More deficits, not fiscal responsibility

So there is a short review of the Hinckley Forum debate here. Not bad, but the title is misleading, since nobody was for for fiscal responsibility in the way it is usually defined, i.e. fiscal contraction. By the way, fiscal responsibility, like fiscal consolidation, is one of those code words for adjustment, that should be avoided. At any rate, if you missed it, that is a reasonable summary.

PS: I also emphasized that uncertainty is not central for the current weak recovery, lack of demand is and Steve agreed that without more demand there will be no more confidence. In fact, Steve's plea was for public investment in infrastructure. That's a way of recovering confidence that I'm also for.

Lucas in context, Keynes out of context

Krugman decided to try his hand at history of macroeconomic thought in one of his last posts. That's great, since history of thought is essential to understand how we got here. It's also bad, since Krugman is still very much a mainstream author, and misses the point of Keynes' contributions, and the limitations of neoclassical (or more properly, marginalist) approach. He suggests correctly that the New Classical (NC)/Real Business Cycle (RBC) project was a failure, but both the reasons for that and his interpretation of the Keynesian project are misguided.

The first proposition in Krugman's reassessment of the recent history of macroeconomics, is that Keynesian models were ad hoc, and assumed wage and price rigidity. The whole of chapter 19 of the General Theory (GT) is about the effects of price and wage flexibility, and how it does not produce full employment. It was with Franco Modigliani's PhD dissertation, done at the New School for Social Research under Jacob Marschak, that the sticky wage version of Keynesian theory that would dominate the neoclassical synthesis was concocted.

Keynes is actually quite explicit about the negative effects of wage reductions. He says (GT, ch.19-link above):

"A reduction of money-wages will somewhat reduce prices. It will, therefore, involve some redistribution of real income (a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.

What will be the effect of this redistribution on the propensity to consume for the community as a whole? The transfer from wage-earners to other factors is likely to diminish the propensity to consume. The effect of the transfer from entrepreneurs to rentiers is more open to doubt. But if rentiers represent on the whole the richer section of the community and those whose standard of life is least flexible, then the effect of this also will be unfavourable. What the net result will be on a balance of considerations, we can only guess. Probably it is more likely to be adverse than favourable."

Hence, the fix-wage version of Keynes' thought is the result of misconception, that suggests that if markets worked well, without imperfections, they would move to full employment. Unemployment is a disequilibrium, by definition a short run situation resulting from a rigidity.

The whole point of the neoclassical synthesis was to suggest that one could continue to teach that markets are efficient, and that supply determined the price and quantity of equilibrium in all markets including those of "factors of production" (i.e. the labor and capital markets), and as a result unemployment could only result  from rigidities in the labor market. Nothing revolutionary there, and in that case, as Keynes foresaw, people would think he was quite wrong or said nothing new.

By the way Krugman does not believe that rigid wages are behind our current lack of full employment (in his view it is the downward rigidity of the rate of interest; Keynes also did not believe in the liquidity trap as the cause of depressions), which makes it more difficult to understand why he defines Keynesians (Old and New) as pragmatic rigid price and wage modelers. You cannot blame then Laurence Kotlikoff for his confusion (here and Krugman's reply and here; Jamie Galbraith, also implicated, gives a better answer since he never said that Keynes is about wage rigidity; scroll down for Jamie's and Kotlikoff's back and forth).

Krugman's second point is that Friedman and Phelps in the 1960s were trying to provide microfoundations to wage and price rigidity. Actually, the microfoundations agenda had more to do with the theoretical development of theories for consumption (Modigliani, Friedman), investment (Eisner, Tobin) and money demand (Baumol, Tobin) behavior. The Phillips Curve (PC) debate and the Friedman-Phelps notion of a natural rate of unemployment is associated to the idea that there is a supply side constraint to the economy, and stimulating demand would ultimately have only effects on prices and not on quantities. The economy naturally moves to full employment, unless there are restrictions, and what is needed is to eliminate the restrictions not stimulate demand.

