Tag Archives: Fiscal Policy

Financial Engineers and The Brave New World

Posted on August 4, 2009 by | Comments Off on Financial Engineers and The Brave New World
And some people say that no one saw this crisis coming. Bright people almost 10 years ago foresaw and understood the risks and consequences of private sector indebtedness and its relation to government surpluses.

by Warren Mosler and Eileen Debold

Just as the Corps of Engineers sustains the army’s fighting ability, our financial engineers have been sustaining the US post-Cold War economic expansion. Financial engineering has effectively supported an expansion that could have long ago succumbed to the ‘financial gravity’ economists call ‘fiscal drag.’ For even with lower US tax rates, the surge in economic growth has generated federal tax revenues in excess of federal spending. This has led to both record high budget surpluses and the record low consumer savings that is, for all practical purposes, the other side of the same coin. As the accounting identity states, a government surplus is necessarily equal to the non-government deficit. The domestic consumer is the largest component of ‘non-government’ trailed by domestic corporations, and non- resident (foreign) corporations, governments, and individuals.



It is our financial engineers who have empowered American consumers with innovative forms of credit, enabling them to sustain spending far in excess of income even as their net nominal wealth (savings) declines. Financial engineering has also empowered private-sector firms to increase their debt as they finance the increased investment and production. And, with technology increasing productivity as unemployment has fallen, prices have remained acceptably stable.

Financial engineering begins deep inside the major commercial and investment banks with ‘credit scoring.’ This is typically a sophisticated analytical process whereby a loan application is thoroughly analyzed and assigned a number representing its credit quality. The process has a high degree of precision, as evidenced by low delinquencies and defaults even as credit has expanded at a torrid pace. Asset securitization, the realm of another highly specialized corps of financial engineers, then allows non-traditional investors to be part of the demand for this lending-based product. Loans are pooled together, with the resulting cash flows sliced and diced to meet the specific needs of a multitude of different investors. Additionally, the financial engineers structure securities with a careful eye to the credit criteria of the major credit rating services most investors have come to rely on. The resulting structures range from lower yielding unleveraged AAA rated senior securities to high yielding, high risk, ‘leveraged leverage’ mezzanine securities of pools of mezzanine securities.

Private sector debt growth can only exceed income growth for a limited time, even if the debt growth is also driving asset prices higher. At some point the supply of credit wanes. But not for lack of available funds (since loans create deposits), but when even our elite cadre of financial engineers exhaust the supply of creditworthy borrowers who are willing to spend. When that happens asset prices go sideways, consumer spending and retail sales soften, jobless claims trend higher, leading indicators turn south, and car sales and housing slump. There is a scramble to sell assets and not spend income in a futile attempt to replace the nominal wealth being drained by the surplus. Consequently, as unemployment bottoms and begins to increase, personal and corporate income decelerate, and government revenues soon fall short of expenditures as the economy slips into recession. The financial engineers then shift their focus to the repackaging of defaulted receivables.

Both Presidential candidates have voiced their support for maintaining the surplus to pay down the debt, overlooking the iron link between declining savings and budget surpluses. For as long as the government continues to tax more than it spends, nominal $US savings (the combined holdings of residents and non-residents) will be drained, keeping us dependent on financial engineering to sustain spending and growth in the global economy.

Mr. Mosler is the chairman of A.V.M. L.P. and director of economic analysis, III Advisors Ltd. Ms. Debold is vice president, Global Risk Management Services, The Bank of New York.

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Another interesting piece, an interview of Professor L. Randall Wray, almost 9 years old saw the current crisis coming.

Q:Based on the current economic scenario, and taking into account the recent interest rates increases, how probable is the hypothesis of a “soft-landing” for the American economy?

LRW: It is highly improbable that an economic slowdown could stop at a “soft-landing”, given economic conditions that exist today. The U.S. expansion of the past half dozen years has been driven to an unprecedented extent by private sector borrowing. Indeed, the private sector has been spending more than its income in recent years, with its deficit reaching 5.5% of GDP in 1999. In order for the economy to continue to grow, this gap between income and spending must continue to grow. My colleague at the Jerome Levy Economics Institute, Wynne Godley, has projected that the private sector’s deficit would have to climb to well over 8% of GDP by 2005 in order to keep economic growth just above 2.5%. Even that is below the current rate of growth (about 4%). A smaller private sector deficit would mean even lower growth. There are two problems with this scenario. First, our private sector has never run deficits in the past as large as those experienced in this current expansion. In the past, private sector deficits reached a maximum of about 1% of GDP and then quickly reversed toward surplus as households and firms cut back spending to bring it below income. Not only are current deficits already five times higher than anything achieved in the past, they have already lasted two or three times longer than any previous deficits. Even more importantly, the private sector has had to borrow in order to finance its deficit spending, which increases its indebtedness. Private sector debt is already at a record level relative to disposable income. As interest rates rise, this increases what are known as debt service burdens—the percent of disposable income that must go to pay interest (and to repay principal) on debt. In combination with an economic slowdown, which reduces the growth of disposable income, many firms and households will find it impossible to meet their payment commitments. Defaults and bankruptcies are already on the rise, and things will only get worse. Thus, I believe there is a real danger that an economic slowdown could degenerate into a deep recession—or even worse.

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Wray also saw it coming (see here), as he put it:

How would Minsky explain the processes that brought us to this point, and what would he think about the prospects for continued Goldilocks growth?

