Tag Archives: Eric Tymoigne

After Great Recession: A Bleaker Employment Recovery than after the Great Depression

By Eric Tymoigne

The last employment numbers provide yet another disappointing bit of news for millions of households all around the country. No net employment gain. However, I am afraid that this is only the very tip of the iceberg because a long-term view shows a much bleaker picture.

Figure 1 shows how long it took for the employment level to return to its peak level after a recession, and how much job loss occurred relative to that peak. The employment numbers exclude people that were employed in the WPA, NYA and CCC, and focuses on individuals employed in nonfarm activities.

During the Great Depression, the employment level declined for 4 years and almost 10 million jobs were lost compared to the peak employment level that prevailed in August 1929. It took 136 months (over 11 years) to return to this level of employment, but, without the avoidable 1937 recession, the full recovery would have occurred after 102 months (8.5 years) if one takes the trend of recovery that prevailed from 1933.

The Great Recession led to a loss of almost 9 million jobs compared to the peak employment level of January 2008. The loss of jobs occurred at a faster rate than the Great Depression but employment recovered sooner and started to rise after 2 years. However, once the employment recovery started, it occurred at a slower rate than during the Great Depression. If the recovery continues at the same pace, AND assuming that no recession occurs during the recovery phase, it will take about 9 years to return to the employment level of January 2008. Thus, given everything else, it will take longer for employment to fully recover than during the years prior to the 1937 recessions.

The picture is even bleaker today if one included New Deal employment programs. Figure 2 shows that those programs allowed employment to recover fully after 80 month (less than 7 years) and only three years after the New Deal Programs were implemented. The timid Bush and Obama stimulus have barely made a dent in the employment problem over the past two years.

This, once again, suggest a powerful employment policy to help the economy. Instead of concentrating its efforts on tax rebates and bailing out banks, and waiting for them to lend to businesses, the federal government should directly hire people and involve them in activity that benefited the entire country. We do not need a temporary stimulus; we need a permanent institutionalized and decentralized government program that hires anybody willing to work and unable to find a job in the private sector. By sustaining income and the productivity of workers, a government employment program would tremendously helps to sustain the employability of workers and would improve the confidence of private business, which would in turn improve private employment.

Figure 1. Difference between peak employment level and current employment level. Nonfarm payroll employment, seasonally adjusted, millions of people.


Sources: BLS (Current Employment Survey), Federal Reserve Bulletin (June and September 1941).
Note: People employed in the WPA, NYA and CCC are not included.

Figure 2. Same as Figure 1 with New Deal Federal Employment Programs.

Sources: Federal Reserve Bulletin, Social Security Bulletin.

Two Theories of Prices

Last May, John T. Harvey wrote a wonderful post about the quantity theory of money (QTM). This post picks up where John stopped, presenting a different theory of the price level and inflation. It’s a bit technical (so bare with me), but many readers have asked us to elaborate on price theory.
First, a quick recap. The QTM starts with the identity MV ≡ PQ, where M = the money supply, V = the velocity of money, P = the price level, and Q = the quantity of output (Fisher’s version is broader and includes all transactions: T). The identity is a tautology, it just says that the amount of transactions on goods and services (PQ) is equal the to the amount of financial transactions needed to complete those transactions. To get a theory of price (the QTM), one must make some assumptions about each variable. The QTM assumes that:
·         M is constant (or grows at a constant rate) and is controlled by the central bank through a money multiplier
·         V is constant
·         Q is constant at its full employment level (Qfe) or grows at its natural rate (gn)
Given this set of assumptions, we get (note the equality sign to signal causality):
P = MV/Qfe
Or, in terms of the growth rate (V is constant so its growth rate is zero):
gp = gm – gn
This is the QTM, which holds that price changes (inflation and deflation) have monetary origins, i.e. if the money supply grows faster than the natural rate of economic growth, there is some inflation.  For example, if gm = 2% and gn = 1% then gp = 1%.  If the central bank increases the money supply, then inflation rises.

John’s post explains the problems with this theory. M is endogenous, V is not constant, and the economy is rarely at full employment. If you want to know more, you should read John’s post.

Let’s move to an alternative theory of the price level and inflation by starting with another identity based on macroeconomic accounting:
PQ ≡ W + U
This is the income approach to GDP used by the Bureau of Economic Analysis. It says that nominal GDP (PQ) is the sum of all incomes. For simplicity, there are only two incomes: wage bill (W) and gross profit (U). Both are measured before tax.
Let’s divide by Q on each side:
P ≡ W/Q + U/Q
We can go a bit further by noting that W is equal to the product of the average nominal wage rate and the number of hours of labor W = wL (for example, if the wage rate is $5 per hour, and L is equal to 10 hours, then W is equal to $50). Thus:
P ≡ wL/Q + U/Q
Q/L is the quantity of output per labor hour, also called the average productivity of labor (APl) therefore:
P ≡ w/APl + U/Q
w/APl is called the unit cost of labor and data can be found at the BLS. The term U/Q will be interpreted a bit later.
Ok let’s stop a bit here. For the moment all we have done is rearranged terms, we have not proposed a theory (i.e. a causal explanation that provides behavioral assumptions about the variables.)  Here they are:
·         The economy is not at full employment and Q (and economic growth) changes in function of expected aggregate demand (this is Keynes’s theory of effective demand).
·         w is set in a bargaining process that depends on the relative power of workers (the conflict claim theory of distribution underlies this hypothesis)
·         U, the nominal level of aggregate profit, depends on aggregate demand (Kalecki’s theory of profit underlies this hypothesis)
·         APl moves in function of the needs of the economy and the state of the economy.
Thus we have:
P = w/APl + U/Q
Thus the price level changes with changes in the unit cost of labor and the term U/Q. What is this last term? To understand it let’s express the previous equation in terms of growth rate. This is approximately:
gp = (gw – gAPl)sW + (gU – gQ)sU
With sW and sU the shares of wages and profit in national income (sW + sU = 1).
Thus, inflation will move in relation to the growth rate of the unit labor cost of labor, which itself depends on how fast nominal wages grow on average relative to the growth rate of the average productivity of labor. As shown in the following figure, in the United States, a major source of inflation in the late 1960s and 1970s was the rapid growth of the unit cost of labor, with the rate of change between 5 and 10 percent.

