Archive for the Category Keynesianism


Current account deficits don’t matter

There are many things that we teach our undergrads, which then get forgotten (or rejected, if I must be polite) by professional economists.  The minimum wage costs jobs, low interest rates don’t mean easy money, trade with China benefits the US, monetary policy remains highly effective at zero rates, etc., etc.  I taught all these ideas right out of the textbooks I used, because I believe them.  And here’s one more: current account deficits are not a problem; they merely represent an imbalance between saving and investment in a particular region.  If we abolished CA deficits for all regions, down to the individual level, we’d have to abolish banks.  You want a house?  Save up some money.

A recent report by the Peterson Institute at least avoids the worst sort of mistake:

In the latest chapter of the saga over countries that seek unfair trade advantages from currency manipulation, the US Treasury has released a new report aimed at curbing the practice. Treasury is correct not to indict any countries for “currency manipulation” at this time but also to create a “monitoring list” of five major countries—China, Germany, Japan, Korea, and Taiwan—that could become “manipulators” in the future and thus require close surveillance. The objective is to deter countries from returning to past practices of manipulation, and the new Treasury report should be quite helpful in that regard. . . .

However, Congress should not have focused on countries that have a bilateral trade surplus with the United States. All that matters for the impact of currency manipulation on the United States is the multilateral current account balance of the manipulators. In today’s world of distributed production, country X may buy materials from the United States, process and sell them to country Y, which then assembles the final goods for shipment to the United States. Country X would have a bilateral deficit with the United States and country Y a bilateral surplus, yet either or both might be guilty of currency manipulation that distorts the overall US current account balance and economy.

That’s half right, the bilateral surplus doesn’t matter, but neither does the multilateral surplus.  There is no plausible harm that could come to the US from other countries running CA surpluses.  There are some vulgar old Keynesian models that claim that high saving policies, which can as a side effect lead to CA surpluses, could hurt the US by reducing global AD. Paradox of thrift. I hope no reader of this blog takes those theories seriously.  And as for the theory that current manipulation is a “beggar-thy-neighbor” policy, it is refuted every time an expansionary monetary policy move in Japan or Europe leads to a rise in global stock prices “despite” the accompanying currency depreciation.

We would underline the importance of Treasury’s decision to limit “allowable” current account surpluses to 3 percent of a country’s GDP. We at the Peterson Institute for International Economics have analyzed “fundamental equilibrium exchange rates” for years and have concluded that any imbalance above 3 percent of GDP, on either the surplus or deficit sides, is excessive and probably unsustainable; Treasury itself has often cited our estimates in its semiannual reports as authoritative. The staff of the International Monetary Fund has developed norms for current account positions that are even tougher, suggesting that both China and Japan should run no surpluses at all. There has been some discussion of defining a “material” (global) current account surplus at a higher level, perhaps 4 percent of GDP, and Treasury itself sought international agreement on such a norm at the G-20 meetings in Korea in 2010. Hence they are to be commended for concluding that “allowable” surpluses should not exceed 3 percent.

I find these proposals to be frightening, as they are based on a misunderstanding of basic international economics.  CA surpluses should be welcomed, as they suggest the surplus country probably has sound fiscal policy, and is not engaged in the sort of ruinous debt run-up that led Greece and Italy and Portugal into their current mess.  Most tax regimes strongly distort the saving/investment process, and hence even switching to a neutral treatment of saving and investment would often lead to a big CA surplus.  The rest of the world should try to copy Germany and Singapore.  We obviously won’t all end up with CA surpluses, but we’ll have more saving and investment, and hence faster economic growth.  If the zero rate bound is a problem, then raise the inflation target high enough so that it doesn’t bind.

To see what’s wrong with the 3% proposal, let’s look at the eurozone, which currently runs a 2.8% CA surplus.  That’s slightly under the proposed Peterson Institute limit, and hence not a problem.  But what about individual eurozone members, should we look at their CA balances?  Well, are they engaged in currency manipulation?  At first glance it would appear the answer is no, they don’t even have their own currency to manipulate. It would be as crazy to complain about the CA surpluses of an individual eurozone member as it would be to complain about the CA surplus of Massachusetts, (which is not actually measured (AFAIK) but would probably be at German proportions if it were.)

