Talking Keynes

My UMass comrades Mark Silverman and Daniel McDonald and I are discussing Keynes' philosophical commitments here and here. Good stuff. Read.

Where do the rich get their money?

Well, from us, of course. All their dollars represent, is claims on our labor.

Still, it's interesting to ask what forms those claims take. Especially since there is a widely-held belief that today, unlike in the bad old days, the incomes of even the super rich are, at least on paper, mainly compensation for their work -- that they're a return on "human capital" rather than the old-fashioned kind. Is there anything to that?

Here's what the IRS Statistics of Income says:

Share of total income by source, filers reporting $1 million or more

Year	Wages and salaries	Interest, dividends, rent	Capital gains	Business income
1995	31.0%	17.2%	28.4%	23.1%
2000	33.2%	10.3%	42.5%	13.1%
2005	26.9%	15.7%	38.1%	22.3%
2008	30.7%	19.8%	30.4%	23.2%

Share of total income by source, filers reporting $10 million or more

Year	Wages and salaries	Interest, dividends, rent	Capital gains	Business income
2000	25.0%	8.6%	58.2%	7.4%
2005	17.5%	17.4%	50.8%	17.8%
2008	18.8%	22.1%	45.4%	18.7%

Share of total income by source, all filers

Year	Wages and salaries	Interest, dividends, rent	Capital gains	Business income
1995	76.4%	7.3%	4.0%	6.9%
2000	70.0%	6.5%	9.7%	6.6%
2005	69.5%	6.8%	8.9%	8.9%
2008	72.0%	8.1%	5.6%	7.5%

Source: IRS Statistics of income, author's calculations
Notes: Income above $1 million not broken out before 2000. All nonwage income is net of losses. Business income includes business/professional income, S corporation and partnership income, and farm income.

So no, it's no more true than it ever was that the rich earn their money, in even the most limited formal sense.


EDIT: In retrospect, I guess it would have been better to do the tables by year, with the rows by income class. Oh well.

What is Keynesianism?

[A bit of thumbsucking inspired by discussion here.]

As a policy of countercyclical demand management, Keynesianism is based on the idea that there are no automatic forces in industrial capitalism that reliably equilibrate aggregate supply and aggregate demand. In the absence of government stabilization policies, the economy will waver between inflationary periods of excess demand and depressed periods of inadequate demand. The main explanation for this instability is that private investment depends on long-term profitability expectations, but since aspects of the future relevant to profitability are fundamentally uncertain [1], these expectations are unanchored and conventional, inevitably subject to large collective shifts independent of current “fundamentals”.

Government spending can stabilize demand if G+I varies less over the business cycle than I alone does. For which it’s sufficient that government spending be large. It’s even better if G and I move in opposite directions, but the reason Minsky answered No to Can “It” Happen Again? was because of big government as such, not countercyclical fiscal policy.

The focus on cyclical stabilization assumes that there is no systematic long-term divergence between aggregate supply and aggregate demand. But Keynes believed that there was a secular tendency toward stagnation in advanced capitalist economies, so that maintaining full employment meant not just using public expenditure to stabilize private investment demand, but to incrementally replace it.

Another way of looking at this is that the steady shift from small-scale to industrial production implies a growing weight of illiquid assets in the form of fixed capital. [2] There is not, however, any corresponding long-term increase in the demand of illiquid liabilities. If anything, the sociological patterns of capitalism point the other way, as industrial dynasties whose social existence was linked to particular enterprises have been steadily replaced by rentiers. [3] The whole line of financial innovations from the first joint-stock companies to the recent securitization boom have been attempts to bridge this gap. But this requires ever-deepening financialization, with all the social waste and instability that implies.

It’s the government’s ability to issue liabilities backed by the whole economic output that makes it uniquely able to satisfy the demands of wealth-holders for liquid assets. In the functional finance tradition going back to Lerner, modern states do not possess a budget constraint in the same way households or firms do. Public borrowing has nothing to do with “funding” spending, it's all about how much government debt the authorities want the banking system to hold. If the demand for safe, liquid assets rises secularly over time, so should government borrowing.

From this point of view, one important source of the recent financial crisis was the surpluses of the 1990s, and insufficient borrowing by the US government in general. By restricting the supply of Treasuries, this excessive fiscal restraint spurred the creation of private sector substitutes purporting to offer similar liquidity properties, in the form of various asset-backed securities. (Here is a respectable mainstream guy making essentially this argument. [4]) But these new financial assets remained at bottom claims on specific illiquid real assets and their liquidity remained vulnerable to shifts in (expectations of) the value of those assets.

