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➡︎ 所得・生産(Ｙ)
均衡所得を増加させる
（マンキューマクロ上邦訳旧第二版270-3頁より）
#24? Modern monetary theory in an open economy – Bill Mitchell – Modern Monetary Theory
2009/10/13
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The capacity of the state and the open economy – Part 1 – Bill Mitchell – Modern Monetary Theory 2016/2/8
Modern monetary theory in an open economy – Bill Mitchell – Modern Monetary Theory
2009/10/13
http://bilbo.economicoutlook.net/blog/?p=5402Modern monetary theory in an open economy
A number of readers write to me asking me about the applicability of modern monetary theory (MMT) to less developed economies and open economies generally. The issues are not entirely the same for both cases but there is a strong commonality. The aim of this blog is to advance the understanding of how MMT deals with open economy issues. They remain mysterious to most people and grossly misrepresented by those who claim to understand.
I have recently completed an assignment for the Asian Development Bank about Pakistan. Consider this statement about Pakistan, which appeared in The Economist, October 23, 2008 edition under the title The Last Resort:
… Pakistan faces economic meltdown … The economy is close to freefall. Inflation is running at about 30%. The rupee has devalued by about 25% in just three months. The fiscal deficit is a whopping 10% of GDP. Foreign-exchange reserves cover just six weeks of imports. A $500m Eurobond matures next February, but the market has already decided it is junk. The country needs at least $3 billion in short order, and a further $10 billion over the next two years to plug a balance-of-payments gap. Without it, default abroad might well coincide with political anarchy at home.
A week or so later The Economist (October 29, 2008) under the title Pakistan’s wounded sovereignty continued to emphasise that:
Without foreign help, Pakistan won’t be able to afford its imports, repay its debts, or quell the insurgents encamped within its borders. Thanks to protracted power cuts, it cannot even keep the lights on in its towns and villages. It is not, in other words, a state in full command of itself … Pakistan is running out of hard currency … The deterioration in Pakistan’s economy has escalated quickly in recent months and the Pakistan Government has now formally requested $US15 billion in financial assistance from the International Monetary Fund … The Government clearly needs time to deal with the burgeoning balance of payments deficits and the unsustainable loss of foreign exchange reserves. The aims of the Government in seeking IMF funds is to, as it sees it, stabilise the macroeconomic imbalances, generate a buffer of foreign exchange reserves and stimulate investment expectations.
So you get the picture – living beyond their means -> currency attack -> depletion of foreign reserves … etc.
The overriding view among economists is that in these situations there is a gross imbalance between aggregate supply and aggregate demand which have generates inflation and rising imports. These problems, in turn, lead to a rapid depletion of foreign exchange reserves and sharp markdowns in the currency.
MMT will never lead us to conclude that a nation is “living beyond its means” and, should therefore, scale back government spending and private consumption, when there is substantial unused capacity and underutilised resources (particularly labour). In those circumstances, the nation could not possibly be living beyond its means. As a consequence the mainstream policy recommendations are always likely to worsen the situation rather than improve it.
Further, MMT does not advocate net public spending per se. There are some growth strategies which will be unsustainable. Overall, a model of long-run growth and sustainable development requires a careful balancing of internal and external forces.
Clearly, when an economy that experiences a depletion of foreign exchange reserves has to take some hard decisions in relation to its external sector, especially if it is reliant on imported fuel and food products. In these situations, a burgeoning CAD will threaten the dwindling international currency reserves.
In some cases, given the particular composition of exports and imports, currency depreciation is unlikely to resolve the CAD without additional measures.
The depreciation, in turn, raises the relative costs of imports, and imparts an inflationary bias to the economy. Moreover, depreciation leads to expectations of further depreciation and fuels the run out of the currency. There may be no interest rate that is high enough to counter expectations of losses due to depreciation and possible default.
In the short run there is probably no alternative but to urgently restore reserves of foreign currency either through renegotiation of foreign debt obligations, international donor assistance or default.
The orthodox interpretation of a burgeoning CAD indicates that the nation “living beyond its means” – with excessive domestic demand that boosts imports; the excessive demand also fuels inflation that restricts exports. The presumption is that this CAD must be “financed” by flows of foreign reserves, which for the most part must be attracted by high returns and a stable political, economic, and social environment.
So the worsening trade account indicates that local consumption becomes dependent on the whims of foreign lenders. Further, if the nation has a large budget deficit, then its government is said to be increasingly dependent on the foreign purchases of its debt to supplement domestic savers’ purchases of government debt.
If the nation cannot attract these needed reserves, it must slow its growth to reduce imports; lower prices and wages could also encourage exports. The obvious portent of the default on foreign debt obligations then is used to argue in favour of restricting government spending. Thus, both monetary and fiscal policy ought to be tightened to encourage such capital flows even as this reduces the need for them.
Further, the orthodox interpretation of fiscal deficits is that they drive interest rates up (through competition for limited loanable funds) while generating inflation (excess demand). High interest rates, in turn, are argued to squeeze out productive investment, making the nation less competitive internationally. This hinders improvement in the trade balance, and competitiveness is further hurt by inflation.
Thus there is a fairly direct link claimed to follow from budget deficits to trade deficits – the so-called “twin deficits” hypothesis. This is why the mainstream believe it is imperative to reduce budget deficits. According to the logic, that would allow interest rates to fall, inflation to be reduced, lowering pressure on the external balance and exchange rates.
The supposed link between net spending and interest rates is predicated on the notion that sovereign governments have to “finance” any deficit spending, in the same way that a household has to fund spending above income (ignoring asset depletion options).
Such a link is purely voluntary and that it is not required for a sovereign government that wishes to maintain a sustainable fiscal strategy based on deficits.
The “twin deficits” hypothesis is further based on crucial assumptions about the private domestic balance (relationship between saving and investment) which have rarely held in practice.
Finally, the “crowding-out” and “twin deficits” arguments are critically based on a supposed relation between government “borrowing” and interest rates where deficits push interest rates higher. As I argue below, MMT shows you that this belief is wholly without foundation and reflects a fundamental misconstruction of the way interest rates are determined.
Inflation biases
Many nations face high inflation and persistent and significant unemployment of its domestic resources. In these instances, what is required is a development strategy that mobilises the domestic resources to improve incomes and reduce supply bottlenecks. Given substantial levels of redundant resources, it should have been obvious that the inflationary bias could not be a simple matter of excessive demand.
Thus, in appraising the inflationary impact it is incorrect to presume that fiscal policy has been excessively expansionary. Budget deficits can result from insufficient aggregate demand – with the budget deficit endogenously expanding via revenue losses and spending increases when gaps in spending appear.
Using budget deficits as evidence of expansionary policy is therefore erroneous, unless the deficits have pushed the economy beyond full capacity use of its resources. For this reason, fiscal restraint may not be the medicine that is required in a situation in which a country is actually living below its means – as indicated by idle or underutilised resources.
But won’t growth via deficit spending worsen this situation? Robust growth will tend to generate a CAD if there is a relatively low income elasticity of demand for the country’s exports.
