Here's my brother on MSNBC talking about Ferguson. He makes an important point: In the vast majority of police shootings a grand jury is never even convened. We can recognize the gross injustice of the non-indictments there and in Staten Island, and still remember that even the minimal steps toward accountability in these cases would never have happened without people in the streets.
Thursday, December 18, 2014
Friday, December 12, 2014
Minsky on the Non-Neutrality of Money
I try not to spend too much time criticizing orthodox economics. I think that heterodox people who spend all their energy pointing out the shortcomings and contradictions of the mainstream are, in a sense, making the same mistake as the ones who spend all their energy trying to make their ideas acceptable to the mainstream. We should focus on building up our positive knowledge of social reality, and let the profession fend for itself.
That said, like almost everyone in the world of heterodoxy I do end up writing a lot, and often obstreperously, about what is wrong with the economics profession. To which you can fairly respond: OK, but where is the alternative economics you're proposing instead?
The honest answer is, it doesn't exist. There are many heterodox economics, including a large contingent of Post Keynesians, but Post Keynesianism is not a coherent alternative research program. [1] Still, there are lots of promising pieces, which might someday be assembled into a coherent program. One of these is labeled "Minsky". [2] Unfortunately, while Minsky is certainly known to a broader audience than most economists associated with heterodoxy, it's mainly only for the financial fragility hypothesis, which I would argue is not central to his contribution.
I recently read a short piece he wrote in 1993, towards the end of his career, that gives an excellent overview of his approach. It's what I'd recommend -- along with the overview of his work by Perry Mehrling that I mentioned in the earlier post, and also the overview by Pollin and Dymski -- as a starting point for anyone interested in his work.
"The Non-Neutrality of Money" covers the whole field of Minsky's interests and can be read as a kind of summing-up of his mature thought. So it's interesting that he gave it that title. Admittedly it partly reflects the particular context it was written in, but it also, I think, reflects how critical the neutrality or otherwise of money is in defining alternative visions of what an economy is.
Minsky starts out with a description of what he takes to be the conceptual framework of orthodox economics, represented here by Ben Bernanke's "Credit in the Macroeconomy":
Or to come back to the specific way Minsky presents the problem. Suppose I have some productive project available to me but lack sufficient claim on society's resources to carry it out. In principle, I could get them by pledging a fraction of the results of my project. But that might not work, perhaps because the results are too far in the future, or too uncertain, or -- information asymmetry -- I have no way of sharing the knowledge that the project is viable or credibly committing to share its fruits. In that case "welfare" will be lower than it the hypothetical perfect-information alternative, and, given some additional assumptions, we will see something that looks like unemployment. Now, perhaps the monetary authority can in some way arrange for deferred or uncertain claims to be accepted more readily. That may result in resources becoming available for my project, potentially solving the unemployment problem. But, given the assumptions that created the need for policy in the first place, there is no reason to think that the projects funded as a result of this intervention wil be exactly the same as in the perfect-information case. And there is no reason to think there are not lots of other unrealized projects whose non-undertaking happens not to show up as unemployment. [5]
Returning to Minsky: A system of markets
Minsky continues:
For Minsky, this fundamental point is captured in Keynes' two-price model. The price level of current output and capital assets are determined by two independent logics and vary independently. This is another way of saying that the classical dichotomy between relative prices and the overall price level, does not apply in a modern economy with a financial system and long-lived capital goods. Changes in the "supply of money," whatever that means in practice, always affect the prices of assets relative to current output.
Coming back to the question at hand, the critical point is that liquidity (or "money") will affect these two prices differently. Think of it this way: If money is scarce, it will be costly to hold a large stock of it. So you will want to avoid committing yourself to fixed money payments in the future, you will prefer assets that can be easily converted into money as needed, and you will place a lower value on money income that is variable or uncertain. For all these reasons, long-lived capital goods will have a lower relative price in a liquidity-scare world than in a liquidity-abundant one. Or as Minsky puts it:
[1] Marxism does, arguably, offer a coherent alternative -- the only one at this point, I think. Anwar Shaikh recently wrote a nice piece, which I can't locate at the moment, contrasting the Marxist-classical and Post Keynesian strands of heterodoxy.
[2] In fact, as Perry Mehrling demonstrates in The Money Interest and the Public Interest, Minsky represents an older and largely forgotten tradition of American monetary economics, which owes relatively little to Keynes.
[3] Walras, Wicksell and many others dismiss the idea that more money can be beneficial by focusing on its function as a unit of account. You can't consistently arrive earlier, they point out, by adjusting your watch, even if you might trick yourself the first few times. You can't get taller by redefining the inch. Etc. But this overlooks the fact that people do actually hold money, and pay real costs to acquire it.
[4] "The dearness of every thing, from plenty of money, is a disadvantage ... This has made me entertain a doubt concerning the benefit of banks and paper-credit, which are so generally esteemed advantageous ... to endeavour artificially to encrease such a credit, can never be the interest of any trading nation; but must lay them under disadvantages, by encreasing money beyond its natural proportion to labour and commodities... And in this view, it must be allowed, that no bank could be more advantageous, than such a one as locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce." Political Discourses, 1752.