In other words, the monetarist approach of Friedman accepts the neoclassical synthesis notion that it is the rigidities that cause unemployment. It just proposes a different policy solution. By pointing out the existence of a natural rate of unemployment analogous to Wicksell's natural rate of interest (which Keynes' criticizes in the GT) Friedman was just emphasizing that if one believes in the neoclassical theory of value and there are no restrictions the system moves to full employment. In fact, Friedman's (1970) theoretical framework, an ISLM cum PC and natural rate model, is remarkably close to the neoclassical synthesis models.

In that sense, the Lucas Revolution and the subsequent move, after Kydland and Prescott's work, of most New Classicals , including Lucas, to the Real Business Cycles camp is a not a break with Friedman, and the New Keynesians (NK) that accept everything (including the natural rate) are part of the same tradition. The difference is that some emphasize the long run neoclassical principles and others the short run rigidities that demand policy action.

The fundamental problem of the neoclassical/marginalist approach, and the importance of Keynes analysis, can ONLY be properly understood in light of the 1960s capital debates (for a good reference go here). The point, for the purposes of our discussion here, is that if there is unemployment and real wages fall, neoclassical theory tells you that according to the principle of substitution, more labor is demanded (the cheap thing that is in excess supply) and less machines (capital) are used, since they are relatively more expensive. However, since labor (which is cheaper) is used in the machine sector too their price should fall too, and is not generally true that there is a tendency for the full utilization of "factors of production" according to their relative scarcities. Further, even if the substitution effects go in the right direction, and more labor is used, the income effect of lower real wages tends to be large and have a negative effect on demand (put simply, workers cannot buy stuff), which implies that less of all "factors of production" are used. In other words, there is no natural tendency to full utilization of labor or capital, and both the natural rate of unemployment and its evil twin the natural rate of interest do NOT exist.

So it is peculiar that Krugman thinks that "NK economics [is] useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism." What logic? New Keynesian models assume a natural rate, and that the economy (without rigidities) moves to full employment! The problem with the NC/RBC/Lucas' type of theory is not that it failed to predict the 1980s recession or that they think that most crises are caused by real shocks (although both propositions are obviously wrong), as Krugman seems to believe, but that they do maintain the fiction of an efficient market that clears (in their case too fast for Krugman's taste) and that produces a natural rate. If he wants to move in the right direction Krugman should follow Galbraith and announce that it is time to ditch the natural rate hypothesis.

PS: That means that progress in economics is not linear, and that one can and should learn from old and forgotten traditions (classical political economy did not assume full utilization of resources).

Christina Romer gets it right on the deficit

Romer's column in the NYTimes, a few days ago, is certainly worth reading. She says among other things:

"Fiscal austerity, not more stimulus, is the answer. This argument makes me crazy. There’s simply no evidence that concern about the current deficit is a significant factor limiting consumer spending or business investment. And government borrowing rates are at record lows, suggesting that financial markets are not worried about the deficit, either... The best evidence shows that fiscal austerity depresses growth and raises unemployment in the near term. That’s the experience of countries like Greece, Portugal and Britain, which have embarked on drastic deficit reduction plans over the last two years. Cut the current deficit and you will raise unemployment, not lower it."

It's high time for Keynesians, of any sort, that may have some influence with the President to be for fiscal expansion.

More on the "New IMF"

More evidence for the changes in our NIMF (New International Monetary Fund). In the executive summary to the last WEO, it argues that:

"Fiscal adjustment has already started, and progress has been significant in many economies. Strengthening medium-term fiscal plans and implementing entitlement reforms are critical to ensuring credibility and fiscal sustainability and to creating policy room to support balance sheet repair, growth, and job creation."

That is, not only they want continuing fiscal adjustment, but also cuts to entitlement programs like pensions (in IMF-speak its entitlement reform; one more for the English-IMF/IMF-English dictionary). Because fiscal consolidation (they mean austerity, cutting spending and increasing taxes) will lead to growth and job creation. Sounds new, doesn't it?