From the mainstream perspective the consequences of encountering balance-of-payments problems before short-term capacity utilisation is reached are straightforward. Demand has to be curtailed, unemployment increased, and capital accumulation has to be reduced. This leads, in the long run, to a relative deterioration of the country’s export potential compared with that of its main competitors. This situation tends to lead to a vicious circle with further balance-of-payments problems.
MMT recognises this problem, but doesn’t recommend the mainstream solution.
For a sovereign nation – that is a “modern money regime” – that includes flexible exchange rates, the government has more domestic policy space than the maintream consider.
The government can make use of this space to pursue economic growth and rising living standards even if this means expansion of the CAD and depreciation of the currency.
While there is no such thing as a balance of payments growth constraint in a flexible exchange economy in the same way as exists in a fixed exchange rate world, the external balance still has implications for foreign reserve holdings via the level of external debt held by the public and private sector.
But it is also advisable that a nation facing continual CADs foster conditions that will reduce its dependence on imports. However, the mainstream solution to a CAD will actually make this more difficult.
Indeed, IMF lending and the accompanying conditions that are typically imposed on the debtor nation almost always reduce the capacity of the government to engineer a solution to the problems of inflation and falling foreign currency reserves without increasing the unemployed buffer stock. A policy strategy based largely on fiscal austerity will create unacceptable levels of socio-economic hardship.
Targets to reduce budget deficits may help lower inflation, but only because the “fiscal drag” acts as a deflationary mechanism that forces the economy to operate under conditions of excess capacity and unemployment.
This type of deflationary strategy does not build productive capacity and the related supporting infrastructure and offers no “growth solution”. And fiscal restraint may not be successful in lowering budget deficits for the simple reason that tax revenue can fall as the taxable base shrinks because economic activity is curtailed.
Moreover, the lessons of how the international crises of the 1990s and early 2000s were dealt with should not be forgotten: fiscal discipline has not helped developing countries to deal with financial crises, unemployment, or poverty even if they have reduced inflation pressures.
There are also inherent conflicts between maintaining a strong currency and promoting exports – a conflict that can only be temporarily resolved by reducing domestic wages, often through fiscal and monetary austerity measures that keep unemployment high. The best way to stabilise the exchange rate is to build sustainable growth through high employment with stable prices and appropriate productivity improvements.
A low wage, export-led growth strategy sacrifices domestic policy independence to the exchange rate – a policy stance that at best favours a small segment of the population.
Then we encounter the “printing money” conception of MMT. Whenever the government runs a deficit (and according to the mainstream it should not on average do this over the cycle), it should turn to “private markets” for its borrowing. It will then need to offer sufficiently attractive interest rates on its debt; this will allow the government’s borrowing costs to rise to market rates.
Further, the argument that nations should adopt inflation targets and prioritise monetary policy in this regard is not supportable. Not only does the preponderance of empirical evidence suggest that moderate inflation does not hinder economic growth, but also recent experience in those countries that have adopted inflation targets or even less restrictive Taylor-type rules for policy formation casts doubt on such approaches.
It is somewhat ironic that the wealthy, developed countries are abandoning such policy while the less developed economies under the bullying of the IMF are being encouraged (forced as part of loan arrangements) to adopt it. Many observers now believe the world is heading into a highly deflationary environment.
Further, in my recent book with Joan Muysken (Full Employment Abandoned) we show that there is very little evidence for the claim that inflation targeting has succeeded where it was tried.
Even if it is believed that inflation targeting following some kind of a Taylor rule – increasing interest rates when prices are rising too fast – can fight some kinds of inflation, there is little reason to believe that monetary policy can successfully fight inflation pressures that arise outside a nation.
If inflation comes largely from commodities and other imports (or even from domestic output that competes in international markets hence that experiences the same price pressures), it is hard to see how higher domestic interest rates can reduce inflation pressures. In some cases, tighter monetary policy might appreciate the exchange rate, so that “pass through” inflation could be reduced. But this will not quell an international asset price bubble.
The final point that has been highlighted in the current crisis is that monetary policy is not nearly so powerful a stabilisation tool as it was once thought to be. The real economy is not excessively sensitive to interest rates movements.
During recessions, monetary policy has little proven effects in activating an economy. In bad times lower interest rates do not induce consumer expenditure. And likewise, lower interest rates do not induce more investment (by making borrowing cheaper) as during these periods there tends to be excess capacity and output is not sold.
Empirical evidence suggests that the interest elasticity of investment is at best low, non-linear, and asymmetric. While an increase in interest rates might moderately reduce investment during economic booms (when the economy is at or above capacity), the reverse is not true. In general, it is the outlook for profitability, rather than the price of credit, that influences investment.
For this reason, direct credit control is a more effective instrument of monetary policy than the interest rate. If monetary policy includes direct credit controls it may be reasonable to assume that there will be some effect on aggregate demand.
In addition, using high interest rates to target inflation generates other undesirable consequences. Interest is a cost of doing business, and tends to be included in price. For this reason, raising interest rates will reduce inflation only if the effects on interest-sensitive spending (lowering aggregate demand) are greater than the effects on costs and prices.
When inflation comes from the supply side, higher interest rates will probably add to supply-side induced inflation by raising costs. Also, interest rate increases will increase the debt service burden. There is one commonly cited condition for sustainability: the interest rate should not exceed the growth rate of income and GNP. If it does, debt will tend to grow faster than ability to service the debt at a constant burden (ratio of debt service to income).
While this constraint is often inappropriately applied to sovereign government (a sovereign government can always service its debt in its own currency), it should be applied to the private sector (and non-sovereign government such as states and provinces or local governments).
So we now know that monetary policy cannot successfully fight inflation that comes from the supply side. We also know that monetary policy as indicated by low interest rates cannot help to pull an economy out of recession. It is certain that fiscal policy will play a much larger role from this point forward, and that alternative methods of fighting inflation pressures will be developed.
Finally, some believe that increases in interest rates will have a significant impact in preventing the depreciation of a currency. This way, imported inflation will not worsen due to the currency depreciation. History is full of many examples of countries trying to use higher interest rates to protect the currency, only to find that the policy was impotent.
Raising interest rates by hundreds of basis points cannot compensate investors for losses due to large currency depreciations. Indeed, the higher rates can stoke a run out of the currency as currency speculators bet that the monetary policy will fail to stabilise the currency.
Monetisation and sterilisation
Before I tackle the external sector issues further a few conceptual matters need to be clarified.
I keep reading that MMT advocates the central bank monetising the deficit. This notion is inapplicable to a flexible exchange rate, fiat currency monetary system.
It stems from the fallacious idea that the national government faces a budget constraint in the same way that a household operates. This errant analogy is advanced by the popular government budget constraint framework (GBC) that now occupies a chapter in any standard macroeconomics textbook. The GBC is used by orthodox economists to analyse three alleged forms of public finance: (1) Raising taxes; (2) Selling interest-bearing government debt to the private sector (bonds); and (3) Issuing non-interest bearing high powered money (money creation).
Various scenarios are constructed to show that either deficits are inflationary if financed by high-powered money (debt monetisation), or squeeze private sector spending if financed by debt issue. While in reality the GBC is just an ex post accounting identity, orthodox economics claims it to be an ex ante financial constraint on government spending.