[5] This leads into Verdoorn's law and anti-hysteresis, a topic I hope to return to.
[6] Daniel Davies should appreciate this.
That said, like almost everyone in the world of heterodoxy I do end up writing a lot, and often obstreperously, about what is wrong with the economics profession. To which you can fairly respond: OK, but where is the alternative economics you're proposing instead?
The honest answer is, it doesn't exist. There are many heterodox economics, including a large contingent of Post Keynesians, but Post Keynesianism is not a coherent alternative research program. [1] Still, there are lots of promising pieces, which might someday be assembled into a coherent program. One of these is labeled "Minsky". [2] Unfortunately, while Minsky is certainly known to a broader audience than most economists associated with heterodoxy, it's mainly only for the financial fragility hypothesis, which I would argue is not central to his contribution.
I recently read a short piece he wrote in 1993, towards the end of his career, that gives an excellent overview of his approach. It's what I'd recommend -- along with the overview of his work by Perry Mehrling that I mentioned in the earlier post, and also the overview by Pollin and Dymski -- as a starting point for anyone interested in his work.
* * *
"The Non-Neutrality of Money" covers the whole field of Minsky's interests and can be read as a kind of summing-up of his mature thought. So it's interesting that he gave it that title. Admittedly it partly reflects the particular context it was written in, but it also, I think, reflects how critical the neutrality or otherwise of money is in defining alternative visions of what an economy is.
Minsky starts out with a description of what he takes to be the conceptual framework of orthodox economics, represented here by Ben Bernanke's "Credit in the Macroeconomy":
The dominant paradigm is an equilibrium construct in which initial endowments of agents, preference systems and production relations, along with maximizing behavior, determine relative prices, outputs and allocation... Money and financial interrelations are not relevant to the determination of these equilibrium values ... "real" factors determine "real" variables.Some people take this construct literally. This leads to Real Business Cycles and claims that monetary policy has never had any effects. Minsky sees no point in even criticizing that approach. The alternative, which he does criticize, is to postulate some additional "frictions" that prevent the long-run equilibrium from being realized, at least right away. Often, as in the Bernanke piece, the frictions take the form of information asymmetries that prevent some mutually beneficial transactions -- loans to borrowers without collateral, say -- from taking place. But, Minsky says, there is a contradiction here.
On the one hand, perfect foresight is assumed ... to demonstrate the existence of equilibrium, and on the other hand, imperfect foresight is assumed ... to generate the existence of an underemployment equilibrium and the possibility of policy effectiveness.Once we have admitted that money and money contracts are necessary to economic activity, and not just an arbitrary numeraire, it no longer makes sense to make simulating a world without money as the goal of policy. If money is useful, isn't it better to have more of it, and worse to have less, or none? [3] The information-asymmetry version of this problem is actually just the latest iteration of a very old puzzle that goes back to Adam Smith, or even earlier. Smith and the other Classical economists were unanimous that the best monetary system was one that guaranteed a "perfect" circulation, by which they meant, the quantity of money that would circulate if metallic currency were used exclusively. But this posed two obvious questions: First, how could you know how much metallic currency would circulate in that counterfactual world, and exactly which forms of "money" in the real world should you compare to that hypothetical amount? And second, if the ideal monetary system was one in which the quantity of money came closest to what it would be if only metal coins were used, why did people -- in the most prosperous countries especially -- go to such lengths to develop forms of payment other than metallic coins? Hume, in the 18th century, could still hew to the logic of theory and and conclude that, actually, paper money, bills of exchange, banks that functioned as anything but safety-deposit boxes [4] and all the rest of the modern financial system was a big mistake. For later writers, for obvious reasons, this wasn't a credible position, and so the problem tended to be evaded rather than addressed head on.
Or to come back to the specific way Minsky presents the problem. Suppose I have some productive project available to me but lack sufficient claim on society's resources to carry it out. In principle, I could get them by pledging a fraction of the results of my project. But that might not work, perhaps because the results are too far in the future, or too uncertain, or -- information asymmetry -- I have no way of sharing the knowledge that the project is viable or credibly committing to share its fruits. In that case "welfare" will be lower than it the hypothetical perfect-information alternative, and, given some additional assumptions, we will see something that looks like unemployment. Now, perhaps the monetary authority can in some way arrange for deferred or uncertain claims to be accepted more readily. That may result in resources becoming available for my project, potentially solving the unemployment problem. But, given the assumptions that created the need for policy in the first place, there is no reason to think that the projects funded as a result of this intervention wil be exactly the same as in the perfect-information case. And there is no reason to think there are not lots of other unrealized projects whose non-undertaking happens not to show up as unemployment. [5]
Returning to Minsky: A system of markets
is not the only way that economic interrelations can be modeled. Every capitalist economy can be described in terms of interrelated balance sheets ... The entries on balance sheets can be read as payment commitments (liabilities) and expected payment receipts (assets), both denominated in a common unit.We don't have to see an endowments of goods, tastes for consumption, and a given technology for converting the endowments to consumption goods as the atomic units of the economy. We can instead start with a set of money flows between units, and the capitalized expectations of future money flows captured on balance sheets. In the former perspective, money payments and commitments are a secondary complication that we may want to introduce for specific problems. In the latter, Minskyan perspective, exchanges of goods are just one of the various forms of money flows between economic units.