And yet, the report does name Germany as a country to watch, probably because its CA surplus is 7.7% of GDP.  But then why not pick on the Netherlands, at 9.7% of GDP? And why focus on individual eurozone countries, but not individual US states?  Believe it or not, it’s no longer enough to stop all “currency manipulation”, the CA surplus opponents now want to stop the sensible countries from being sensible, they want them to start running up large budget deficits.  After, all the recent Chinese case proves that this is not about currency manipulation.  China is working hard to prevent the yuan from falling, despite their large CA surplus.  Germany doesn’t even control their currency, and at the ECB they always push for a stronger euro.

It’s a myth that CA surpluses are some sort of “imbalance” that markets would correct if only governments would stop manipulating the currency.  Is Massachusetts manipulating the US dollar?  Indeed, without recent Chinese “manipulation”, the yuan would fall and their CA surplus would expand even further.  To their credit, the smarter Keynesians understand that the CA surpluses actually reflect saving/investment differentials, and can only be attacked with government policies aimed at reducing that imbalance, i.e. with tax cuts and/or higher government spending.

But in that case, Massachusetts is just as guilty as the Germans or the Dutch.  Maybe someone should put sanctions on Massachusetts’s products until my home state starts running a Puerto Rican-style fiscal policy.

In Australia they use Australian workers to build $400,000 condos on the beach, and then trade the condos to the Chinese in exchange for 400 HDTVs made by Chinese workers.  If both sides agree to this transaction, what possible harm could it do?  Can someone explain that to me?  But in the world in international economics, there is something sinister about this voluntary exchange, as it leads to a $400,000 CA “deficit” for Australia, and a “surplus” for China. What does that even mean? In America we might trade the mortgages on homes built with American labor, for Chinese goods. Again, there is supposedly something sinister about this normal business transaction. I don’t get it.

Of course it could be worse, in the world of American politics the transaction would be described as China “raping” the US.

PS.  Commenter HL suggested that Japan’s recent problems with an appreciating yen flow from the passage of this new law:

The latest step by Treasury was required by the Trade Enforcement and Trade Facilitation Act (the “customs bill”), which became law in February 2016.

I’m not sure if that’s true, but it’s interesting that Japan’s recent problems began in February.  In fact, the BOJ needs to drive the yen far lower, and thus they should say “to hell with the US”.  Unfortunately, they probably need to wait until mid-November to make that move.  And even then, the Japanese are too polite.  The others can ignore us, however.  We can’t touch the Germans as they are in the EU.  And China now has the world’s biggest economy; it’s too late to kick them around.  If Trump’s elected he’ll find himself kissing Xi’s ring.

Screen Shot 2016-05-02 at 4.31.19 PMPPS.  Over at Econlog I have a new post discussing the recent moves in the yen.

Misremembering history

The Week has an article by Jeff Spross, which tries to rewrite the history of the early 1980s:

The story of how Volcker fulfilled his mission is complicated. But it boiled down to a massive hike in interest rates: The Fed’s primary target for those rates reached an astronomical 19 percent in 1981.

Actually, during 1979-82 the Fed switched from targeting interest rates to targeting the money supply.  (Although there is debate about whether they actually were targeting the money supply.)

The basic problem, as economist Dean Baker explained to The Week, is there’s no way to tame inflation that doesn’t involve inflicting damage on the economy. But using interest rate hikes to spark recessions is a methodology that loads the bulk of the pain onto everyday workers, and people who are marginalized in our society. The national unemployment rate (the blue line below) briefly reached 10.8 percent — higher than it got even in the Great Recession — and it didn’t get back to 5 percent until 1989. Which was bad enough. But the unemployment rate for lower class workers is always much higher than for upper class ones. Ditto racial minorities: The unemployment rate for African-Americans (the red line below) topped 20 percent by 1983.

And that’s not all:

The Volcker recession also roughly coincides with a remarkable inflection point in the American economy. Before the mid-1970s, labor markets were often tight and full employment was common. After the Volcker recession, full employment — when there are more jobs available than workers, so employers have to bargain up wages and work conditions — basically disappeared. Union membership had already fallen 5 percentage points from roughly 1960 to 1980. But after the Volcker recession, its decline accelerated, falling another 10 percentage points from 1980 to roughly 1995.

Most strikingly, the Volcker recession falls almost right atop the moment when inequality took off:

So what’s the alternative?

All of that raises the obvious question: Could we have done things differently?

The 1970s were actually a relatively straightforward version of standard Keynesian macroeconomic theory, in which an overheating economy drives up the inflation rate. The real economic growth rate was actually quite strong that decade, bouncing around near 5 percent.