The GBC leads students to believe that unless the government wants to “print money” and cause inflation it has to raise taxes or sell bonds to get money in order to spend. A student who takes a typical macroeconomics course at any university will go away with the totally erroneous view that taxation and debt-issuance takes money from the private sector, which is then respent by the government. Nothing could be further from the truth.
What is missing is the recognition that a household, the user of the currency, must finance its spending beforehand, ex ante, whereas government, the issuer of the currency, necessarily must spend first (credit private bank accounts) before it can subsequently debit private accounts, should it so desire. The government is the source of the funds the private sector requires to pay its taxes and to net save (including the need to maintain transaction balances) as we have seen in the previous section. Clearly the government is always solvent in terms of its own currency of issue.
Standard macro textbooks struggle to explain this to students. Usually, there is some text on so-called money creation but no specific discussion of the accounting that underpins spending, taxation and debt-issuance. Blanchard’s 1997 macroeconomics book is representative and tells us that government (p.429):
… can also do something that neither you nor I can do. It can, in effect, finance the deficit by creating money. The reason for using the phrase “in effect”, is that – governments do not create money; the central bank does. But with the central bank’s cooperation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance the deficit. This process is called debt monetization.
To monetise means to convert to money. Gold used to be monetised when the government issued new gold certificates to purchase gold. Monetising does occur when the central bank buys foreign currency. Purchasing foreign currency converts, or monetises, the foreign currency to the currency of issue. The central bank then offers federal government securities for sale, to offer the new dollars just added to the banking system a place to earn interest. This process is referred to as sterilisation.
In a broad sense, a federal (fiat currency issuing) government’s debt is money, and deficit spending is the process of monetising whatever the government purchases. All government spending in a flexible exchange rate system, is operationalised by the government crediting bank accounts (directly or indirectly by issuing cheques). This process adds to bank reserves. Alternatively, taxation payments to government result in bank accounts being debited and reserves being reduced. So a budget deficit is a net reserve add or a net credit to commercial bank accounts.
If we understand the banking operations that accompany these transactions further, we will learn that those who receive the net payments from the government are in possession of bank liabilities which are matched by the banks’ reserve positions which are central bank liabilities. Some of the deposits are held in the form of cash but this is a nuance.
Note that irrespective of what else the government (via the treasury or the central bank) does in relations to the operational management of the cash system (bond sales) and/or aggregate demand management (taxation changes), government spending is the same process. So the alleged three sources of finance noted in the GBC literature are misnomers and mislead you into thinking that the process of government spending differs depending on how it is “financed”. The problem with this conception, of-course, it that government spending does not need to be financed in a fiat monetary system.
But this operational understanding of the way governments spend has no application for the subject of “monetisation” as it frequently enters discussions of monetary policy in economic text books and the broader public debate. Following Blanchard’s conception, debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury. In other words, the federal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be “printing money”.
Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation. However, fear of debt monetisation is unfounded, not only because the government doesn’t need money in order to spend but also because the central bank does not have the option to monetise any of the outstanding government debt or newly issued government debt.
Why is the central bank so constrained?
As long as the central bank has a mandate to maintain a target short-term interest rate, the size of its purchases and sales of government debt are not discretionary. The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation in typical times. The central bank is unable to monetise the government debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to any support rate that it might have in place for excess reserves.
But what about a zero interest rate situation? Good question. Then the central bank does not have to conduct any debt-issuance when there is a budget deficit. They just have to leave sufficient reserves in the system to bid the overnight rate down.
The more important point though is the GBC is just an accounting statement (identity) of all the transactions that have gone on between the government and the non-government sector.
As a result of the institutional arrangements (debt is issued to match net spending etc), we know that whenever government spending increases you will find an equal increase in the sum of taxation revenue + high powered money (bank reserves and cash) + public debt. You might like to read this blog to get some further insights on this – Will we really pay higher taxes?.
As an ex post accounting statement this sum carries no further weight. It certainly doesn’t substantiate the view that the increased taxation, money base, or debt provided any funds to the government which enabled it to spend.
There is a related concept that also introduces confusion and leads to erroneous statements. This is the term – central bank sterilisation. It stems from the gold standard, fixed exchange rate system and occurs when the central bank attempts to insulate (sterilise) the domestic economy from its foreign exchange market interventions designed to maintain the fixed (agreed) parity.
So the central bank in an economy with a trade deficit (that is, facing downward pressure on its exchange rate) will buy its own currency (reducing supply) and sell foreign currency (increasing demand). Of-course, the contraction in the money supply has domestic impacts (higher interest rates and less aggregate demand).
To overcome the domestic interest rate impacts, the central bank can simultaneously conduct open market operations and buy public debt back thus increasing the money supply to offset the contraction occcuring via the forex market.
That is how sterilisation occurs in the fixed exchange rate system. It assumes many things about the capacity of the central bank to control the money supply. But it is also totally inapplicable in a flexible exchange rate regime where the central bank does not have to compromise its exogenous capacity to set domestic interest rates.
This also helps us clear up a lot of nonsense about who funds whom. We continually read that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings. This claim is particularly potent in the current US-China context.
In MMT, this sort of claim would never make any sense. As I have indicated often a CAD can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the CAD. This desire leads the foreign country (whichever it is) to deprive their own citizens of the use of their own resources (goods and services) and net ship them to the country that has the CAD, which, in turn, enjoys a net benefit (imports greater than exports). A CAD means that real benefits (imports) exceed real costs (exports) for the nation in question.
This is why I always say that the CAD signifies the willingness of the citizens to “finance” the local currency saving desires of the foreign sector. MMT thus turns the mainstream logic (foreigners finance our CAD) on its head in recognition of the true nature of exports and imports.
Subsequently, a CAD will persist (expand and contract) as long as the foreign sector desires to accumulate local currency-denominated assets. When they lose that desire, the CAD gets squeezed down to zero. This might be painful to a nation that has grown accustomed to enjoying the excess of imports over exports. It might also happen relatively quickly. But at least we should understand why it is happening.
Sterilisation enters the scene here as well. It is often erroneously thought that financial inflows (corresponding to the CAD) via the capital account of the Balance of Payments boost commercial bank reserves. Mainstream economists who operate within the defunct money multiplier paradigm think this might be inflationary because it will stimulate bank credit creation.
The flawed logic is – increased bank reserves -> increased capacity to lend -> increased credit -> excess aggregate demand -> inflation.
You might like to read this blog – Money multiplier and other myths – to understand why that is totally at odds with the way the credit creation system operates.
The claim is that the central bank can “sterilise” this impact by selling government debt via open market operations. However, if there is excess capacity in the economy, the central bank might refrain from sterilising and allow aggregate demand to expand.
But think about what a CAD actually means. I always argue that it is essential to understand the relationship between the government and non-government sector first. A common retort is that this blurs the private domestic and foreign sectors. My comeback is that the transactions within the non-government sector are largely distributional, which doesn’t make them unimportant, but which means you don’t learn anything new about the process net financial asset creation.