First, I think he would argue that consumers became ready, willing, and able to borrow, probably to a relative degree not seen since the 1920s. Credit cards became much more available; lenders expanded credit to sub-prime borrowers; bad publicity about redlining provided the stick, and the Community Reinvestment Act provided the carrot to expand the supply of loans to lower income homeowners; deregulation of financial institutions enhanced competition. All of these things made it easier for consumers to borrow. Consumers were also more willing to borrow. As Minsky used to say, as memories of the Great Depression fade, people become more willing to commit future income flows to debt service. The last general debt deflation is beyond the experience of almost the whole population. Even the last recession was almost half a generation ago. And it isn’t hard to convince oneself that since we’ve really only had one recession in nearly a generation, downside risks are small. Add on top of that the stock market’s irrational exuberance and the wealth effect, and you can pretty easily explain consumer willingness to borrow.

I would add one more point, which is that until very recently, most Americans had not regained their real 1973 incomes. Even over the course of the Clinton expansion, real wage growth has been very low. Americans are not used to living through a quarter of a century without rising living standards. Of course, the first reaction was to increase the number of earners per family—but even that has allowed only a small increase of real income. Thus, I think it isn’t surprising that consumers ran out and borrowed as soon as they became reasonably confident that the expansion would last.

The result has been consistently high growth of consumer credit…The expansion might not stall out in the coming months, but continued expansion in the face of a trade deficit and budget surplus requires that the private sector’s deficit and thus debt load continue to rise without limit…What would Minsky recommend? So long as private sector spending continues at a robust pace, he would probably recommend that we do nothing today about the budget surplus. He would oppose any policies that would tie the hands of fiscal policy to maintenance of a surplus. Rather, he would push toward recognition that tax cuts and spending increases will be needed as soon as private sector spending falters. That means it is time to begin discussion of the types of tax cuts and spending programs that will be rushed through as the recession begins. For the longer run, he would recommend relaxation of the fiscal stance so that surpluses would be achieved only at high growth rates (in excess of the full employment rate of economic growth). For the shorter run, he would oppose monetary tightening, which would increase debt service ratios and push financial structures into speculative or Ponzi positions. He would support policies aimed at reducing “irrational exuberance” of financial markets; most importantly, increased margin requirements on stock markets would be far more effective and narrowly targeted than are general interest rate hikes that have been the sole instrument of Fed policy to this point. Most importantly, Minsky would try to shift the focus of policy formation away from the belief that monetary policy, alone, can be used to “fine-tune” the economy, and from the belief that fiscal policy should be geared toward running perpetual surpluses—in Minsky’s view, this would be high risk strategy without strong theoretical foundations.

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The Sector Financial Balances Model of Aggregate Demand—Revised

Posted on July 26, 2009 by | 10 comments

By Scott Fullwiler

Given the recent posts by Daniel Negreiros Conceição and Eric Tymoigne to this blog, and conversations both in the comments section and privately, a revision of my previous post on the topic of modeling the sector financial balances is in order. As before, earlier posts by Rob Parenteau, and Bill Mitchell, in addition to later posts by Daniel and Eric, describe many of the details of this approach and how they fit the graph posted by Paul Krugman. Rob is correct to suggest this would be a much better framework for understanding macroeconomics than the traditional IS-LM model, which was highly flawed to begin. My purpose here is as before is to build on these posts and demonstrate a few uses of the model.First, it must be noted that what we are doing here is merely putting a simple graphical representation to a model that has already been in wide use by many of us for years, and the details for which have been elaborated in much more complex models commonly referred to as “stock-flow consistent models” developed by Wynne Godley, Genarro Zezza, Claudio Dos Santos, Marc Lavoie, and numerous others. Much of this research can be found in publications on the Levy Institute’s website or in the book Monetary Economics: An Integrated Approach to Credit, Money, Income, Production, and Wealth (2006, Palgrave-Macmillan) by Godley and Lavoie. Also, as Eric noted, the SFB model presented here illustrates only financial flows; it is thus showing only a slice of what is presented in the larger models these authors have developed that integrate both flows and stocks coherently and consistently.

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Another Great Depression?

Posted on July 20, 2009 by | Comments Off on Another Great Depression?
By Felipe Rezende

In a previous post, I explained that automatic stabilizers- i.e. the fact that the federal government’s budget moves counter-cyclically and in an automatic fashion – imparts a great stabilizing force to aggregate demand.
However, the picture below shows that, during the Great Depression the government sector was too small relatively to the rest of the economy.

Source: Tymoigne, 2008: 12

The implementation of New Deal policies created automatic stabilizers which work by putting a floor under aggregate demand, preventing a deflationary spiral, but they also put ceilings in place, as rapid economic growth translates into rising tax revenues which destroy income and temper the expansion.
Nowadays, the size of the government and the impact of large automatic stabilizers explain why we can have a deep recession but another Great Depression is unlikely.
But how do automatic stabilizers work? What happens over the cycle? Hyman Minsky sheds light on these issues.

Minsky’s financial instability hypothesis can be described as follows. Let us consider that the whole U.S. economy is in a hedge position, i.e. that cash inflows are greater than outflows for every period, so that debt/payment commitments can be fulfilled while safety margin are kept at some positive level, for instance 20%. As firms and households become more optimistic about future earnings, and as their expectations get validated by economy growth, they change their behavior and reduce their margins of safety, let’s say now to 10%.

As the economy booms, and future earnings turn out to be more than expected, firms and households revise their expectations upwards, they begin to believe they were too pessimistic in the past and, therefore, reduce their cushions of safety, and start to take on more and more riskier projects. They have voluntarily moved into a position Minsky called speculative. A speculative position is one in which cash inflows are enough to meet interest payments, i.e. as they cannot repay the principal they need to refinance the outstanding debt. Borrowers start to discount risk and lenders, now more optimistic about prospective future earnings and profits, increase their willingness to lend.

