Brief note on public debt and interest rates in Brazil

Robin Brooks, previously the chief economist at from the Institute of International Finance (IFF), and now at Brookings, suggests Brazil needs austerity, and, here is the punch line, that would promote growth (laugh track here).

The notion that it is the fiscal balances that determine the interest rate on public debt, and that fiscal deficits and high debt must imply high interest rates has no correlation with reality. Imagine the rate of interest that Japan would have if that was correct. In the case of Brazil the higher interest rates are entirely associated to Central Bank decisions.

In fact, if one looks at the correlation between interest rate and the size of public debt as a share of GDP, the correlation is weak, statistically insignificant, and negative. That is, higher debt is associated with lower interest rates by the central bank.

Let alone that the idea of expansionary fiscal contraction has been completely debunked with the austerity policies that followed the European crisis more than a decade ago. Ask Tories in the UK how well that worked!

Nominal and Real Interest Rates

The persistence of low interest rates has dominated the news. In general related to whether the Fed will or will not increase the interest rate by the end of the year. The Economist tried a few weeks ago to put things in perspective, and suggested not only that the current nominal rates close to zero are unprecedented, but it sort of indicated that the negative real rates are also to some extent a new phenomenon. The explanations for low rates can be found here, and the consequences, according to The Economist here (btw, for them is a pension crisis; and yeah, just wait this will be used to call for privatization).

I'm not particular keen, as you know, on the idea of a savings glut, as an explanation for the low rates. The reason is much simpler and is associated to the fall out from the previous crisis. But at any rate I just wanted to check the data. They showed the nominal short term rate in the UK (below), which is not very different from what can be found in other sources used here before (like this one).

However, they only show the real rate for the last three decades or so (see below). This seems to suggest, even though is never quite stated, that the current trend, with lower real rates is also unprecedented. But that is not the case.

In fact, what is really unprecedented is the fact that in previous eras of low or negative real rates, as far as I can judge from the data, were caused by relatively high levels of inflation, while now it is essentially the result of very low nominal rates (see below for previous eras of low or negative real rates; btw, my graph matches theirs, but the period is shorter for the nominal rate, and way longer for the real rate).

This seems to suggest to me that the explanation must be related to the short term nominal rate, which is a policy decision of the central bank, rather than something that affects the levels of inflation, and according to some theories (the loanable funds) what that does to savings. If I'm right then, the cause of the low rates is the financial excess of the last three decades, that forced central banks to keep rates low to save the economy, and preclude further problems. Very unlikely that would change any time soon.

On the Fed's decision at the Rick Smith Show

Fed keeps interest rate close to zero

The Fed has left the interest rate unchanged... for now. One dissident vote for raising the rate now. The main reason according to the press release is that: "Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term." Pressures for a hike in October or December will increase significantly, even if the official position is vague enough. They say: "The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term."

Even The Economist is against raising the interest rate

In the last issue, The Economist suggests that the Fed should not be concerned too much with inflation, and that they should not raise the interest rate for now. They say: "Weak wage growth suggests that there is still lots of slack in the labour market. Underemployment, which includes workers who are part-time but want a full-time job, and discouraged workers who might be tempted back into the labour force, stands at just over 10%, higher than before the crisis. This measure probably has further to fall before wage growth picks up. The Fed may also be underestimating how far unemployment can fall without stoking inflation." Instead of raising it now, Yellen should wait until the December meeting. In their words: "A rate rise would cause a big market reaction, because it is not fully expected. Markets place roughly a one-third probability on it happening. Were Ms Yellen to hold off, she would have time to lay the groundwork for a more predictable rise in December."

Massimo Pivetti on Interest Rates and Gross Profit Margins In Recent Experience of Advanced Capitalism

From a paper prepared for the colloquium “What have we learnt on Classical economy since Sraffa?” Paris, October 2014

According to the monetary explanation of distribution, as elaborated over the past 25 years on the basis of a well known suggestion by Sraffa, the normal rate of profit would be arrived at in each sphere of production by adding up two autonomous components: the rate of interest on long-term riskless financial assets, plus a normal rate of profit of enterprise, viewed as a component of normal production costs and reflecting objective (or widely perceived as objective) elements of risk attached to each different productive employment of capital. Since the normal margins for profit, given production techniques, depend on normal profit rates, the same two variables, the rate of interest and the rate of the profit of enterprise, would govern also the course of net normal profit margins in the different production spheres. For any given set of profits of enterprise, the long-term rate of interest would thus act in the economy as the regulator of the ratio of prices to money wages. Once the normal profit of enterprise in each sphere of production is taken as given, in that it is determined separately from both the rate of interest and the rate of profit, attention is focused in this approach on the rate of interest.