The response to the crisis in 2008 then consists of the Fed retroactively correcting the undersupply of government liabilities by engaging in a wholesale swap of public for private liabilities, leaving banks (and liquidity-demanding wealth owners) holding government liabilities instead of private financial assets. The increase in public debt wasn’t an unfortunate side-effect of the solution to the financial crisis, it was the solution.

Along the same lines, I sometimes wonder how much the huge proportion of government debt on bank balance sheets -- 75 percent of assets in 1945 vs. 1.5 percent in 2005)contributed to the financial stability of the immediate postwar era. With that many safe assets sloshing around, it didn't take financial engineering or speculative bubbles to convince banks to hold claims on fixed capital and housing. But as the supply of government debt has dwindled the inducements to hold other assets have had to grow increasingly garish.

From which I conclude that ever-increasing government deficits may in fact be better Keynesianism – theoretically, historically and pragmatically – than countercyclical demand management.

[1] Davidson, Shackle, etc. would say nonergodic. This strand of Post Keynesian thinking often wanders beyond my comfort zone.

[2] This shift is ongoing, not just historical -- not only do capital-output ratios continue to rise in manufacturing, but we're seeing the "industrialization" of retail, health care, etc.

[3] Schumpeter is the only major economist to give sufficient attention to the sociology of the capitalist class, IMO. Marx's insistence that the capitalist is simply the human representative of capital is a powerful analytic tool for many purposes, but it leaves some important questions unasked.

[4] Here is another.

Does fiscal policy need to be paid for in advance?

Let’s be clear: Paul Krugman is a national treasure. On fiscal policy – and politics generally – he has been saying exactly what should be said, clearly and forcefully, and just as important, from a platform that people can’t ignore. No one of remotely his stature has been as clear or consistent a critic of the Administration from the left.

That said, his economics can be … problematic.

I don’t know if it’s just because I’m interested in trade, or if, ironically but perhaps more likely, it’s because it’s where he made most of his own contributions, but it’s on international economics that Krugman seems most committed to orthodoxy, and correspondingly out of tune with reality.

Case in point: This blog post, where he notes, correctly, that the most consistent expansionary response to the crisis has been in Asia, and then goes on to endorse the suggestion of David Pilling (in the Financial Times) that today’s Asian stimulus is the reward for fiscal rectitude in previous years:

Deficit spending is what you should do only when the economy is depressed and interest rates are at or near the zero lower bound. When times are good, you should be paying debt down. Pilling: “The scale of Asia’s stimulus may have matched, even surpassed, the west. But the context has been entirely different. Asian governments had plumped-up their fiscal cushions after the 1997 crisis, building a formidable pool of reserves. … when the crunch came, they had the wherewithal to spend.”

I’m sorry, but this is just wrong.

First of all, let’s look at stimulus spending and earlier fiscal stances in various Asian countries:

Country	Fiscal stimulus 2008	Average fiscal surplus, 1998-2007	Average fiscal surplus, 2003-2007
Malaysia	0.9	-1.72	-1.72
India	1.5	-5.50	-2.93
Indonesia	2.7	10.04	10.04
Australia	4.4	-3.00	-1.65
Philippines	4.5	-0.69	-0.69
Korea, Rep. of	5.4	0.98	1.20
New Zealand	5.9	-2.10	-2.23
Thailand	7.7	-4.80	n/a
Singapore	8	-1.34	-1.93
China	13.5	2.70	4.69
Japan	14.6	-0.80	-0.95

See that striking correlation between prior surpluses and stimulus spending? Yeah, me neither.

It’s true that some countries, like China and Korea, show prior surpluses and big stimulus. But others that are pursuing expansionary policy have had fiscal deficits for years, like Japan (as Krugman should know as well as anyone.) Empirically, the Krugman-Pilling argument that in Asia, fiscal surpluses paved the way for fiscal stimulus just does not hold up.