Minsky continues:
In this structure, the real and the financial dimensions of the economy are not separated. There is no "real economy" whose behavior can be studied by abstracting from financial considerations. ... In this model, money is never neutral.The point here, again, is that real economies require people to make commitments today on the basis of expectations extending far into an uncertain future. Money and credit are tools to allow these commitments to be made. The more available are money and credit, the further into the future can be deferred the results that will justify today's activity. If we can define a level of activity that we call full employment or price stability -- and I think Keynes was much too sanguine on this point -- then a good monetary authority may be able to regulate the flow of money or credit (depending on the policy instrument) to keep actual activity near that level. But there is no connection, logical or practical, between that state of the economy and a hypothetical economy without money or credit at all.
For Minsky, this fundamental point is captured in Keynes' two-price model. The price level of current output and capital assets are determined by two independent logics and vary independently. This is another way of saying that the classical dichotomy between relative prices and the overall price level, does not apply in a modern economy with a financial system and long-lived capital goods. Changes in the "supply of money," whatever that means in practice, always affect the prices of assets relative to current output.
The price level of assets is determined by the relative value that units place on income in the future and liquidity now. ...
The price level of current output is determined by the labor costs and the markup per unit of output. ... The aggregate markup for consumption goods is determined by the ratio of the wage bill in investment goods, the government deficit... , and the international trade balance, to the wage bill in the production of consumption goods. In this construct the competition of interest is between firms for profits.Here we see Minsky's Kaleckian side, which doesn't get talked about much. Minsky was convinced that investment always determined profits, never the other way round. Specifically, he followed Kalecki in treating the accounting identity that "the capitalists get what they spend" as causal. That is, total profits are determined as total investment spending plus consumption by capitalists (plus the government deficit and trade surplus.)
Coming back to the question at hand, the critical point is that liquidity (or "money") will affect these two prices differently. Think of it this way: If money is scarce, it will be costly to hold a large stock of it. So you will want to avoid committing yourself to fixed money payments in the future, you will prefer assets that can be easily converted into money as needed, and you will place a lower value on money income that is variable or uncertain. For all these reasons, long-lived capital goods will have a lower relative price in a liquidity-scare world than in a liquidity-abundant one. Or as Minsky puts it:
The non-neutrality of money ... is due to the difference in the way money enters into the determination of the price level of capital assets and of current output. ... the non-neutrality theorem reflects essential aspects of capitalism in that it recognizes that ... assets exist and that they not only yield income streams but can also be sold or pledged.Finally, we get to Minsky's famous threefold classification of financial positions as hedge, speculative or Ponzi. In context, it's clear that this was a secondary not a central concern. Minsky was not interested in finance for its own sake, but rather in understanding modern capitalist economies through the lens of finance. And it was certainly not Minsky's intention for these terms to imply a judgement about more and less responsible financing practices. As he writes, "speculative" financing does not necessarily involve anything we would normally call speculation:
Speculative financing covers all financing that involves refinancing at market terms ... Banks are always involved in speculative financing. The floating debt of companies and governments are speculative financing.As for Ponzi finance, he admits this memorable label was a bad choice:
I would have been better served if I had labeled the situation "the capitalization of interest." ... Note that construction finance is almost always a prearranged Ponzi financing scheme. [6]For me, the fundamental points here are (1) That our overarching vision of capitalist economies needs to be a system of "units" (including firms, governments, etc.) linked by current money payments and commitments to future money payments, not a set of agents exchanging goods; and (2) that the critical influence of liquidity comes in the terms on which long-lived commitments to particular forms of production trade off against current income.
[1] Marxism does, arguably, offer a coherent alternative -- the only one at this point, I think. Anwar Shaikh recently wrote a nice piece, which I can't locate at the moment, contrasting the Marxist-classical and Post Keynesian strands of heterodoxy.
[2] In fact, as Perry Mehrling demonstrates in The Money Interest and the Public Interest, Minsky represents an older and largely forgotten tradition of American monetary economics, which owes relatively little to Keynes.
[3] Walras, Wicksell and many others dismiss the idea that more money can be beneficial by focusing on its function as a unit of account. You can't consistently arrive earlier, they point out, by adjusting your watch, even if you might trick yourself the first few times. You can't get taller by redefining the inch. Etc. But this overlooks the fact that people do actually hold money, and pay real costs to acquire it.
[4] "The dearness of every thing, from plenty of money, is a disadvantage ... This has made me entertain a doubt concerning the benefit of banks and paper-credit, which are so generally esteemed advantageous ... to endeavour artificially to encrease such a credit, can never be the interest of any trading nation; but must lay them under disadvantages, by encreasing money beyond its natural proportion to labour and commodities... And in this view, it must be allowed, that no bank could be more advantageous, than such a one as locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce." Political Discourses, 1752.
[5] This leads into Verdoorn's law and anti-hysteresis, a topic I hope to return to.
[6] Daniel Davies should appreciate this.