So does the IMF think that the periphery of Europe should not continue to tighten fiscal policy? Here is what they have to say:

"In the economies of the periphery [of Europe], a major task will be to find the right balance between fiscal consolidation and structural reform on the one hand and external support on the other, so as to ensure that adjustment in these economies can be sustained."

So external support yes, and of course continue with the adjustment. And yes in IMF-speak structural adjustment means cuts in social programs, or entitlement reform. Again nothing like the fresh new approach at the Fund.

And in Latin America? Well no worries they also have a new approach. For them:

"Some emerging market economies are contributing more domestic demand than is desirable (for example, several economies in Latin America); ... [Latin America] needs to restrain strong domestic demand by considerably reducing structural fiscal deficits and, in some cases, by further removing monetary accommodation."

Yes, more contractionary fiscal and monetary policies. The NIMF is full of 'new' ideas! Uhm, that nice smell of new policy measures!

The New IMF and Argentina

There has been a certain view, that was already quite popular around the time Strauss-Kahn still managed the IMF, that with Christine Lagarde the Fund has become less orthodox, not just regarding capital controls, but now also supposedly on fiscal issues. See for example the article in the NYTimes by Liz Alderman.

In the last World Economic Outlook, the Fund argues (WEO, p. 110) that Argentina's inflation results from excessively expansionary policies (no analysis backs this claim and the effects of a more devalued currency and commodity prices are not discussed) and suggests (p. 42) that monetary tightening is necessary. Also, the report continues the tone of the previous WEO, suggesting that in developed countries fiscal adjustment should continue to reduce the debt burden, and in developing ones, like Argentina, to avoid overheating.

So fiscal and monetary contraction is their policy advice. The IMF forecasts a significant slowdown next year for Argentina (4.6% for 2012 down from 8% this year). The logic is that Argentina's growth is not sustainable and perhaps a crisis is around the corner.

Andrés Velasco, ex-finance minister of Chile, suggests so much in his last column for project syndicate. This notion that Argentina is close to an external crisis is peculiar to say the least. Velasco had published a paper with Ricardo Hausmann after the 2001-2 crisis that recognized that the problems were not fiscal, but related to exchange rate misalignments, export performance and access to international financial markets.

Although shrinking, Argentina still has a current account surplus, has not depended on international financial inflows (but on its own exports), and the ratio of short term external obligations to reserves is relatively small. So if the whole world economy sinks into lower growth, Argentina, that is forecasted to be the second fastest growing economy after China in 2011, will probably slowdown, but there is no reason for the macroeconomic policy to push for a slowdown for fears of an external crisis.

In that sense, it seems that the default position at the Fund, and in mainstream academic circles (Velasco was at Harvard, before returning to Chile) is that fiscal adjustment is needed in Argentina. And apparently almost anywhere in the world. The New IMF looks a lot like the old one to me!

Class warfare

Only now I saw this great video by Mark Fiori in Marie Duggan's blog.

Complements Krugman's column today. A must read.

The IMF still believes in fiscal austerity

In May, Olivier Blanchard, the head of the research department at the IMF, said:

"Earlier fears of a double-dip recession—which we did not share—have not materialized... The inventory cycle is now largely over and fiscal stimulus has turned to fiscal consolidation, but private demand has, for the most part, taken the baton."

The lame excuse for this ludicrous forecast now is that:

"the initial U.S. data understated the size of the slowdown itself. Now that the numbers are in, it is clear that more was going on."

In all fairness I criticized that view in May (here) and in July (here), since it was clear that fiscal austerity (Blanchard says consolidation, but he means reduction of spending and increases in taxes, that is austerity measures, which may not lead to a reduction in deficits, i.e. consolidation; one day I'll publish the IMF-English/English-IMF Dictionary) would not work.