In the case of CAD, what mostly happens is that local currency bank deposits held say by Australians are transferred into local currency bank deposits held by foreigners. If the Australian and the foreigner use the same bank, then the reserves will not even move banks – a tranfer occurs between the Australian’s account in say Sydney, to the foreigner’s account with the same bank in say Frankfurt.
If the transactions span different banks, the central bank just debits and credits, respectively, the reserve accounts of the two banks and the reserves move.
What happens next depends on the approach the commercial banks take to the reserve positions. Just as we saw in the discussion about “monetisation”, excess reserves put downwards pressure on overnight interest rates and may compromise the rate targetted by the central bank.
The only way the central bank can maintain control over its target rate and curtain the interbank competition over reserve positions is to offer an interest-bearing financial asset to the banking system (government debt instrument) and thus drain the excess reserves. So sterilisation in this case merely reflects the desire of the central bank to maintain a particular target interest rate and is not discretionary. The alternative is to offer a return on excess returns equivalent to the target rate.
Back to trade etc …
MMT shows that fiscal deficits result in net injections of banking system reserves that due to common (voluntarily imposed) arrangements are drained through sales of government debt either in the new issue market (by Treasury) or through open market sales (by the central bank).
If the (stupid) voluntary arrangements which force governments to match $-for-$ their net spending with bond sales were abandoned then the central bank would start accumulating treasury assets (maybe via formal bond sales but more sensibly via some numbers in an accounting ledger to keep record of the transactions). International financial markets would immediately (and erroneously) believe that this accumulation of represents “monetisation of the deficit”, and that this contributes to inflationary pressures, although the empirical evidence is scant.
If there is inflationary pressure, it would result from the government spending, not from the bond sales that drain excess reserves.
Problems are greatly compounded if the nation has issued foreign-currency denominated debt. If this debt is issued by private firms (or households), then they must earn foreign currency (or borrow it) to service debt. To meet these needs they can export, attract FDI, and/or engage in short-term borrowing. If none of these is sufficient, default becomes necessary.
There is always a risk of default by private entities, and this is a “market-based” resolution of the problem.
If however the government has issued (or taken over) foreign currency denominated debt, default becomes more difficult because there is no well delineated international method. Often, the government is forced to go to international lenders to obtain foreign reserves; the result can be a vicious cycle of indebtedness and borrowing.
Since international lenders request austerity, domestic policy becomes hostage. For this reason, it is almost always poor strategy for government to become indebted in foreign currency. By contrast, a sovereign government can never face insolvency in its own currency.
Budget deficits in a sovereign, floating, currency never entail solvency risk. Sovereign government can always “afford” whatever is for sale in terms of its own currency. It is never subject to “market discipline”. A sovereign government spends by crediting bank accounts, and it can never “run out” of such credits.
When it credits the bank account of any recipient of its spending (whether this is for purchases of goods and services or for social welfare spending), the central bank simultaneously credits the bank’s reserve account. If this leads to excess reserves, these are then exchanged for treasury debt. While the IMF and other mainstream financial analysts criticise sales of treasury debt to the central bank (or corresponding accounting entries), it actually makes no difference whether treasury sells the debt to private banks. In effect the sales directly to the central bank simply bypass the bank “middlemen”.
If you think there is a difference between treasury debt being sold the central bank or to the commercial banks then you do not understand reserve accounting which is at the heart of MMT.
The reality is that the end result will be the same: the distribution of treasury debt holdings between the central bank and the private sector will depend on portfolio preferences of the private sector. These preferences are reflected in upward or downward pressure on the overnight interest rate. To hit its target, the central bank must accommodate private sector preferences by either taking the debt into its portfolio, or by selling the debt to reduce bank reserves.
The only complication is that the treasury can issue debt of different maturities. Very short-term treasury debt is equivalent to bank reserves that earn interest. Long term treasury debt is not a perfect substitute because capital gains and losses can result from changes to interest rates.
Hence if there is a lot of uncertainty about the future course of interest rates, trying to sell long-term treasury debt to private markets can affect interest rates and the term structure. For example, selling long-term debt that is not desired by the private sector will lead to low prices and high interest rates for that debt. In this case, it is not really the case that budget deficits are affecting interest rates, but rather the decision to sell debt with a maturity that is not desired by markets. The solution would be to limit treasury debt to short-term maturity.
A country that operates on a gold standard, or a currency board, or a fixed exchange rate is constrained in its ability to use the monetary system in the public interest, because it must accumulate reserves of the asset(s) to which it has pegged its exchange rate.
This leads to significant constraints on both monetary and fiscal policy because they must be geared to ensure a trade surplus that will allow accumulation of the reserve asset. This is because such reserves are required to maintain a credible policy of pegging the exchange rate. On a fixed exchange rate if a country faces a current account deficit, it will need to depress domestic demand, wages and prices in an effort to reduce imports and increase exports. In a sense, the nation loses policy independence to pursue a domestic agenda.
Floating the exchange rate effectively frees policy to pursue other, domestic, goals like maintenance of full employment.
An important point to be made regarding treasury operations by a sovereign government is that the interest rate paid on treasury securities is not subject to normal “market forces”. The sovereign government only sells securities in order to drain excess reserves to hit its interest rate target. It could always choose to simply leave excess reserves in the banking system, in which case the overnight rate would fall toward zero.
When the overnight rate is zero, the Treasury can always offer to sell securities that pay a few basis points above zero and will find willing buyers because such securities offer a better return than the alternative (zero).
This drives home the point that a sovereign government with a floating currency can issue securities at any rate it desires—normally a few basis points above the overnight interest rate target it has set.
There may well be economic or political reasons for keeping the overnight rate above zero (which means the interest rate paid on securities will also be above zero). But it is simply false reasoning that leads to the belief that the size of a sovereign government deficit affects the interest rate paid on securities.
You might wonder why so many governments around the world fail to understand this – I don’t wonder that – it is simply because they are politically pressured by neo-liberal ideology into a state of ignorance.
When the central bank desires to target a non-zero interest rate, budget deficits will thus lead to growing debt and increased interest payments. However, the interest rate is a policy variable for any sovereign nation which can increase its deficits and its outstanding debt while simultaneously lowering its interest payments by lowering interest rates.
Let us contrast the discussion above with the situation of a non-sovereign nation that tries to peg its exchange rate. A non-sovereign government faces an entirely different situation. In the case of a “dollarised” nation, the government must obtain dollars before it can spend them. Hence, it uses taxes and issues IOUs to obtain dollars in anticipation of spending.
Unlike the case of a sovereign nation, this government must have “money in the bank” (dollars) before it can spend. Further, its IOUs are necessarily denominated in dollars, which it must incur to service its debt. In contrast to the sovereign nation, the non-sovereign government promises to deliver third party IOUs (that is, dollars) to service its own debt (while the US and other sovereign nations promise only to deliver their own IOUs).
Furthermore, the interest rate on the non-sovereign, dollarized government’s liabilities is not independently set. Since it is borrowing in a foreign currency, the rate it pays is determined by two factors. First there is the base rate on the foreign currency. Second, is the market’s assessment of the non-sovereign government’s credit worthiness. A large number of factors may go into determining this assessment. The important point, however, is that the non-sovereign government, as user (not issuer) of a currency cannot exogenously set the interest rate. Rather, market forces determine the interest rate at which it borrows.