Monday, December 8, 2014
The Future of Monetary Policy, according to Paul Krugman, Elizabeth Warren and Me
I will be speaking at this event tomorrow. I'll post video if/when it becomes available.
UPDATE: Unfortunately there were AV problems and in the video my presentation gets cut off about a minute in. But you can find the talks by Elizabeth Warren, Paul Krugman, and a couple of the other panelists at the link.
UPDATE: Unfortunately there were AV problems and in the video my presentation gets cut off about a minute in. But you can find the talks by Elizabeth Warren, Paul Krugman, and a couple of the other panelists at the link.
Sunday, December 7, 2014
What to Read on Liquidity
In comments, someone asks for references behind "the point is liquidity, the point is liquidity, the point is liquidity." So, here are my recommended readings on liquidity.
Mike Beggs: "Liquidity as a Social Relation." This is the best single discussion I know of the Keynesian view of liquidity. Beside laying out the fundamental conceptual issues, and sketching the historical development of the concept, this piece also has a good discussion of how the definition of liquidity used in monetary policy has been transformed over the past couple decades. This is the first thing I'd recommend to anyone who wants to understand what exactly those of us in the left-Keynsian tradition mean by "liquidity."
John Hicks: "Liquidity." A lucid and intelligent summary of where the discussion of liquidity stood 20 years after Keynes' death.
Jorg Bibow: “Liquidity preference theory revisited: to ditch or to build on it?” A rigorous analysis of the role of liquidity in the Keynesian theory of interest rates, with particular attention to the dynamics of conventional expectations. If you want to know how Keynes' ideas about liquidity fit into contemporary debates about monetary policy, Bibow is your man. Also worth reading: "On Keynesian Theories of Liquidity Preference," and Bibow's book.
J. M. Keynes: chapters 12, 13, 15, 17 and 23 of the General Theory. Also: "The General Theory of Employment"; "The Ex-Ante Theory of Interest." The original source. I think the presentation in the articles is clearer than in the book. Beggs and Hicks and Bibow are even clearer.
Jean Tirole, "Illiquidity and All Its Friends." Within the mainstream, Tirole has by far the best discussion of liquidity that I'm aware of. I have profoundly mixed feelings about his approach but I've certainly learned from him -- for example, the distinction between funding liquidity and market liquidity is genuinely useful. If you're tempted to criticize "mainstream" economics' treatment of liquidity, you need to seriously engage with Tirole first -- he incorporates a surprisingly large part of the Keynesian vision of liquidity into an orthodox framework.
Jim Crotty, "The Centrality of Money, Credit and Intermediation in Marx's Crisis Theory". Addresses liquidity in a somewhat different context than most of the above -- he asks how the specifically monetary character of capitalist production shapes the dynamics of accumulation as described by Marx and his followers. It's a bit askew to the other pieces here, but the underlying questions are, I think, the same. And it is one of the most brilliant scholarly essays I have read.
Perry Mehrling, "The Vision of Hyman Minsky." I think this lays out the logic of Minsky's work better than anything by Minsky himself. Also see Mehrling's book, The Money Interest and the Public Interest. Everything we need to know about liquidity is in there, though you may have to read between the lines to find it. His "Inherent Hierarchy of Money" is also useful, making the point that any system of payments is inherently hierarchical, with the same instrument appearing as credit at one level and as money at the level below.
EDIT: Should also include Joan Robinson, "The Rate of Interest," which has a useful taxonomy distinguishing illiquidity in the strict sense from capital uncertainty, income uncertainty and lender's risk.
By the way, the phrasing the post starts with is taken from Tree of Smoke, Denis Johnson's Vietnam war novel. (I know that's not what you were asking.) It's the best novel I read this year, I recommend it almost unreservedly. There of course the point is Vietnam.
Mike Beggs: "Liquidity as a Social Relation." This is the best single discussion I know of the Keynesian view of liquidity. Beside laying out the fundamental conceptual issues, and sketching the historical development of the concept, this piece also has a good discussion of how the definition of liquidity used in monetary policy has been transformed over the past couple decades. This is the first thing I'd recommend to anyone who wants to understand what exactly those of us in the left-Keynsian tradition mean by "liquidity."
John Hicks: "Liquidity." A lucid and intelligent summary of where the discussion of liquidity stood 20 years after Keynes' death.
Jorg Bibow: “Liquidity preference theory revisited: to ditch or to build on it?” A rigorous analysis of the role of liquidity in the Keynesian theory of interest rates, with particular attention to the dynamics of conventional expectations. If you want to know how Keynes' ideas about liquidity fit into contemporary debates about monetary policy, Bibow is your man. Also worth reading: "On Keynesian Theories of Liquidity Preference," and Bibow's book.
J. M. Keynes: chapters 12, 13, 15, 17 and 23 of the General Theory. Also: "The General Theory of Employment"; "The Ex-Ante Theory of Interest." The original source. I think the presentation in the articles is clearer than in the book. Beggs and Hicks and Bibow are even clearer.