Major Sector Productivity and Costs Index (BLS)

Series Id:  PRS85006112
Duration:   % change quarter ago, at annual rate
Measure:    Unit Labor Costs
Sector:     Nonfarm Business
Inflation will also move in relation to the difference between the growth rate of U and the growth rate of the economy (gQ). U follows Kalecki’s equation of profit, which broadly states that that the level of profit in the economy is a function of aggregate demand. Thus the term, (gU – gQ) represents the pressures of aggregate demand on the economy. If gU goes up and gQ is unchanged, then gP rises given everything else. However, to assume that gQ is constant is not acceptable unless the economy is at full employment, so a positive shock on aggregate demand will usually lead to a positive increase in gQ.
Thus, overall, there are two sources of inflation in this approach, a cost-push source (here summarized by the unit labor cost) and a demand-pull source (here summarized by the aggregate demand gap). Note that the money supply is absent from this equation. Money does not directly affect prices. Assuming that a drop of money from the sky leads to inflation, first, does not understand how the money supply is created (it is at least partly created to produce goods and services), second, assumes that people will automatically spend rather than hoard the addition funds obtained (people do hoard for all sorts of reasons and do derive “utility” from hoarding money), third, assumes that the economic output cannot respond to additional demand. If more people suddenly go to the store, producers usually produce more rather than raise prices. Output is not a fixed pie that involves allocation to one group at the expense of another group. The size of the pie increases and decreases with the number of people demanding pie.
A version of this theory has been used in many different models that have endogenous money, liquidity preference, demand-led theory of output and other non-mainstream characteristics. Godley’s and Lavoie’s Monetary Economics as well as Lavoie’s Foundation of Post Keynesian Economics are good books to get more modeling. Of course, modern mainstream monetary economics is rejected in those books; income effect dominates over substitution effect, production is emphasized over allocation, monetary profit affects economic decisions, etc. Be prepared for a change of perspective in which scarcity is not the starting point of economics.

$50 Billion in Infrastructure Spending: A drop in the Bucket

The White House released the following statement regarding its new recovery plan: “The President today laid out a bold vision for renewing and expanding our transportation infrastructure – in a plan that combines a long-term vision for the future with new investments. A significant portion of the new investments would be front-loaded in the first year.”
This front load is worth $50 billion…a lot of money…but an insignificant amount compared to the size of what is needed. It is not a bold vision it is a very timid vision. Don’t believe me? Ask the American Society of Civil Engineers. In its 2009 Infrastructure Report Card, it gave a D average to US infrastructures and recommended $2.2 trillion of dollars of spending over the next 5 years. And that is just to bring current infrastructures back to good condition; trillions more are needed to respond to growing needs.

Money is not a problem for the federal government, all this could be started tomorrow like we have done to finance wars, bail outs the financial sector and other wasteful items. We did it before, when the country had a truly bold vision and was much less wealthy, and we could do it again. Besides current infrastructures, we need to start to use our underused resources (especially labor) to address the future needs of our aging population and our environmental problems: education, infrastructure, social networks, technology, energy, food production, and many others sectors need help.

The CBO’s Misplaced Fear of a Looming Fiscal Crisis

By Eric Tymoigne

The Congressional Budget Office (CBO) has just released an 8-page brief titled “Federal Debt and the Risk of a Fiscal Crisis.” In it you will find all the traditional arguments regarding government deficits and debt: “unsustainability,” “crowding out”, bond rates rising to “unaffordable” levels because of fears that the Treasury would default or “monetize the debt,” the need to raise taxes to pay for interest servicing and government spending, the need “to restore investor’s confidence” by cutting government spending and raising taxes. This gives us an opportunity to go over those issues one more time.

  1. “growing budget deficits will cause debt to rise to unsupportable levels”

A government with a sovereign currency (i.e. one that creates its own currency by fiat, only issues securities denominated in its own currency and does not promise to convert its currency into a foreign currency under any condition) does not face any liquidity or solvency constraints. All spending and debt servicing is done by crediting the accounts of the bond holders (be they foreign or domestic) and a monetarily-sovereign government can do that at will by simply pushing a computer button to mark up the size of the bond holder’s account (see Bernanke attesting to this here).

In the US, financial market participants (forget about the hopelessly misguided international “credit ratings”) recognize this implicitly by not rating Treasuries and related government-entities bonds like Fannie and Freddie. They know that the US government will always pay because it faces no operational constraint when it comes to making payments denominated in a sovereign currency. It can, quite literally, afford to buy anything for sale in its own unit of account.

This, of course, as many of us have already stated, does not mean that the government should spend without restraint. It only means that it is incorrect to state that government will “run of out money” or “burden our grandchildren” with debt (which, after all, allows us to earn interest on a very safe security), arguments that are commonly used by those who wish to reduce government services. These arguments are not wholly without merit. That is, there may well be things that the government is currently doing that the private economy could or should be doing. But that is not the case being made by the CBO, the pundits or the politicians. They are focused on questions of “affordability” and “sustainability,” which have no place in the debate over the proper size and role for government (a debate we would prefer to have). So let us get to that debate by recognizing that there is no operational constraint – ever – for a monetarily sovereign government. Any financial commitments, be they for Social Security, Medicare, the war effort, etc., that come due today and into the infinite future can be made on time and in full. Of course, this means that there is no need for a lock box, a trust fund or any of other accounting gimmick, to help the government make payments in the future. We can simply recognize that every government payment is made through the general budget. Once this is understood, issues like Social Security, Medicare and other important problems can be analyzed properly: it is not a financial problem; it is a productivity/growth problem. Such an understanding would lead to very different policies than the one currently proposed by the CBO (see Randy’s post here).

  1. “A growing portion of people’s savings would go to purchase government debt rather than toward investments in productive capital goods such as factories and computers.”

First, this sentence seems to imply that government activities are unproductive (given that, following their logic, Treasury issuances “finance” government spending), which is simply wrong, just look around you in the street and your eyes will cross dozens of essential government services.

