Trade and Finance

Teaching a course on international economics (trade and finance) for international relations students. More on that later. Just wanted to post the exports to GDP ratio for the world.

This is to give students a sense of the increase in trade in the last few decades, and also the relative stagnation since the 2008 Global Financial Crisis. Note that while exports are about US$ 23 trillion in a year, the daily turnover in the foreign exchange market is about US$ 5 trillion, according to the last time I checked the BIS Report.

I put the US recessions bars too. Note that it seems that US recessions always have a significant impact on the expansion of world exports.

Foreign Exchange Trading and the Dollar

The new Bank for International Settlements (BIS) Triennial Central Bank Survey was published last month. The Foreign exchange turnover is down for the first time since they started in 1996. As the press release says: "Trading in FX markets averaged $5.1 trillion per day in April 2016. This is down from $5.4 trillion in April 2013." The figure below shows the main results.

Not surprisingly the dollar remained the key vehicle currency, being on one side of around 88% of all trades, while the euro has continued to slide down approximately from 39% in 2010 to 31% now. Also, while the yuan or renminbi is now the most actively traded developing country currency, the rise in the share in global foreign exchange turnover is from 2.2% to 4%.

PS: For those interested here there is an old paper, but I think still relevant, on the dollar after the crisis, and why there should be no fear about its dominant position.

A novel capital control proposal

New book

By Pablo Bortz (Guest blogger)*

After the breakdown of the Bretton Woods regime and the subsequent deregulation in capital flows around the globe, the movement of financial assets and liabilities has increased several times faster than trade and GDP growth. While still mainly concentrated between advanced countries, financial flows to emerging and developing economies (EDEs) have been rising at an exponential rate, particularly in the last two decades. However, public external debt (as per cent of GDP) has been on a downward trend in the 2000s (though the trend has been slightly reversed since the 2008 crisis), with a larger proportion being denominated in domestic currency, but attracting more non-resident private investors (Arslanalp and Tsuda 2014). The other big story of the last fifteen years, notwithstanding, is quite different: private external debt has been on a marked rise. As Akyüz (2014) reviews, the share of private debt denominated in a foreign currency has increased sharply, and that is not the only concerning feature observed in the data. Avdjiev et al (2014) notice the importance of private non-bank lenders in in the external financing of many emerging countries, and the role of overseas affiliates of EDEs corporations established in off-shore financial centers, rendering its recording more difficult. And though cross-border bank lending still represents the larger share of total external borrowing, there has been a fast increase in the issuance of debt securities by the private non-banking sector of EDEs and its off-shore affiliates (Butzen et al 2014), a more volatile kind of flow, together with portfolios investment.

Far too numerous crises in emerging (and some advanced) economies have been preceded by explosions in private foreign borrowing, starting from the 1970s in Latin America, and continuing during the 1990s also in Latin America and (above all) South-East Asia, as told by Palma (2001). And in the last decade we have seen the burst of the Eurozone, also triggered by sharp increases in foreign indebtedness (Storm and Naastepad 2016). Financial fragility is not the sole cause of these crises and the lasting damage they leave behind. As I mention in my recent book (Bortz 2016), private foreign borrowing turn the odds of wage bargaining against labor, lowering the wage share and putting aggregate demand in a more fragile standing. Motives for this result abound: the impact of higher indebtedness and debt servicing on firms’ balance sheet (costs that firms try to pass on consumers); the fact that mounting foreign borrowing and capital inflows are matched by financial deregulation that stimulates alternative outlays other than capacity-building investment; and because they are tied to the rise of sectors such as the FIRE sector (financial, insurance and real state) lowering aggregate productivity, among other reasons. Jayadev (2005), Stockhammer (2009) and Furceri and Loungani (2015) all find empirical support for these hypothesis.

After amending in 1997 its Articles of Agreement, requiring member countries to liberalize their capital account, the IMF has joined the large chorus of voices calling for capital controls, although in the most muted way possible (IMF 2012, p. 2). Calls for restoring capital controls rise across the economic spectrum, from authors with a more orthodox point of view such as Hélène Rey (2013) to non-mainstream economists such as Vernengo and Rochon (2000), Epstein (2005), Bibow (2011), Gallagher (2014), Grabel (2015), among many others. International institutions such as UNCTAD have been at the frontier of the debate (UNCTAD 2001, 2014), and even recent research by IMF staff has dwelled into the topic (Ostry et al 2011, Canuto and Ghosh 2013).