For a real world example of the benefits of adopting a floating, sovereign, currency we can look to Argentina.
The crisis was engendered by faulty (neo-liberal policy) in the 1990s. Between 1991 and 2002, Argentina essentially adopted a currency board by pegging the Argentine peso to the US dollar for reasons that beg belief. This faulty policy decision ultimately led to a social and economic crisis that could not be resolved while it maintained the currency board.
However, as soon as Argentina abandoned the currency board, it met the first conditions for gaining policy independence: its exchange rate was no longer tied to the dollar’s performance; its fiscal policy was no longer held hostage to the quantity of dollars the government could accumulate; and its domestic interest rate came under control of its central bank.
At the time of the 2001 crisis, the government realised it had to adopt a domestically-oriented growth strategy. One of the first policy initiatives taken by newly elected President Kirchner was a massive job creation program that guaranteed employment for poor heads of households. Within four months, the Plan Jefes y Jefas de Hogar (Head of Households Plan) had created jobs for 2 million participants which was around 13 per cent of the labour force. This not only helped to quell social unrest by providing income to Argentina’s poorest families, but it also put the economy on the road to recovery.
Conservative estimates of the multiplier effect of the increased spending by Jefes workers are that it added a boost of more than 2.5 per cent of GDP. In addition, the program provided needed services and new public infrastructure that encouraged additional private sector spending. Without the flexibility provided by a sovereign, floating, currency, the government would not have been able to promise such a job guarantee.
Argentina demonstrated something that the World’s financial masters didn’t want anyone to know about. That a country with huge foreign debt obligations can default successfully and enjoy renewed fortune based on domestic employment growth strategies and more inclusive welfare policies without an IMF austerity program being needed. And then as growth resumes, renewed FDI floods in.
One commentator wrote a few years ago that that the Argentinian Government appears to have perpetuated the perfect crime. The Government offered the world financial markets a ‘take-it-or-leave-it’ settlment which was favourable to the local economy. At the time, the rhetoric claimed that countries that treat foreign creditors so badly would surely stagnate and suffer a FDI boycott.
This is the standard neo-liberal line that is used to coerce debtor nations into compliance with the needs of ‘first-world’ capital largely defined through the aegis of the IMF. But the Argentinean case shows this paradigm to be toothless because the Government defied the major players including the IMF and the Argentine economy went on to boom despite it.
It is clear that many foreign firms are expanding in Argentina in addition to strong investment from Argentine interests. The country’s biggest real estate developer explained (in 2005) the quandary facing the neo-liberals as such: “there has never been a better time to invest in Argentina … [as for foreign banks, after shunning Argentina for a while] … now the banks are coming to us … It’s been tough. We will have restrictions … But in terms of access to capital, what defines access? Greed. When opportunities look profitable, access to capital will be easy.”
This is a lesson all countries should learn. International capitalism, ultimately does not really take ‘political’ decisions – it just pursues return.
The clear lesson is that sovereign governments are not necessarily at the hostage of global financial markets. They can steer a strong recovery path based on domestically-orientated policies – such as the introduction of a Job Guarantee – which directly benefit the population by insulating the most disadvantaged workers from the devastation that recession brings.
Argentina’s defiance has lessons for Australia. Many critics of the Job Guarantee argue that the international financial markets would wreak havoc on the Australian economy if it was introduced here. This is clearly just a neo-liberal myth. My view is that the international investment community would soon realise that rather than being a threat to their activities, the introduction of a Job Guarantee would provide them with an even better investment climate in which to chase return. It is time that we abandoned the neo-liberal myths and instead realise that in capitalism ‘greed comes before prejudice’.
Should CADs be prevented?
The other implication of the mainstream view is that policy should be focused on eliminating CADs. This would be an unwise strategy.
First, it must be remembered that for an economy as a whole, imports represent a real benefit while exports are a real cost. Net imports means that a nation gets to enjoy a higher living standard by consuming more goods and services than it produces for foreign consumption.
Further, even if a growing trade deficit is accompanied by currency depreciation, the real terms of trade are moving in favour of the trade deficit nation (its net imports are growing so that it is exporting relatively fewer goods relative to its imports).
Second, CADs reflect underlying economic trends, which may be desirable (and therefore not necessarily bad) for a country at a particular point in time. For example, in a nation building phase, countries with insufficient capital equipment must typically run large trade deficits to ensure they gain access to best-practice technology which underpins the development of productive capacity.
A current account deficit reflects the fact that a country is building up liabilities to the rest of the world that are reflected in flows in the financial account. While it is commonly believed that these must eventually be paid back, this is obviously false.
As the global economy grows, there is no reason to believe that the rest of the world’s desire to diversify portfolios will not mean continued accumulation of claims on any particular country. As long as a nation continues to develop and offers a sufficiently stable economic and political environment so that the rest of the world expects it to continue to service its debts, its assets will remain in demand.
However, if a country’s spending pattern yields no long-term productive gains, then its ability to service debt might come into question.
Therefore, the key is whether the private sector and external account deficits are associated with productive investments that increase ability to service the associated debt. Roughly speaking, this means that growth of GNP and national income exceeds the interest rate (and other debt service costs) that the country has to pay on its foreign-held liabilities. Here we need to distinguish between private sector debts and government debts.
The national government can always service its debts so long as these are denominated in domestic currency. In the case of national government debt it makes no significant difference for solvency whether the debt is held domestically or by foreign holders because it is serviced in the same manner in either case – by crediting bank accounts.
In the case of private sector debt, this must be serviced out of income, asset sales, or by further borrowing. This is why long-term servicing is enhanced by productive investments and by keeping the interest rate below the overall growth rate. These are rough but useful guides.
Note, however, that private sector debts are always subject to default risk – and should they be used to fund unwise investments, or if the interest rate is too high, private bankruptcies are the “market solution”.
Only if the domestic government intervenes to take on the private sector debts does this then become a government problem. Again, however, so long as the debts are in domestic currency (and even if they are not, government can impose this condition before it takes over private debts), government can always service all domestic currency debt.
Conclusion
A national government should always aim to to design a budget with a view to the economic effects desired, rather than with a deficit target in mind. In other words, tax and spending reform should be formulated to accomplish economic, social, and political objectives rather than to hit a deficit target.
Further, governments will not be able to achieve their budget deficit target even if it were to cut drastically spending on social services (education, health, etc.) and development expenditures. This is because such draconian cuts would be likely to throw the economy into a deep recession that would reduce tax revenues.
If a country has a chronic and crippling shortage of foreign reserves, then the government should negotiate with the multilateral agencies to develop a program that would allow the country to service its external debt, and gradually reduce its trade deficit until it reaches a more manageable level.
Unilateral default on external obligations following Argentina’s experience is always an option. While it is frequently argued that default on debt is dangerous because future access to credit will be denied, that does not appear to be the case, historically. Indeed, entering formal bankruptcy proceedings often eases access to credit markets for households and firms for the obvious reason that relief from debt burdens makes it easier to service new debt.
