Understanding deficit spending
A common fallacy is to assume that if spending on consumption falls, then investment spending will increase because there are more savings available for investment, so that there is no change to output.
If (and only if) C falls while Y remains constant, then of course the additional spending must have come from one of the other components in the identity. If G and NX do not rise then it must be from I—this is simply circular reasoning.
However, you cannot hold output constant: it is the dependent variable, the determinate of the other variables in the identity. Aggregate savings do not increase as C falls. This paradox is hard to grasp, but let me give it a shot.
Consider a closed economy at T0 with potential output of $100 and a stock of money equal to the same. If at T1 AD is $100 the economy is at potential. But what happens when the economy as a whole saves 5% of its income? At T2 total spending equals $95 and so total income equals $95. GDP is now $95—output has fallen below potential and the economy is in recession. The stock of paper wealth did not increase so there are no additional funds available to boost investment spending—all we have is the same $100 we started with.
There can never be an aggregate increase in paper wealth from within this closed system. It has to come from somewhere else—a cross-sectoral deficit flow.
Notes on the natural rate
Natural rate:
- no trade off between inflation and unemployment;
- monetary policy is neutral in the long run;
For monetarism, read “money supply” instead of “natural rate”.
New Consensus updates monetarism for a neo-Wicksellian banking sysetm where CB controls base rate not money supply.
Natural rate is… the rate at which money supply growth is neutral in the long run?
Thoughts: Does this contradict money supply endogeneity? What does money supply endogeneity mean with respect to the natural rate? WTF is this money supply endogeneity anyway?
Money supply endogeneity is: CB targets a base rate; liquidity preference of market determines differential; supply of loans infinitely elastic at a given interest rate, and collateral and regulatory requirements
Go FSA!
Great news, just in–the FSA grows a pair:
In an extraordinary ultimatum that has shocked some of the City’s biggest companies, the Financial Services Authority (FSA) told bank bosses that 60pc of all pay must be deferred, with no exceptions, even for those whose contracts conflicting with the edict.
Many of the global players have in recent weeks made representations to the City watchdog, in particular about pre-existing employment contracts that guarantee bonuses over a year or more. But their appeals have been met with the FSA’s toughest yet response.
One pay executive in a major bank told The Daily Telegraph: “The message came back that while the FSA agreed that it does not have jurisdiction over contractual law, it does have jurisdiction over issuing bank licences in London, and that we should go away and unwind the contracts.”
Sad news from Greece
It looks like Greece is going to be forced into a tighter fiscal position by its fellow EU member states. Its deficit is 12.5% of GDP (similar to the UK, Spain and Ireland) and the national debt is over 100%. Sadly, austerity measures will inevitably worsen the government deficit, since the policy of tightening in a recession is highly recessionary and recessions reduce tax revenue and increase automatic stabiliser payouts.
Tell that to Otmar Issing:
The German economist Otmar Issing told the BBC that after years of violating rules and cheating on its statistics, Greece had to reform its own economy without a bailout from Brussels.
“These reforms which are needed will be blood and tears… but without that, Greece will never overcome the difficulties,” he said.
Recessions are good for you.
Basically, Germany should leave the EMU, where it could run current account surpluses with other European states with the benefit of an exchange rate adjustment mechanism and be as hawkish as it damn well likes.
Update:
But under the economic pressures of the past year, the Greek government budget has slipped into ever greater deficit and investors have increasingly become uncomfortable about the possibility of future default. This impending doom was postponed for a while by the ability of banks – mostly Greek – to use these bonds as collateral for loans from the European Central Bank (so-called “repos”).
But from the end of this year, the ECB will no longer accept bonds rated below A by major ratings agencies – and Greek government debt no longer falls into this category. The market can do this kind of math in about 20 seconds: If the ECB won’t, indirectly, lend to the Greek government, then interest rates will go up in the future; in anticipation of this, interest rates should go up now.
That is trouble enough for an economy like Greece – or any of the weaker eurozone countries that have been known, for some time and not in an endearing way as the “PIIGS”. But paying higher interest rates on government debt also implies a worsening of the budget; this is exactly the sort of debt dynamics that used to get countries like Brazil into big trouble.
Help with Macro
Fabius Maximus is having trouble understanding US government debt. He writes that (US) government sector debt is “rising because we love to spend.” Of course, basic accounting identities tell us that government net spending enables the private sector to net save. The government sector deficit equals exactly the private sector (incorporating the household, corporate and foreign sectors) surplus. The US national debt is rising because the public (the non-government sector) is trying to save. This is recessionary, because the government deficit is not large enough to close the output gap and take up the slack in the economy. The government deficit itself is not large enough because the government lacks both the political will and the economic understanding to do so. An unfortunate dynamic begins: attempts to increase savings for the whole private sector without a large enough offsetting government deficit result in too little aggregate demand, resulting in rising unemployment and falling output, increasing the public’s desire to save (and increasing the government deficit in any case, through falling tax revenues and automatic stabiliser outlays), which leads to even less aggregate demand and reduced savings, and so on…
Fabius was not happy with this explanation, and repeatedly asked for “expert citation”, whatever that means. (Ironically, Fabius also has a post titled, “The Greatness of Lord Kenyes”, or some such). Apparently, tautologies based on accounting identities are not good enough, so, for those of you who are similarly inclined, here is James Galbraith:
Accounting relationships state definite facts about the world in relational terms. In particular, the national income identity (which simply states that total expenditure is the sum of its components) implies, without need for further proof, that there is a reciprocal, offsetting relationship between public deficits and private savings. To be precise, the financial balance of the private sector (the excess of domestic saving over domestic investment) must always just equal the sum of the government budget deficit and the net export surplus. Thus increasing the public budget deficit increases net private savings (for an unchanged trade balance), and conversely: increasing net private savings increases the budget deficit.