It is within this context that I suggest a novel proposal for consideration, the implementation of which should obviously reflect the particularities of each economy. What I propose is a refundable tax on foreign private borrowing, that discourages speculative borrowing in favor of productive investment. The basic idea is simple: companies should pay a tax when they borrow abroad, either through banks, issuing debt securities, when they borrow from their home companies or off-shore affiliates. That tax would be reimbursed if firms can prove that these credits have been used to fund productive investment.

This proposal is particularly fit to counter lending and borrowing between affiliates, a common channel to facilitate transfers of funds in times of need with disregard of the economic conditions of the country. For instance, it was one of the major channels by which affiliates in EDEs transferred large amounts of foreign currency to their home companies in developed countries during the 2008 financial crisis and the Eurozone crisis.

Implementation aspects raise a couple of questions of which I am fully aware. First, there is the need to define precisely what “productive investment” stands for: does it include software licenses and patents? Second, the State would require the administrative capabilities to verify the companies’ claims on the nature of their borrowing, while assuring that banking funds are indeed available in the domestic market (perhaps through public banks and/or development banks). However, the main intention of this proposal is to pass the burden of the proof to firms rather than the State. A further issue to be discussed concerns cross-border bank lending. The scheme should discriminate in favor of foreign lending for investment purposes, though its implementation would involved more thoughts and efforts in its design.

This proposal should not be thought of as a substitute for more specifically-FDI-oriented policies. There may well be different and valid reasons for countries to discourage FDI, and this measure does not stand in its way. It is not incompatible with other typical capital control measures such as unremunerated reserve deposits on financial investments or measures that restrict capital flights. This proposal is just one instrument, perhaps a modest one, to try to curb speculative borrowing by firms, particularly in foreign currency, an ever-increasing practice which offers negligible benefits and which adds to headwinds when foreign reserves are needed the most (Chui et al 2014).

*Pablo G. Bortz is currently Professor at the National University of San Martin. He is the author of Inequality, Growth and ‘Hot’ Money, published by Edward Elgar. With the usual caveats, the author thanks Edgardo Torija Zane for our fruitful discussions on this proposal.

References

Akyüz, Y. (2014): Internationalization of finance and changing vulnerabilities in emerging and developing economies, Discussion Paper No. 217, United Nations Conference on Trade and Development, Geneva.

Arslanalp, S. and Tsuda, T. (2014): Tracking global demand for emerging market sovereign debt, Working Paper No. 14/39, International Monetary Fund, Washington, DC.

Avdjiev, S., Chui, M. and Shin, H.S. (2014): Non-financial corporations from emerging market economies and capital flows, BIS Quarterly Review 2014, December, pp. 67–77.

Bibow, J. (2011): Permanent and selective capital account management regimes as an alternative to self-insurance strategies in emerging-market economies, Working Paper No. 683, Levy Economics Institute of Bard College, Annandale-on-Hudson.

Bortz, P. (2016): Inequality, Growth and ‘Hot’ Money, Edward Elgar, Cheltenham.

Butzen, P., Deroose, M. and Ide, S. (2014): Global imbalances and gross capital flows, National Bank of Belgium Economic Review 2014, September, pp. 41–60.

Canuto, O. and Ghosh, S. (eds) (2013): Dealing with the Challenges of Macro Financial Linkages in Emerging Markets, World Bank, Washington, DC.

Chui, M., Fender, I. and Sushko, V. (2014): Risks related to EME corporate balance sheets: the role of leverage and currency mismatch, BIS Quarterly Review 2014, September, pp. 35–47.

Epstein, G. (ed) (2005): Capital Flight and Capital Controls in Developing Countries, Edward Elgar, Cheltenham UK.

Furcer, D. and Loungani, P. (2015): Capital account liberalization and inequality, Working Paper No. 15/243, International Monetary Fund, Washington, DC.

Gallagher, K. (2014): Ruling Capital: Emerging Markets and the Re- regulation of Cross-Border Finance, Cornell University Press, Ithaca, NY.

Grabel, I. (2015): The rebranding of capital controls in an era of productive incoherence, Review of International Political Economy, Vol. 22 (1), pp. 7-43.

International Monetary Fund (2012): The liberalization and management of capital flows: an institutional view, International Monetary Fund, Washington, DC.

Jayadev, A. (2005): Financial liberalization and its distributional conse- quences: an empirical exploration, Ph.D. dissertation, University of Massachusetts Amherst.