Second, the internal logic gets confusing for two reasons. One, if people are so afraid of a growing fiscal crisis, why would they buy more treasuries with their precious savings? Why not use their savings to buy bonds to fund “productive capital goods”? Using the CBO’s own logic, higher rates on government bonds would not help given that a “fiscal crisis” is expected and given that participants are supposed to allocate funds efficiently toward the most productive economic activity (and so not the government according to them). Second, we are told that “it is also possible that investors would lose confidence abruptly and interest rates on government debt would rise sharply.” I will get back to what the government can do in that case, but you cannot get it both ways; either financial market participants buy more government securities or they don’t.

Third, this argument drives home the crowding-out effect. I am not going to go back to the old debates between Keynes and others on this, but the bottom line is that promoting thriftiness (increasing the propensity to save out of monetary income) depresses economic activity (because monetary profits and incomes go down) and so decreases willingness to invest (i.e. to increase production capacities). In addition, by spending, the government releases funds in the private sector that can be used to fund private economic activity; there is a crowding-in, not a crowding-out. This is not theory, this is what happens in practice, higher government spending injects reserves and cash in the system, which immediately places downward pressure on short-term rates unless the Fed compensates for it by selling securities and draining reserves (which is what the Fed does on a daily basis).

  1. “if the payment of interest on the extra debt was financed by imposing higher marginal tax rates, those rates would discourage work and saving and further reduce output.”

No, as noted many times here, all spending and servicing is done by crediting creditor’s account not by taxing (or issuing bonds). Taxes are not a funding source for monetarily-sovereign governments, they serve to reduce the purchasing power of the private sector so that more real resources can be allocated to the government without leading to inflation (again all this does not mean that the government should raise taxes and takeover the entire economy; it is just a plain statement of the effects of taxation). All interest payments on domestically-denominated government securities (we are talking about a monetarily-sovereign government) can be paid, and have been met, at all times, whatever the amount, whatever their size in the government budget.

  1. “a growing level of federal debt would also increase the probability of a sudden fiscal crisis, during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates.”

If the US Treasury cannot issue bonds at the rate it likes there is a very simple solution: do not issue them. This does not alter in any way its spending capacity given that the US federal government is a monetarily-sovereign government so bond issuances are not a source of funds for the government. Think of the Federal Reserve: does it need to borrow its own Federal Reserve notes to be able to spend? No, all spending is done by issuing more notes (or, more accurately, crediting more accounts) and if the Fed ever decided borrow its own notes by issuing Fed bonds to holders of Federal Reserve notes (a pretty weird idea), a failure of the auction would not alter its spending power. The Treasury uses the Fed as an accountant (or fiscal agent) for its own economic operations; the “independence” of the Fed in making monetary policy does not alter this fact.

  1. “It is possible that interest rates would rise gradually as investors’ confidence declined, giving legislators advance warning of the worsening situation and sufficient time to make policy choices that could avert a crisis.”

It is always possible that anything can happen, but what is the record? The record is that there is no relationship between the fiscal position of the US government and T-bond rates. Massive deficits in WWII went pari passu with record low interest rates on the whole Treasury yield curve. With the help of the central bank, the government made a point of keeping long-term rates on treasuries at about 2% for the entire war and beyond, despite massive deficits. There is a repetition of this story playing out right now, and Japan has been doing the same for more than a decade. Despite its mounting government debt, the yield on 10-year government bonds is not more than 2% as of July 2010. In the end, market rates tend to follow whatever the central bank does in terms of short-term rates, not what the fiscal position of the government is.

As we already stated on this blog before, a simple observation of how government finance operates shows that government spending injects reserves into the banking system (pressing down short-term interest rate), while the payment of taxes reduces/destroys reserves (pushing short-term rates up). The Fed has institutions that allow it to coordinate on a daily basis with the Treasury (they call each other every day) to make sure that all these government operations do not push the interest rate outside the Fed’s target range.

  1. “If the United States encountered a fiscal crisis, the abrupt rise in interest rates would reflect investors’ fears that the government would renege on the terms of its existing debt or that it would increase the supply of money to finance its activities or pay creditors and thereby boost inflation.”

That’s a repeat of the first question but with a bit of elaboration. The US government cannot default on its securities for financial reasons, it is perfectly solvent and liquid. (Sovereign governments can, as we have conceded on this blog, refuse to pay – e.g. Japan after the war – but that is because it was unwilling to repay, not because it was unable to pay.) Thus, despite Reinhart and Rogoff’s warnings, the credit history of the US government (and any monetarily-sovereign government) remains perfect. No government with a non-convertible, sovereign currency has ever bounced a check trying to make payment in its own unit of account.

The US government always pays by crediting the account of someone (i.e. “monetary creation”). If the creditor is a bank, this leads to higher reserves, if it is a non-bank institution it leads also to an increase in the money supply. It has been like this from day one of Treasury activities. It is not a choice the government can make (between increasing the money supply, taxing or issuing bonds); any spending must lead to a monetary creation; there is no alternative. Again taxes and bonds are not funding sources for the US federal government; however they have important functions. Taxes help to keep inflation in check (in addition to maintaining demand for the government’s monetary instruments). Bond sales allow the government to deficit spend without creating excessive volatility in the federal funds market. If financial market participants want more bonds, the Treasury issues more to keep bond rates high enough for its tastes; if financial market participants do not want more treasury bonds, the government does not issue to avoid raising rates. The US Treasury (and any monetarily sovereign government as long as they understand it) has total control over the rate it pays on its debts; whether the government understands this or not is another question. A monetarily sovereign government does not have to pay “market rates” in order to convince markets to hold its bonds. Indeed, it does not even have to issue securities if it does not want to. In the US, it is usually the financial institutions that beg the Treasury to issue more securities.

The recent episode of the “Supplementary Financing Program” is a very good illustration of that point. Financial market participants were crying for more Treasuries and the Fed could not keep pace. As a consequence the Treasury agreed to issue more Treasuries than expected to meet the demand and help the Fed drain reserves and thereby hit their interest rate target. According to the Federal Reserve Bank of New York (DOMESTIC OPEN MARKET OPERATIONS DURING 2008, page 28): “To help manage the balance sheet impact of the Federal Reserve’s liquidity initiatives, the Treasury announced the establishment of a temporary Supplementary Financing Program (SFP) on September 17. The program consists of a series of Treasury bills issued by Treasury, the proceeds of which are deposited in an account at the Federal Reserve, draining reserve balances from the banking sector.”

