Too many things wrong (Sargent and Field edition)



And not enough time to blog about all of them. Two that seem to be really important and worth noticing in recent debates around the blogosphere among the chattering classes are the idea  (subscription required) that State Defaults after the Jacksonian economic crisis were good to establish US credibility, and the notion that Total Factor Productivity (TFP) was essential for the US recovering from the Great Depression.

Very briefly I’ll discuss why these two propositions are just wrong. Sargent argues that by guaranteeing State debts the Hamiltonian system created moral hazard, and that the States defaults of the 1840s, which resulted from this arrangement, were instrumental in creating a credible fiscal commitment to sound finance. In his words: “in refusing to bail out the states in the early 1840s … the federal government reset its reputation vis-à-vis the states, telling them in effect not to expect it to underwrite their profligacy.” The lesson for Europe is let the periphery default, and, by the way, that would lead them to fiscal consolidation by even more austerity (yep he never heard of multipliers). At any rate, this account of the United States experience is pure fiction.

First of all the collapse had nothing to do with profligacy, and all to do with prices of cotton falling, and States defaulting on foreign debt, not domestic debt. In Europe the countries do print the money in which their debt is denominated, the problem is that the ECB is not willing to do it. The crisis is self-made, and if the ECB monetized a bit of debt there would be no danger of inflation, since the economies are really (really) far from full employment.

Further, the US national government at that point had no public debt (Jackson paid it down and caused a financial crash; he also required payments of public lands in specie, that is the crisis was worsened by austerity and sound money), and no national bank or monetary authority. Hence, it could not bail the States out. Only after the Civil War, with greenbacks, a more centralized management of debt and money were created in the US. So there is no possibility that the reputation of something that did not exist until the 1860s was built in the 1840s.

Sargent's anal fixation with austerity in order to pay debts, even those in domestic currency, and his lack of understanding of basic events in the history of the United States are appalling. And this guy got a Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (yep, it’s not a real Nobel!).

Field is an interesting case. The mistake in his book is not of his making, in all fairness, but the result of the profession's lack of understanding of basic economic principles. His point, well explained by Mark Thoma, is that part of the recovery in the 1930s was caused by rapid growth in productivity (TFP). Nothing against the argument, which might be (and probably is) true, to some extent. Note also that productivity is not only pro-cyclical but also structural and demand-led, which means that some of the increase in productivity was actually caused by the recovery. But the problem is that TFP is not a measure of productivity.

Note that TFP is based on the notion that there is a production function in which output (Y) is a function of labor (N) and capital (K), and forget for a second the problems of using the notion of a quantity of capital. In addition, we know that income (Y) is equal to the payments to labor (N) and capital (K). So we have a theoretical construct and an identity:

Y=f(N, K) and Y=wN+rK

Obviously if you derive Y with respect to time, you must obtain from either equation that the growth of Y over time is a function of growth in labor and capital, and either some additional part, which depends on the technology f(…) in the theoretical construct, and the weighted average of the growth of wages (w) and profits (r) in the identity. And yes the second is an identity and by definition (constructed in the national accounts) true. So TFP is a residual that says something about income distribution. Let’s please use labor productivity, when discussing productivity. For more on that see, for example, Felipe and McCombie (2001; subscription required).

Long-term versus short-term debt

In a previous post I have referred to the Fiscal-Military State, and Brewer's classic book on it. It is worth remembering, for those afraid about debt these days, that public debt in the UK during the Napoleonic Wars peaked at more than 250% of GDP.

One of the important ways in which the British were able to out-finance the other major European powers, fundamentally France, during the 18th century was the ability to borrow long at at low rates. The graph below shows the proportion of unfunded to funded debt (from Brewer's book). The UK rapidly moved from almost 100% of unfunded debt to less than 10%.

Funded debt, was debt for which specific taxes were set aside to service it, and it tended to be long-term, while unfunded debt was usually short-term debt. Debt service consumed a great amount of the budget, but that was simply the result of the incredibly large amount of debt, since interest rates remained relatively low. I guess the lesson is that long term debt in your own currency is okay.

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.