Ostry, J.D., Ghosh, A.R., Habermeier, K., Laeven, L., Chamon, M., Qureshi, M.S. and Kokenine, A. (2011): Managing capital flows: what tools to use?, Staff Discussion Note No. 11/06, International Monetary Fund, Washington, DC.

Palma, J.G. (2001): Three-and-a-half cycles of ‘mania, panic, and (asymmetric) crash’: East Asia and Latin America compared, in H.J. Chang, J.G. Palma and D.G. Whittaker (eds): Financial Liberalization and the Asian Crisis, Palgrave, Basingstoke.

Rey, H. (2013): Dilemma not trilemma: the global financial cycle and monetary policy independence, Proceedings of the Economic Symposium of the Federal Reserve Bank of Kansas City, Jackson Hole, WY.

Stockhammer, E. (2009): Determinants of functional income distribution in OECD countries, IMK Studies No. 05/2009, Hans Böckler Stiftung, Düsseldorf.

Storm, S.T.H. and Naastepad, C.W.M. (2016): Myths, mix-ups and mishandlings: understanding the Eurozone crisis, International Journal of Political Economy, Vol. 45 (1), pp. 46-71.

UNCTAD (2001): Trade and Development Report, UNCTAD, Geneva.

UNCTAD (2014): Trade and Development Report, UNCTAD, Geneva.

Vernengo, M. and Rochon, L.P. (2000): Exchange rate regimes and capital controls, Challenge, Vol 43 (6), pp. 76-92.

On the blogs

Kakistocracy -- Mario Nuti on the Greek negotiations, up to the agreement reached the other day. Note that he sees the extension as a good thing. So do I. I don't think Greece caved, as many on the left have been saying. This is an agreement were everybody can claim victory. Greeks got more time, which they need, Germans didn't make concessions, at least not very early in the process.

Warning: too much finance is bad for the economy -- The Economist, following research from Cecchetti at the BIS. And yes they are right, but for the wrong reasons. Finance hurts not because the genius that would have gone to physics ends up in the hedge fund. The reason is too much unregulated finance is prone to crisis.

Human Capital Controversy -- David Ruccio on the debate that followed Branko Milanovic's post on ditching human capital, with Nick Rowe among others.

Graph/Table of the Week: Wage Compression -- The URPE post, with a link to Ezra Klein's discussion of the Obama economy.

Does anybody really want to solve this mess? On the European Crisis

Pablo G. Bortz* (Guest Blogger)

It has been more than five years since Ireland had to rescue its failing banks. Almost four since the beginning of the crisis in Greece. Something similar for the explosion of the housing bubble in Spain. France is submerged in a persistent recession, like Italy. A 0.1% “growth” in a quarter is celebrated as an irrefutable proof of the “success” of the austerity programs. In the most realistic scenario, the Eurozone face a long decade of stagnation, high unemployment and rising social tensions. Many of the solutions are disregarded, never considered, such as a fiscal union or Eurobonds. Others are sabotaged, such as the banking union. Debt restructures are postponed for years, even though their necessity is plain to see. Somebody may ask, why hasn’t the Eurozone crisis been solved by now? At this stage, it is hard to avoid the conclusion that the crisis has not been solved because there is no intention to solve it. But who does not have that intention?

Some countries performed better than others, so one cannot safely state that no country succeeded in this period. However, there are sectors that did succeed. In this piece I want to focus on one of such sectors, with a huge influence in the decision-making spheres of European politics, which faced high risks at the beginning and throughout this stormy period, but which has seen events develop in its favor and now is starting to push towards the split up of the Eurozone. I will not present new information, but I do intend to briefly offer an interpretation of why they have done better than most and why are they in the position they are. I am talking about the big German banks. I also hope to make clear convincingly what economic benefits the German government has obtained by playing along with the interests of the banks, except in very specific situations, about which more will be said later.

The basic underpinning of this post is illustrated by graphs 1 and 2. Both show the exposure of German banks to selected countries of the periphery, based on data from the BIS (Table 9d of the Consolidated Banking Statistics). The black curve in graph 2 corresponding to Cyprus is measured in the right-hand-side axis.