This alternative doesn’t get off to a promising start.  Real growth was closer to 3%, not 5%.  And even that was mostly due to very fast labor force growth (boomers like me, plus women entering in large numbers).  In fact, the 1970s was the decade when the Keynesian model basically collapsed, and had to be replaced by New Keynesianism, which, as Brad DeLong later pointed out, was to a substantial extent monetarism.

Keynesianism says that hiking taxes and balancing the budget, or even driving it into surplus, will put a drag on economic growth and slow down inflation. So we could’ve raised taxes and returned to the mid-century model of lots of brackets and really high rates at the top. That would’ve inflicted most of the damage on richer Americans who can afford to absorb it, rather than the workers and the poor who can’t.

Where to start?  Even if this were true, the old Keynesian (Phillips curve) model says the slowdown in inflation would have produced mass unemployment, regardless of whether it was caused by fiscal austerity or tight money.  And of course the model is not true.  LBJ tried to control inflation with tax increases in 1968, and failed.  That was one of the key policy experiments (along with Volcker’s later success in controlling inflation, during a period of fiscal stimulus under Reagan) that led economists to abandon old Keynesianism. The theory simply does not work.  Even worse, the left-wing solution of high taxes was tried in Sweden during the 1970s and 1980s, and had to be abandoned in the early 1990s, as Sweden was rapidly losing ground relative to other developed countries.

On top of that, inflation was exacerbated by several historical flukes. The most obvious was the rise in oil prices over the 1970s, driven by OPEC’s oil embargo against the U.S., and then by the shutdown in Iranian oil exports brought on by the Iranian revolution.

This is a common myth, at least for the decade as a whole (perhaps true for 1974 and 1979).  During the period from 1972-81, NGDP growth averaged 11%, divided into 3% RGDP growth and 8% inflation.  Oil shocks may impact inflation, but they don’t impact NGDP.  Even if we had had no oil shocks during the 1970s, an 11% NGDP growth rate was enough to generate 8% inflation.  Even with 4% RGDP growth, inflation would have averaged 7%.

All these problems would’ve likely worked themselves out regardless of what Volcker did. The error in the CPI was corrected in 1982. The run-up in oil prices from the Middle East drove a massive surge in oil production in other parts of the world, and a big uptick in energy efficiency, all of which would’ve naturally pushed inflation back down. And as mentioned, unions were losing their clout, with membership already on a downslide.

“We could’ve expected inflation to fall in any case,” Baker continued. “Probably not as quickly and not as much.”

“But suppose it took us 6 years to get down to 4 percent inflation? What would’ve been the problem with that?”

The real problem was different; the short 1980 recession was a complete waste, accomplishing nothing.  Volcker got cold feet in the summer of 1980 and adopted an extremely expansionary monetary policy (the Fed was worried about Carter’s chances in the fall election).  For those who like “concrete steps”, the Fed drove real interest rates sharply negative in mid-1980.  This pushed NGDP growth up to an astounding 19.2% in 1980:4 and 1981:1.  Thus the Fed had to tighten again in mid-1981.  The recession from mid-1981 to the end of 1982 should have started at the beginning of 1980, in which case it would have been over by mid-1981.  And it would have been milder than the actual 1981-82 recession, because inflation expectations were even more deeply entrenched after the 19.2% spurt in NGDP after the brief 1980 recession.

Plus, Ronald Reagan would have looked far more heroic if the recession had ended in mid-1981.

Kocherlakota on negative supply shocks

Marcus Nunes directed me to an article by Narayana Kocherlakota, discussing the impact of negative supply shocks:

Let’s consider three ideas that have been popular on the campaign trail.

  • Increasing the minimum wage. What if Congress decided to increase the federal minimum wage by 10 percent a year over the next five years? Typically, economists would be concerned about the impact on employment: Higher wages might lead businesses to employ fewer workers. With monetary policy out of the picture, though, the move might actually help. The expectation of higher wages would cause consumers to expect more inflation over the next few years, leading them to buy more goods and services now, before prices went up. To meet this added demand, businesses would have to boost production and hiring.
  • Increasing import tariffs. Suppose Congress gradually raised tariffs on imported intermediate goods, such as steel and sugar. Economists would worry that this would reduce the benefits of free trade. But as long as the Fed didn’t respond by raising interest rates, there would also be a positive effect: Households would expect higher prices, which would again   prompt them to demand more goods and services today — creating much-needed demand for businesses.
  • Imposing restrictions on immigration. Most economists would oppose such a move, because immigration is seen as an important contributor to overall growth. Yet again, though, the logic changes somewhat if inflation is too low and the Fed is passive. Households might expect the relative scarcity of labor to drive up wages and prices, triggering purchases that would benefit businesses and the economy more broadly.