While budget deficits are likely to raise living standards which will increase the CAD it should always be noted that all open economies are susceptible to balance of payments fluctuations. These fluctuations were terminal during the gold standard for deficit countries because they meant the government had to permanently keep the domestic economy is a depressed state to keep the imports down. For a flexible exchange rate economy, the exchange rate does the adjustment.
Is there evidence that budget deficits create catastrophic exchange rate depreciations in flexible exchange rate countries? None at all. There is no clear relationship in the research literature that has been established. If you are worried that rising net spending will push up imports then this worry would apply to any spending that underpins growth including private investment spending. The latter in fact will probably be more “import intensive” because most LDCs import capital.
Indeed, well targetted government spending can create domestic activity which replaces imports. For example, Job Guarantee workers could start making things that the nation would normally import including processed food products.
Moreover, a fully employed economy with skill development structure embedded in the employment guarantee are likely to attract FDI in search of productive labour. So while the current account might move into deficit as the economy grows (which is good because it means the nation is giving less real resources away in return for real imports from abroad) the capital account would move into surplus. The overall net effect is not clear and a surplus is as likely as a deficit.
Even if ultimately the higher growth is consistent with a lower exchange rate this is not something that we should worry about. Lower currency parities stimulate local employment (via the terms of trade effect) and tend to damage the middle and higher classes more than the poorer groups because luxury imported goods (ski holidays, BMW cars) become more expensive.
These exchange rate movements will tend to be once off adjustments anyway to the higher growth path and need not be a source of on-going inflationary pressure.
Finally, where imported food dependence exists – then the role of the international agencies should be to buy the local currency to ensure the exchange rate does not price the poor out of food. This is a simple solution which is preferable to to forcing these nations to run austerity campaigns just to keep their exchange rate higher. The IMF would do well to reform its charter and adopt this role instead of the destructive role it currently plays around the world.
The capacity of the state and the open economy – Part 1 – Bill Mitchell – Modern Monetary Theory
2016/2/8
http://bilbo.economicoutlook.net/blog/?p=32920The capacity of the state and the open economy – Part 1
Wolfgang Merkel wrote in his recent Op Ed (February 5, 2016) – Economy, Culture And Discourse: Social Democracy In A Cosmopolitanism Trap? – that “we are dealing with a partially deliberate, partially careless surrender of the state’s capacity to regulate and intervene in an economy that structurally creates socio-economic inequality and erodes the fundamental democratic principle of political equality”. I highlight, the “partially deliberate, partially careless surrender” description of what has occurred over the last several decades as neo-liberalism has gained traction. Today’s blog continues my series that will form the content for my next book (due out later this year) about the impacts of globalisation on the capacities of the nation state. Our contention (I am writing this with Italian journalist and author Thomas Fazi) is that there has been no diminuition in the power of the state to impact on the domestic economy. The neo-liberal era has seen many commentators deny that proposition, yet, knowingly advocate use of these powers to further advantage capital at the expense of labour. The state is still central to the picture – it just helps capital more and workers less than it did during the full employment period in the Post World War II decades.
This blog continues the themes began in the blog – The Modigliani controversy – the break with Keynesian thinking
As background to this blog, the following articles were cited in Part 1:
1. Modigliani F. and Padoa-Schioppa, T. (1977) ‘La politica economica in una economia con salari indicizzati al 100% o più’, Moneta e Credito, 117, 3-53. Download
2. English version (1978) – The Management of an Open Economy with ‘100% Plus’ Wage Indexation, Essays in International Finance, Princeton University, 130, 221-259.
3. Cattabrini, F. (2012) ‘Franco Modigliani and the Italian Left-Wing: the Debate over Labor Cost (1975-1978)’, History of Economic Sword and Policy, 75-95]. He argued that the first cited paper began a vigourous debate in Italy at the time, which was influential in changing the way the Left thought about macroeconomic policy.
In Part 1, I considered some factors, which led to the essential insights in John Maynard Keynes’ General Theory being hijacked by the neo-classical school (of which the neo-liberals have come out of).
In part, this was due to Keynes himself accepting the essential neo-classical assumption that in the capitalist economy the real wage is set equal to the marginal product of labour (the so-called Postulate I).
This acceptance of Postulate I meant that Keynes accepted the idea of diminishing marginal productivity (that is, that as employment rose each additional worker would be less productive than the last), a fundamental neo-classical proposition.
In turn, this meant that he accepted the neo-classical proposition that “any means of increasing employment must lead at the same time to a diminution of the marginal product and hence of the rate of wages measured in terms of this product”.
In other words, he accepted that there was an inverse relationship between real wages and employment.
The causation that Keynes invoked to explain that association between employment and the real wage was different to the Classical theory. But in the General Theory, Keynes considered that the firms were always “on” their demand curve (Postulate I) and aggregate demand fluctuations shifted employment up and down that curve.
For Keynes, it was that aggregate spending determined employment, but with fixed money wages, as output rose, prices rose (he also assumed competitive prices) because unit costs rose as firms it diminishing marginal productivity. As a result, the real wage also fell (higher prices deflating fixed money wages), which established the inverse relationship between employment and the real wage.
But he understood that cutting the wage as a remedy to unemployment would not work because it would likely reduce spending and at any rate would reduce unit costs and prices would fall accordingly, probably leaving the real wage unchanged.
The point is that his underlying logic was blurred as other economists from the neo-classical tradition sought to reconstruct his theory of effective demand and make it compatible with the extant neo-classical doctrine, which Keynes had, in fact, thoroughly rejected (after a long struggle in his own work to do so).
Within a year of the General Theory being released, the English economist J.R. Hicks proposed the so-called IS-LM model of joint product and money market equilibrium, which became one of the centrepieces of the so-called Neo-classical Synthesis in the Post WWII period.
The model was not at all consistent with Keynes’ vision and eliminated, among other things, the importance of expectations and investment behaviour – a key idea in the theory of effective demand and the tendency of monetary economies operating under conditions of endemic uncertainty to generate mass (involuntary) unemployment.
In the early 1970s, the OPEC oil crises and the inflation that followed the rise in oil prices, provided the vehicle to extend this hijacking of Keynes’ work into more objectionable doctrine in the form of Monetarism.
After a long period of academic insurgency led by economists at the University of Chicago (led by Milton Friedman), their attack on interventionist fiscal policy embodied in what became known as Monetarism began to quickly permeate both the Academy and then the policy-making process.
In the same way that the ‘Keynesian’ rescue of capitalism after the Great Depression, had, in John Kenneth Galbraith’s words been motivated “not from businessmen, bankers or owners of shares but … from intellectuals” (the so-called “Mandarin Revolution”), the Monetarist rise to dominance came out of the Academy and was the product of a deep resentment among free-market economists with the practice of government intervention.
[Reference: Galbraith, J.K. (2001) The Essential Galbraith, New York, Houghton, Mifflin and Harcourt. (Chapter The Mandarin Revolution, quote is from page 224)].However, unlike the ‘Keynesian Revolution’, Monetarism was also bankrolled by the strong and growing involvement of so-called ‘think tanks’, which were well-funded by the corporate sector and deliberately designed to bias the public debate in favour of the Monetarist policy agenda, which had morphed into a full-scale assault on the economic intervention at both macro and micro levels by the state.