The crisis of 2008 hit German banks severely, not only because they had bought significant volumes of asset-based securities in the US, but also because they had financed housing (and commercial property) bubbles in the periphery. Considering that their exposure to Ireland amounted to 137% of the Irish GDP, it is no surprise that the burst of the Irish housing bubble, among other measures, forced the German government to rescue Hypo Real Estate. But that was not the only public help they got: it is well known by now that the ECB forced the Irish government to make good the guarantees extended on the debt of its major banks. In any case, the financial crisis forced a certain retreat of German banks from periphery countries, though the same holds for the US. Around the second quarter of 2009 the situation had stabilized and they were willing to lend once again to these countries. 

The Eurozone crisis was triggered in the last quarter of 2009 and early 2010, with the change in government in Greece and the recognition of its falsified statistics and bigger-than-expected fiscal deficits. At that moment, it became evident that Greek debt was not sustainable, that the government would not be able to face its commitments on its own, and that help was needed, either as a loan, as a debt restructure, or as both. Heck, even Keynes explicitly said that in situations like these a rescue was unavoidable, and he wrote that seventy years ago!

Eventually, loans were granted in exchange for the conditions already known by everybody. A debt restructure was implemented in October of 2011, and a second one followed suit some months later. However, that word “eventually” took a long time to materialize: those measures were implemented years after the burst of the crisis. In the meantime, as the graphs show, German banks substantially reduced their holdings of Greek debt (particularly avoiding the second Greek default), selling their holdings to the ECB, now a major creditor of Greece and other European countries with one of the worst implemented buying programs ever, and the European Financial Stability Facility/European Stability Mechanism (ESM) (check page 17-18). In Spain they also pulled out, before the required bank capitalization was implemented through loans from the ESM. In Cyprus they also pulled out, when it was clear that the Cypriot banks would need another bailout due to the impact of the first Greek default. The Cypriot bailout took place almost a year and a half after the first Greek PSI. That was the main benefit that German banks (and French banks too) got from the way the crisis was “managed”: time. Time to pull out, to heal wounds, to offload their holdings into the hands of the public sector, both at the national and the continental level.

Probably the first indication that the worst had already passed was the fact that Deutsche Bank did not participate in the Long Term Repurchase Operation 2 in February 2012. By the second quarter of 2012, that is, a quarter before Draghi announced the Outright Monetary Transaction (OMT) Program, the claims of German banks vis-a-vis Spanish and Italian debtors hit the floor, and the downward trend regarding Irish borrowers decelerated. They also got time regarding the implementation of the banking union and its different components. Whatever problems the German banks may have, their exposure to the European countries in difficulties is not a major one, perhaps not even a problem at all. And they do not need to lend to these troublesome economies: they have a booming housing market at home to feed.

The time German banks enjoyed to reduce their exposure to periphery debt was obtained by the German government (in particular the German Ministry of Finance), the Bundesbank and the ECB (especially during Trichet’s term). Blaming the “reckless spending spree” of Greek, Spanish, Irish and Italian governments, they refused to acknowledge any possibility of debt restructuring. The EFSF was instrumented when Greece was already bankrupted, and the increase on interest rates (as investors flee the countries) was used as a threat in order to force governments to implement austerity policies. We all know this. We all know the reluctance of the ECB to act as a lender of last resort, and then when they finally decided they had to buy some debt, they did it badly. Compare that performance with the announcement of OMT: without actually buying any bonds, the ECB has succeeded in lowering interest rates.

The Greek default is also illustrative. First it was plainly rejected; later they figured out that Greek public debt in the possession of the private sector had to be written down by 21%, later on they extended to 50%, and eventually it was around 70% NPV. Those changes took months.

The Bundesbank has been the main opponent to any measure that can reasonably help (in some measure or the other) struggling governments. In fairness, they didn’t even want those countries in the Eurozone to begin with. They opposed OMT, the buying of public debt, either because it was (in their interpretation) explicitly prohibited by the Treaty of Maastricht, or against its “spirit”. They reject the idea that ESM can lend directly to banks (instead of lending to governments); they are rejecting (or seeking to restrict) the supervision of German banks by the ECB, and rejecting any possibility of a redemption fund at the European level in case some money is needed in banks liquidation processes without burdening national governments. They have rejected granting a banking license to ESM. This position aims at securing the advantage of German banks vis-a-vis their competitors in the Eurozone, who are crippled not only by the poor state of their borrowers’ finances but also, in the periphery, by the interaction with the public sector’s finance, either as debtors, or as possible rescuers.