Now look how this was deformed by the Treasury (quite a few journalists and bloggers followed): “The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve. The program will consist of a series of Treasury bills, apart from Treasury’s current borrowing program, which will provide cash for use in the Federal Reserve initiatives.” No, Mr. Treasury, this was not done for funding purpose; it was done to drain reserves from the banking system. The Fed does not need any cash from the Treasury. The Fed is the monopoly supplier of cash.

A final point regarding inflation. Inflation is a potential issue, as we have always maintained. But, there is no automatic causation from the money supply to inflation (a point Paul Krugman appears to have forgotten). Inflationary pressures depend on the state of the economy (supply and demand-side factors). Most importantly, perhaps, it depends on people’s desire to hoard vs. spend cash. Even the massive deficits during WWII, when resources were fully employed, did not lead to a spiraling out of control of inflation. Finally, it is quite possible that causation actually runs the other way around – i.e. from inflation to the money supply – given the endogeneity of the money supply, but that’s a story for another day…

Can we spend our way out of the recession? Is the fiscal deficit unsustainable? And is it time to cut government spending?

By Eric Tymoigne

If the reader is familiar with history, she or he will note a close similarity between the current policy debates and those of the 1930s; the latest similarity is the proposed spending freeze by the Obama Administration. In the early 1930s, President Roosevelt first criticized President Hoover for engaging in deficit spending and driving the country down the road to ruin, and then proceeded to implement policies that further increased the fiscal deficit of the federal government to about 5% of GDP (a historical record at that time). These policies greatly helped the economy to get out of the Great Depression, but were the subject of ferocious attacks on the ground that the “massive” deficits would lead to the insolvency of the country, uncontrollable inflation, wasteful spending, the taking over of the economy by the government, and, ultimately, the rise of Communism. A cartoon in the Chicago Tribune says it all. Those criticisms were so ferocious and effective at frightening the population that Roosevelt decided to return to a balance budget during the election year of 1936, just like President Obama wants to do.

Did any of those problems actually materialize? As the saying goes “the proof is in the pudding.” There was no government takeover, no rise of Communism, and no insolvency. In fact, Roosevelt proceeded to increase government deficit over 20% of GDP during WWII without any of those problems arising. The non-sense about insolvency and government takeover of the economy have been explained elsewhere on this blog (here and here) and on Bill Mitchell’s blog and no additional time needs to be devoted to that subject. Instead, let us see what the actual consequences of rising federal government deficit (current government outlays minus current government receipts) and rising public debt (the sum of all past and current federal government deficits and surpluses) were.

Staying in the pre-WWII period, unemployment went down steeply to about 10% of the economy, once one removes people employed by government programs from the unemployment data. Even if one just follows the official BLS data (the gray line in Figure 1), unemployment rate was down to 15%. Far from great but much better than 25%. Unemployment would have declined much further if Roosevelt had let the government spending grow. However, political pressures pushed him to limit government spending and government deficit and to actually reduce them massively. This generated a recession in 1937, followed by rising unemployment.

Figure 1. Annual Unemployment Rate in the U.S.: 1890-2009.

The main argument used for counting people employed by the CCC, WPA and other government programs as unemployed, is that those jobs were makeshift jobs not driven by the needs of the private sector. They were wasteful employment not justified by the profit motive. However, while they probably were not profitable, they were extremely beneficial for the welfare of the US population and provided the foundation for the long period of stability after WWII. Here are some of the achievements through June 1940, 3 years before most employment programs ended (NRPB is the National Resources Planning Board’s Security Work and Relief Policy):

Work Projects Adminitration (WPA)
“Through December 31, 1940, some of the tangible accomplishments of WPA projects were as follows: over 560,000 miles of highways, roads and streets constructed or improved; almost 5,000 schools built and 30,000 improved; 143 new hospitals provided and almost 1,700 improved; over 2,000 stadiums, grandstands, and bleachers built; 1,490 parks, 2,700 playgrounds, and more than 700 swimming pools constructed; 19,700 miles of new storm and sanitary sewers laid; over 2,000,000 sanitary privies built. Conservation work included the planting of more than 100,000,000 trees, and the construction or improvement of over 6,000 miles of fire and forest trails. The work in airport and airway facilities included some 500 landing fields and over 1,800 runways. During January 1941, 1,000,000 adults and 37,000 children were enrolled in classes and nursery schools; over 280,000 persons received music instruction and over 67,000 art instruction; and attendance at concerts reached almost 3,000,000 people. Participant hours in various recreational activities totaled almost 14,000,000. Since the beginning of the WPA, welfare activities have included a total of 312,045,000 garments completed by sewing projects and of 85,270,000 other articles, while more than 57,000,000 quarts of food have been canned and almost 600,000,000 school lunches were served.” (NRPB 1942: 342, n.4)
National Youth Administration (NYA)
“Through June 30, 1940, the accomplishments of youth workers on the out-of-school program had included the following: New construction or additions to more than 6,000 public buildings, such as schools, libraries, gymnasiums, and hospitals, and addition to or repair or improvement of about 18,300 others; construction of almost 4,000 recreational structures, such as stadiums, bandstands, and park shelters, and repair or improvement of nearly 6,000 others; construction of 350 swimming or wading pools and 3,500 tennis courts. About 1,500 miles of roads had been constructed and 7,000 repaired or improved; nearly 2,000 bridges had been built. Seven landing fields had been constructed at airports. 188 miles of sewer and water lines had been laid, and 6,200 sanitary privies built. Over 6.5 million articles of clothing had been produced or renovated, nearly 2 million articles of furniture constructed or repaired, and 350,000 tools or other mechanical equipment constructed or repaired. 77.5 million school lunches had been served by NYA youth; nearly 4 million pounds of foodstuffs had been produced and nearly 7 million pounds canned or preserved. Conservation activities had included the construction or repair of 127 miles of levees and retaining walls and 15,700 check and storage dams.” (NRPB 1942: 342, n.5)