It is now important to introduce how the level of investment is determined according to Minsky’s framework. Firms invest if the demand price of capital exceeds the supply price of current output. “The quantity of investment goods purchased (OId) is determined where PId = PIs” (Tymoigne and Wray 2008, p.9)

The demand price, Pk, is the price that firms are willing to pay for the capital asset. The demand price depends upon the cash flows that ownership is expected to yield and the liquidity of the asset. The curve is horizontal up to the point where firms only commit their internal funds. However, once firms rely on external financing then the subjective borrower’s risk comes into play. This risk is incurred by firms as they may not be able to service their debt. Thus, the price that firms are willing to pay for capital assets decline as the amount they have to borrow to finance it increases.

The supply price, Pi, is the price that firms actually have to pay for the capital good. Firms can use their internal funds up to Oif , and only up to this point, the supply price equals costs + markup. When firms have to borrow to buy capital goods, the supply price of investment is raised by the interest payments on the loan. The curve slopes up after the point Oif because of the lender’s risk. The lender’s risk is the risk the firm will not repay the loan. The more the individual firm borrows, the greater the lender’s risk associated and the higher the interest rate charged on the loan.

When lenders and borrowers become more optimistic about future earnings and profits, they start to discount risks. Firms take on riskier projects and financial institutions riskier loans. Thus, the belief is now that future income will be enough to cover debt commitments. They are in a speculative position.

If there is a change in the economic environment firms’ financial positions may be adversely impacted. Let’s consider the following situation where the economy accelerates and inflation becomes a concern to the monetary authority. The turning point would happen when the Fed decides to increase the overnight interest rate. If the interest rate specified on contracts is allowed to fluctuate, firms incur in higher financial costs to service the loan. At the new circumstance, firms can either abandon the project, as it is no longer profitable at higher interest rates, or they can borrow, from willing financial institutions, the funds they need to meet the interest payments on the previous loans. In other words, if interest rates are increased to such a point where firms’ income inflows are no longer sufficient to meet the firms’ outflows, they have involuntarily moved into a new financial position that Minksy called Ponzi. In a Ponzi scheme, firms have to capitalize interest. If financial institutions become worried about the future performance of the economy as a whole or the firm in particular, and decide to no longer extend those Ponzi loans, then firms are no longer capable of meeting their financial commitments and may default on their loans. This situation can be compounded as firms decide to sell their assets at fire sale prices in order to meet their obligations, setting in a Fisher-type debt deflation process which triggers a domino effect on the economy.

Another situation we could consider as a turning point is one in which firms’ expectations about future earnings/profits is not fulfilled. In such an environment, firms will revise their expectations downwards and cut investment. As we know, this will have a multiplier effect in the economy. As income is reduced, so is consumption. Firms cut back production and investment, which depresses incomes further. The economic activity spirals down squeezing incomes even more. As firms’ income inflows were significantly reduced, firms may get to a point where they can no longer meet their liability commitments. Once again, a debt-deflation process may be set in place by the new economic environment when firms decide to sell their assets at fire sale prices trying to meet their obligations.

Now, we may ask ourselves: what is the role of automatic stabilizers in this process?
The answer becomes even clearer. With big government automatic stabilizers are large enough to offset the swings in private spending. As explained in a previous post, when the economy goes into recession, unemployment rises which means that income transfers such as unemployment compensation and welfare are automatically increased.

According to Minsky, there are 3 major effects derived from automatic stabilizers: the income and employment effect, the cash flow effect, and the portfolio effect. Let me briefly explain each one:

The income effect is the traditional Keynesian multiplier. As the economy slows down, the government deficit increases as there is an automatic increase in spending and a reduction of the amount of taxes collected. As noted in previous posts (here and here), a sovereign government spends by crediting bank accounts which means that the banking system, all else equal, now has excess reserves (ERs). The ERs put a downward pressure on the fed funds rate. If the Fed is to hit its overnight nominal interest rate target, it has to intervene and conduct open market sales (OMS) to drain the ERs. As the Fed provides an interest bearing alternative – such as government securities – this is adds to the private sector’s income.
Therefore, transfer payments and interest payments automatically increase when the economy is moving into a recession.

The other one is the cash flow effect. The idea is that government deficits maintain the flow of profits. Following Kalecki (1972) and national accounting identities, in the simplest version, aggregate profits equal investment plus the government’s deficit, Π = Invest. + Gov. Deficit. In the expanded model, gross profits, after corporate tax, equals investment plus government fiscal deficit plus consumption out of profits plus net exports less saving out of wages, i.e. Π = Invest. + Gov. Deficit + CC + NX– SW. This means that government deficits add to profits (private wealth). The flow of profits prevents the collapse of expectations and the deterioration of private sector’s balance sheet.

Finally, the portfolio effect is generated by the increase in the sale of government bonds as a consequence of the (mostly automatic) increased government deficit (as I have just explained). These bonds are safe assets and their holdings on private sector’s balance sheets help to keep expectations from collapsing below a certain level.

The Big Bank (the Fed) act as a lender of last resort, it can prevent or minimize the fall in asset prices. In other words, the Fed can always put a floor to asset prices. This can be done in many ways, such as by calling up banks and say that they need to lend to investors who want to buy assets. The Fed can also decide to buy a wide range of private assets to smooth market transactions. If the Fed decides to buy a wide range of assets to provide liquidity to markets it smoothes liquidity concerns of market participants. It can also regulate markets and discourage bad loans such as subprime real state booms in some regions so that banks will not provide those loans. However, ceilings should also be put in place such as supervision and regulation, as has been emphasized by William K. Black.

In the current recession, the forecast is that the personal saving rate will reach something like 10% in 2009 and that it could jump to 14-16% by 2010. To meet the private sector rising saving desire the government should implement another stimulus package (in the context of the Krugman’s cross described here, this would be equivalent to a shift of the government sector balance -GSB- curve to the right) thus preventing a deflationary spiral and further declines of income due to rising private sector saving desire. At the same time, it becomes important to adopt policies that make the curve steeper by enhancing the role of automatic stabilizers. One possibility is an employer of last resort program in which the federal government provides a job to everyone willing and able to work at a given nominal wage. As argued in previous posts(here and here) such program would reduce both unemployment and poverty and minimize declines in the economic activity by enhancing the ceilings and floors of the system.