Jean Tirole, "Illiquidity and All Its Friends." Within the mainstream, Tirole has by far the best discussion of liquidity that I'm aware of. I have profoundly mixed feelings about his approach but I've certainly learned from him -- for example, the distinction between funding liquidity and market liquidity is genuinely useful. If you're tempted to criticize "mainstream" economics' treatment of liquidity, you need to seriously engage with Tirole first -- he incorporates a surprisingly large part of the Keynesian vision of liquidity into an orthodox framework.
Jim Crotty, "The Centrality of Money, Credit and Intermediation in Marx's Crisis Theory". Addresses liquidity in a somewhat different context than most of the above -- he asks how the specifically monetary character of capitalist production shapes the dynamics of accumulation as described by Marx and his followers. It's a bit askew to the other pieces here, but the underlying questions are, I think, the same. And it is one of the most brilliant scholarly essays I have read.
Perry Mehrling, "The Vision of Hyman Minsky." I think this lays out the logic of Minsky's work better than anything by Minsky himself. Also see Mehrling's book, The Money Interest and the Public Interest. Everything we need to know about liquidity is in there, though you may have to read between the lines to find it. His "Inherent Hierarchy of Money" is also useful, making the point that any system of payments is inherently hierarchical, with the same instrument appearing as credit at one level and as money at the level below.
EDIT: Should also include Joan Robinson, "The Rate of Interest," which has a useful taxonomy distinguishing illiquidity in the strict sense from capital uncertainty, income uncertainty and lender's risk.
By the way, the phrasing the post starts with is taken from Tree of Smoke, Denis Johnson's Vietnam war novel. (I know that's not what you were asking.) It's the best novel I read this year, I recommend it almost unreservedly. There of course the point is Vietnam.
Saturday, December 6, 2014
Four Questions about Fiscal Policy
Earlier this fall, I spent a pleasant few days at the 12th Post Keynesian Conference in Kansas City, including a long chat over beers with Robert Skidelsky. In addition to presenting some of my current work, I took part in an interesting roundtable discussion of functional finance with Steve Fazzari, Peter Skott, Marc Lavoie and Mario Seccarechia. Here is an edited version of what I said.
We all agree that fiscal policy is effective. If output is too low, by whatever standard, higher public spending or lower taxes will cause it to rise. And we all agree that the current level of public debt has no implications for the feasibility or desirability of fiscal policy, at least in a country like the United States. In the wider world that might be a controversial statement but in this room it is not.
It’s not productive to repeat points on which we all agree. So instead, I want to pose four questions about functional finance on which there is not a consensus. These aren’t questions I necessarily have (or expect to hear) good answers to at the moment, but ones that I hope will be the focus of future work. First, the political economy question. Why does the idea of a government financial constraint have such a tenacious hold on both the policy conversation and the economics profession? What function, what interest, does this idea serve? Second, how confident are we about the level of aggregate expenditure that policy should target? Is there a well-defined level of potential output that corresponds to both full employment and price stability? Third, what is the problem that we imagine fiscal policy to be solving? Is it stabilizing of output in the face of “shocks” of some kind, or is it adjusting the long term trend? And what are the sources for the variation in private demand to which policy must respond? Finally, if functional finance means that fiscal policy replaces monetary policy as the main tool for managing aggregate expenditure, what role does that leave for the interest rate?
1. The political economy question. We all agree that in a country like the modern United States (or the EU as a whole), public budgets are never constrained by the willingness of the private sector to hold the government’s liabilities. There are a number of routes, both logical and empirical, to reach this conclusion, which I won’t repeat here. And yet both policymakers and academic economists are, with few exceptions, committed to the idea that government does face a financial constraint. I don’t think it’s a sufficient explanation that people are just stupid. I was on an earlier panel with Randy Wray, where he quoted Paul Samuelson describing the idea of a government financial constraint as “religion” that has no rational basis but is nonetheless "scares people ... into behaving the way that civilized life requires." [1] Randy focused, understandably, on the first half of that quote, the acknowledgement that a balanced budget is desirable only on ritual or aesthetic criteria. But what about the second part? What is the civilized life that benefits from this taboo?
The political salience of the balanced-budegt myth has been particularly clear in the debt-ceiling fights of the past few years. You read John Cassidy in New Yorker: “Every country needs to pay its creditors or face ruin.” [2] This is framed as a statement of fact, but it really describes a political project. Creditors need to threaten countries with ruin if they are going to be obeyed. The threat doesn’t have to be real, but it does have to be believed.
The most important political use of the government budget constraint today is undoubtedly in the Euro area, where it seems clear that a central part of the elite motivation for the single currency was precisely to reimpose financial constraints on national governments. This view of the euro project was forcefully expressed by Massimo Pivetti in a 2013 article in Contributions to Political Economy. As he puts it, the ultimate effect of European countries’ renunciation of monetary sovereignty has been the dismantling of the social democratic order.