Read rest here.

Financialization and the Resource Curse in Brazil

"Financialization and the Resource Curse: The Challenge of Exchange Rate Management in Brazil"

By Kevin P. Gallagher and Daniela Magalhães Prates

Indeed, Brazil has been blessed and cursed with high commodity prices (from 2003 to mid-2008 and 2009-2011) and low interest rates in the core economies after the 2008 global financial crisis. Such an environment, coupled with the high domestic policy rate and the sophistication of the Brazilian financial system, has made Brazil a much sought after destination for carry trade operations through short-term financial flows that are largely transmitted through the foreign exchange derivatives market. Speculative operations into this market have accentuated the upward pressure on the exchange rate, which has come with higher commodities prices, leading to what we refer to here as a financialization of the resource curse (pp. 2).

Read rest here.

Why interest rates will (likely) stay low

Or they need to stay low. That's what the editorial board of the NYTimes says, quite correctly in my view, after the Jackson Hole speech by Janet Yellen last Friday. Yellen is more cautious and it is not exactly clear what will happen next. She said:

Earlier this year, ... with the unemployment rate declining faster than had been anticipated and nearing the 6-1/2 percent threshold, the FOMC recast its forward guidance, stating that "in determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee would assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation." As the recovery progresses, assessments of the degree of remaining slack in the labor market need to become more nuanced because of considerable uncertainty about the level of employment consistent with the Federal Reserve's dual mandate.

I'm not going to try numerology or any other dark science to foresee the future decisions of the FOMC, but it is clear that pressures for tightening are increasing.

I think overall the speech suggests slightly more weight to the dovish view, and that interest rates, at least for now, will remain low. She said:

... the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions... [and]... wage inflation, as measured by several different indexes, has averaged about 2 percent, and there has been little evidence of any broad-based acceleration in either wages or compensation. Indeed, in real terms, wages have been about flat, growing less than labor productivity. This pattern of subdued real wage gains suggests that nominal compensation could rise more quickly without exerting any meaningful upward pressure on inflation.

Yes, then she cautioned that "the current very moderate wage growth could be a misleading signal of the degree of remaining slack." But that's basically to say that they will act if inflation signals appear. The interesting thing is that although the whole discussion of the risks of inflation is associated to the slack (or lack of) in the labor market, and other measures of the current level of activity vis-à-vis the optimal level (unemployment or output or GDP gap), she admits quite candidly that: "historically, slack has accounted for only a small portion of the fluctuations in inflation." It is a remarkable admission of the absence of evidence for the dominant model that orients monetary policy. The natural rate is dead, long live the natural rate!

Fiscal balances in Brazil, 2002-2012

This is from an unpublised paper by Fernando Maccari Lara, Roberto de Souza Rodrigues, and Carlos Pinkusfeld Bastos.* Figure below shows the nominal and primary balances as a share of GDP, and the financial expenditures, which make the difference between the two balances (i.e. a primary surplus becomes a nominal deficit after the interest payments on outstanding debt). All figures as a share of GDP.

Note that during the whole Lula, and the first two years of Dilma, the Brazilian government kept primary surpluses, as it has done essentially for a few decades now, with few exceptions. There is a tendency for the expenses with interest rates to go down, they remain at 3.5% of GDP (in 2012), which means that it remains the largest 'social' program in Brazil, larger than the Bolsa Familia.

From the asbtract: 

Brazilian economy adopts a set of economic policies after the crisis in the end of the 1990s decade. Setting a target for the primary fiscal surplus was the main objective of the fiscal policy, and it has been in used since then. In fact, the Workers Party (PT), which was initially critical to this policy, maintained it after assumed the government in 2003. Therefore, this article analyzes the fiscal policies during this party government period from 2003 to 2012. To achieve this objective it will be used both government's official raw data and a calculation of fiscal impact of outlays and taxation. We conclude that there is no clear rationale behind the determination of primary fiscal surpluses which became more of a political dogma than a useful policy instrument. In terms of economic growth one cannot say that the fiscal policy has been effectively contractionist but in some years it most certainly did not contribute to a more robust rate o economic growth and did not respond to stabilization policy needs.

* To be published in the Annals of the Brazilian Keynesian Association Meetings.