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A Third Stimulus Package and Job Creation

Posted on July 20, 2009 by | 3 comments

Our own L. Randall Wray and Lawrence Mishel say that additional stimulus is needed to create jobs immediately.

http://www.reuters.com/resources/flash/include_video.swf?edition=US&videoId=108026

Read more here, here, here, and here.

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Krugman’s New Cross Confirms It: Job Guarantee Policies Are Needed as Macroeconomic Stabilizers

Posted on July 19, 2009 by | 10 comments
By Daniel Negreiros ConceiçãoKrugman’s new explanation of business cycles in the form of a GSFB-PSFB (government sector financial balances – private sector financial balances) model (see his post entry here) has invoked a sort of call-to-arms by some dedicated Keynesian economists. Though those of us who have acquired the habit of looking at both sides of every nominal flow in the economy may see less novelty in Krugman’s new framework, the cross itself is still a very nice tool for presenting our arguments. And, if Krugman’s cross actually succeeds in replacing the unfortunate IS-LM interpretation of Keynes’ General Theory, it will have moved the New Keynesian approach in a constructive new direction.

I will not rehash the details of the Krugman cross in this post, since other bloggers have already explained the cross and some of its implications (see, e.g., Rob Parenteau’s, Scott Fullwiler’s, and Bill Mitchell’s). Instead, I want to draw out a particular (and potentially revolutionary) implication of the model.I believe that what Krugman was able to finally see, with the help of his cross, is nothing but the restatement of Keynes’s old paradox of thrift for a closed economy with a government sector able to run a deficit (though one can also represent the original paradox of thrift taught in intermediate macroeconomics if the GSFB – government sector financial balances – curve coincides with the horizontal zero deficit/surplus line, i.e. if governments run a balanced budget). Much like the simple exposition of the paradox of thrift for a closed economy without a government sector where aggregate savings are unavoidably equal to the size of aggregate investments, in an economy with a government sector the value of the private sector surplus is unavoidably determined by the government deficit. This means that when the desired level of private sector surplus rises as a share of each level of GDP, the tautological stubbornness of the accounting identity forces the adjustment to take place in one of two ways (or a combination of both). Either:(1) The government deficit rises so that the private sector is able to achieve its new desired level of surplus at the current level of GDP

or

(2) GDP must fall until the GS (government sector) deficit reaches the new desired level of PS (private sector) surplus as a share of GDP

This is the exact equivalent to what Keynes argued with regard to an increase in the propensity to save. When people decide that they want to save more as a share of their incomes (or alternatively, when capitalists decide to increase the mark up over wage costs), for a given level of aggregate investment, aggregate incomes must fall so that the same aggregate savings becomes a greater share of the reduced aggregate income. As Rob Parenteau argued, “If Paul [Krugman] recalls his reading of Keynes’ General Theory (and he is to be applauded for being one of the few New Keynesians to actually read Keynes in the original), this is one of the reasons Keynes argues incomes adjust to close gaps between intended investment and planned saving.”

It is time to play a little with the shapes of the curves. Here I believe that Krugman’s analysis is especially useful for explaining policy prescriptions advanced by Post Keynesian economists. First of all, in the GSFB-PSFB model I see none of the interdependency problems and stock/flow inconsistencies that exist in the IS-LM model (so far…). As many of the bloggers (Felipe Rezende here) have demonstrated, under the current set of economic policies in the US, GS deficits tend to rise substantially when GDP falls also substantially. In Krugman’s framework this is represented as a relatively steep GSFB curve. The steeper the curve, the faster the deficit increases for a given reduction of GDP bellow a given threshold (given by the level of GDP where the GSFB curve intercepts the zero surplus/deficit horizontal axis). However, it is also true that the same government who responds promptly to a fall in GDP by raising its deficit significantly also responds aggressively to an increase in GDP above the threshold by raising its surplus since the curve is equally steep going down below the intercept as it is going up above it. Maybe we should represent the curve as having different steepness below and above the threshold, but this is less important as it depends on more sophisticated assumptions about government policies. While Prof. Krugman makes the interesting and convincing argument that the fact that today’s GSFB curve is much steeper than that of the early 1930s (meaning that GS deficits in the 30s did not rise significantly despite a great reduction in aggregate incomes) has kept us from experiencing another Great Depression, we have just begun to experiment with the shapes of the curve.

First of all, let us look at extreme situations:

(1) In the absence of government deficits or surpluses in the economy (i.e. if governments were blindly committed to having balanced budgets), the horizontal GSFB curve would coincide with the zero deficit/surplus line and changes in desired PS surplus out of savings would necessarily lead to aggregate income adjustments so that new equilibrium would be reached at the new intercept where PS surplus was zero. Income fluctuations would be the most violent under these conditions since changes in spending preferences by the private sector would lead to full income adjustments. Note that any horizontal GSFB curve would produce such effect. In other words, macroeconomic instability is the result not of the unwillingness of governments to run a deficit (indeed a horizontal GSFB curve above the horizontal axis could represent any size of GDP independent GS deficits), but of governments not adjusting the size of their deficits to changes in spending propensities out of given incomes.

(2) What if governments decided to determine the level of GDP for the economy (hopefully at full employment)? Then governments could accommodate any change in the level of desired PS surplus by raising and reducing its deficit accordingly so that GDP never needed to adjust. This would be represented by a vertical (or, more realistically, almost vertical if some GDP adjustments still took place) GSFB curve at full employment GDP. These are the kind of policies we should be looking for as automatic stabilizers: policies that make the GDFB as close to vertical as possible at full employment GDP. The most effective way to achieve it: an employer of last resort policy where changes in desired PS surplus at full employment GDP that lead to falling aggregate expenditures and employment in the private sector would be largely compensated by increases in government transfers to the newly hired workers in the form of wages. Even though it is not necessarily the case that the deficit brought about by such policy will be exactly equal to the new desired PS surplus at full employment GDP so that the GSFB is completely vertical, in addition to other stabilizers such policy will significantly raise the steepness of the curve.