The Fed’s response is crucial in all these cases. Typically, the central bank reacts to increases in inflation by raising interest rates sharply — a move that would choke off any demand that the policy measures might generate. With inflation running well below target, however, it’s appropriate for the Fed to hold rates low even if it sees a modest increase in inflationary pressures. It’s this subdued reaction function that allows the policy initiatives to have more positive effects.

I find this peculiar, for a number or reasons.  First, I doubt that any demand-side effects of negative supply shocks would overcome the negative supply-side effects of these policies.  Second, I deny that these policies would boost demand, even at the zero bound. Higher minimum wages will lead to expectations of lower profits, and this will reduce investment.  What makes corporations invest more is higher expected NGDP.  What makes firms build more houses, is more immigration.  The crackdown on immigration in 2006 slowed the housing boom.

If you prefer Keynesian language, negative supply shocks reduce the Wicksellian equilibrium interest rate, making the “zero bound” problem worse.  Low immigration is exactly why the zero bound problem is most severe in Japan, and high rates of immigration is one reason why Australia never even hit the zero bound.  Fast NGDP growth leads to higher nominal interest rates, and no zero bound problem.

So even at the zero bound these policies do not work, as we found out when FDR raised wages sharply in July 1933, aborting a robust recovery in industrial production.  But it’s far worse.  We are not at the zero bound, and hence the Fed would simply raise rates to neutralize the effect on inflation.  Kocherlakota writes the final paragraph in a way that almost seems to suggest the Fed agrees with him, and would react the way he wishes.  But clearly they would not, or the Fed would not have raised rates in December.  So it’s a moot point.  Elsewhere, Kocherlakota says:

The Federal Reserve faces a big challenge: It wants to get inflation up to its 2-percent target, but so far its stimulus efforts have failed to reach that goal.

That’s simply inaccurate, for reasons that Kocherlakota has himself explained numerous times.  The Fed raised rates in December over Kocherlakota’s (wise) objections.  That means the Fed does not share Kocherlakota’s inflation objectives, or else they think they’ve already succeeded in the sense that expected future inflation is 2%.  But either interpretation is inconsistent with Kocherlakota’s “tried and failed” suggestion.  Either they are not trying, or they think they’ve succeeded. Take you pick, there are no other plausible options.

In fact, these initiatives would tend to reduce NGDP growth, as monetary policy would tighten to prevent any increase in inflation, thus reducing real GDP growth. Because wages are sticky, lower NGDP growth would boost unemployment.  And in the case of higher minimum wages, the unemployment effect would be especially large.

The fact that even a dove like Janet Yellen is aggressively raising interest rates to keep inflation from exceeding the Fed’s two percent target is a shot across the bow to progressives.  Yellen is essentially saying; “You go ahead and raise wages to $15/hour.  But we aren’t going to allow higher inflation.  Instead, we’ll raise interest rates enough to create lots more unemployment.”  The progressives have been warned, the only question is whether they care.

I’m starting to see a trend in the comment section that I never thought I’d live to see.  Progressives write in complaining that it’s cruel to have an economic system where low productivity people need to work (even with wage subsidies.)  Instead we should have a guaranteed annual income, so they can pursue other activities, such as hobbies, or volunteer work.

Maybe my lack of empathy comes from the fact that I was abused as a child.  My father tried to give away surplus games to charity, from his little store.  Things like Monopoly games with a few pieces missing.  But the charity would not take them, insisting that children receiving these slightly flawed gifts would be mentally scarred.  So instead he gave them to us.  Since then, I’ve never been the same.

Even worse, I ingested megadoses of lead.


Krugman suggests that New Keynesianism has disappeared (in the long run all theories are dead)

Here’s Paul Krugman:

Brad DeLong asks why monetarism — broadly defined as the view that monetary policy can and should be used to stabilize economies — has more or less disappeared from the scene, both intellectually and politically.

That’s not just a description of monetarism; it also describes New Keynesianism, as DeLong pointed out in 1999.  Is New Keynesian economics actually dead?  Here’s an example of New Keynesianism, from the same year that DeLong wrote the article:

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.

Will somebody please explain this to me?

Yes, I’d say that NK view from 1999 (expressed by Paul Krugman, BTW) is essentially dead.  I’m not sure what we have now: new, new Keynesianism, old Keynesianism, or as many Keynesianism as there are Keynesians.  (I vote for the latter.) Just as old monetarism is mostly dead, having been replaced by market monetarism.