Now that he admits that private demand has not taken the baton you think he would admit that fiscal consolidation (austerity really) is not the solution. You would be wrong, of course. He says in the new World Economic Outlook foreword (WEO, Sept, 2011) that:

"Fiscal consolidation cannot be too fast or it will kill growth. It cannot be too slow or it will kill credibility."

Not very different from what Christine Lagarde, his boss, has been saying. That is, we need fiscal austerity, but not too much (see my critique here). The new claim (in the last WEO) is that China has to import more, since the US private demand will not pick up (and fiscal austerity is needed).

By the way, according to the IMF China will grow 9.5% in 2011, and the yuan has appreciated strongly in real terms (particularly when you deflate by the real wage, that grows astronomically in China). So it's unclear how China could, besides growing sufficiently fast to keep a good chunk of the world economy (in particular exporters of commodities) expanding, also get the US out of its recession.

Perhaps, Blanchard and the IMF should revise their views on fiscal policy for developed countries (the IMF could also change it's adjustment programs based on austerity in Europe too!).

If you’re surprised, that means that you were part of the problem

Back in July, in the midst of the debt-ceiling debate, Paul Krugman argued that those that were surprised by the GOP tactic of blackmailing the administration, threatening a default in exchange for cuts on social spending and the maintenance of the tax cuts for the rich were part of the problem. Normal was already not part of the GOP. I agree.

Now Krugman tells us that in this crisis a "lot of the blame goes to the economists, by the way, who abandoned what they used to know." But the thing is that the mainstream of the profession has been dominated by the academic equivalent of the Tea Party for a very long time. My point is that if you didn't know that economists forgot certain things about recessions, and never learned a few other things, you have not been paying attention and/or you must be part of the problem too.

Krugman knows this well, since he argued that:

“By the early 1980s it was already common knowledge among people I hung out with that the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable. And yes, that was conscious knowledge, which shaped the kinds of papers we wrote. So you could do exchange rate models that actually had realistic assumptions about prices and employment, but put the focus on rational expectations in the currency market, so that people really didn’t notice. Or you could model optimal investment choices, with the underlying framework fairly Keynesian, but hidden in the background. And so on.”

That is, in order to publish (in 'respectable' journals) you had to wrap your reasonable assumptions in crazy models. So it should have been clear back then that rational expectations, real business cycles, supply siders, and their political counterparts in the Reagan administration were more dangerous that Old Keynesians and New Old Keynesians (or Old New Keynesians for that matter) were willing to admit.

The problem is not just that New Keynesians of all sorts and political affiliations (Ben Bernanke, Brad DeLong, Paul Krugman, Greg Mankiw, Christina Romer or Larry Summers) can be seen as equivalents to the old Neoclassical Synthesis, the modern equivalents of John Hicks and Alvin Hansen, trying to incorporate the Keynesian insights that lack of effective demand was behind the Great Depression (now our Great Recession), and that fiscal stimulus is necessary, while maintaining the contradictory argument that the price and quantity of all "factors of production", including labor, can be determined by the equilibrium in the labor market. [If this is true lower real wages should equilibrate the labor market and involuntary unemployment should vanish].

From a policy point of view this is certainly important, but it misses the more essential question that Keynes theory was not (at least was not intended to be) about imperfections, and arguably the inability of the Neoclassical Synthesis of overcoming that original contradiction is part of the reason of the rise of New Classical economics, and the acceptance by New Keynesians of the Friedmanian notion of a natural rate.  Can you blame the profession that believes in the self-adjusting nature of the system towards the natural rate (included in all New Keynesian models) that fiscal stimulus is only needed in the short run and that the economy is on its path to recovery?

Hansen (1938, p. 34), in the book depicted above, said that the profession was: "living in a time when economics stands in danger of a sterile orthodoxy." [The time, by the way, was the 1937-38 recession]. We are in that position again, and people like DeLong and Krugman, as I said before, the best within the mainstream, would miss the opportunity of providing a more solid foundation for economic theory if they do not recognize the importance of the heterodox contributions of the more radical disciples of Keynes and Kalecki. We do not need another Neoclassical Synthesis, and we should try not to miss this new opportunity to complete the Keynesian Revolution.