2. Next, I think we need to interrogate the notion of potential output more critically. The assumption of almost the entire functional finance literature — including my own work — is that there is a well-defined level of aggregate expenditure that policy should be targeting, which corresponds to full employment and full utilization of society's resources. In the standard formula, once we see rising inflation, we know that this target has been reached and there should be no further expansionary policy. In this respect, there is no difference between functional finance and mainstream policy thought. The difference is about the tools used, not about the goal. Most importantly, both policy orthodoxy and functional finance assume that neither inflation nor employment is affected directly by macroeconomic policy, but only via the level of output. So output, inflation and employment can be treated as three indicators for a single target. [3]
It is not obvious, though, why the goals of full employment, price stability and steady output growth should always coincide. Now, in practice it may be that they generally do, or at least are close enough that this is not a big problem. One thing Arjun and I do in our paper is examine this question directly. We compute a number of different measures of the output gap from 1953 to the present. We compare output gaps based on the deviation of current output from trend, the level of unemployment, the level of inflation, and the change in inflation, as well as a measure combining unemployment and the change in inflation that corresponds to the Taylor rule. The interesting thing is that these different measures perform very similarly. The output and unemployment measures fit especially closely, with a simple correlation coefficient of 0.94. In other words, the Okun relationship between output and unemployment is very stable, and the Phillips curve relationship between output or employment and inflation is also fairly stable. So the statement “When output is above trend, you will see rising inflation; when output is below trend, you will see high unemployment” does in fact seem to be a reliable generalization. (See figure below.)
But even if these measures agree with each other for the US over the past 60 years, that doesn’t mean they will agree in other times and places. And in fact, we see that the inflation-change measure does not agree with the others for the post-2007 period, suggesting a much smaller negative output gap. (This is because inflation has stabilized at a low level, rather than continuing to fall.) And even if these measures do generally agree with each other, that doesn’t mean they are right, or that interpreting them is straightforward. In particular, we should ask if hysteresis might not be a more general phenomenon, and that the inflation that comes with output above potential isn't better thought of as an adjustment cost. This brings me to the next question.
3. Is aggregate demand only an issue in the short run, or does it matter in the long run as well? In other words, is the problem to be solved by policy deviations of output around a trend that is determined on the supply side, or is the trend itself the object of policy?
If the former, shouldn't we have a more positive theory about what these "shocks" are that policy is responding to. This has always struck me as one of the weirdest lacunae in mainstream macro. The entire problem of policy in this framework is responding to these shocks, so you would think that a central question would be where they come from, how large they are, whether there are identifiable factors that affect their distribution. But instead the existence of these vaguely defined "shocks" is just the unquestioned starting point of analysis. Now obviously there are reasons for this. Shocks, by definition, are changes in the state of the world that are not due to rational optimization, so if that's your methodology, then "shocks" just means "things I have nothing to say about." (And I have a sneaking suspicion that there is a logical inconsistency between the existence of unanticipated shocks and the idea of intertemporal equilibrium. But maybe not.) But on our side we don't have that excuse. We shouldn't limit ourselves to showing that changes in the government budget position can offset changes in desired private spending. We should try to explain why desired private spending varies so dramatically.
And what if demand matters in the long run, thanks to hysteresis (and what I call anti-hysteresis) in the laborforce, and Verdoorn-Kaldor changes in productivity growth? [4] In that case these questions are even more urgent. And we also have to face the political question that was banished from respectable macro in the 1980s: What is the desirable tradeoff between output and inflation? More broadly, if we can't take a given path of potential output as given, how do we define the goals of macro policy?
4. What is the role of interest rate policy in a functional finance framework, given that it is no longer the primary tool for adjusting aggregate expenditure? On Thursday’s panel, we had three different answers to this question. Arjun and I say that if for whatever reason the public debt to GDP ratio is a concern for policymakers, adjusting the policy interest rate is in general sufficient to stabilize that ratio at some desired level. Peter Skott says that if we have some idea of the optimal long-run capital-output ratio (or perhaps more precisely, the optimal choice of technique), the interest rate can be set to achieve that. And Randy says that we shouldn’t worry about the debt-GDP ratio and that business investment decisions are not very responsive to the interest rate, so its main consequences are distributional. Since there is no social interest in providing a passive, risk-free income to rentiers, the nominal interest rate should be set to zero permanently.
[1] The quote is from an interview with Mark Blaug: "I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires."
[2] The title of the piece is "Why America Needs a Stock Market Crash."
[3] This isn’t strictly correct, since an important component of functional finance in its modern UMKC form is a job guarantee or employer of last resort (ELR) policy. But given the stability of the Okun relationship, employment and output can safely be treated as a single target in practice. The problem is the relationship of employment and output, on the one hand, with inflation, on the other.
[4] As late as the 1980s, people like Tobin took it for granted that the reason that inflationary or deflationary gaps would not continue indefinitely, was that aggregate supply would adjust.
* * *
We all agree that fiscal policy is effective. If output is too low, by whatever standard, higher public spending or lower taxes will cause it to rise. And we all agree that the current level of public debt has no implications for the feasibility or desirability of fiscal policy, at least in a country like the United States. In the wider world that might be a controversial statement but in this room it is not.