The government, in turn, takes more or less the same line as the Bundesbank. After all, because of this crisis the interest rate it pays is at a record low, allowing some savings of around 10 billion euros. Small and medium-size German companies, at the heart of the German economic success and an important source of votes for the CDU, are paying interest rates almost 2% lower than equivalent and equally competitive Italian SMEs, for instance. Germany is becoming the major destination for young and skilled migrants that want to escape the grim and hopeless situation in their own countries. German officials are explicitly encouraging this movement, which is worsening even further the long-term prospects of the economies affected. In some sense, it is actually quite hard to escape the conclusion that Germany is “stealing population” from the periphery.

But there were a couple of circumstances in which the views of the Bundesbank and the German government diverged. Strangely enough, in those episodes it seems that the Ministry of Finance agreed more with the Bundesbank than with the Chancellor. One such episode is the aforementioned dispute, described in the article from Der Spiegel, concerning the inclusion or not of Italy in the euro. The other major event was the vote in the Governing Council of the ECB regarding the implementation of OMT.

That proposal won with a result of 23 positive votes and 1 negative vote. And there are two German officials. Joerg Asmussen, a member of the Executive Board, voted in favor of OMT, while Jens Weidmann, the president of the Bundesbank, voted against it. This highlights, in my view, that when the time comes Angela Merkel is willing (much more than Schauble) to do the bare minimum effort in order to save the Eurozone.

The Bundesbank is not willing to do so. It is not willing, because major German banks do not need the Eurozone any more. Not only they dislike the measures that are on the table to regulate them, linked to the banking union (even though the German government is fighting tooth and nail to defend them); not only because they have to focus on healing their wounds from other messes (like their derivatives exposure and lawsuits in the US) and strengthening their capital ratios: but also because if, for instance, Greece leaves, there might be new opportunities for purchasing assets at an even lower price and realizing huge capital gains. Heads I win, tails you lose.

I will not discuss the benefits for periphery countries of leaving the Eurozone, as the big German banks (and the Bundesbank) want them to do. In my view, these benefits exist and are sound and solid. But even if they agree on this, the periphery should not expect any support from German banks. They will not oppose further austerity packages, but they will oppose any favorable measure. The measures that would solve the Eurozone crisis while keeping everybody on board are relatively easier to implement, from a strictly economic point of view, than the whole set of measures required for periphery states to leave in an orderly fashion and succeed as independent states. However, the political willingness in Brussels (and Berlin and Frankfurt) to cure the crisis is non-existent, and the views range from desire to keep starving the ill countries, to complete disregard for their fate.

*Ph.D. Candidate, Delft University of Technology. I am very grateful for the comments and suggestions of Frances Coppola, Jan Kregel and Matías Vernengo, though the views and possible mistakes of this article should be attributed only to myself.

Desperately seeking the natural rate of interest

The Economist Free Exchange (FE) blog gets into the debate of where is the elusive natural rate of interest. I've already discussed Krugman's views (see here and here) that the natural rate of interest is negative, and that's why we need fiscal policy, something that he refers to as the Liquidity Trap. FE suggests that William White, formerly from the Bank of International Settlements (BIS) and now from the Organization for Economic Cooperation and Development (OECD), believes that the natural rate is higher than the monetary rate.

According to FE White believes that: "the Wicksellian natural rate must be high and monetary policy too loose because low rates have encouraged all sorts of yield-chasing behavior." If one reads White's paper, we find that he says more precisely the following:

"Moreover, given this particular way of thinking and noting that the financial rate is now constrained by the ZLB [zero lower bound interest rate], this gap can only be redressed by raising the natural rate to encourage investment."

In other words, he believes that central banks, like the Fed, can move the natural rate, by affecting savings behavior presumably associated with inflationary expectations. This would lead to a monetary rate that is lower than the natural rate and increased investment. This is actually the same story that Krugman has favored, which I suggested is an inflationary expectations confidence fairy.

Interestingly enough, still according to FE, DeLong, who seems to be on the same page with Krugman, has responded to White, if FE's description is correct, suggesting that there is little that the Fed can do about the natural rate, and is stuck with a very low monetary rate for a while.

Mind you, the search for the holy grail of the natural rate is futile anyway (yep capital debates; it's been a while). And no act of the Fed will lead to more inflationary expectations and higher spending. And because of the Tea Party, and also fiscal hawks in the Democratic Party, there is no hope for fiscal stimulus. This FE post shows the incredible confusion of the mainstream.