UNCTAD against fiscal austerity

The Trade and Development Report (TDR, 2011) has been published.  It says many important things, but I think that what stands out in the the current environment is its defense against fiscal austerity.  It says:

"The current obsession with fiscal tightening in many countries is misguided, as it risks tackling the symptoms of the problem while leaving the basic causes unchanged. In virtually all countries, the fiscal deficit has been a consequence of the global financial crisis, and not a cause. (...) Policymakers should not focus only on debt stock. They need to consider the relationship between the stock of debt and the flow variables, including interest rates and fiscal revenues that affect a country’s ability to support its debt. A major factor that influences changes in the burden of public debt is GDP growth: it is virtually impossible to lower high debt-to-GDP ratios when an economy is stagnant, unless the debtor obtains a significant debt reduction. Hence, the level of a country’s fiscal deficit (or surplus) needs to be viewed from a more holistic and dynamic perspective, in the context of its impact on the sustainability of a country’s financial position and on its economic stability and growth prospects."

Economic growth is the way out of debt, and that should be done with more deficits now.

PS: The NYTimes has a story citing Heiner Flassbeck the head of the Division that writes the TDR report.

Public debt is too small

That's what Alex Izurieta says in his last paper (available here). He provides several important points to justify this view. First, once one excludes the debt owned by intra-government institutions the net debt-to-GDP ratio is around 60%. Not particularly large. Second, since 2009 government spending has faded away in its contribution to growth is turning negative, which means that in the absence of other sources of demand, the government is the only thing between us and a protracted recession. More importantly, since agents are in a "liquidation phase", that is still dealing with the consequences of falling assets prices on their balance sheets, then:

"to recover from a financial crisis, the ideal instrument is government support in the form of public debt, i e, government liabilities that are transferred to the balance sheets of private sector agents as their assets."

Not very likely to happen, but the reasons are not economic, and the solution is within the reach of reasonable, well-informed policy makers.

Lorie Tarshis on National Debt

Tarshis was a student of Keynes, and the author of an early textbook (published in 1947, a year before Samuelson's more well known manual), which included the main elements of Keynesian economics (Colander and Landreth discuss the reception of the book here).  One of the last chapters of the manual deals with national (meaning public) debt.  Note that this was written when the debt-to-GDP ratio in the United States was around 120 percent. First, contrary to many economists today, he clearly distinguishes public and private debt, and notices that:

"Since it [the Federal Government] may either impose taxes, or borrow through its control of the banking system, there can be no question of the federal government going bankrupt."

Interestingly, at that time, even at the beginning of the McCarthyte Red Scare, he would not imagine the possibility of the debt-ceiling not being raised.  So default in domestic currency is impossible. Further, he argues that:

"Even though a high federal debt threatens neither bankruptcy nor an exhaustion of government credit, it does have certain other consequences. ... If the government collects taxes to pay interest on its debt, it transfers money from the tax payer to the bondholder ... the transfer is in the direction of those in the higher income brackets ... [that] generally reduces the propensity to consume."

For him, there are a few solutions for the contractionary bias of public debt financed by taxes.  Reduce the rate of interest, by having the Fed buy bonds, and borrow from the Fed.  Shift taxation from the poor to the rich, reducing Social Security taxes and increasing the marginal tax for higher income brackets.  Republicans are adamantly opposed to the second alternative, and are going to eliminate the first by not allowing the debt-ceiling to be raised.  The consequences are clearly contractionary, as a good manual, back in 1947, already showed.

PS: To have an idea of how strong anti-Keynesian ideas were among businessmen see the following letter in response to Leonard Reed's campaign against Tarshis's book.  Would also recommend Invisble Hands, by Kim Phillips-Fein.

Who holds the American public debt?

Just a clarification following up my comments on Nick Rowe's post.  Several people are under the impression that the Fed can still monetize debt if the debt-ceiling is not raised beyond the US$ 14.3 trillion limit.  Not the case. Otherwise there would be no default by definition.  There might have been some problems associated with monetization, but not default (see more about monetization here).

Of the US$ 14 trillion of debt outstanding by December 2010, around US$ 5.6 were held by the Fed and other intra-government agencies (Fed holds around US$ 1.6; see Dean Baker's proposal and discussion here).  So if the Fed buys debt, to monetize it, it just reduces the privately held part of the debt and increases the publicly held, but it cannot increase the total amount.  The graph below shows the public, private, and the foreign (within the private) held shares of US public debt.