Krugman has hit on something of great importance. I hope others will think through the implications of his approach and not allow the momentum to wane.

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Washington Finally Proposes Real Help to Deal with Foreclosures

Posted on July 19, 2009 by | 7 comments

By L. Randall Wray

The Washington Post reported on Friday that Washington is finally considering meaningful steps to deal with the on-going foreclosure crisis. The article reports:

“A top Treasury Department official told a Senate panel yesterday that the government is considering a proposal to allow homeowners to stay in their home as renters after a foreclosure.”

The administration appears to be conceding that all of its proposals to date have been complete flops. The report goes on:

“Under the federal program known as Making Home Affordable, lenders are paid to lower borrowers’ mortgage payments. About 160,000 loans have been modified into lower-cost loans so far. The administration has said the federal effort has already been more successful than previous programs.”


That program was designed by the lenders, who wanted yet another government hand-out. But it was doomed to fail because mortgages that have been packaged into complex securities cannot be modified easily. If, instead, the government had directed aid to homeowners from the very beginning, it could have slowed the downward spiral of real estate markets. Reports yesterday put the number of foreclosures this year at another 2 million, with similar projections for next year. What is needed now is relief for the millions of families who have lost, or will soon lose, their homes.

Allowing families to stay on as renters after a foreclosure is a step in the right direction. However, the government should go further by following the plan put forward by Warren Mosler, as I summarized previously:

When banks begin to foreclose, the government would step in to purchase the property at the lower of market price or outstanding mortgage balance. Establishing market price in a glut is not simple, but it is not impossible. Mosler proposes that the federal government would rent homes back to the dispossessed owners (Dean Baker has a similar plan) for a specified period (perhaps two years) at fair market rent. At the end of that period, the government would sell the home, with the occupant having the right of first refusal to buy it. Reducing evictions by offering a rental alternative will help reduce the pain of foreclosure. It might also allow the process to speed up (with smaller losses for banks) since many families would choose to stay-on as renters, with the possibility that they could later buy their homes at more reasonable prices.

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The Sector Financial Balances Model of Aggregate Demand

Posted on July 17, 2009 by | 18 comments

By Scott Fullwiler

Paul Krugman’s recent post indicates that perhaps those of us taking a stock-flow consistent approach to macroeconomics may be making some headway. My fellow blogger, Rob Parenteau, and another friend, Bill Mitchellboth describe many of the details of this approach and how they fit the graph posted by Krugman. Rob is correct to suggest this would be a much better framework for understanding macroeconomics than the traditional IS-LM model, which was highly flawed to begin. My purpose here is to build on both of these posts and demonstrate a few uses of the model (thus, those not familiar with this framework should read Rob’s and/or Bill’s posts first, probably).To begin, consider the graph in Krugman’s post below:

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Employing Krugman’s Cross: Farewell, Mr. Hicks?

Posted on July 17, 2009 by | 17 comments
By Robert Parenteau

Paul Krugman’s July 15th blog post diagramming financial balances makes some important steps in revealing the analytical power of the financial balance approach to macroeconomics – something once understood by J.M Keynes and early Keynesians like Nicholas Kaldor, Abba Lerner, and Joan Robinson, but long since lost in the headlong rush over the past three decades of mainstream macroeconomics to become a special branch of microeconomics, which itself appears to have become a special branch of applied calculus in some sort of rather twisted physics envy. I suspect reading Minsky has helped Paul immeasurably in seeing these relationships, and I would urge him and others to go find some of Wynne Godley’s contributions (many of which are available online at the Levy Economics Institute) to a stock/flow coherent macroeconomics, and it may all become that much clearer.

The diagram Paul presented at first (reproduced below) threw me for a loop, but I believe I now see what he was doing, as the labeling did not initially make it clear, and perhaps by walking through Paul’s diagram, others can avoid my initial confusion.


The upward sloping line should be labeled the private sector financial balance (PSFB), and the downward sloping line should be labeled the government financial balance (GFB). Only the part of the PSFB schedule above the horizontal axis is in surplus, if this horizontal GDP axis crosses the vertical sectoral financial balance axis at zero. Similarly, only that part of the GFB schedule above the horizontal axis is in deficit. I believe Paul has defined the vertical axis such that the range above zero represents a rising PSFB, and at the same time, a falling GFB of the same absolute amount, but of opposite sign. Then the area below zero is a falling PSFB and a rising GFB. Above zero represents a private sector financial surplus and a government deficit, while below zero represents a private sector deficit and a government surplus.

Confusing at first, but this follows because Paul has simplified the analysis to two sectors, and sectoral financial balances must balance ex post for any accounting period. The range above zero representing a private sector surplus must also represent a government deficit (GFB must be of equal magnitude but opposite sign to the PSFB). This would seem consistent with Paul’s GFB schedule falling below zero as GDP increases, since a falling fiscal deficit would eventually give way to an increasing fiscal surplus as income increases if automatic stabilizers work as we believe they do (see previous post here). Similarly, the rising PSFB schedule is consistent with traditional Keynesian stability conditions, with saving increasing faster in income than investment does, although we should all keep in mind, as Minsky emphasized, that explosive growth dynamics (Minsky’s upward instability) can arise in economic expansions characterized by euphoric asset pricing. Hence, the last two US business cycle expansions have been characterized by a falling PSFB (that is, deficit spending by the household and business sectors combined), not a PSFB rising as income rises, but that can be accommodated in less simplified versions of Krugman’s cross.