PS: In this post FE also tells us that the natural rate of unemployment is 5.5%. Oh well.

The position of the dollar was enhanced by the crisis

The BIS Triennial Central Bank Survey shows that over the last three years the position of the dollar as key currency has become more dominant. The figure below shows the turnover by currency and currency pairs.

You can see that the dollar was on one side of the operation 87% of the time, compared to 84.9% three years ago. The euro has lost some ground. Also, the average daily turnover in foreign exchange markets in April was around US$ 5.3 trillion.

Macroeconomics and the financial cycle

Claudio Borio from the BIS has written a widely cited paper. The Economist has linked to it and suggested that so far his advice for including the financial cycle into macroeconomics has only been followed by a few. Besides Borio, Minsky, Godley and Lavoie and Keene are also cited by The Economist. The paper by Borio (he only cites Minsky), which has been a very influential voice suggesting that capital flows were pro-cyclical and more regulation was needed before the financial crisis, is somewhat underwhelming though.

For starters the definition of the financial cycle is based on individual perceptions. In his view, financial cycles result from "self-reinforcing interactions between perceptions of value and risk, attitudes towards risk and financing constraints, which translate into booms followed by busts." Then there is the question of the theoretical features for modeling the financial cycle according to Borio. There are three that are essential according to him. First, that financial cycles have endogenous causes, second, that debt must be present, and last but not least a different measure of the output gap. The last one is really the central theoretical modification in his scheme [note that heterodox models, like Kaldor's 1940 cycle model were endogenous, and Keynes had debt in the General Theory, in chapter 19 it is central, in fact].

The new output gap measure would include financial variables. He correctly notes that output gap measures take into consideration only inflation, when ascertaining whether the economy is above the potential or not, and that "it is quite possible for inflation to remain stable while output is on an unsustainable path" [and you can have inflation without being at full employment too, I would add]. His measure of the output gap would include information about asset price inflation too (property prices and measures of credit booms) and is shown for the US and Spain as the red line below.

Note that the new output gap shows the economy growing way beyond its potential in both the US and Spain before the crisis, more than in the alternative measures using a Hodrick-Prescott filter (green) and a conventional production function (blue). He concludes that: "potential output and growth tend to be overestimated" by conventional methods. Further, his point when arguing that the cycle is endogenous is that excessive booms are the cause of the collapse, so what is needed is to smooth out the boom. The prescription is to grow less and avoid to surpass the potential level, which is supply determined and exogenous presumably (since no word on this is uttered).*

He wants then to constrain booms, and macroprudential policies should be used for that aim. Further, while noting that in balance sheet recessions (following Koo) it is important to deal with agents losses head on, he suggests that "fiscal policy is less effective than in normal recessions" and that as a result of excessive monetary expansion after the bust "the central bank’s autonomy and, eventually, credibility may come under threat." So one really needs to kill booms, since nothing much beyond re-writing debt down and acting as lender of last resort with moderation can be done after.

I have several problems with these views, even if there are some good things, beyond good intentions, in Borio's paper. In fact, I think that there is significant evidence for the notion that potential output varies with demand expansion (Kaldor-Verdoorn Law), so that if a revision of the way potential output is measured it would be in the opposite direction. Mind you, if you check the chart above it means that Spain now is close to its potential level. I guess the natural rate of unemployment in Spain is around 20% or so (slightly below the current level). Note, also, that in Latin America we have been smoothing the boom with the consequence that our crises are not milder than Asia, but we end up growing less (see the paper by Pérez and Pineda linked here).

However, in my view the biggest flaw in the approach to financial cycles proposed by Borio is the absence of any discussion of how debt-deflation (the balance sheet recessions) affect and are affected by income distribution. There is no understanding of how wage stagnation in the center was as instrumental as financial de-regulation for the collapse, as noted by Barba and Pivetti (link here) or Jamie Galbraith's last book, not by chance called Inequality and Instability. This is again something that heterodox economists have known for a while and that the mainstream still has to learn.

* The reasons for the excess in the boom are associated to excessive finance [which he calls excess elasticity of the system], as in Shin's (2011) global banking glut, and not excessive savings, since he correctly points out that "expenditures require financing, not saving."