Civilian Conservation Corps (CCC)
“Through June 30, 1940, the accomplishments on these [CCC] projects included: The construction of 37,203 vehicle bridges, 21,684,898 rods of fence, and 79,538 mileage of telephone lines; the development of almost 21,000 springs waterhole, and small reservoirs; the building of more than 5 million permanent and temporary check dams in connection with treating gullies for erosion control; as well as the planting, seeding, or sodding of 114 million square yards of terraces for protection against erosion; the planting or seeding of almost 2,000,000 acres of forest land with an average of 1,000 trees to the acre; 5,741,000 man-days spent in fighting forest fires and 5,392,000 man-days in fire presuppression and prevention work; forest-stand improvement on 3,694,930 acres; development of about 55,000 acres of public camp and picnic grounds; stocking lakes, ponds, and streams with 9.3 million fish.” (NRPB 1942: 343, n.8)

The overall cost of running those programs was extremely small, less than 1% of GDP. Despite their limited scope, they helped millions of people to make a living, helped to avoid waste of resources (if they had been left idle), and promoted the growth of U.S. infrastructures. In addition, the large deficit spending flooded the private sector with cash; thereby, restoring profitability and willingness to employ. War deficit spending reinforced this trend by flushing banks and private businesses with money and by creating a long period of financial stability. All this without any sign of insolvency of the federal government.

A final complaint is usually that government deficit always creates huge inflation and even hyperinflation. There is here a ton of data going against this argument. One just needs to look at Japan over the past 20 years: massive debt, very low interest rate, deflation or stable prices. But we do not have to go that far. Here is the United States, the “massive” deficits of the 1930s and 1940s did not generate high inflation.

Figure 2. Annual CPI Growth in the US.

In the 1930s, inflation stayed moderate at about 3%, after WWII inflation did spike to 15% for one year but that was it. And this spike is explained by the disturbances in the production system induced by WWII. After the production capacities were reoriented toward meeting the demands of a peaceful economy, inflation declined tremendously even though public debt was still very high relative to GDP. Today for the first time since 1955, the US economy experienced deflation despite rapidly rising deficits. Thus, there is no automatic relationship between government spending and inflation. It all depends on the state of the economy. If the economy is at full employment, any type of spending (private domestic consumption, private domestic investment, exports, and government spending) leads to inflation. If production capacities are underemployed, as they are today, companies can meet all the additional private or public demand without increasing their prices.

So can we spend our way out of a recession? Yes we can; provided that spending is high enough. Will a sovereign government go bankrupt by doing so? No, it will not. Does government spending lead to inflation? No, it does not. Does bigger government spending mean that the government will take over the economy? No, it does not. Does it mean that all types of spending are equally beneficial? Definitely not. Government spending can be wasteful if there is no improvement in the welfare of society through infrastructure spending, better social programs, and other government spending, preferably employment-enhancing, that improve the standard of living of the population. That is the major critique that one can make about the Obama administration under the guidance of Geithner and Summers. Far too much money was spent on wasteful financial rescues and far too few dollars were used for the benefits of the overall population. The clear example of this is that, while unemployment as leveled off it has not declined significantly. Even more telling is what has happened to the employment-population ratio. The latter has been dropping so much that all the gains of the past 25 years have been eliminated.

Figure 3. Employment-Population Ratio

We need a second “stimulus.” Even better, we need a permanent employment policy that provides a buffer against unemployment through employment-government programs. Those who promote small government do so on the basis of a value system, not on the basis of sound economic arguments or historical data. Unfortunately, this value system is highly dangerous for the well-being of the U.S. population. The alternative is not government takeover but rather using the government in a productive fashion to improve economic well being. Make your voice heard, not just by hanging passively signs in the streets and going to vote, but through massive organized protests and, if necessary, strikes. This is how a healthy democracy works. This is what happens all the time in other democratic countries and this is what this country did in the 1930s with the Bonus Marchers, industrial strikes, and the peasant movements. Want a few ideas to fight for? What about increasing healthcare benefits, eliminating the payroll tax, engaging in massive green infrastructure programs, providing free education in the fields in need (definitely not finance)? Those were the sort of commitments made during the 1930s and they have been hugely popular among the U.S. population, have contributed to the rise of US economic power, and have not affected at all the solvency of the United States. Again the proof is in the pudding: just look at the popularity of Medicare, Social Security, the air transportation system, the highway system and many other achievements of the New Deal and post-WWII policies.

Some Things to Consider Before Reappointing Bernanke

By Eric Tymoigne

Chairman Bernanke has been praised for his handling of the crisis. Nobody disputes the fact that the massive emergency lending programs of the Federal Reserve helped to stabilize the financial system in the short-term; however, judging the first term of the Chairman purely on this ground is rather narrow minded.

It is important to remember that the preamble of the Federal Reserve Act lays out a dual mandate for the Federal Reserve System: (1) provision of “an elastic currency” and (2) “effective supervision.” While the former provides short-term stability in the form of a lender of last resort (during crises) and of a reliable refinancing channel for banks (in normal times), the latter is intended to promote long-term stability.

Unfortunately, supervision has always been seen as a secondary duty of the Federal Reserve System. The Fed, which is now overwhelmingly populated by economists (probably the least qualified to supervise banks), has too often ignored its dual mandate in favor of a single policy objective — managing price stability – which, importantly, was never the intended role of the Fed. Chairman Bernanke continues this tradition.

First, he (along with Governor Mishkin) is the main proponent of inflation targeting. Since 1999, he has been a strong advocate of purely focusing interest-rate settings on meeting an inflation target, while ignoring output growth and asset-price volatility. The models “showed” that price stability is the holy grail of policy goals that guarantees high (and stable) economic growth and financial stability. During his tenures as Governor and Chairman, this view has been at the core of his policy choices, and financial fragility has been largely left aside. Thus, from 2006, he continued Greenspan’s policy of raising policy rates to fight a presupposed looming “high” inflation, without any regard for an economy already extremely fragile. These policy actions contributed tremendously to systemic risk by pushing financial institutions and households into more leveraged positions (the worst mortgage originations occurred in 2005 and 2006, when the fed funds rate target was rising fast) and by creating large payment shocks on exotic mortgages. In addition, Chairman Bernanke did not consider the relevance of systemic risk until mid-2008, while many economists, journalists and bloggers from the financial community had been warning about the huge problems since 2005 at least.