No, what's allowed Asian countries to respond aggressively to the crisis is not their (mostly nonexistent) fiscal surpluses, but their current account surpluses. Unlike in past crises (or lots of countries in the current crisis, especially on the periphery of Europe) they are not dependent on private capital inflows, so they are under no pressure to undertake contractionary policy to maintain external balance. The case of Korea is exemplary. True, it was running a fiscal surplus prior to the crisis -- but it was also running a fiscal surplus in the mid-1990s prior to the Asian Crisis, to which it responded with brutal austerity. The difference was that the current account was in deficit then, and in surplus this time. The fiscal position was irrelevant.

(Incidentally, Pilling literally does not seem to realize there is a difference between a current account surplus and a fiscal surplus. That's why he's able to write something like "Asian governments had plumped-up their fiscal cushions after the 1997 crisis, building a formidable pool of reserves," without realizing it's a non sequitur.)

What about the larger argument, that good Keynesian governments should engage in the precautionary accumulation of financial assets in good times to finance demand-boosting spending in bad times? Krugman himself admits that the Bush deficits are not a binding constraint on fiscal policy today, which is rather a blow to his argument. More broadly, it's far from clear that there is any meaningful sense in which the existing level of public debt affects the space for fiscal policy. The argument for prudential saving might apply to the government of a premodern or underdeveloped country, which rests on a narrow fiscal base; but if substantial excess capacity exists in an industrialized country the government always can mobilize it. (Matt Yglesias gets this, even if Krugman does not.) As for the traditional Keynesian argument for federal surpluses in boom times, it has nothing to do with precautionary accumulation of financial assets, and everything to do with preventing aggregate demand from running ahead of aggregate supply.

In the end, I suspect this idea of paid-in-advance Keynesianism says less about his intellectual weaknesses than about his institutional commitments. As a certified big-name economist, you have to make some concessions to orthodoxy if you don't want to see your intellectual capital devalued. And what orthodoxy demands now -- above all from those who want more expansionary policy -- is gestures of somber concern with future deficits. (If not austerity today, at least austerity tomorrow.) With a few honorable exceptions, even left-leaning economists seem happy to comply.

Some Thoughts on the Euro

[I just posted this in response to a query on the UMass-Amherst economics department listserv. I reckon it might as well double as content for the blog.]

i've heard some people say that it would be best to keep the euro and the dollar at a 1:1 exchange rate. why would this be good? why might it be bad?

The Euro is currently at about $1.22. The last time it was significantly lower than this was in late 2003. The last time it was as low as $1.00 was in October 2002. So what you are hearing are proposals for a substantial depreciation of the Euro.

Why do people want this? I don't think it's any more complicated than (1) Europe, like the US, continues to see employment and output held down by inadequate aggregate demand, (2) political elites in Europe (especially Germany) are resistant to any effort to boost either public or private consumption, leaving exports as the only potential source of increased demand, and (3) net exports are assumed to respond to relative prices, and relative prices are assumed to move with exchange rates.

Folks like Dean Baker and Paul Krugman have been making similar arguments for the US -- that given the lack of political support for further expansion of public spending, getting back to full employment will require a big improvement in the current account, meaning a big depreciation of the dollar. (Krugman tends to express this -- unhelpfully IMO -- in terms of Chinese "manipulation" of the yuan-dollar exchange rate, but the argument is the same.) Baker even gives the same figure you're hearing -- 20 percent -- as an appropriate amount for the dollar to fall.

Problems:

First, since the US and the Euro area are both so large in world trade, it might be hard for both currencies to depreciate simultaneously. This is less of a problem than you might think, since there's surprisingly little direct trade between the US and Euroland -- less than 20 percent of the exports of each go to the other. (The US sells more to Canada's 33 million residents than to the Euro area's 330 million.) But it's still the case that if the Euro is to fall against the dollar while the dollar itself is depreciating, both would have to fall even more against third-country currencies, which might be harder to achieve, and more disruptive if it were.

Second, the two cases are not symmetric. The US is starting from a position of big current account deficits, which have to be financed by large financial inflows which, arguably, contributed to the financial crisis. There is a plausible argument that, given the lack of international institutions to regulate capital flows, stable growth is more likely if countries remain in rough current account balance. So -- by this logic -- an improvement in the US current account wouldn't just increase demand in the US, it would help prevent future financial crises. The Euro area, on the other hand, is in rough balance already -- since 1999, the Euro area has run a current account deficit averaging just 0.2 percent of GDP. So an improvement in the Euro-area current account would mean a movement toward big surpluses, i.e. toward larger trade imbalances that would have to be financed by larger international capital flows. In other words, it would require the Euro area to assume a (larger) net creditor position towards its trade partners, i.e. to recapitulate the dynamic between Germany and Greece, Spain, etc. earlier in this decade. Perhaps the folks you are talking to feel that was a big success?