Another way to see why this interpretation of the diagram must be correct is that when the PSFB schedule shifts up and to the left, representing a higher desired net private saving at each level of income, the new point of intersection with the GFB schedule would, for example represent a new short run equilibrium point where say a $250b net private saving position is met by a $250b fiscal deficit. Again, sectoral financial balance must balance ex post (as explained in prevoius posts here and here). If one sector is running a net saving or surplus position, the other sector must be dissaving or deficit spending. That is the tyranny of double entry book keeping – not high Keynesian theory.

If I now have the orientation of the diagram straight in my head (and this is the only way I can see that it makes sense), those who believe in fiscal rectitude may wish to notice two aspects of the world we live in. If you view a balanced fiscal budget as the ultimate and over riding goal, you can get there one of two ways from Paul’s second PSFB schedule (the higher line we seem to have shifted to, as asset prices and profitability have collapsed over the past year, thereby forcing lower private investment and driving saving out of private income flows higher).

To arrive at a fiscal balance, you can shift the GFB schedule down and to the left by jamming tax rates higher and lowering the government spending propensities out of tax revenue income until the GFB schedule intersects the PSFB schedule at the point where the PSFB schedule crosses the horizontal axis at the zero financial balance mark. Notice the level of income the economy is then operating at, and all of you who pay dues to the Concord Coalition, please consider whether existing private debt loads could actually be serviced at that lower level, since most private debt contracts are fixed nominal payment commitments. Think post Lehman bankruptcy, on steroids, and you might get a taste of what you are praying for with perpetually balanced fiscal budgets.

The second way to get to a fiscal balance is to encourage the PSFB schedule to shift down and to the right until it intersects the GFB schedule at the point at which it crosses the horizontal axis. That means increasing incentives for the private sector to invest more money at each income level and save less money at each income level. Given the residential housing stock overhang, and the need for households to save out of income flows if they cannot rely on serial asset bubbles to deliver the appropriate nominal net worth at retirement, that means ways must be found to encourage US businesses to pursue a higher reinvestment rate in the US, rather than borrowing money to buy back shares to boost stock prices or reinvesting abroad. Not easy, but not impossible either. Notice also that the second form of adjustment leaves you at a higher equilibrium income level, and the existing private debt to GDP ratio will stabilize, since there will be no additions to the private debt stock, as net private deficit spending is zero at the new income flow level.

Of course, this should all eventually be recast in dynamic terms. For example, income won’t grow unless the GFB is continually shifting up and to the right, or the PSFB is continually shifting down and to the right (or some combination of the two). There is also no obvious endogenous mechanism shifting the PSFB toward a position of full employment income over time, given the position of the GFB. Of course, in theory, policy could be geared such that given reasonable estimates of the likely position of the PSFB schedule, the GFB schedule could be shifted out (or less likely, in) to achieve the level of income associated with full employment. Alternatively, fiscal policy could be structured so the GFB schedule could be perfectly vertical at the full employment level of income, which in many ways is what an employer of last resort (ELR) driven fiscal policy attempts to do.

Finally, for those insistent that public and private debt to income ratios must be held fixed from here to eternity for whatever reason, then starting from Paul’s initial equilibrium, income growth could only be accomplished if the PSFB schedule could be encouraged to shift outward, and the GFB could be shifted in concert such that either the realized financial balances of both sectors were kept at zero, or there was some cycling between the two, such that periods of private sector financial deficits were followed by periods of government sector deficits of similar magnitude and duration.

The trade balance must also be brought back into the story, as a trade surplus is the only way both the GFB and the PSFB can maintain a net saving position at the same time (assuming for whatever reason that was a worthy goal), but at least it is a promising start at representing how sectoral financial balances are related, and it reveals many of the misconceptions that unnecessarily cloud the debate.

If the Krugman Cross does nothing more than provide a stepping stone away from the dead end trap of the Hicks/Harrod/Meade IS/LM diagram, then this is a useful initial contribution. Caught under the spell of IS/LM conventions, Paul and other New Keynesians have spilled far too much ink trying to devise ways of instituting negative real interest rates to get the economies out of a balance sheet driven recession. With policy rates near zero, this analysis has devolved into arguments about how best to increase inflation expectations or actual inflation in order to achieve a sufficiently negative real interest rate. From a practical point of view, the last thing households facing heavy debt servicing loads with falling wage and salary incomes need are rising consumer prices that drain their already reduced discretionary income. Households need higher money incomes, not higher consumer prices, expected or actual, to exit their current difficulties. Real interest rates are diversion from the real problem at hand in a balance sheet recession, which is how to get the economy to a point where money income levels can service most private debts. Krugman’s Cross makes it obvious – shift the GFB schedule in response to shifts in the PSFB schedule.

As always, we must be careful about sliding between the usual ex ante/ex post distinctions, as the income multiplier lies masked behind these interactions, as does the reconciliation of new liability issuance with portfolio preferences, among other balance sheet and asset price considerations that must be brought into play for a coherent stock/flow macroeconomics, of which Hick’s IS/LM approach was a pale shadow that concealed more than it revealed.

For example, the private sector may plan to net save more at any given expected income or GDP level, but unless some other sector net saves less or deficits spends more, private incomes will adjust downward, and the desired private net saving will be thwarted, paradox of thrift style. If Paul recalls his reading of Keynes’ General Theory (and he is to be applauded for being one of the few New Keynesians to actually read Keynes in the original), this is one of the reasons Keynes argues incomes adjust to close gaps between intended investment and planned saving. Interest rates do not equilibrate investment and saving – incomes do, in Keynes’ General Theory. Paul has taken a very large step in this direction with his financial balance diagram, which hopefully he will find more powerful than his IS/LM analytics which he employed in the case of the Japanese balance sheet recession.