Prices and quantities

Mainstream economics suggests that prices and quantities should be treated simultaneously, as it should be if market prices as determined by supply and demand are at the center of the analytical framework. With supply and demand, it must be the case that the quantity produced, and the equilibrium price, both are determined simultaneously. Further, it is the case that, with price flexibility, the quantity produced is optimal from the perspective of the utilization of resources and the preferences of the agents. And if that is true for bananas, or any other commodity for that matter, it must be true too for labor and ‘capital.’

As I discussed before, in particular with respect to capital, this approach (supply and demand or marginalist), which contrasts with the surplus approach, has serious problems. Even if we dismiss, for simplicity sake, the subjective part (about preferences) and concentrate just on supply conditions, the difficulties are insurmountable. Producers only supply more at higher prices, which means that they must encounter increasing costs (diminishing returns). It cannot be the case that they are only willing to supply more at higher prices (higher remuneration) even if costs are not higher, since if one producer obtained higher remuneration free entry of new producers (attracted by the higher remuneration) would imply that more would be produced. So the supply curve depends on diminshing returns.

And diminishing returns are a highly improbable proposition, as Sraffa argued back in the 1920s. Not many producers, if any, would tell you that they don’t produce more because their costs would go up (and that would reduce demand as prices get higher). Most simply would reply that, although they could produce more at the same price, they don’t have enough demand. But the diminishing returns fetish dominates the profession (I won’t say anything here about imperfect competition, but Franklin Serrano noted here that this would be related to barriers to entry).

In the surplus approach, that concerns itself with the way in which societies reproduce themselves (usually in an amplified scale and with accumulation), prices and quantities are treated separately. Since costs of production, for a given technology, seem to be independent from the quantity produced (i.e. the cost would be the same if you produced slightly more or less), then the quantity can be taken as given for the discussion of the determination of prices. It is well know that, in that case, prices depend on the technology, which must allow for reproduction (including of the labor force) and by the way in which the surplus (what is left over, above and beyond the needs of reproduction) is divided between classes.

This separation between prices and quantities has been called by Garegnani the 'method of given quantities.' Note that it does not imply that the quantities are determined by supply or given at a level that is optimal from the point of view of utilization of resources. And that is why it is perfectly compatible with Keynes’ notion of a demand determined level of activity (yes you can, and should, add Sraffa to your Keynes, or Kalecki). Also, it does not mean that there is no technical change or that distribution does not affect output (all propositions that have been discussed here in the blog).

Be that as it may, I’m more interested in the macroeconomic implications of the mainstream views about prices and quantities. Since the late 1960s, these views have coalesced around the notion that, whereas there is a short run tradeoff between prices and quantities (the so-called Phillips Curve, PC), in the long run the tradeoff vanishes. Put simply, if you push demand too much (through fiscal and monetary policy), output would increase, unemployment fall (as per Okun’s Law: higher output implies lower unemployment) and inflation would accelerate. In the long run, however, the economy is self-adjusted and output cannot be above the optimal level, so the only effect of the expansionary policies would be inflation (Friedman dixit).

By the way, the same (the mainstream loves symmetry) is true for deflation. Yes it may cause some problems, but the system returns to full employment, even in the face of contractionary policies (the Greek should not worry about contraction, because markets would produce full employment if they are allowed to work; hence, the need of labor market flexibility). In the long run contractionary policies only would affect prices. In sum, supply and demand would lead to the optimal price and quantity, so if you get off my market (cranky old neoclassical guy would say), and stop expanding demand, there would be no inflation.

The evidence for a natural rate or for a PC is incredibly weak. In order to argue that there is a natural rate, the mainstream has basically suggested that it moves around all the time. So in the 1980s the natural rate was higher (in the US), when the actual unemployment was higher, than in the 1990s (particularly towards the end of the decade), when the actual rate was also lower. The ad hoc nature of the solution is evident. They tell you that the natural (which they measure as an average of the actual) is the attractor of the actual rate, and not the reverse.

The continuous ad hocery of the mainstream is on display now too. This is evident in discussion about the fears of inflation in the US, according to which the tripling of the monetary base would lead to hyperinflation (Krugman criticizes that here, and in several other places). Inflation does not take place, but it must be that expectations of inflation are low.

Also, it is evident in the IMF, the Bank for International Settlements (BIS) and other international institutions (since last year at least) arguments for fiscal and monetary contraction in the periphery (which is still growing faster than the center). The IMF believes fiscal expansion is no longer needed since “private demand has, for the most part, taken the baton” (IMF, 2011: xv). Moreover, the BIS argues that inflation is presently the main risk in an otherwise recovering world economy, and therefore suggests “policy [interest] rates should rise globally” (BIS, 2011: xii). According to this view then, if demand is controlled then prices would stop growing fast, and inflation would be under control.