Second, Chairman Bernanke has been a proponent of market-oriented regulation in the spirit of Basel II, and of the financial innovations that have been at the heart of the crisis. Mega financial institutions are supposed to know their business better and so, with some light oversight from the government, are supposed to be able to regulate themselves. Risk management, financial innovations and credit rating agencies are supposed to provide the proper signals and buffers against risks. This regulatory philosophy has failed miserably to prevent not only this crisis but also previous crises, and has contributed to growing financial instability over the past 30 years. In addition, the Federal Reserve has been unwilling to apply existing regulations to handle problematic banks and the Chairman has backed the shameless stress tests implemented under TARP. As Bill Black noted elsewhere, federal regulators are mandated to force recapitalization or to place in receivership insolvent institutions no matter how big they are. Receivership was done during the S&L crisis in a very smooth and competent way and it should be done today.

Third, the way the lender of last resort policy of the Federal Reserve has been implemented during the crisis has been flawed. The emergency lending programs have been highly opaque, creating suspicions of favoritism and unfair competitive practices. SIGTARP, US COP, and Bloomberg have been pushing hard for greater transparency (Bloomberg won a court battle but the Fed is now appealing). All those programs should have been done through the discount window, which should be destigmatized by making it the main way the fed intervenes on a daily basis.

Overall, Chairman Bernanke is not the right person to deal with the main concern that the Federal Reserve should, above all else, strive to maintain financial stability. Before the crisis, Chairman Bernanke ignored (or simply missed) the many warning signs until it was too late, and after the crisis he will likely return to his favored policy of targeting expected inflation.

One may wonder who the President should appoint as Fed Chairman. While I am not in the position to name anybody in particular, I can suggest some criteria. First, the Chairman should be a person who is old enough not to be concerned about finding a job once he or she leaves the Chairmanship. Second, she or he should be someone who is known for his or her independence of mind. Third, she or he should be someone that puts financial stability above all other criteria (because that is what the Fed was originally mandated to do and because it is the best way the Fed can promote price stability and stable economic growth). Finally, he or she should be someone who does not try to please the financial sector, and who involves much more other sectors of the economy in policy decisions.

Another Take on the Financial Balances

By Eric Tymoigne

First, regarding the identity itself, for a domestic economy we have, in terms of economic flows:


With PDFB the private domestic financial balance, RWFB the financial balance of the Rest of the World, and GFB the government financial balance. This identity holds all the time, in any domestic economy (in a world economy RWFB disappears). For economic analysis, it is insightful to arrange this identity differently in function of the type of monetary regime.
In a country that is monetarily sovereign the federal government has full financial flexibility. By monetary sovereignty, one means that there is a stable and operative federal/national government that is the monopoly supplier of the currency used as ultimate means of payment in the domestic economy, and that the domestic currency is not tied to any asset (like gold) or foreign currency. Other posts have already explained the implications of this in terms of federal government finance (taxes and T-bonds do not act as financing sources for federal government spending, the federal government always spends by creating monetary instruments first, etc.) and banking (bank advances create deposits, credit supply is endogenous and is created ex-nihilo (i.e. banks do not need depositors to be able to provide an advance of funds to deficit spending units), higher reserve ratios do not constrain directly the money supply process in a multiplicative way, etc.). All this also has implications in terms of accounting and in terms of modeling.

First, in terms of accounting identity, in a monetarily sovereign country, the government financial balance (GFB), through the federal government financial balance, is the ultimate means to accommodate the changes in holdings of the domestic currency by other sectors (private domestic sector and the Rest of the World). This means that, for a monetarily sovereign country, the most insightful way to arrange the national accounting identity is:




Where NGFB is the non-government financial balance (the sum of the financial balance of the private domestic sector and the Rest of the World). This way of arranging the identity shows well that the government sector (through its federal branch) is the ultimate provider/holder of domestic currency: government fiscal deficit (surplus) is always equal to non-government financial surplus (deficit). The graph below shows the identity for the US.

Fiscal balances for the United State (billions of dollars)

Source: BEA (Table 5.1).
Note: Statistical discrepancy was distributed evenly among the three sectors (Private Domestic, Rest of the World, and Government).

Any net injection of dollars (i.e. financial deficit) by any sector must be accumulated somewhere else (i.e. financial surplus). As the monopoly supplier of ultimate domestic means of payment, usually the US government sector is the net injector of dollars, while the private domestic sector and the Rest of the World usually accumulate the dollars injected. For a while, like from 1997 to 2007 in the US, the private domestic sector and the Rest of the World may transfer the domestic currency among each other while the government runs a surplus; however, this cannot last because ultimately one of them (private sector or Rest of the World) will run out of domestic currency and/or will have to become highly indebted in domestic currency leading ultimately to a Ponzi process that collapses. Only the federal government has a perfect creditworthiness and can always meet its financial obligations denominated in the domestic currency (that is why US Treasury bonds are not rated, default rate is zero).

In addition, one may note that the Rest of the World and the private sector cannot accumulate any domestic currency unless the government sector injects them in sufficient quantity in the first place. Stated alternatively, the Rest of the World (e.g., the Chinese) does not help to finance the deficit of the federal government (US federal government). On the contrary, the federal government deficit allows the Rest of the World to accumulate dollars. This pressure to generate a deficit is all the more strong on the dollar that it is the reserve currency of the world, so there is a net demand for the dollar from the Rest of the World.

This also works the other way around, i.e. if the Rest of the World disaccumulates the domestic currency the government must be the ultimate acquirer of this domestic currency and so must run a surplus if the private domestic sector does not accumulate it in a large enough quantity.
Once it acquires the domestic currency, the government may destroy them (federal government has huge shredders or they are deleted from the computer memory), or store them into a safe/computer for later use (especially true for state and local governments). Destruction of bank notes occurs usually because they are in bad shape. Hundreds of millions of dollars worth of bank notes are destroyed every month at the Fed banks in the US; then they are used as compost (during my last tour of the San Francisco Fed last March, I was told that about $56 million worth of bank notes are destroyed every day at the SF Fed, and then are spread on the fields of California). If you go visit a fed bank this will be the main attraction.