Krugman also suggests that monetarism is dead because real world governments don’t implement our policies, exactly as we sketch them out.  (He forgets that market monetarists invented negative IOR).  Which of course means that Krugman’s Keynesianism is also dead, as governments are certainly not doing the sort of fiscal stimulus that he recommends.  Indeed the Japanese recently combined fiscal austerity with monetary stimulus, and he seemed to think the Japanese were doing a pretty good job when he met with them recently:

We are all very much wishing, I am a great admirer of the policy moves that have been made by Japan, but they are not good enough, partly because all of the rest of us are in trouble as well.

Yes, he would have preferred they not raise taxes, but the tax increase did not cause a setback to the labor market:

Screen Shot 2016-04-16 at 12.51.44 PMAnd monetary stimulus did get them out of deflation:

Screen Shot 2016-04-16 at 12.57.07 PM

However the BOJ needs to do much more if they don’t want to slip back into deflation.

PS.  Ramesh Ponnuru also has a reply to Paul Krugman.

HT:  James Elizondo

Benn Steil on Krugman

Benn Steil has a new piece in the Weekly Standard entitled:

Why is Paul Krugman Still Calling for Fiscal Stimulus?

Here’s an excerpt:

With the Fed having raised rates in December, the zero bound – for whatever it might have meant – is gone in the United States. This should mean Krugman, if he is truly following economic science as he claims to understand it, abandoning his calls for fiscal stimulus.

Yet he is not only still advocating a big increase in government spending, he is calling for government intervention to boost wages and union bargaining power. He further says that “mercantilism makes a fair bit of sense” in this environment. Yes, mercantilism – import barriers, export subsidies, and the like. Bring on the trade war.

Krugman justifies all this by arguing that we are still in a topsy-turvy liquidity-trap world because rates are “near zero.” Yet whatever debate we might have about the effectiveness of negative rates and QE, there can be no debate over whether we are in a liquidity trap. We are not. When the Fed’s policy rate is above zero, by any amount, it means that it has determined (rightly or wrongly) that – given the current stance of government fiscal and other policies – the appropriate rate for the economy is positive. Not zero or negative. Importantly, this also means that if the government does significantly increase spending, as Krugman wants, the Fed will react to the higher level of demand by raising rates more rapidly than it would otherwise have done. This will counteract the higher government spending; such effect is known as “monetary offset,” a concept which Krugman considers uncontroversial. Thus calling for fiscal stimulus with positive interest rates is the logical equivalent of wanting to eat more because you are a little bit pregnant. It makes no sense: you cannot be a little bit pregnant, nor can you be in a liquidity trap when rates are positive.

Krugman ended the 1990s sounding much more market monetarist than Keynesian.  As late as 1999, a year after his famous 1998 paper on liquidity traps, Krugman was still dismissive of fiscal stimulus, even at the zero bound:

What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.

Will somebody please explain this to me?

By 2012 he had shifted from monetarist to new Keynesian, believing fiscal policy can be useful, but only when rates are at the zero bound:

People in my camp have repeated until we’re blue in the face that the case for fiscal expansion is very specific to circumstance — it’s desirable when you’re in a liquidity trap, and only when you’re in a liquidity trap.

Here’s another example from 2012:

From the very beginning of the Lesser Depression, the central principle for understanding macroeconomic policy has been that everything is different when you’re in a liquidity trap. In particular, the whole case for fiscal stimulus and against austerity rests on the proposition that with interest rates up against the zero lower bound, the central bank can neither achieve full employment on its own nor offset the contractionary effect of spending cuts or tax hikes.

This isn’t hard, folks; it’s just Macro 101. Yet a large number of economists — never mind politicians or policy makers — seems to have a very hard time grasping this basic concept.

Notice that he’s exasperated with dumb people who believe what he still believed in 1999.

And there are dozens of other examples over the past 8 years.  As Benn Steil points out, Krugman has now shifted again, from new Keynesian to old-fashioned Keynesian.  Krugman was right that EC101 says fiscal stimulus doesn’t work when rates are positive.  EC101 also says that attempts to artifically raise wages will reduce employment.  Ec101 also says the protectionism will impoverish a country.  But EC101 doesn’t matter anymore to a growing number of Keynesians.  Keynesian economics circa 2016 is starting to remind me of the most extreme forms of supply-side economics from the 1980s.

One begins to wonder if the theory and evidence produce the policy implications, or if the policy needs are producing an ever changing set of ad hoc theories.