Specifically, Paul refers to the need for net private saving being “absorbed” by the public deficit spending. That assumes the net private saving can exist without some other sector deficit spending at the same time, which is impossible. William Vickrey and James Tobin used to make a similar slip, with Vickrey arguing the private saving had to be recycled by public deficit spending (see Vickrey’s otherwise useful piece on 15 fundamental fallacies, linked at CFEPS here.

In Paul’s 2 sector model, unless the public sector spends more money than it takes in as tax receipts, the private sector cannot earn more money than it spends, no matter what its plans or intentions or ex ante designs. Net private saving is created, allowed, or constrained by the size of the public deficit. Net private saving cannot exist as anything more than a hope and a prayer unless some other sector is willing and able to deficit spend. Ex post, in a 2 sector model, as a matter of basic accounting, the net saving of one sector must be equal to the net deficit spending of the other. That is the short run accounting “equilibrium” or reality.

Moving beyond a simple 2 sector model to the world we actually inhabit, it is really as simple as this. The US household sector cannot net save in nominal terms (spend less money than it earns) unless some other sector (or combination of sectors) is willing and able to spend more money than it earns.

It can be the government, the business, or the foreign sector or some mix of the three that net deficit spends – take your choice. But keep in mind, of the three, a government with a sovereign currency (not convertible into fixed quantities of a commodity or another currency on demand) and no debt denominated in foreign currencies is the only one of those three that cannot go bankrupt and cannot default on its debt while continuously deficit spending – unless it chooses to default for some odd political reason.

The sooner we face this fundamental reality of contemporary monetary and economic arrangements, the better. It does not require swearing allegiance to high Keynesian theory – it is simply an accounting reality. Reject it, and you will also have to throw at least seven centuries of double entry book keeping out the window as well.

Since the US economy does appear to have entered a debt deflation spiral for the first time in a lifetime, and it does appears that the spiral has been contained for the moment by a reduction in the trade deficit and a surge in the fiscal deficit, it might be a good time for economists, investors, policy makers, and the general public to once and for all find some clarity on these questions regarding financial balances and the economy. Perhaps Paul’s simple back of the napkin diagram of financial balances takes us one step in that direction.

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A note on Automatic Stabilizers

Posted on July 16, 2009 by | 2 comments

What has so far prevented a deep depression in 2009? The answer, as Paul Krugman explained yesterday, are automatic stabilizers. Indeed, as Hyman Minsky emphasized more than 20 years ago in his book Stabilizing an Unstable Economy (1986), this feature of the federal government’s budget – i.e. the fact that it moves counter-cyclically in an automatic fashion – imparts a great stabilizing force to aggregate demand.

The figure below sheds light on the non-discretionary (i.e. automatic) nature of government deficits. In an economic downturn, tax receipts automatically fall, and government expenditures automatically rise, resulting, automatically, in budget deficits. (net govt saving = right hand scale)

Source: Bureau of Economic Analysis (BEA)

The components of government spending that rise automatically are called ‘transfer payments’, that include unemployment compensation, Medicaid, grants-in-aid to state and local government, etc.
With these forms of payment increasing and tax receipts declining due to falling economic activity, the federal budget moves automatically into deficit.

Source: Bureau of Economic Analysis (BEA)

So far the stimulus package was not what saved the US economy. The budget projections show that 24% of the total cost of the stimulus package will occur in fiscal year 2009 (which means $198 billion) and 47% of it occurring in fiscal year 2010.

“The ARRA is estimated in the budget to cost $825.4 billion over the next 10 years. These costs are split between $600.0 billion in increased outlays and $225.4 billion in reduced receipts. Although the cost of the ARRA is spread over 10 years, the budget projections show 24 percent of the total cost occurring in fiscal year 2009 and 47 percent of the total cost occurring in fiscal year 2010…The budget estimates that receipts will be reduced $77.4 billion in fiscal year 2009 and $152.3 billion in fiscal year 2010 primarily because of the tax provisions of ARRA… The budget estimates that outlays will be increased about $120.2 billion for fiscal year 2009 and $237.8 billion for fiscal year 2010 because of the spending and investment provisions of the ARRA.”

As noted in previous posts (here, here, and here), government deficits, themselves, perform an important stabilizing function, because they allow the private sector to net save. Given that during a recession there is a sharp increase in uncertainty and insecurity, the private sector desires to spend less than its income which translates into a rising personal saving rate. In the current recession, the forecast is that the personal saving rate will reach 10% in 2009 and that jump to 14-16% by 2010. Such large decline in consumption means falling sales, production and further declines in GDP. As noted above, to meet the private sector rising saving desire the government should run bigger deficits to prevent a deflationary spiral.

Source: Jan Hatzius, Goldman Sachs

As Minsky emphasized, the problem, during the Great Depression, was that the government sector was too small relative to the rest of the economy; it couldn’t fill the demand gap and allow the private sector to save as much as it desired. In the absence of large enough automatic stabilizers to offset swings in private spending, GDP contracted to the point where desired net nominal saving equaled actual net nominal saving. Note that in second half of the last century, given the private sector’s desire to have positive net nominal saving, the US government normally ran budget deficits.

As Wray pointed out, “Since WWII we have had the longest depression-free period in the nation’s history. However, we have had nine recessions, each of which was preceded by a reduction of deficits relative to GDP.” This directly results from the impact of large swings in the federal government’s budget.