Besides the poor condition of some bank notes, the destruction of dollars by the federal government may also occur for other reason, e.g., because there is a lack of storage capacity (safe is too small, computer memory is too small). One central point is that the dollars that are accumulated by the federal government do not increase its financing capacity because the federal government created those dollars in the first place. It chooses not to destroy them all because it takes time and it is costly to destroy and to make monetary instruments, and because it has the storage capacity.

For the moment, we stayed at the level of the identity, which basically tracks where the domestic currency comes from and where it goes. Every dollar comes from somewhere and must go somewhere. There is no dollar floating around that is not held by a sector. No desire/behavioral equation were included in the analysis above. However, even that basic identity provides us a powerful insight. Indeed, it shows us that it is impossible for all sectors to be in surplus; at least one of them must deficit spend and usually it is the government sector because of its monetary sovereignty. The reverse is also true, i.e. not all sectors can be in deficit at the same time; at least one of them must be in surplus (usually the private domestic sector). As Randy noted in a previous post, this is probably not understood well; even the Wall Street Journal did not make the connection in early the 2000s between the federal government surplus and the households’ negative saving. It is often assumed that if they wish, all sectors could be in surplus; one just needs to work hard enough at it (note that this is one of the promises that is always made during presidential campaigns: “we should save more, reduce our trade deficit and reach a fiscal surplus”). Economic reality does not work that way.

In terms of the model (where one includes desires and so behavioral aspects as well as an explanation of the adjustment mechanisms to those desires in relation to the state of the economy), for the analysis of a monetarily sovereign country, I would rather put the desired financial balance of the Rest of the World with the desired private domestic financial balance and call the sum the desired financial balance of the non-government sector (NGFBd). The model does not deal with stocks at all and their relation to flows (IS-LM did try but failed to do it correctly; read Hicks’s own account in his JPKE article “IS-LM: An explanation”); however, the financial-balance model is a good place to start in Econ 101. If students can understand the model, the identity and how they relate to each other, it would be a HUGE step forward in terms of removing this counterproductive phobia of government fiscal deficits (then one would have to learn about government finance and the monetary creation process, which, like many other things, are all taught backward in textbooks).

If the Rest of the World has too many dollars relative to its taste it and cannot bring them back into the domestic economy, by buying enough goods and services or financial assets from the private domestic and government sectors, the currency depreciates and/or long-term interest rate falls. This boosts exports and reduces imports. This may also promote investment and consumption if the state of expectations is stable.

If the non-government sector desires to save more, then, unless the government sector increases its spending propensity or reduces tax rates, the economy will enter a slump; possibly a debt-deflation process if debt levels are far too high. All this was done nicely in previous posts.
Before, during, and after the adjustment processes (variation of flows, levels and prices) the identity holds and the actual financial balance always sum to zero. The sum of GFBd and NFGBd will be different from zero except when the adjustment is completed, i.e. when actual and desired balances are equal (“at equilibrium” if you want to call it that way, even though markets may not be cleared).

Can Better Risk Management Techniques Prevent “It” From Happening Again?

by Eric Tymoigne

The risk-management approach to financial regulation has been around for a long time and it has failed consistently. It has not only failed to promote safer economic decisions and prevent the emergence of crises, but it has also failed to provide a relevant protection against major financial problems. Since at least 1864, with the imposition of capital adequacy ratios on national banks, regulators have tried to establish adequate buffers against expected and unexpected financial losses. Over time, the calculation of those buffers (liquidity, loan provisions, capital equity, etc.) has been refined, and Basel II was supposed to provide the latest improvements in this area. The current crisis has already made Basel II obsolete and many economists have noted the importance of accounting for liquidity issues in addition to loss issues.

Recent reports (e.g., CRMPG, BIS, IMCB, FSF, and the Department of the Treasury) have suggested that risk management can be improved by accounting for systemic risk and liquidity risk, and by making capital adequacy ratios more countercyclical. In addition, improvements were suggested in terms of reinforcing the role of risk officers in the governance of companies and in terms of remuneration methods.

Two of the major drawbacks of these proposals are that, first, like all previous risk-management policies, they do not deal with the core cause of financial instability and, second, they aim at being the least “intrusive,” which gives them only a very indirect impact on the management of financial stability.

Regarding the latter point, the philosophy of the past and current regulatory approaches has been to let individuals take whatever risk they find appropriate given market signals. Regulation is just there to tweak costs and returns in order to give an incentive to make “prudent” decisions as defined by arbitrary ratios of capital and liquidity (as well as by insurance premiums). As a consequence, as long as financial institutions meet the regulatory ratios, they are assumed to be safe and prudently managed, no matter how risky their asset positions and funding methods are. In addition, financial institutions can self-righteously complain further supervisory scrutiny if they meet their capital requirements, which greatly limits the effectiveness of supervision. All this is rather a permissive approach to financial regulation that is highly reluctant to forbid unsustainable financial practices. This is all the more so that economic agents are willing, and are forced by market mechanisms, to use those financial practices to improve their economic situations (unfortunately without consideration for the long-term indirect consequences of their choices).

Regarding the former point, the core cause of systemic financial crisis is the growing use of Ponzi finance over enduring periods of economic expansion. Ponzi finance means that the servicing of a given amount of debts requires the growing use of refinancing operations and/or liquidation of assets at rising prices. Ponzi funding methods are usually associated with crooks like Madoff, but the most devastating Ponzi processes are those that involve legal economic activities that are at the core of the economic growth process. Consumer finance for the past twenty years and the mortgage booms of the past ten years were Ponzi processes that involved honest and creditworthy borrowers who just wanted to improve their standard of living; lenders were more than eager to promote this trend to maintain their profitability and competitiveness, which was seen as a proud achievement of American free enterprise. Thus several Ponzi processes were at play and they all were used “judiciously” to maintain economic growth and business activities.