Further, although we have our Hansens, so to speak, we do not have our Lauchlin Currie or our Marriner Eccles.  That is, the real heterodox Keynesians within the administration. Currie, by the way, wrote an unpublished review of the General Theory, for the eyes of the Board only, that is far better than most responses in academia, which did not rely in either interest rate (liquidity trap) or real wage rigidity. In fact, Currie argues correctly that (following chapter 19 of the General Theory) falling wages would make things worse. If respectable economists in the mainstream, like Krugman and DeLong, miss this opportunity this period will be remembered as 'the years of low theory.'

PS: For a discussion of Eccles and Currie see here. The classic book on Currie is by Roger Sandilands here.

Hinckley Forum - Thursday 9/22 at 10:45

Roundtable on the Global Financial Crisis
Lance Girton, Professor, Economic Department, U of U;

Minqi Li, Associate Professor, Economic Department, U of U;

Steve Reynolds, Professor, Economic Department, U of U;

Matías Vernengo, Associate Professor, Economic Department, U of U;

Tom Maloney (moderator) Chair, Economic Department, U of U

Greek Debt is not that large

The NYTimes tells us that Greek debt is out of control, and financial markets fear that a default is around the corner.  It might be true, but the size is not a big problem. According to the Times:

"Total Greek public debt is about 370 billion euros, or $500 billion. By comparison, Argentina’s debt was $82 billion when it defaulted in 2001; when Russia defaulted, in 1998, its debt was $79 billion."

The point of this is that it is supposed to be large even when compared to Argentina and Russia that defaulted. Note, however, that the GDP of the euro-17 (the 17 countries of the euro currency area) is around 12.3 trillion euros, and as a result Greek debt corresponds to slightly more than 3% of the euro-17 income.  It is true that the euro countries, or the ECB, may not want for political reasons to buy Greek bonds, but given its size and the potential risks it is puzzling, to say the least.

In Argentina and Russia that option was out of the table altogether, since debts were in dollars, and no world central bank could stand to actually buy their bonds. So default was the only alternative. At this point, it is as if the ECB and the European elites do not want to save the euro. And the Greek people's patience is running thin.

The inflation monster

Kids are afraid of monsters, and so are Republican candidates apparently. The inflation monster that is. It really makes it hard to teach macro, since lots of students still think, because of the unrelenting 24 hour media coverage of GOP debates that since money supply increased (from about 7.5 to close to 9.3 trillions from Dec. 2007 until last July, using M2) we are in for a huge increase in prices. Hyperinflation should be around the corner.

It's not. As anybody with common sense knows the velocity of circulation does change (fell from slightly more than 2 to around 1.7 for M2), and the increase in money supply has no effect on spending. Banks are not lending, since demand is not growing sufficiently (if in doubt search endogenous money, now known as MMT, Modern Monetary Theory). And inflation has been subdued as the graph below shows (2011 is an IMF forecast for CPI inflation), even more after the 2007-8 crisis.

Inflation has increased a little bit in 2011, fundamentally associated to higher energy and food prices, but the pass-through to general prices in the US is relatively small (black line is a three year moving average). As noted by Adam Posen, central banks should continue to maintain low rates of interest. Unless they believe in monsters!

PS: Funny coincidence, after I posted this I saw that Krugman uploaded a graph of M2 velocity after the 1960s here.

Robert Barro vs. Jamie Galbraith

Jamie Galbraith goes head to head with Robert Barro, in the enemy's territory (Bloomberg). Several important points raised by Jamie. Beware of the delirium about the post-1980s being the start of two decades of prosperity. In fact, medium income stagnated after that, and growth has been based on a series of unsustainable bubbles.

An update on the Eurocrisis

I was again on Background Briefing with Ian Masters, Pacifica News KPFK 90.7, Los Angeles.  You can listen the to whole program here.  Previous interview is here.

PS: I'm in the second part of the program at around minute 20.