As you can see, since the Great Recession, the private share increased from around 50% to close to 60%, and of that the increase has been mostly associated to foreign ownership.  So apparently nobody has been worried (correctly so) about the possibility of an American default.  In fact, since the crisis Treasuries have been increasingly a demanded asset by the private sector, particularly foreign investors, as a safe heaven against the risk of default (data here).  The problem is that the debt-ceiling limit creates a situation which would otherwise be impossible, namely: the US can default on bonds issued in its own currency.

Well understood what the debt-ceiling limit implies is a fiscal restriction, and it would force drastic cuts in spending.  Consider it a very large government shutdown.  So in reply to Nick, if you are Keynesian, and believe your model, this is really bad news.

The debt-ceiling limit: a guide for the bewildered

It is very difficult to explain American politics to those that are not Americans and/or have not lived here long enough. Add to that the confusion over basic economic principles, and it becomes almost impossible to explain the debt-ceiling debate to rational people.

As noted by James Galbraith, this is not a fiscal crisis, which should be obvious, since it was a Wall Street driven bubble.  Also, contrary to what you think the Republicans are the big government party. The graph below shows total federal government spending as a share of GDP (in black), and some spending categories as a share of government spending (in colors). As it can be seen total spending goes up in 1981, 1989, 2001, when Republicans assumed the administration, and down in 1993, when Clinton did.  Also, note that even if spending went up in 2009, as a result of the crisis, it did come down in 2010 (which is not a good thing, by the way) with Obama.

Read the rest here.

Fiscal expansion is expansionary!

Talk on fiscal policy at the ILO.  The preliminary paper is here.  The graphs I refer to in the talk are at the end of the paper. The link for the other papers presented is here.  The session was on macroeconomic policies for employment creation.

Many Economies, Just One Medicine

The IMF in its last Fiscal Monitor suggests that developed countries must adjust because public debt is growing out of hand, and Latin American (and other developing regions) should do fiscal adjustment because their economies are overheated.  First, the graph below shows public debt in four developed countries.  It is clear that in all debt-to-GDP ratios went up after the crisis.  In other words, public debt is the result of the crisis not is cause.



It is important, also, to remember that the crisis has destroyed private wealth (even though governments went out of their ways to compensate some for their losses, in particular the big banks that got us into the crisis).  If private debt falls, and with it private demand, then public demand (spending) has to increase to compensate, unless one wants lower levels of activity.  So it is far from clear that the increase in public debt is problematic at all, and surprising that the “reformed” IMF already is pushing for contraction (note that the IMF has a central role in promoting brutal fiscal adjustments in Eastern Europe and the periphery of the euro too).

But what is really interesting is that if increasing public debt is a sign of dangerous fiscal profligacy, one would expect that Fund to at least be more lenient with countries that have constant or decreasing public debts.  The figure above shows the case of four Latin American countries.

In other words, if debt increases do fiscal adjustment. If debt falls do fiscal adjustment.  I’m starting to think the IMF is always for fiscal adjustment.  Instead of Dani Rodrik’s One Economics, Many Recipes, their motto is Many Economies, Just One Medicine.



Glenn Hubbard's family



Mark Blyth sent a nice letter  (subscription required) to the Financial Times.  You must remember that "Give it your Best Shot" Hubbard (of Inside Job fame) was the Chairman of Bush's Council of Economic Advisors, and a cheerleader of tax cuts for the very wealthy.  Hubbard had written an op-ed in the FT (no need to read it, since it's really bad) saying that public debt is out of control.  Of course he is still against taxes for the wealthy.  First Mark gets correctly the point that public debt is not analogous to private debt and lectures the economist (that should have known this):

"the Hubbard family does not issue its own script, owe itself money, borrow other people’s savings with their own paper, or allow new entrants into the family on the basis of skills and contribution to taxes."

Then he points out that:

"the blame for the current predicament lies in the “discretionary spending binge of the past decade”, which would be the cost of bailing the banks that he argued should be less regulated, and the unfunded tax cuts which he championed. Odd then that having cut into revenue so drastically Professor Hubbard resists raising it through taxes, especially on the top 1 per cent, who, even if we were to double their share “would not right the fiscal ship”. Perhaps, but since they made off with 20 years of gains, and got their assets bailed, I’d just feel a bit more part of the family if they did."

Here is another case of a Republican economist caught between the logic of the problem at hand and their bizarre solutions.  Before anybody complains, I'm not to worried about the size of debt, or the fact that is growing, but I'm in favor of higher taxes for the rich.