Dean Baker - Housing & The Downturn: It's Really Not That Complicated

By Dean Baker

Neil Irwin has a piece noting housing's importance in the downturn, which gets things half right. First, housing is typically important in economic cycles, as he says, but the picture is quite different than Irwin implies. In a typical recession housing construction falls because it is very sensitive to interest rates. Most recessions are brought on by the Fed raising interest rates to slow the economy. In these cases the decline in housing is a deliberate outcome of Fed policy, not an accidental outcome to be avoided. In contrast, the most recent downturn was brought on by a collapse of a housing bubble. This made it qualitatively different from most prior downturns (the 2001 recession was also bubble induced) in several different ways. First, construction was proceeding at an extraordinary rate of more than 6.0 percent of GDP before the collapse, compared to an average rate of just over 4.0 percent of GDP. This meant that housing contracted far more than it would in a typical downturn. Furthermore, because of the overbuilding of the bubble years, housing fell further than normal, hitting levels just above 2.0 percent of GDP. And, because the downturn was not brought on by a rise of interest rates it could not be reversed by a drop in interest rates.

Read rest here.

Tokunaga & Epstein - Endogenous Finance of a Dollar-Based World-System: A Minskian Approach

Junji Tokunaga & Gerald Epstein 

From the Abstract:

Global financing patterns have been at the center of debates on the global financial crisis in recent years. The global imbalance view, a prominent hypothesis, attributes the financial crisis to excess saving over investment in emerging market countries which have run current account surplus since the end of the 1990s. The excess saving flowed into advanced countries running current account deficits, particularly the U.S., thus depressing long-term interest rates and fuelling a credit boom there in the 2000s. According to this view, the financial crisis was triggered by an external and exogenous shock that resulted from excess saving in emerging market countries, not the shadow banking system in advanced countries which was the epicenter of the financial crisis. Instead, we argue that a key cause of the global financial crisis was the dynamic expansion of balance sheets at large complex financial institutions (LCFIs)(Borio and Disyatat [2011] and Shin [2012]), driven by the endogenously elastic finance of global dollar funding in the global shadow banking system. The endogenously elastic finance of the global dollar contributed to the buildup of global financial fragility that led to the global financial crisis. Importantly, the supreme position of U.S. dollar as debt- financing currency, underpinned by the dominant role of the dollar in the development of new financial innovations and instruments, and was a driving force in this endogenously dynamic and ultimately destructive process.

Read rest here 

Gerald Epstein on why the Fed is pushing interest rates higher

Gerald Epstein

The quantitative easing is when the Federal Reserve essentially prints money and then buys Treasury bills and mortgage-backed securities and other things like that. And they've been doing about $85 billion a month and are now tapering--what they call tapering it down to $65 billion a month. And by doing that, they're putting less money and credit into the economy. And when there's less money and credit in the economy, that tends to raise interest rates. And hence you've seen a big shift in financial markets here in the U.S. and all over the world as a result of this expectation that both short-term and long-term interest rates are going to go up.

Oskar Lange theory of interest and the ISLM

By Roberto Lampa (Guest blogger)

In two previous posts, dated 2011 and 2013, Matías Vernengo clarified that the ISLM model can accommodate changes that incorporate the criticisms of several heterodox groups. In particular, he stresses that the ISLM can accommodate an investment function in which the level of activity (rather than the rate of interest) is central, so that the accelerator can be incorporated. More importantly, he also states the ISLM does not imply a natural rate of unemployment, thus allowing for relevant discussion of policy issues.

Both these aspects can be found in Oskar Lange's 1938 contribution to the neoclassical synthesis, in which he assumes that investment (mostly) depends on consumption, which in turn is permanently distorted by the “irrational” distribution of income, typical of any capitalist economy. More precisely, Lange outlines the mutual dependence of investment and consumption as a sort of ‘indirect’ relationship.

Firstly, he states that, as in traditional theory, in his model an increase in the propensity to save induces a decrease in the rate of interest. However, his reasoning runs along more unconventional lines than the (Neo)-Classical interaction of both supply (of) and demand (for) capital curves:

"…an increase in the propensity to save [implies that] expenditure on consumption is now lower. This causes (…) a lower quantity of investment (…). Total income decreases (…). The consequence is a fall in the rate of interest." (pp. 17-18)

In other words, in Lange's view the immediate effects of an increase in the propensity to save are a decrease in consumption, investment and total income. Therefore, as recognized by Keynes himself:

"The analysis which I gave in my General Theory of Employment is the same as the ‘general theory’ explained by Dr. Lange on p.18 of his article, except that my analysis is not based (as I think his is in this passage) on the assumption that the quantity of money is constant." (Keynes J.M., 1973a, p.232n)

Following this train of thinking, we deduce that it’s only afterwards that the decreased level of the rate of interest will stimulate investment, consumption and total income. The final result of an increase in the propensity to save will then depend on the ‘specific weight’ of each of these two effects.

