Functional Finance, MMT and Blanchard's Presidential Address

So Olivier Blanchard gave the AEA presidential address at the Atlanta meetings earlier this year. If you missed it you can watch it here. The paper is also here. In all fairness, there is nothing new there. He notes the famous rule by Evsey Domar about sustainability of public debt, meaning that if the rate of interest on debt is lower than the rate of growth, debt-to-GDP ratios tend to be stable and you are in no danger in pursuing active fiscal policies.

Note that functional finance is in many ways compatible with Old Neoclassical Synthesis Keynesianism, and it should not be a surprise that New Keynesians accept some of the same arguments. Certainly Domar was an Old Keynesian in that mold, and although he was more difficult to classify, Abba Lerner the founder of functional finance accepted many marginalist arguments.

Blanchard actually is quite conventional and argues that public debt has negative welfare effects and reduces growth (forget this, that the Industrial Revolution was done on a pile, a huge pile, of public debt). He is very clear that he's not in general in favor of more debt, but only under the current circumstances, in which the rate of growth would be above the risk free interest rate of government bonds (that he calls the safe rate) and the marginal efficiency of capital (which really means he thinks in terms of a natural rate, in Wicksellian fashion).

Yet, of course, pundits went crazy. A typical reaction is from Desmond Lachman, and ex-IMF economist (i.e. worked for Blanchard), and fellow at the American Enterprise Institute in the Wall-Street Journal. Two things, one he suggests that Blanchard is a defender of MMT, which is a stretch. MMT involves more than functional finance, like a notion of endogenous and chartal money, and a policy preoccupation with full employment, often embodied in an Employer of Last Resort (ELR) proposal (that's a non exhaustive list). The second issue is that his whole argument is that the rate of interest will go up soon (as a result, presumably of foreign bond holders; in his words: "It’s more likely that investors, particularly from overseas, will demand higher government bond yields to compensate for the elevated inflation or default risk they see from an ever-increasing public debt ratio"). In other words, the foreign crowding-out of the old Mundell-Fleming model.

Of course, the are many problems with this arguments. The Fed has considerably more room than other central banks, and US bonds play a special role in the global economy. The dollar has been relatively appreciated, even with very low rates of interest, and the notion that something has to be done, even with some depreciation, is bogus. Depreciation is neither inflationary, nor contractionary in the US, in contrast to developing countries. The chances of higher inflation, are also subdued, even with the current long, but slow, recovery with low official unemployment. But it says something that there is all this crazy reaction about a very modest defense of fiscal expansion (note also that after Bernie, and AOC, MMT has become synonymous with fiscal expansionism, in ways that Keynesianism was before; naked Keynesianism, you might argue).

PS: If you are interested on the effects of monetization of public debt read this old post that replied to Krugman (who has warmed up to some functional finance/MMT ideas).

Some thoughts on currency crises and overshooting

So I've been teaching an international finance class, after a long while I might add. The discussion of currency crises models I think is interesting, since it is very revealing of the mainstream assumptions about the long run. Typical discussion would imply that in the long run the Quantity Theory of Money (QTM) and Purchasing Power Parity (PPP) hold. PPP means simply that the exchange rate adjusts for differences between the domestic and foreign price levels. Hence, we have that S =P/P*, where the star indicates foreign variable. If in addition we believe with the QTM that the central bank (CB) controls prices by controlling the money supply, then the CB can control the exchange rate indirectly.

In the figure below the 45o line shows the equilibrium levels of the exchange rate (S) as the price level, which is related to the money supply. Now suppose that the central bank fixes the exchange rate at S1 (the graph is based on Dornbusch representation in his classic paper; for now disregard the QQ curve). If the money supply is below the level that corresponds to P1, then the fixed exchange rate is too depreciated for the current stock of money, stimulating exports, discouraging imports, and leading to Current Account (CA) surpluses. In this case, the central bank would accumulate international reserves. The accumulation of reserves leads to increasing money supply and the economy moves to a new equilibrium.