More on public debt and the rate of interest

An important point in the conservative (sound finance) argument against the increase in public debt, and the need for fiscal adjustment is that higher debt-to-GDP ratios would eventually lead to higher real interest rates.  In other words, the increase in debt would imply that economic agents would demand remuneration for holding government bonds.  The figure below shows the correlation between the change in public debt and the real rate of interest on bonds, between 1981 and 2009.

The result shows that an increase in the debt-to-GDP ratio of 1% leads to an increase of the real rate of interest on bonds os 0.07%.  In other words, the effect is in economic terms insignificant.  Much ado about nothing.

PS: As Nate Cline and Franklin Serrano kindly noticed, causality most likely runs from the rate of interest to debt.  Sure thing; the point here is just to note that even if the conservative point was correct, the actual effect would be insignificant.

Debt dynamics for dummies

Krugman again does a great job showing that the risks of explosive debt are way overblown.  As he says:

"So even with substantial deficits, the pace of long-term budget worsening is very slow."

It is not difficult to understand debt dynamics.  The ratio of debt to income (GDP) is a measure of the capacity to repay debt.  If the economy grows faster than debt, the debt-to-GDP ratio falls.  GDP grows with demand expansion, and debt grows at the pace of the interest on the debt.  In other words, if the economy grows faster than the rate of interest, then the debt-to-GDP ratio will fall even if the government runs deficits.

The graph below shows the growth rate and the real rate of interest on government bonds for the US since 1990.  As it can be seen, since 2003, with the exception of the Great Recession, the rate of interest has been below the rate of growth.

The debt-to-GDP ratio has only increased (see graph below), because the crisis has caused significant deficits to accumulate.  Note that in the 1990s, a combination of lower interest rates, higher growth and fiscal surpluses had stabilized debt, which starting growing in the Reagan years.

Finally, note the growing deficits in the figure below have reversed with a very mild recovery in 2010. Interest will remain low. What is needed is a stronger recovery to get growth going and that would increase revenue (allow for reduced spending on several things like unemployment insurance) and eventually lead to a lower debt-to-GDP ratio.

The way out of the fiscal problems is growing!  Even dummies should get this right.

Honest economists and other unicorns

So Dean Baker just nailed Greg Mankiw.  Bush's Council of Economic Advisors's chairman (yep he was part of that economic team) asks three questions in his NYTimes column.  Namely:

1) How long will inflation expectations remain anchored?

2) How long will the bond market trust the United States? 

3) How long will it take for the economy’s wounds to heal? 

The reply to the first (I changed the order) is pretty good, in part because it dismisses the whole exaggeration about the role of expectations (what people think you think they might think will actually happen).  Also, and more importantly Dean emphasizes that wages have been subdued (to say the least; and one might add with unemployment at this level and years of weakened unions no chance of recovery anytime soon), and the only source of inflationary pressures are higher commodity prices.  He elegantly puts aside Mankiw's nonsense about the credibility of the Fed.

The second question is also dealt with the same clear understanding of economic principles that mainstream economists (that missed the coming crisis, and where cheerleaders of the policies that got us here seem to be oblivious to).  It is worth quoting Dean on this one.  He points out that:

"The idea being pushed by many in policy circles that at some point the bond markets will lose faith in the ability of the U.S. government to pay its debts is absurd on its face. This would be like saying that if I issued iou's, that were payable in my iou's, that the markets would be worried about my ability to meet my commitments."

It is, in fact, a very common idea, even in progressive circles, as I noted in my previous post.  Mankiw's notion that a day of reckoning for US debt is inevitable is disingenuous, which seems to be a pattern in certain mainstream circles.

On this I should say that all so-called New Keynesian economists, that is, those that think that involuntary unemployment might exist, and did not fall for Real Business Cycles and other crazy theories (please somebody explain to me how the last crisis was a real one!), that have advised Republican governments (John Taylor, in his recent rants against Krugman, is another example) are in a similar pickle.  They have to defend ideas (e.g. cutting taxes for the rich) that are clearly wrong for political reasons.  This means that Republicans are left with cranks that actually believe in supply-side economics and Santa Claus, and reasonably informed neoclassical economists that say things that they know are not quite correct.

But on question two, as Dean notes, if insolvency is not a problem, and inflation is not going to get out of hand, interest rates will remain low and there is no reason why the government cannot go on borrowing to finance its deficits.  If anything deficits should be larger.