Brazil actually did that last year, that is, fiscal contraction (with some monetary easing, but from a very tight stance, since it still maintains very high real interest rates). Output decelerated from 7.6% growth in 2010 to a mere 2.7% growth last year. A reduction of almost 5%. Did inflation then fell significantly as it should according to the mainstream? The Consumer Price Index (CPI) of the Fundação Getúlio Vargas increased from 6.24% to 6.36% in the same period, that is, it was almost constant. Something similar took place in Argentina between 2008 and 2009, when output decelerated around 10% (from high growth to negative growth), and inflation remained at high levels (fell perhaps around 6% or so, in an year that commodity prices collapsed). The mainstream argument is that the policies were not credible and as a result inflation expectations remained high.

In other words, it is not that the theory does not work, even though facts show that their predictions are false. It's a problem of the complexity of the phenomenon, and the need to account for expectations (anything can enter here, and no hypothesis can be tested if you take this seriously).

A simpler solution would be to admit that prices have little to do with demand (at most weaker demand and lower employment reduce the bargaining power of workers and reduce wage resistance). In other words, get rid of the notion of natural rate of unemployment and of a PC for which there is no reliable evidence (as should be done by any serious scientist). The contractions demanded by the IMF and the BIS led to recession (they affect quantities), and prices in Brazil did not fall because costs (which include imported goods and wages) did not fall. No need to suggest that expectations are responsible for inflation not falling. [Keen on his debate with Krugman has also referred to these subterfuges to keep theory in the face of lacking evidence; epicycles if you will]. By the way, expectations have been traditionally a way to argue that anything can happen, and allow theories that are not consistent with facts to get away with the incoherence. But I'll let that for another post.

References:

BIS (2011). 81st Annual Report. Basel, Bank for International Settlements, June.

IMF (2011). World Economic Outlook. Washington, DC, April.

Global Monetarism Strikes Back



Olivier Blanchard, the chief economist at the International Monetary Fund (IMF) announced in a triumphalist tone that “earlier fears of a double-dip recession—which we did not share—have not materialized” and defended the need for “fiscal consolidation that is neither too fast, which could kill growth, nor too slow, which would kill credibility.” For Blanchard fiscal expansion has done its job, since “private demand has, for the most part, taken the baton.” The risks are associated to the higher prices of commodities and inflation. The Bank of International Settlements (BIS) has added to the IMF’s view that inflation is the main risk on an otherwise recovering world economy. In their recent Annual Report they argue that: “spread of inflation dangers from major emerging market economies to the advanced economies bolsters the conclusion that policy rates should rise globally.” That is, add monetary contraction to the policy mix.

Read the rest of the entry here.

Basel III and the BIS

Two news from Basel this Monday. None good. First, in their just released Annual Report, the Bank of International Settlements (BIS) complements the IMF's demands for fiscal contraction, with their own calls for monetary contraction.  In their view:

"Inflation risks have been driven up by the combination of dwindling economic slack and increases in the prices of food, energy and other commodities. The spread of inflation dangers from major emerging market economies to the advanced economies bolsters the conclusion that policy rates should rise globally. At the same time, some countries must weigh the need to tighten with vulnerabilities linked to still-distorted balance sheets and lingering financial sector fragility. But once central banks start lifting rates, they may need to do so more quickly than in past tightening episodes."

It is bad enough not to have sufficient fiscal stimulus in the developed world, but to export the behavior of the ECB to other central banks would be a terrible idea.  In this case, they think that developing countries are exporting inflation, and developed countries should act swiftly.

In part, the misguided recommendation of the BIS follows from an incorrect view of what caused the crisis.  For them low rates of interest now will create new risks in the financial system.  Yet, the crisis was not the result of low rates of interest, but a consequence of deregulation.

And that leads to the second news.  The Basel Committee on Banking Supervision has added a surcharge of extra capital (on top of the Basel III ones) requirements between 1 and 2.5% of the value of risk adjusted assets for large banks (here; subscription required).  I'm sure people more qualified will discuss the nitty gritty details of this proposal, but from my point of view the problem is that this perpetuates large institutions, and avoids the old New Deal commitment to break them up and separate the speculative activities from the financing of productive activities.  There is no reversing of the so-called "revenge of the rentiers."