If the central bank follows the rules of the game and it is credible (and the assumptions are also valid, meaning the economy has a tendency to full employment and increase in money supply only affect prices) then the money supply increases/decreases with the CA surpluses/deficits and the system converges to a stable equilibrium. However, if the commitment to the fixed-peg is not credible, and the rules of the game are not followed, then problems might arise. Imagine a situation in which the monetary authority continues to print money, to finance fiscal deficits for example, and the fixed exchange rate would now be below its equilibrium value (below the 45o line). Beyond the equilibrium point the central bank would start losing reserves. At some point, say when the money supply reaches the money supply level compatible with P2, the stock of reserves would be depleted. At this point, the central bank cannot defend the exchange rate anymore and the exchange rate jumps to S2. The Krugman model basically assumed exactly this, with the difference that if agents have rational expectations (perfect foresight in this case), then they would have an advantage to try to speculate against the currency before reserves are exhausted.*

In the model above the currency crisis occurs because the CB does not follow a monetary policy consistent with the fundamentals, that is, prints too much money to finance the government. Although, not immediatly obvious the model above is a simplified version of the Mundell-Fleming (MF) model, in the long run, when prices rather than income is the adjusting variable.In this case, the MF model can be represented with the exchange rate and prices, rather than output, as the adjusting variables. The QQ curve is a downward sloping curve, since higher prices increase money demand (or reduce the real money supply), leading to a higher rate of interest and a more appreciated exchange rate (lower S). Note the QQ curve is just the old LM for an open economy.

Also, because the QTM and PPP hold it must be true that increases in money supply lead to higher prices which lead to a proportional change in the nominal exchange rate, for a given foreign price and foreign money supply. In other words, the 45o degree line which corresponds to the proportional changes in domestic prices and the nominal exchange rate must still hold. We can derive the IS curve too, which would be upward sloping, but it is unnecessary, since if PPP holds then the economy must be in the long run on the 45o degree line.**

Dornbusch's trick, which was considered the first New Keynesian model (featuring both rational expectations and price rigidities), is that the nominal exchange rates adjusts faster than prices, then an increase in money supply would shift the QQ (LM) curve upwards. An increase in money supply reduces the domestic interest rate, leading to a depreciation of the currency. The economy moves from point A to point B. Then as depreciation increases net exports, and a lower rate of interest leads to more investment, there will be excess demand in the goods market, and for an economy that is at full employment, prices would go up. As prices go up, then the economy moves down the new QQ’ curve from point B to C, since with higher prices money demand increases and the rate of interest must increase (less than the initial decrease) causing some appreciation (less than the initial depreciation). At the new equilibrium the exchange rate is more depreciated than at the original equilibrium, but because of the short run rigidity of prices, the exchange rate overshoots its equilibrium value in the short-run. The point was that even if markets were efficient, in the sense that with price flexibility they tend to full employment and to the equilibrium exchange rate (PPP), the use of the exchange rate to deal with shocks might lead to excessive volatility.

There are many problems with the long run MF model (meaning the one solved in the S-P space). The obvious one is the notion that price flexibility leads to full employment, something that Keynes long ago suggested was NOT the case. Although Keynes was aware of the possibility of the system returning to full employment with price flexibility, he suggested that if lower prices had a negative impact on firms that are indebted, then investment would fall. In his own words: "indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency, — with severely adverse effects on investment." In other words, with price flexibility the IS shifts back, and there is no tendency to full employment. That means that one should stick with the solution of the model in S-Y space, if one wants to introduce the open economy (one such model, without full employment and many other mainstream characteristics is available here).

Alternative (classical-Keynesian, post-Keynesian or whatever you prefer to call them) models would not only emphasize the role of quantity adjustments, but also the the sustainability of the current account (CA), rather than fiscal deficits in the explanation of currency crises. While conventional currency crises models of all generations (including the more heterogeneous 3rd generation models) suggest that at the heart of currency crisis there is a fiscal crisis, post-Keynesians emphasize terms of trade shocks and hikes to foreign rates of interest, highlighting the role of the balance of payments constraint in currency crises. Note that the economy in this view is not at full employment, and, hence the effect of fiscal expansions is not on prices, but on the level of activity. Higher level of income leads to increasing imports and a deteriorating CA. It’s the deteriorating CA and not the fiscal deficits that matter and the CA position might worsen even if the fiscal accounts are balanced. Further, after a currency crisis the central bank hikes the rate of interest, increasing the costs of debt-servicing, and, hence, government spending, at the same time that the recession reduces the revenue, leading to a weakening of the fiscal accounts. In this case, it is the external currency crisis that causes the domestic fiscal crisis. Causality is reversed. My two cents.