It’s not productive to repeat points on which we all agree. So instead, I want to pose four questions about functional finance on which there is not a consensus. These aren’t questions I necessarily have (or expect to hear) good answers to at the moment, but ones that I hope will be the focus of future work. First, the political economy question. Why does the idea of a government financial constraint have such a tenacious hold on both the policy conversation and the economics profession? What function, what interest, does this idea serve? Second, how confident are we about the level of aggregate expenditure that policy should target? Is there a well-defined level of potential output that corresponds to both full employment and price stability? Third, what is the problem that we imagine fiscal policy to be solving? Is it stabilizing of output in the face of “shocks” of some kind, or is it adjusting the long term trend? And what are the sources for the variation in private demand to which policy must respond? Finally, if functional finance means that fiscal policy replaces monetary policy as the main tool for managing aggregate expenditure, what role does that leave for the interest rate?
1. The political economy question. We all agree that in a country like the modern United States (or the EU as a whole), public budgets are never constrained by the willingness of the private sector to hold the government’s liabilities. There are a number of routes, both logical and empirical, to reach this conclusion, which I won’t repeat here. And yet both policymakers and academic economists are, with few exceptions, committed to the idea that government does face a financial constraint. I don’t think it’s a sufficient explanation that people are just stupid. I was on an earlier panel with Randy Wray, where he quoted Paul Samuelson describing the idea of a government financial constraint as “religion” that has no rational basis but is nonetheless "scares people ... into behaving the way that civilized life requires." [1] Randy focused, understandably, on the first half of that quote, the acknowledgement that a balanced budget is desirable only on ritual or aesthetic criteria. But what about the second part? What is the civilized life that benefits from this taboo?
The political salience of the balanced-budegt myth has been particularly clear in the debt-ceiling fights of the past few years. You read John Cassidy in New Yorker: “Every country needs to pay its creditors or face ruin.” [2] This is framed as a statement of fact, but it really describes a political project. Creditors need to threaten countries with ruin if they are going to be obeyed. The threat doesn’t have to be real, but it does have to be believed.
The most important political use of the government budget constraint today is undoubtedly in the Euro area, where it seems clear that a central part of the elite motivation for the single currency was precisely to reimpose financial constraints on national governments. This view of the euro project was forcefully expressed by Massimo Pivetti in a 2013 article in Contributions to Political Economy. As he puts it, the ultimate effect of European countries’ renunciation of monetary sovereignty has been the dismantling of the social democratic order.
What is being liquidated is but one of the most advanced experiences of civil coexistence the world has ever known—in fact, the greatest ever achievement of the bourgeois civilization. ...
Surrender of national sovereignty in the monetary and fiscal fields subscribed by European governments produced a situation of political ‘irresponsibility’, which greatly facilitated their declining commitment to high employment and the redistribution of income, as well as the priority given to reducing inflation, the gradual dismantling of the welfare state, and the privatization drive. ... [The euro] is an infernal machine: a machine born out of a deliberate continental project to undermine wage earners’ bargaining powers.Wolfgang Streeck similarly argues that policies that result in rising debt are not the result of rising demands for redistribution and public services, but rather have been supported by the wealthy, precisely because “rising public debt can be utilized politically to argue for cutbacks in state spending and for privatization of public services.” You can find similar arguments by Perry Anderson (in The New Old World), Gindin and Panitch, and others. Financial constraint “disciplines” “irresponsible” policymakers — in other words, it makes them responsive to the interests of owners of financial assets. And I would stress the same fundamental point emphasized by Gindin and Panitch — the interest that counts here is not a direct pecuniary interest, defined within the economic system. It is the interest of wealthowners as a class in the perpetuation of a social order based on the accumulation of private wealth.
2. Next, I think we need to interrogate the notion of potential output more critically. The assumption of almost the entire functional finance literature — including my own work — is that there is a well-defined level of aggregate expenditure that policy should be targeting, which corresponds to full employment and full utilization of society's resources. In the standard formula, once we see rising inflation, we know that this target has been reached and there should be no further expansionary policy. In this respect, there is no difference between functional finance and mainstream policy thought. The difference is about the tools used, not about the goal. Most importantly, both policy orthodoxy and functional finance assume that neither inflation nor employment is affected directly by macroeconomic policy, but only via the level of output. So output, inflation and employment can be treated as three indicators for a single target. [3]
It is not obvious, though, why the goals of full employment, price stability and steady output growth should always coincide. Now, in practice it may be that they generally do, or at least are close enough that this is not a big problem. One thing Arjun and I do in our paper is examine this question directly. We compute a number of different measures of the output gap from 1953 to the present. We compare output gaps based on the deviation of current output from trend, the level of unemployment, the level of inflation, and the change in inflation, as well as a measure combining unemployment and the change in inflation that corresponds to the Taylor rule. The interesting thing is that these different measures perform very similarly. The output and unemployment measures fit especially closely, with a simple correlation coefficient of 0.94. In other words, the Okun relationship between output and unemployment is very stable, and the Phillips curve relationship between output or employment and inflation is also fairly stable. So the statement “When output is above trend, you will see rising inflation; when output is below trend, you will see high unemployment” does in fact seem to be a reliable generalization. (See figure below.)
 |
| The figure shows measures of the difference between current output and potential based on (1) trend GDP, as computed by the BEA; (2) the deviation of unemployment from its long-term average; (3) the average of the deviations of unemployment and inflation from their long-term averages; (4) the average of the deviation of unemployment from average and the year-over-year change in inflation; and (5) the year-over-year change in inflation. |
But even if these measures agree with each other for the US over the past 60 years, that doesn’t mean they will agree in other times and places. And in fact, we see that the inflation-change measure does not agree with the others for the post-2007 period, suggesting a much smaller negative output gap. (This is because inflation has stabilized at a low level, rather than continuing to fall.) And even if these measures do generally agree with each other, that doesn’t mean they are right, or that interpreting them is straightforward. In particular, we should ask if hysteresis might not be a more general phenomenon, and that the inflation that comes with output above potential isn't better thought of as an adjustment cost. This brings me to the next question.
