Martin Wolf column making this argument, which I’ll add to this post when/if I find it. It’s made more systematically in a couple recent articles by Jorg Bibow. (Bibow’s work is about the best I’ve seen on the whole question of “global imbalances”.) He argues that current account surpluses and reserve accumulation should be seen as a form of “self-insurance” by countries that have become disillusioned with the IMF as a provider of insurance against balance-of-payments shocks (its supposed raison d’etre). Bibow is fairly critical of this approach, which is natural from the point of view of someone steeped in Keynes’ ideas of a rational international order. We don’t, after all, think it would be such a great thing if people dispensed with health insurance and saved up money for future health expenses instead. But if your insurer insisted that you donate at least a kidney before they’d approve a blood transfusion, self-insurance might look like a better option.

There’s a couple important points here. First, the economic point:

The direct effects of trade flows on aggregate demand are usually dwarfed by the indirect effects, as government spending and investment adjust to accommodate the balance of payments constraint. This is why trade is not, in a Keynesian framework, a zero-sum game, and why the mewling of American economists about Asian “mercantilism” so misses the point. When capital flowed out of Asia in 1997, the whole development process had to be thrown into reverse in order to make up the shortfall in foreign exchange. That’s what happens when you’re pushed up against your balance of payments constraint. It didn’t haVppen this time because of their past ten years of self-insurance. In the US, on the other hand, the external balance doesn’t constrain expansionary fiscal policy at all, only the stupidity of our politics does.

Maybe even more important, the political point. How is it that these countries managed to reject the siren song of the Washington Consensus? After all, it promised (1) development would be so much faster with access to the savings of the rich world via unfettered financial flows; (2) if something did go wrong, the IMF loans were always available to bridge short-term foreign-exchange shortfalls; and, implicitly, (3) if things fell apart completely, unrestricted financial flows would ensure that elites could extract their wealth from a wrecked economy.

Around 1990, when I was first becoming aware of politics, we took it for granted that the IMF was one of the great forces for evil in the world. And you know what? I think we were right.

Which makes it all the more remarkable that some substantial fraction of the world has managed to tear itself free of those usurers. In principle, there’s the potential for progressive struggle whenever the sociological basis of a form of political consciousness requires it to cohere somewhere beneath the top of a value chain. But in practice, it’s hard to do. Much easier for the representatives of a subordinate class or geography to constitute themselves as an agent of the elites above rather than the masses below. So while self-insurance via reserve accumulation might seem like a small step towards socialism, I think it’s kind of a big deal. Economically, you have to recognize that Asian economies are not in depression now thanks to prudential state action, not the pseudo-logic of “conditional convergence”. And politically it’s even more remarkable, in the scale of things, that Asian elites have been able even to this extent to identify themselves with their national economies rather than the global owning class.

[1] “All Forex Inflows” is the sum of gross portfolio inflows, inward FDI, other inward investment and exports. (The gross numbers are conceptually the correct ones, for reasons I can’t explain here but hopefully are obvious.) The peak quarter is 1997Q2 for the 1997 crisis. For the recent crisis it is  2008Q2 for Indonesia, 2007Q4 for Korea, 2007Q2 for the Philippines and 2008Q1 for Thailand. The IMF does not have data for Malaysia prior to 1999.

[2] As on so many topics, Joan Robinson’s contribution is essential and mostly unacknowledged.

[3] The ratio of the necessary fall in output to the balance of payments gap to be closed is equal to one over the marginal propensity to import. Countries in this situation almost always sharply raise the domestic rate of interest, which theoretically helps attract short-term financial flows to bridge the gap, but in practice is mostly just a mechanism to reduce domestic incomes.

How I Learned to Stop Worrying and Love Default

If the debt-ceiling negotiations (summarized here) drag on to the point where there is real doubt about the full repayment of Treasury securities, would that be a disaster? Or could it actually raise output and employment?

Nick Rowe has a very smart argument for the latter, on straightforward Keynesian grounds:

Take the standard ISLM model… Draw the LM curve horizontal; either because the central bank conducts monetary policy by setting a rate of interest, or because the economy is stuck in a liquidity trap where money and government bonds are perfect substitutes. Now let’s hit it with a shock.

The shock is that all the bond rating agencies downgrade the rating on government bonds. Specifically, the rating agencies say that whereas the previous default risk was zero, there is now a 1% chance per year that the government will renege on 100% of all promises to pay money on its bonds. (Or a 10% chance per year of reneging on 10% of repayments, whatever.) And assume that everybody believes the rating agencies. Further assume that the central bank holds the interest rate on government bonds constant… What happens?

My answer to this question is the same as the standard textbook answer to the question where the shock is an increase in expected inflation by 1%. … And if you: did believe in the ISLM model; and did believe that the economy was stuck in a liquidity trap; and did believe the economy needed an increase in Aggregate Demand; and did believe that fiscal policy either should or could not be used, for whatever reason; you would say that this increase in expected inflation is a good thing. At first sight, the answer to the question “what is the effect of a 1% increase in perceived risk on government bonds?” is exactly the same as the answer to the question “what is the effect of a 1% increase in expected inflation?”. … Both result in the same 1% fall in the real risk-adjusted rate of interest on private saving and investment and the same rise in AD and real income.

This is one of those points that seems bizarre and counterintuitive when you first hear it and completely obvious once you’ve thought about it for a moment. Suppose a bond already pays zero interest; how can its yield go lower? One way is for inflation to get higher, so the principal repayments are expected to be worth less. But another is for the default probability to rise, which also reduces the expected value of the principal repayments. At the level of abstraction where a lot of these debates happen, for important purposes the two should be identical. If you believe the zero lower bound story — that monetary policy would have brought unemployment down to normal levels by now, if it were just possible to reduce the federal funds rate below zero — then you should support a (temporarily) nonzero default risk on government debt for the exact same reason that you support (temporarily) higher inflation — it creates the economic equivalent of negative interest rates.

There are lots of caveats in practice. (There are almost always lots of caveats.) And if you’re a ZLB skeptic — if you don’t believe even a negative interest rate would be effective in boosting demand — then default risk won’t help much either. But analytically, it’s still an important point. Among other things, it helps explain why the threat of default has not moved the price of Treasury securities at all.
I’d assumed, up until now, that it was because asset owners took it for granted that the debt ceiling would, in fact, be raised, or that if not debt payments would be prioritized over everything else.

I still suppose that’s true. But here’s a more general reason. Another way of thinking of the zero lower bound phenomenon is that the government’s commitment to issue zero-interest liabilities in the form of cash and reserves sets a ceiling on the price of its liabilities (remembering that price and yield move inversely.) This price ceiling means there is excess demand. So if you have some exogenous factor that would normally lower the price of Treasuries, it doesn’t do so; at the margin, it just reduces the backlog of frustrated buyers at the current price.

Cool.

UPDATE: And here, right next to the Rowe piece in Google Reader, is an FT Alphaville item about how settlement failures (not delivering a security at the date contracted) seem to be becoming increasingly deliberate in secondary markets for Treasuries, as a form of “unconventional financing.” It’s not an exact analogy, but there’s an important parallel: In private financial markets, when an interest rate is stuck at zero, how completely a debt is honored becomes the natural margin on which terms adjust.