Third, leaving aside the desirability of an improvement in the Euro-area current account, there's a question of how effective a tool Euro depreciation would actually be to realize it. I don't have any estimates of exchange-rate elasticity for the Euro area handy. But for the US, estimates of import elasticity generally fall between 0.1 and 0.3 and export elasticity between 0.6 and 0.8, meaning that the Marshall-Lerner-Robinson condition is satisfied weakly at best, and a depreciation would produce little or no improvement in the trade balance. Of course the more favorable starting trade balance works in Europe's favor here, making it more likely that a depreciation would improve the current account. But in the absence of concrete evidence for reasonably high exchange-rate elasticities, one shouldn't just assume -- as too many people do -- that exchange rate changes reliably produce the "right" effect on trade.

So those are some arguments against. A few more issues.

One, why parity specifically? The argument one sometimes hears is that the goal should be PPP parity. Personally, I don't buy that either -- it assumes there are no systematic divergences in the ratio of tradable and non-tradable prices between the US and Euroland -- but at least it has some principled basis. The International Comparison Program of the World Bank, which is the main source of PPP estimates, gives a range from $1.08 to the Euro for Germany to $1.25 Euro to the dollar for Spain (price levels vary across the Euro area) but there's no major Euro country for which the PPP Euro is as weak as $1.00, let alone for the area as a whole. So 1 euro = 1 dollar looks like undervaluation by any standard.

Two, is this an argument mainly about the level of the Euro, or is it also about the desirability of fixing the Euro-dollar exchange rate? There's a huge literature on fixed vs. floating exchange rates, which I'm not going to try to summarize here.

Finally, there's the question of how a lower Euro would actually be achieved. For various reasons, I suspect the tool might be lower short-term interest rates, rather than (or in addition to) direct foreign-exchange market intervention. In that case, a policy of weakening the Euro might in effect be an excuse for the ECB to take a more expansionary stance than it is willing to do on domestic grounds. Ten years ago, the ECB's attempts to strengthen the Euro were defeated by the perception that the higher interest rates involved would reduce European growth. (See here.) The opposite could happen now -- lower interest rates, by increasing domestic demand and growth prospects, could increase imports and foreign investment into the Euro area, resulting in the current account moving more towards deficit rather than surplus -- the opposite of the intended result. Which, ironically, would be the one good argument in favor of the policy.

A Difference of Perspective

So I'm reading Menzie Chinn's helpful primer on different ways of calculating real effective exchange rates. And it's got a bunch of pictures in it like this one, of various real exchange rates between the Indonesian rupiah and the dollar:



What do we see here? Well, when the dollar got strong in the early 1980s, the rupiah fell against it in real terms defined relative to export prices, but much less so in terms of domestic goods as measured by the CPI. Whereas when the rupiah fell in the Asian crisis, the real exchange rate fell whether you measured it by CPI or by export prices, albeit more by the latter. In other words, the strong dollar of the '80s did not substantially increase American incomes relative to Indonesian, but the fall in the Rupiah in the '90s did reduce Indonesian incomes relative to American. Interesting!

So when Chinn writes, "there are a number of interesting stylized facts to be gleaned from these figures," I expect him to say something about these movements. But not a word! Instead, his discussion is all about the CPI-deflated series' "more pronounced upward trend (or a less pronounced downward trend)" over the long run(the parenthetical is a nice concession to reality). "This pattern is often explained as the outcome of the Balassa-Samuelson model, wherein more-rapid productivity growth in the tradable sector than in the nontradable sector results in a rise in the relative price of nontradables." So what Chinn sees in these figures is the rather dubious long-run pattern predicted by theory; he doesn't notice the exciting ups and downs at all. And he's one of the good ones.

"When the storm is long past, the ocean is calm again..."


EDIT: Now that I think about it, I've got the story of the '80s wrong. The rupiah was pegged at that point, so when the dollar rose, the rupiah rose with it (apart from the two devaluations visible as downward spikes in the graph.) The decline in the export-price deflated series represents Indonesian exporters cutting their own-currency prices to remain competitive in world markets, something that US exporters, for various reasons, did not do. The larger point still holds.