3. Is aggregate demand only an issue in the short run, or does it matter in the long run as well? In other words, is the problem to be solved by policy deviations of output around a trend that is determined on the supply side, or is the trend itself the object of policy?
If the former, shouldn't we have a more positive theory about what these "shocks" are that policy is responding to. This has always struck me as one of the weirdest lacunae in mainstream macro. The entire problem of policy in this framework is responding to these shocks, so you would think that a central question would be where they come from, how large they are, whether there are identifiable factors that affect their distribution. But instead the existence of these vaguely defined "shocks" is just the unquestioned starting point of analysis. Now obviously there are reasons for this. Shocks, by definition, are changes in the state of the world that are not due to rational optimization, so if that's your methodology, then "shocks" just means "things I have nothing to say about." (And I have a sneaking suspicion that there is a logical inconsistency between the existence of unanticipated shocks and the idea of intertemporal equilibrium. But maybe not.) But on our side we don't have that excuse. We shouldn't limit ourselves to showing that changes in the government budget position can offset changes in desired private spending. We should try to explain why desired private spending varies so dramatically.
And what if demand matters in the long run, thanks to hysteresis (and what I call anti-hysteresis) in the laborforce, and Verdoorn-Kaldor changes in productivity growth? [4] In that case these questions are even more urgent. And we also have to face the political question that was banished from respectable macro in the 1980s: What is the desirable tradeoff between output and inflation? More broadly, if we can't take a given path of potential output as given, how do we define the goals of macro policy?
4. What is the role of interest rate policy in a functional finance framework, given that it is no longer the primary tool for adjusting aggregate expenditure? On Thursday’s panel, we had three different answers to this question. Arjun and I say that if for whatever reason the public debt to GDP ratio is a concern for policymakers, adjusting the policy interest rate is in general sufficient to stabilize that ratio at some desired level. Peter Skott says that if we have some idea of the optimal long-run capital-output ratio (or perhaps more precisely, the optimal choice of technique), the interest rate can be set to achieve that. And Randy says that we shouldn’t worry about the debt-GDP ratio and that business investment decisions are not very responsive to the interest rate, so its main consequences are distributional. Since there is no social interest in providing a passive, risk-free income to rentiers, the nominal interest rate should be set to zero permanently.
[1] The quote is from an interview with Mark Blaug: "I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires."
[2] The title of the piece is "Why America Needs a Stock Market Crash."
[3] This isn’t strictly correct, since an important component of functional finance in its modern UMKC form is a job guarantee or employer of last resort (ELR) policy. But given the stability of the Okun relationship, employment and output can safely be treated as a single target in practice. The problem is the relationship of employment and output, on the one hand, with inflation, on the other.
[4] As late as the 1980s, people like Tobin took it for granted that the reason that inflationary or deflationary gaps would not continue indefinitely, was that aggregate supply would adjust.
Thursday, December 4, 2014
Cochrane on Economic Orthodoxies
John Cochrane has a good post saying something I've been thinking about for a while. There are two disjoint orthodoxies in economics, one in policy and one in scholarship. Both are secure on their own territory, but they have little connection with each other. This isn't obvious from the outside since many of the same institutions and even individuals contribute to the reproduction of both orthodoxies, but as intellectual projects they are entirely distinct.
Cochrane:
Cochrane:
There is ... a sharp divide between macroeconomics used in the top levels of policy circles, and that used in academia.
Static ISLM / ASAD modeling and thinking really did pretty much disappear from academic research economics around 1980. You won't find it taught in any PhD programs, you won't find it at any conferences ..., you won't find it in any academic journals... "New-Keynesian" DSGE (Dynamic Stochastic General Equilibrium) models are much in vogue, but have really nothing to do with static Keynesian ISLM modeling. Many authors would like it to be so, but when you read the equations you will find these are just utterly different models.
Static ISLM thinking pervades the upper reaches of the policy world. ... If you read the analysis guiding policy at the IMF, the Fed, the OECD, the CBO; and the larger policy debate in the pages of the Economist, New York Times, and quite often even the Wall Street Journal, policy analysis is pretty much unchanged from the Keynesian ISLM, ASAD, analysis I learned from Dornbush and Fisher's textbook, taught in Bob Solow's undergraduate Macro class at MIT about 1978.Note that Cochrane is agnostic about which of these projects is on the wrong track. This is a habit of mind we should all try to cultivate: The interesting questions are the ones where we can seriously imagine more than one answer.
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