Not coincidentally, Lange explicitly assumes in equation (3) – by drawing on Karl Marx's realization crisis – that consumption directly affects investment, as an excessive growth in saving (i.e. an excessive contraction of consumption, investment and total income) cannot be counter-balanced by the subsequent decrease in the rate of interest, as it destroys any incentive to invest, "at least in a capitalist economy where investment is done for profit" (Lange, 1938, p.23). He thus firmly rejects the (Neo)-Classical assumption that any abstinence from consumption implies automatically an increase in investment: according to him, such a direct relationship holds only until a certain limit (i.e. the optimum propensity to consume), beyond which the collapse of the demand for investment goods will drastically diminish investment itself. Therefore, the real issue becomes if and how it is possible to determine (and to maintain) such an optimum propensity to consume, given a market economy. Lange's opinion is definitely non-optimistic:

"In a society where the propensity to save is determined by the individuals, there are no forces at work that keep it automatically at its optimum, and it is well possible, as the under-consumption theorists maintain, that there is a tendency to exceed it." ( p.32)

In other words, the result of Lange's analysis converges with (and radicalizes, as well) Keynes' pivotal idea, that is, the tendency towards a chronic under-consumption crisis.

Recently, I have published a detailed analysis of this rather obscure work in the Cambridge Journal of Economics. I explore in depth Lange's theory of interest and its tortuous relationship with both Keynes’ General Theory (1936) and Hicks' synthesis (1937), developing two graphical models that show the non-linearity of Lange's investment function as well as the consequences of his equilibrium solution. Through an unedited manuscript, I also reconstruct Lange's beliefs about the chronic sub-optimality of the capitalist economy and his scientific endorsement of the socialist economy.

Full paper is available here.

P.S. It is worth noting that Keynes himself was prompted to reflect that Lange's article "follows very closely and accurately my line of thought" (Keynes, 1973a) notwithstanding the analytical differences. Lange was, after all, standing on the same "side of the gulf," as he clearly rejected the notion that capitalism could be a "self-adjusting system" (Keynes, 1973b).

Lars Syll on Loanable Funds Theory

By Lars Syll

The classical theory of the rate of interest [the loanable funds theory] seems to suppose that, if the demand curve for capital shifts or if the curve relating the rate of interest to the amounts saved out of a given income shifts or if both these curves shift, the new rate of interest will be given by the point of intersection of the new positions of the two curves. But this is a nonsense theory. For the assumption that income is constant is inconsistent with the assumption that these two curves can shift independently of one another. If either of them shift, then, in general, income will change; with the result that the whole schematism based on the assumption of a given income breaks down … In truth, the classical theory has not been alive to the relevance of changes in the level of income or to the possibility of the level of income being actually a function of the rate of the investment.

There are always (at least) two parts in an economic transaction. Savers and investors have different liquidity preferences and face different choices — and their interactions usually only take place intermediated by financial institutions. This, importantly, also means that there is no “direct and immediate” automatic interest mechanism at work in modern monetary economies. What this ultimately boils done to is — iter — that what happens at the microeconomic level — both in and out of equilibrium — is not always compatible with the macroeconomic outcome. The fallacy of composition has many faces — loanable funds is one of them.

Read the rest here.

Duménil and Lévy and the Apotheosis of Capital

Graph below from Duménil and Lévy's (D&L) The Crisis of Neoliberalism (p. 61) [my previous post on their book here].

Note that contrary to the Fed's base rate, which is negative in real terms, the rates paid by corporations are relatively high. Note that firms my borrow to finance, not production, but to buy back stock and pay dividends, and enrich stockholders, including management. That's what happened according to D&L (see below, p. 62).

In other words, on average higher rates of interest (even if lower in periods of financial crises) sustain redistribution towards fat cats. The opposite of Keynes' euthanasia of the rentier indeed.

Investment in infrastructure is a no brainer

NYTimes comic strip that gets economics right, which is more than you can say about most pundits and a good chunk of the profession.