The problem with the type of Ponzi processes that we have experienced, is that, no matter how sophisticated and well informed financial players are, and no matter how efficient financial markets are, it always fails; and when it does, no buffer, no matter how high it is, can protect against the collapse. Pyramid Ponzi processes cannot be “risk managed.”

To better prevent the emergence of Ponzi processes an emphasis should be put on cash flows (rather than accounting profit) and on how economic entities plan to meet their financial commitments. Rather than asking, “Will you pay on time?” to determine creditworthiness, a more relevant question would be, “How will you pay on time?” And rising collateral price and access to refinancing channels should not be used to determine the expected capacity to repay of a borrower. Collateral liquidation (and so price) would only be used as a defensive means to protect banks against unexpected default, rather than as an offensive means to grow market shares and lending volumes. Ponzi processes should be eliminated or discouraged, no matter how good (or necessary) they appear for the competitiveness and (short-term) improvement of standards of living.

All financial institutions should be regulated, and the restructuring of the financial system should be based on promoting hedge financing of economic activities. By focusing on the financial practices of financial institutions, strong financial stability will be promoted and economic growth will proceed on more solid grounds (albeit probably at a slower pace).

BIS Report Warns That Main Problems Have Not Been Solved

by Eric Tymoigne

The Bank for International Settlements (BIS) in its 79th Report makes several interesting points that are consistent with what has been argued on this blog. Echoing an argument made by William Black, the BIS notes that we must thoroughly analyze banks’ balance sheets in order to rebuild the financial system: “A major cause for concern is the limited progress in addressing the underlying problems in the financial sector . . . a precondition for a sustainable recovery is to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuid its capital base. These conditions are not being met. . . The banks must . . . adjust by becoming smaller, simpler and safer.”

The report also notes rightly that worries about “exit strategies” for current central banks’ policies are misplaced, because “even if central banks are not able to shrink their balance sheets, they can withdraw liquidity through repurchase operations or the issuance of central bank bills or by making it more attractive for banks to hold reserves.” As noted in previous posts by Scott Fullwiler and L. Randall Wray, there are straightforward means for a central bank to always meet its interest rate targets, and these strategies are not intrinsically inflationary.

The report also recognizes that “there must be a mechanism for holding securities issuers accountable for the quality of what they sell. This will mean that issuers bear increased responsibility for the risk assessment of their products.” The Report, however, does not go far enough in recognizing that some products should be banned even if used by “sophisticated” financial institutions. Not all financial innovations are a desirable sign of progress. This is especially so if they promote Ponzi finance, which should be a central criterion to judge the safety of a financial product and an institutional organization.

A final interesting point is the acknowledgement that price stability and economic growth are not guaranteed by fine-tuning policies, and that there is a need to manage financial stability. Indeed, the crisis has shown that price stability does not guarantee financial stability and that, contrary to what most economists believed until very recently (and some still believe), the fine-tuning of inflation by interest rates is of limited effectiveness. “The crisis has confirmed that the monetary and fiscal policy framework that delivered the Great Moderation cannot be relied upon to stabilize prices and real growth forever . . . policymakers must be given an explicit financial stability mandate and that they will need additional tools to carry it out.”

However, the way financial stability should be promoted is highly contentious. Most economists argue that the causes of financial instability are imperfections of markets (asymmetry of information, mispricing, etc.) or of individuals (lack of financial education, irrationality, etc.). Hyman Minsky provided a very different explanation of financial instability that did not rely on imperfections and bubbles but on the intrinsic mechanisms of market economies over a long period of economic growth. According to Minsky, over periods of long-term expansion, economic growth and the maintenance of competitiveness require the growing use of Ponzi finance. As a consequence, not only illegal and fraudulent activities, but also legal economic activities become financially fragile. He advocated policies that strongly discourage the use of Ponzi practices (e.g., tax incentives) and/or an outright elimination of legal and illegal Ponzi processes, no matter how necessary they may seem to be for the (short-term) improvement of standards of living and competitiveness. This, rather than improvements of risk-management techniques or improvements in the management of asset prices (detection and pricking of bubbles), would help to prevent financial instability. That would require a much more flexible regulatory system that includes all financial institutions and products, without any exception, and that constantly monitors innovations (i.e. new ways of using existing products or new products) to prevent the emergence of Ponzi processes.

Question: “How big is the debt problem?” Answer: “ENORMOUS”

By Eric Tymoigne

The U.S. now has the highest ratio of debt-to-GDP in its history: nearly 5. And, while much has been made of the public sector’s growing debt levels, private finance has been the leading contributor to this massive growth of indebtedness. Two other contributors are GSEs (private/public financial sector) and households.

Figure 1: Total Financial Liabilities by Sectors Relative to GDP
Sources: Historical Statistics of the United States: Millennium Edition, Historical Statistics of the United States: Colonial Times to 1970, NIPA, Flow of Funds (from 1945).

Securitization, together with internationalization of finance, has been the main driver of those tendencies, enabling the financial sector to reap large profits…until recently.

Figure 2: Proportion of Corporate Profit Received by the Financial Sector*

*Excludes Federal Reserve Banks.
Source: BEA. Tables 6.16B, 6.16C, and 6.16D. Corporate profit with inventory valuation and net of capital consumption.

Interestingly, debt levels in the 1980s rivaled those of the Great Depression, which gave a hint that the quality of indebtedness matters as much as the quantity of debt. Take mortgages for example: IO mortgages were a major problem during the Great Depression, which led to a reform of the mortgage industry toward long-term fixed, fully-amortized mortgages. Until the early/mid 2000s, IOs and other exotic mortgages were of limited proportion or non-existent, but as the quality of mortgage deteriorated so did the capacity to sustain a given level of indebtedness.

Solving the debt problem is going to take many years and radical steps (some of them on the distributive and employment sides rather than the financial side). Already financial institutions are cutting the amounts due on credit cards (sometimes in half!) if customers are willing to repay in full at once. Creditors are beginning to understand the enormous problem posed by massive indebtedness. Policymakers should take note: a sustainable economic recovery cannot take place without first allowing private sector balance sheets to recover.