* Later models, like Obstfeld's, shown that if the costs of defending the parity are high, for example because in order to preclude the loss of reserves associated with a currency attack, the central bank hikes the rate of interest and pushes the economy into a recession, then there is a chance that self-fulfilling speculation might lead to a crisis.

** The IS curve would be positively sloped and steeper than a 45o line, since depreciation creates excess demand in the goods market. To restore equilibrium, domestic prices would have to increase, though proportionately less, since an increase in domestic prices affects aggregate demand, both via the relative price effect and via higher interest rates.

PS: I had posted before on my course here, were there is a link to Serrano and Summa's critique of the MF model.

Mundell-Fleming, Independent Central Banks, Inflation and Openness

Bucknell's Academic West (Bertrand Library in the background)

Teaching international finance this semester, after a long while. At Utah I taught mostly intermediate macro and Latin American Development for undergrads (and macro and history of thought for graduate students), and the eventual elective. But here the course was up for grabs, so to speak. Decided to use Peter Montiel's International Macroeconomics, since his books always provide competent presentations of the mainstream views, plus having worked at the IMF and World Bank, he always tries to cover real problems with plenty of developing country examples.

The limitation of the book is, as it should be expected, that the mainstream analytical view is, as Montiel's (p. x) says: "a generalized and modernized [sic] version of the original Mundell-Fleming model." The book does present in the last chapter the 'modern' intertemporal approach to the current account. In a later post I'll discuss the limitations of the Mundell-Fleming model, but for those interested check this paper by Serrano and Summa. In other words, Montiel's book can present the mainstream views, but lacks any critical perspective, which is not uncommon, but certainly problematic given the poor state of the mainstream understanding of how the economy works.

It is illustrative of the lack of alternatives in the book, the presentation of the relation between openness and inflation. Montiel's follows the evidence on an inverse relation between openness (that can be measured in many ways: import share, imports plus exports over GDP, etc.) and inflation presented in David Romer's well-known paper (see here). Montiel argues that in closed economies governments might tend to run fiscal deficits, that if monetized, would lead to inflation. In a more open economy, the higher deficits and inflation would lead to higher rates of interest, since international creditors faced with a risky government would demand a higher premium. In this context, "the higher interest rates that the government has to pay would tend to discourage excessively expansionary fiscal policies, thus reducing pressures on central banks to expand the money supply." If the central bank is more autonomous or independent from the Treasury then you should expect also less inflation (that would be Bernanke's explanation for the Great Moderation; here).

Many problems, as you can see. Yes, for Montiel inflation is caused by excess demand (fiscal deficits) and by increasing money supply, which seems to be what the central bank controls (let alone that all central banks control really the rate of interest). Worse, in a sense, is the notion that fiscal deficits in domestic currency (presumably, since nothing is said), may cause foreign investors to punish the government. Note that what should have investors concerned would be the current account surplus (which provides foreign reserves) and the amount of foreign reserves held by the central bank. The evidence on interest rates and fiscal deficits, by the way, is less than forthcoming for Montiel's story (see here).

A simple alternative suggests that inflation more often than not is caused by cost pressures, rather than excess demand, and that two of the main sources of cost pressures are the prices of imported goods and wage pressures. In a more open economy, in which firms are faced with competition from foreign firms, and workers might be afraid of losing their jobs, then wage resistance might be subdued. Note that over the last few decades unionization rates have declined and that also constrains the ability of workers to demand higher wages (see here). In this case, lower inflation in the globalized economy has been predicated on a weaker labor force that faces more international competition, and is more willing to accept stagnant wages. Inequality and stagnant wages, rather then well-behaved governments and independent central banks are behind the Great Moderation in this story.