This ‘conspiracy’ to present so-called ideological polemic as independent argument and authority helped the neo-liberal approach gain traction, particularly within the political process.
The biases in the appointment promotion process, editorial policies of so-called learned journals, grant awarding committees tand the design of graduate programs in economics ensured the spread of Monetarist ideas were rapid within the Academy.
While the ‘Keynesians’ considered government intervention was required to ensure there was sufficient aggregate spending to sustain full employment, the Monetarists claimed that such efforts were, ultimately self-defeating and ended in accelerating inflation and no change in the unemployment rate, which they said would converge over time on what they called the ‘natural rate of unemployment’.
Another aspect in the rising Monetarist dominance was that it was argued that Keynes’ General Theory was written in a closed economy context (no financial flows or trade between nations) and, in the context, of the increasing globalisation of supply chains and cross-border financial flows in the 1960s, this meant the conceptual insights were unable to cope with the changing world.
Keynes had clearly demonstrated that there was no automaticity in the capitalist system to full employment if we abstract from international trade and finance.
But to say that he neglected any open economy considerations is untrue. He understood that when trade was introduced to the analysis the so-called spending multiplier would take a different value (leakages from imports, which were considered to rise when domestic income rose, would reduce the impact of a domestic government spending stimulus on real GDP).
He understood that there was little difference between an increase in foreign investment and domestic investment when considering the spending effects on employment.
He also understood that reductions in nominal wages might, under some circumstances, reduce a balance of trade deficit (via falling imports).
In the General Theory, Keynes explicity discussed the beggar-thy-neighbour of consequences of export-led growth strategies which combined domestic cost cutting with exchange rate devaluation. He argued that while this might reduce unemployment in one economy, it does so by increasing it elsewhere:
He saw “export-led growth policy” as being (382-83):
… a desperate expedient to maintain employment at homeby forcing sales on foreign markets and restricting purchases, which, if successful, will merely shift the problem of unemployment to the neighbour which is worsted in the struggle …
Accordingly, he advocated learned “to provide themselves with full employment by their domestic policy … there would no longer be a pressing motive why one country need force its wares on another or repulse the offerings of its neighbor” (p.382). So despite the existence of international trade and capital flows (albeit in volumes much lower than today), Keynes believed that the state could use its macroeconomic policy choices to maintain full employment in all nations.
But he also indicated (Keynes, 1980, p.25) that, at times, restrictions on capital flows might be necessary because:
[Reference: Keynes, J.M. (1980) The Collected Writings of John Maynard Keynes, Volume 25, Moggridge, D. (ed.), London, Macmillan].Loose funds may sweep round the world disorganizing all steady business. Nothing is more certain than that the movement of capital funds must be regulated …
But despite this recognition, it is fair to say that the ‘Keynes versus Classics’ debate was not about the consequences of trade liberalisation or capital flows. Rather, it was focused on domestic policy choices, in particular, the impact of money wages on employment and the role interest rates play on real GDP levels.
That emphasis morphed into a central concern about balance of payments issues and market power in the 1970s.
The rejection of ‘Keynesian’ orthodoxy though was not only coming from the right, however. Even before the OPEC oil crisis, there was an emerging literature in the late 1960s and early 1970s, which declared in not as many words that the ‘Keynesian’ era had ended.
John Kenneth Galbraith wrote an article in The New York Times Magazine (June 7, 1970) where he argued that the inflation that was emerging in the early 1970s could not be exclusively explained in terms of the US government expenditure associated with the prosecution of the Vietnam War.
This would have constructed the inflation as a demand-pull event, which was totally consistent with the perceived ‘Keynesian’ wisdom of the day. Instead, Galbraith argued that it was a build up of cost factors (so-called ‘cost-push’ inflation) that were associated with the distributional struggle between labour and capital that were at the root cause of the emerging problem.
He argued that the idea that the ‘market’ was operational in determining the allocation of resources and the prices that emerged was outdated and that ‘market competition’ had been usurped by the emerging of large, price fixing institutions in the economy – trade unions and large, multinational firms.
These non-competitive institutions were able to fix wages and prices to the detriment of the general population through capricious use of their respective monopoly powers.
He noted that with rising unemployment rates in the US in the late 1960s into the early 1970s, that trade unions were still pushing for and gaining increasing wage settlements that outstripped any measures of labour productivity growth. He also noted that manufacturing firms were able to push up end prices for goods and services despite significant idle capacity being evident at the time.
[Reference: Galbraith, J.K. (1970) ‘Wage-Price Controls—The Cure for Runaway Inflation’, The New York Times Magazine, June 7, 1970]The following year, Galbraith wrote a further Op Ed article in the The New York Times (July 20, 1970) where he said that “Keynes has become obsolete” as a result of the monopoly power exerted by big business and the powerful trade unions. The problem that Keynes had addressed related to demand-side (spending) deficiencies, which led to mass unemployment, whereas the contemporary issue for Galbraith was was on the supply-side – the struggle between labour and capital for greater shares on national income.
[Reference: Galbraith, J.K. (1971) ‘GALBRAITH URGES WAGE-PRICE CURB; Asks Permanent Controls on Big Unions and Concerns Galbraith Urges a Permanent Wage-Price Curb’, New York Times, July 20, 1971].Canadian Keynesian economist John Cornwall brought his earlier work together in the 1983 book – The Conditions for Economic Recovery where he sought to explain why the 1970s was marked by low real GDP growth, “high and rising unemployment” (p. 199) and continuing inflation.
He considered that Keynes’ General Theory “had been written in response to another major breakdown, revealed largely in terms of mass unemployment” (p.199).
Keynes had rightly identified that elevated and persistent unemployment was “part of the natural evolution of capitalism; a failure of industrialized capital to generate enough aggregate demand to provide full employment” (p.199).
However, Cornwall’s argument “was that for employment, affluent capitalism generates new problems … a propensity to overspend, not just for employment but even when the economy still has a good deal of slack” (p.199).
He argued that during the so-called ‘Golden Age’ following World War II (p.199-200):
… as the economy moves towards full employment, different groups intensify their efforts to increase their share of income (through price and wage increases) in order to increase their demands on output … this inflationary bias was revealed in a noticeable acceleration of inflation rates …
In turn, “governments responded with restrictive aggregate demand policies … [which] … led to an increase in unemployment rates … [and] … a reduction in rates of growth of productivity. The additional restrictive measures undertaken almost everywhere in response to balance of payments difficulties, brought on by OPEC, only accentuated these policy-induced problems” (p.200)
[Reference: Cornwall, J. (1983) The Conditions for Economic Recovery, Oxford, Martin Robertson].The idea was that this inflation bias introduced asymmetries in the way wages and prices responded to fluctuations in aggregate spending. So in bouyant times, wages and prices might accelerate upwards relatively quickly, as big business and unions battled it out for higher income shares, but when spending was weak, wages and prices would not fall quickly, if at all.