Gagnon FTW!
The following specificactions in the near term would help set the world into a solid recovery with stable prices and a return of economic activity to its trend growth path by the end of 2011:
- Th e Federal Reserve should purchase an additional $2 trillion of longer-term debt securities with an average maturity of around seven years.
- The European Central Bank (ECB) should lower its main refi nancing rate to 50 basis points, continue to extend unlimited 12-month credit to the banking system at this rate, and purchase €1 trillion of longer-term debt securities.
- The Bank of Japan should state more clearly its intention to return infl ation to at least 1 percent over the next two years, purchase an additional ¥100 trillion of longer-term debt securities with an average maturity of around seven years, and commit to a further ¥100 trillion in such purchases in 2011 if core infl ation over the next 12 months remains negative.
- The Bank of England should purchase an additional £200 billion of longer-term sterling bonds or an equivalent amount of longer-term foreign-currency bonds with the interest and principal hedged using currency swaps.
Renewed asset price bubbles and financial market excesses are unlikely in the current circumstances, but policymakers must be ready to use supervisory and regulatory tools to combat risky financial activities should they occur.
The World Needs Further Monetary Ease, Not an Early Exit, Joseph E. Gagnon
Some advice for Ben
Ben Bernanke, the Federal Reserve chairman, recently had some downbeat things to say about our economic prospects. The economy, he warned, “confronts some formidable headwinds.” All we can expect, he said, is “modest economic growth next year — sufficient to bring down the unemployment rate, but at a pace slower than we would like.”
Actually, he may have been too optimistic: There’s a good chance that unemployment will rise, not fall, over the next year. But even if it does inch down, one has to ask: Why isn’t the Fed trying to bring it down faster?
Some background: I don’t think many people grasp just how much job creation we need to climb out of the hole we’re in. You can’t just look at the eight million jobs that America has lost since the recession began, because the nation needs to keep adding jobs — more than 100,000 a month — to keep up with a growing population. And that means that we need really big job gains, month after month, if we want to see America return to anything that feels like full employment.
How big? My back of the envelope calculation says that we need to add around 18 million jobs over the next five years, or 300,000 jobs a month. This puts last week’s employment report, which showed job losses of “only” 11,000 in November, in perspective. It was basically a terrible report, which was reported as good news only because we’ve been down so long that it looks like up to the financial press.
So if we’re going to have any real good news, someone has to take responsibility for creating a lot of additional jobs. And at this point, that someone almost has to be the Federal Reserve.
Bernanke’s Unfinished Mission, Paul Krugman
Reading Thatcher’s legacy
[I]n the aftermath of the biggest financial crisis since the 1930s, one that centred upon the US and UK, where the world’s two leading financial centres are located, what is left of the Thatcher revolution?
(…)
The world has… changed. The state has been forced to rescue the financial sector from implosion. Macroeconomic stability has vanished: in the third quarter of 2009, UK gross domestic product was 10 per cent below where it would have been if the trend from 1991 (annual growth of 3 per cent) had continued after the beginning of 2008. A huge fiscal deficit has also emerged: current spending for this financial year was forecast in the March 2009 Budget to be 3 per cent higher than had been forecast a year earlier, but the forecast of nominal GDP was 9 per cent lower and of current revenue 18 per cent lower. This last debacle largely explains the deficits experienced and forecast.
Gone, it seems, is the rapid growth and high profitability of the financial sector. Gone, too, must be the assumption that governments should merely get out of the way of markets. So how much is left of the belief that these reforms durably strengthened the UK economy?
First, even with the recession, UK GDP has grown far more than that of the big continental European countries or Japan…
Second, a part of this performance will surely prove a mirage. But…the UK will retain a good part of the advantage it won during the expansion. The era of reforms was definitely not a waste.
Third, stabilisation clearly did not go far enough. In particular, before the crisis, fiscal indebtedness – net debt to GDP at about 40 per cent – and running deficits were too high to give the country the room for manoeuvre it needed…
Finally, if such a painful outcome is to be avoided, the alternatives must be a disastrous inflationary default or a resurgence of growth. The faster the growth, the more manageable the fiscal crisis will be….
The Thatcher and post-Thatcher eras were not wasted. But the UK became complacent in the fat years about where markets were taking the economy and so about the true fiscal position. Overheated financial markets are a dangerous economic guide, as Keynes once argued; and fiscal positions should also be judged with great caution. What is needed now from the politicians is a focus on growth. That is the only palatable way to manage the shock.
The post post-Thatcher era begins, Martin Wolf
elite, n. the most powerful, rich, gifted, or educated members of a group [from Latin ēligere, to elect]
“The natural state is a mixture of mutually interdependent economic and political interests that reinforce each other. The economic interests are the elites that produce economic activity. But they tend to support political groups that in turn will protect them from too much competition. The interplay is the elites in the political world protecting the economic elites from too much competition and giving them monopolies, while on the other hand the economic elites provide the funds that support the political elites.”
Douglass North, From Poverty to Prosperity