Two ex-graduate students of mine, Perry and Cline (yes, someone was paying attention after all), teamed up and provided some empirical evidence in favor of the alternative story (go here). If you want to see alternative views on inflation, implicit in this discussion, go to the linked posts and papers here.

The IMF and stylized fiction

The IMF has posted their Top 20 list of most popular entries since the launch of the blog. At #3 they have the Ten Commandments of Fiscal Adjustement in Advanced Economies, which is from 2010, but still worth reading, since their views have hardly changed. I am not going to go through the whole list, even though it does merit careful analysis. I want just to point out a few problems with three of the commandments (do they really need the religious analogy?). This 10 Commandments are based on the IMF's views on the stylized facts of fiscal consolidations.

Note that the IMF wants a reduction in debt-to-GDP ratios in the long run (commandment #3), even if nobody knows exactly what is the difference of having a 40% ratio, which they recommend for 'emerging markets' (meaning developing economies), or a 250%, as the UK had during the Napoleonic Wars (here). My first concern is with the idea that consolidation (by which they mean austerity) should be done by cutting spending and not increasing taxes (#4), because this is more conducive to growth.

This is a proposition they repeat in their last Fiscal Monitor (2012: p. 35), where we are told that:

"a number of earlier studies have shown that expenditure-based fiscal consolidations have a more favorable effect on output than revenue-based consolidations, in spite of the standard multiplier analysis … Chapter 3 of the October 2010 World Economic Outlook reaches the same conclusion (IMF, 2010b) and notes that this result is partly because, on average, central banks lower interest rates more in the case of expenditure-based consolidations (perhaps because they regard them as more long-lasting)."

Note, however, that the reason for the superior performance for cutting spending instead of raising taxes (on the rich one would hope) is that the Central Bank does not hike rates in the former case, since it is part of a conservative plan to reduce the size of government (note that the IMF asks for consolidations to be fair, #6, but then wants to cuts social spending, #5). Worse the notion is also based on the idea that lower (higher) spending brings down (up) the rate of interest and leads to crowding in (out) of private investment. The problem is that the evidence for a positive (negative) effect of fiscal deficits (surplus), or public spending increase (reduction), on interest rates, is that it is almost non-existent (see UNCTAD, 2011, chapter 3 for a review).

The other point is related to the last commandment (#10), which says that you should coordinate your macroeconomic policies with other countries. I'm not even going to deal with the problems of coordination. My problem is that the arguments tend to be based on the Mundell-Fleming (MF) model (the ISLMBP with perfect capital mobility), which suggests that fiscal policy is less efficient in a small open economy. In this case, fiscal policy raises the rate of interest, with capital mobility, pressures for inflows lead to an appreciation of the currency, and lower trade surpluses. Instead of crowding out, meaning lower investment, one gets lower output from the external accounts. That's why they say in their last Fiscal Monitor that "in line with the theory, fiscal multipliers tend to be smaller in more open economies" (2012, p. 33).

Again this depends on a weak empirical relation. In the United States seldom is the case that expansionary fiscal policy causes higher rates of interest. In fact, the policy of the strong dollar, with the impact on manufacturing output and exports, has often been detached from fiscal expansionism or higher rates of interest (e.g. the Clinton years in which a strong dollar went hand in hand with fiscal consolidation and monetary easing to feed the dot-com bubble).

Finally, note that even small open economies in several periods were able to have very effective fiscal policies, because in spite of relatively flexible exchange rates, they used capital controls to avoid the effects of volatile capital flows on their external accounts. In this sense, the world of relatively regulated capital flows, rather than of fixed exchange rates (even if sometimes the two are confounded as a result of the Bretton Woods arrangement), seems to be more conducive to effective fiscal policy. So the lesson should not be that small open economies cannot do effective fiscal policy, but that capital controls (which they are not quite okay with contrary to what you might have heard, but I leave for another post) are necessary.

PS: For a more consistent theoretical critique of the MF model see Serrano and Summa (2012).