So there was a ratcheting up of wages and prices – with powerful and increasingly militant unions tending to the interests of their own members rather than considering the overall well-being of workers and big firms who were well aware that lengthy industrial action could lead to declining market share.
He argued that both realities prevented the wage price system adjusting to detrimental supply-side shocks. For example, at a time when a major deterioration in a nation’s terms of trade occurred (say, due to an oil price rise), there were no mechanisms in place to allow the economy to adjust to the decline in real income, that the external input price shock generated.
Real wage resistance and profit-margin push both prevented a non-inflationary resolution to a national real income loss from occurring.
Cornwall, however, rejected the idea that using “restrictive demand policies to curb inflation without a painful, prolonged period of high unemployment” could work (p.200). He argued that this approach also undermined the incentives for private investment, which, in turn, reduced labour productivity growth – and stagnation ensued.
Also, the lower rate of capital accumulation, lowered potential real output growth, which then undermined any attempts to reduce unemployment by increased fiscal spending. The recessed economy would hit the inflation barrier much more quickly as a result of the lower potential real output.
Importantly, Cornwall noted that these problems did not prove “that the Keynesian emphasis on aggregate demand is incorrect … the existence of asymmetrical responses of wages and prices in no way disproves the Keynesian view of the output and employment effects of changes in aggregate demand. Increases and decreases in aggregate demand have symmetrical (Keynesian) output and employment impacts” (p.200).
The correct conclusion, according to Cornwall was that “demand management is a most unsuitable instrument for reducing inflation” (p.201).
This insight the supported the call for wage and price guidelines that Keynesian economists such as J.K. Galbraith, Sydney Weintraub and John Cornwall had advocated to attend to the distributional struggle on the supply side without the need for costly mass unemployment, which was implied by the Monetarist approach.
After US President Nixon effectively abandoned the Bretton Woods fixed exchange rate system on August 9, 1971, he took the advice of economists such as J.K. Galbraith, and a week later (on August 15, 1971), he introduced price controls in the form of a 90-day freeze on wages and prices.
This was in expectation that as the US dollar floated freely, it would depreciate and impart import price rise impulses into the domestic economy, which was already enduring higher inflation rates than were deemed acceptable.
The initial 90-day freeze in August 1971, in fact, didn’t end until 1973. They provided the federal government with non-inflationary fiscal space to introduce expansionary policies aimed at increasing domestic growth and reducing unemployment
This is the context that the input of Modigliani and Padoa-Schioppa becomes relevant. The Monetarists were implacably opposed to the wage and price controls with Milton Friedman constantly attacking the government for interfering with the free market system.
Among the measures they opposed were automatic escalator clauses built into labour contracts to preserve real wages in the face of rising inflation.
In many countries, governments introduced indexation systems to protect wages as the oil shock-induced inflation increased and threated to erode real living standards for workers.
As an example, Italy, modified its wage indexation system by “establishing of a 100% indexation of wages to the rate of inflation” in 1975 (Cattabrini, p.2).
Modigliani and Padoa-Schioppa adopted the Monetarist ‘natural rate’ concept at the outset, despite there being major disputes about its validity (see Mitchell and Muysken, 2008).
They claimed that “ther exists, for each level of the … real wage, at most one level of output and employment that is consistent with price stability” (p.2). They called this level of output the “noninflationary rate of output” or NIRO (p.2).
Its importance in their theoretical structure was that (p.2):
If output is maintained above the NIRO by appropriate demand policies, then, even if output is maintained below fullemployment, a process of continuous inflation will be set into motion. The rate of inflation will tend toward a steady value that is higher the greater the excess of output over the NIRO. There is thus a tradeoff between the rate of inflation and output, and it is monotonically increasing.
Any increase in unit labour costs will worsen this trade-off (higher inflation at any given output level). So given that wage indexation (or any increase in the temporal adjustment of wages to inflation) would push up unit production costs, such a policy move would worsen the trade-off.
So fiscal policy, designed to maintain lower unemployment than is implied by the NIRO, is ultimately powerless to “affect the rate of output” (p.3) because it only feeds into accelerating inflation.
They argued that this problem is amplified when they consider the open economy. They said that new considerations include the observation that “prices may be directly influenced by foreign prices through foreign competitition in both international and domestic markets” (p.19).
Business firms thus might be unable to fully pass-on wage increases ahead of productivity growth because they are restricted by international competitive pressures.
Further, they introduced the ‘balance-of-payments constraint’, which says that the excess of imports over exports is limited “by the availability of foreign reserves” (p.20). Of course, this form of external constraint is binding if the nation determines that it will peg its exchange rate to another or a basket of currencies. Otherwise, trade imbalances not offset by capital flows will lead to an exchange rate shift rather than lost (or gained) foreign reserves.
Their main conclusion was that attempts to index wages to price movements would stifle profit rates because “international competition on foreign and domestic markets prevents firms from passing through to prices the entire increase in labor costs” (p.23), which also pushes out imports and worsens the balance of payments.
The external deficit can only persist if “the rest of the world is ready to finance …” it. But “the need to balance the foreign accounts implies the existence of a tradeoff between real wages and output just as in the closed economy” (p.23).
The government then has to stifle imports via restrictive demand policies or else devalue the currency. The latter drives up import prices, which then feed into the domestic price level, and sparks off further wage demands (and rises if indexation is in place).
However, when exchange rates float, the external balance is maintained at acceptable levels judged by foreign speculators, but the domestic inflation rate still behaves as it does when unit labour costs rise or fall in a closed economy.
[BILL NOTES: I WILL BE CONTINUING THIS IN PART 3]Interestingly, Modigliani and Padoa-Schioppa qualified their rejection of fiscal policy as an instrument to stimulate domestic demand.
They said (p.3, and p.14)
These generalizations must be qualified only in the sense that the noninflationary rate of employment may be affected by direct government employment policies …
Contrary to the monetarist tenet,there is one conventional fiscal measure, the expansion of public employment, that can increase total employment even though it cannot increase private output …
In this sense,the swelling of public employment can offer a solution to the unemployment-inflation dilemma … It should be clear, however, that this is a sick type of solution which replaces productive private jobs with presumably less productive public employment and which,in the long run, will tend to worsen the situation by reducing investment and incentives in the private sector.
Conclusion
This is a further part of a series I am writing as background to my next book on globalisation and the capacities of the nation-state. More instalments will come as the research process unfolds.
The series so far:
1. Friday lay day – The Stability Pact didn’t mean much anyway, did it?
2. European Left face a Dystopia of their own making
3. The Eurozone Groupthink and Denial continues …
4. Mitterrand’s turn to austerity was an ideological choice not an inevitability
5. The origins of the ‘leftist’ failure to oppose austerity
6. The European Project is dead
7. The Italian left should hang their heads in shame
8. On the trail of inflation and the fears of the same ….
9. Globalisation and currency arrangements
10. The co-option of government by transnational organisations
11. The Modigliani controversy – the break with Keynesian thinking
The blogs in these series should be considered working notes rather than self-contained topics. Ultimately, they will be edited into the final manuscript of my next book due later in 2016.
That is enough for today!
(c) Copyright 2016 William Mitchell. All Rights Reserved.
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