Which gets him to the last question.  And yes, he asks how could "honest economists debate" whether the recession was actually worse than expected.  Dean is to nice to say that they might be clueless, in which case they should not be teaching in the "best" universities or writing for the Times, let alone advising government, or they are just not honest.  And yes, we do need more stimulus.

PS: Democrats have the reasonably well informed neoclassical (mostly New Keynesian) economists, but also some very good heterodox economists (which do not get the amount of influence they should, but that's another story).  In the Democratic camp the reasons for crazy things, like the belief that deregulation would increase financial stability, followed the monetary incentives (let's call it that).  But at least most of their economists do believe that unemployment is a problem.

There is no public debt problem in the United States

Jamie Galbraith's clearly shows that fears of an American default are exaggerated.  He says:

Let's suppose that the Treasury actually says to the People's Bank of China, sorry, we can't write a check to you right now. Well, in the case of the People's Bank of China, the bond that they hold would become a defaulted bond, but it would still be there. And the Treasury would still recognize its obligation on that bond and would presumably be willing to pay accrued interest on it. The Treasury would probably say, it's going to be a few days while we resolve this, and the People's Bank of China would, in my view, probably do nothing. If I were sitting in the position of a foreign holder of U.S. Treasury securities in that situation, the last thing I would want would be a panic. I would want this problem to go away.

And by the way, Standard & Poor's doesn't matter also.

It's not the size, but how you use it: A note on the debt-ceiling limit

According to the New York Times we barely averted the government shutdown to move on to the war over the debt-ceiling limit. Tim Geithner has argued that the government will hit, no later than May 16, the federal debt-ceiling limit of US$ 14,2 trillion. In fact, contrary to what one might expect the debt-ceiling limit is often increased. The question, of course, is whether the increase in debt vis-à-vis the capacity to repay, normally measuring debt as a share of GDP, is of such magnitude that the economy is doomed.

When we hit the limit, federal public debt will be slightly below the 100% mark. Historically, is not the highest debt-to-GDP level in the US, neither unprecedented by historical standards. The graph below shows British debt-to-GDP from 1692 to 2011.

The peak in British debt, at the end of the Napoleonic wars, was about 260%, and it had grown consistently during the 18th century. David Hume argued in 1752 that: “either the Nation must destroy public credit, or public credit will destroy the Nation.” He was obviously wrong (that’s probably why his theories are still taught by economists!). Not only public debt, which is what he meant by public credit, did not bankrupt the UK, but also it allowed for an Industrial Revolution and the victory in the hegemonic wars against France. A pile of debt laid the foundations for the Victorian economy boom and world dominance.

Note that during the 18th century the UK had higher taxes to pay for the higher debt levels than France, but interest rates were considerably lower, which implied that the burden of debt (interest payments out of total spending) was not much bigger than in France. James MacDonald has a very good book on the British debt history.

This suggests that more important than the growing debt-to-GDP ratio in the US is how it is used, and how it is funded. The function of the deficits and debt is more important than the size, as Abba Lerner argued. Hence, if we spend money to create jobs (e.g. remaking the infrastructure) and tax the rich rather then cut spending on programs for the poor, increasing the debt-ceiling limit should be a no-brainer.

Dean Baker vs. Paul Krugman

I often tend to agree with Dean, and its no different this time around, but it should be remembered that Volcker not only caused pain domestically with unemployment, he caused the debt crisis by hiking interest rates to the stratosphere.

Dean is right that the US will not be Greece, and that common currencies, like the euro (or dollarization in Latin American countries like Ecuador or El Salvador) imply that external imbalances must be adjusted with lower levels of output growth and higher unemployment.   But it is important to note that the US will also not be Zimbabwe. Hyperinflation is not about monetization of public debt. The German and Latin American cases show that is about being unable to keep the external value of the currency when faced with a balance of payments crisis.

If the US monetizes debt, and the economy is not at full employment, the level of activity should increase. If hypothetically it gets to full employment, monetization of public debt may lead to private agents using money to repay existing debts, to some currency substitution, and to some excess demand (which would force business to invest to adjust capacity to demand).

The last two may lead to some demand inflation.  Certainly during World War II, when unemployment reached 1.2%, and in the late 1960s, when unemployment fell below 3.5%, some demand pull inflation forces were at work.  But Zimbabwe is not related to that at all!!!