Automatic stabilizers work by putting a floor under aggregate demand, preventing a deflationary spiral, but they also put ceilings in place, as rapid economic growth translates into rising tax revenues which destroy income and temper the expansion. The impact of large automatic stabilizers explains why we can have a deep recession but not a Great Depression. As Wray noted:

“With one brief exception, the federal government has been in debt every year since 1776. In January 1835, for the first and only time in U.S. history, the public debt was retired, and a budget surplus was maintained for the next two years in order to accumulate what Treasury Secretary Levi Woodbury called “a fund to meet future deficits.” In 1837 the economy collapsed into a deep depression that drove the budget into deficit, and the federal government has been in debt ever since. Since 1776 there have been six periods of substantial budget surpluses and significant reduction of the debt. From 1817 to 1821 the national debt fell by 29 percent; from 1823 to 1836 it was eliminated (Jackson’s efforts); from 1852 to 1857 it fell by 59 percent, from 1867 to 1873 by 27 percent, from 1880 to 1893 by more than 50 percent, and from 1920 to 1930 by about a third. (Thayer 1996) The United States has also experienced six periods of depression. The depressions began in 1819, 1837, 1857, 1873, 1893, and 1929. Every significant reduction of the outstanding debt has been followed by a depression, and every depression has been preceded by significant debt reduction. Further, every budget surplus has been followed, usually sooner rather than later, by renewed deficits. However, correlation—even where perfect—never proves causation. Is there any reason to suspect that government surpluses are harmful?”

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Gift-Wrapping the White House for the GOP

Posted on July 15, 2009 by | 4 comments

by Stephanie Kelton

It looks like Christmas has come early for one of President Obama’s most vocal critics. Rush Limbaugh said he hoped the president would fail, and the GOP is doing everything it can to make sure he does. The party stands united in its opposition to a (much-needed) ramping up of the federal stimulus effort. And, at the moment, the president is playing right into their hands.

Sen. Jon Kyl, R-Ariz., has called the $787 billion stimulus effort a “flop,” adding:

“The reality is, it hasn’t helped yet. . . Only about 6.8 percent of the money has actually been spent. What I propose is, after you complete the contracts that are already committed, the things that are in the pipeline, stop it.”

In other words, he thinks the stimulus isn’t working because the government isn’t spending the money FAST enough. And, with the lion’s share of the spending about to kick in, he wants to scrap the entire effort, just to make sure it won’t work.

The only thing more disappointing than hoping the president – any president – will fail is actively working to keep millions of Americans unemployed in order to score political points in the coming election. But that’s exactly what’s happening, and the president may be painting himself into a losing corner.

President Obama has insisted that: (1) the stimulus is working as planned; (2) a second stimulus is not needed; and (3) he will cut the deficit in half by the end of his first term.

If he sticks to his guns, I believe he will dig his own political grave (not to mention prolonging the agony for millions of Americans). He cannot have it both ways. He cannot reverse the effects of the worst economic downturn since the Great Depression and do it on a shoestring.

That isn’t to imply that $787 billion is chump change, but it pales in comparison to the losses that have already been borne by homeowners, businesses and investors. As Dean Baker recently pointed out, annual consumption is down about $700 billion (due to the loss of roughly $16 trillion in real estate and stock market wealth). Add to that “a reduction in annual rates of construction of about $450 billion” and a decline of “approximately $200 billion” in demand due to losses in the non-residential sector, and Baker says we’re looking at an annual loss of about $1,350 billion. And we’re trying to offset it with $300 billion or so (the annual stimulus) in spending by the federal government! It’s like using an umbrella to stop an avalanche. It won’t work.

But it gets worse, because Baker’s figures don’t account for the void that has been created by state and local governments, where expenditures have fallen by more than $64 billion in the last two quarters alone. And, with virtually every state bracing for even bigger cuts next year, we could easily lose another $100 billion or so in fiscal 2010. Then, of course, there’s the multiplier, which has been hard at work, exacerbating the magnitude of these cuts and costing us untold trillions in lost GDP.

But the president seems convinced that $787 billion will do the trick – at least according to his definition of the trick. You see, the Obama administration has not set the bar very high, and this seems to be why the president believes the stimulus has “worked as intended.” As he explained, it “wasn’t designed to restore the economy to full health on its own, but to provide the boost necessary to stop the free fall.” And this is why even bad news – e.g. 565,000 people filing first time jobless claims – can be interpreted as an indication that the stimulus is working as intended. (Recall that this was the smallest number since January 2009.)

Indeed, the president’s top economic advisors have always been careful to use the words “create or save” when describing the objective of the stimulus plan. And this means that net job creation isn’t the goal. The economy can continue to lose jobs faster than it creates them, and the policy will be described as “working” because the stimulus money helped at least some workers keep their jobs.

So the stimulus may be working “as intended,” but I don’t think the president can rely on semantics to carry him to victory in 2012. If President Obama wants a second term, he must join the growing chorus of voices calling for another stimulus and press forward with an ambitious program to create jobs and halt the foreclosure crisis. I have outlined my twelve-step recovery program, and others on this blog have put forward similar ideas. A payroll tax holiday that cuts FICA contributions to zero will provide immediate relief to millions of working families and their employers, boosting take-home pay as well as business profits. An additional $1,000 per capita will help ease the on-going budget crisis so that states can avoid further cuts to education and social services. A job-guarantee program, modeled on the WPA, will provide useful work and retraining opportunities for the many Americans who will not find jobs even after the economy recovers. Investing in our nation’s infrastructure – roads, bridges, transmission lines, etc. – will address years of neglect and improve the safety and security of all Americans.

These are the kinds of tangibles the American people will think about when they decide for themselves whether the stimulus was a success. At the end of the day, President Obama must cut loose the deficit bogy and abandon any date-specific goal for cutting the deficit in half. It is his Achilles heel. Let the deficit (and the debt) go where it will. With a sufficiently flexible fiscal response, GDP will explode, tax receipts will pour in, and the dreaded debt-to-GDP ratio will drop like a rock.

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Posted in Policy and Reform, Stephanie Kelton, The Federal Government Deficit, The National Debt, Uncategorized

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