Prospects and Challenges for the US economy

Here is the latest Strategic Analysis paper from the Levy Economics Institute of Bard College on the prospects and challenges for the US economy over the next few years. The Levy Institute is officially nonpartisan, but much of its output is in the post-Keynesian tradition, and influenced by luminaries such as Hyman Minsky and Wynne Godley.

Minsky and Godley were instrumental in highlighting the interdependence of the real and financial sectors of the capitalist economy and the role of the latter in contributing to its periodic instability.

The post-Keynesian or ‘left Keynesian’ tradition is a broad church, but is generally critical of capitalism while suggesting policies which attempt to mitigate its defects, in particular the presence of unemployment, inequality and instability. It emphasises the importance of aggregate demand and macroeconomic categories and relationships.

The Levy Institute publishes a short Strategic Analysis on the US economy like this one every year. It is accessible while being based on a stock-flow consistent macroeconomic model that Godley spent the final years of his life helping to build.

The paper highlights the risks to the US over the next few years of an overvalued stock market, overstretched and fragile corporate sector balance sheets, an overvalued dollar, a slowing global economy and the US administration’s erratic trade policy. It is well worth a read.

Understanding the ‘Three Balances’

This 14 minute animated video is a nice introduction to the Three Sectoral Financial Balances, which are an important part of macroeconomics, or the study of the economy as a whole. The dialogue sounds a little odd, but stick with it.

The video helps to dispel some myths about the desirability or otherwise of government budget deficits and surpluses, and how the associated money flows interact with the rest of the economy: the private sector (firms and households) and the foreign sector (the rest of the world).

In particular, the discussion outlines how the US government ran budget surpluses in the late 1990s, but also how this was more than offset by the private sector deficit, and the resultant accumulation of private debt, which ultimately proved unsustainable.

The post-Keynesian economist Wynne Godley, originator of the Three Balances approach, warned about this in 1999 here, and forecast a recession, accompanied by rising unemployment and government deficits, as these trends necessarily began to unwind over the medium term.

Budget deficits forever?


Below is a helpful quote from post-Keynesians Wynne Godley and Marc Lavoie on fiscal deficits and full employment. I am sceptical, based on economic history, that full employment can be sustained for lengthy periods under capitalism, which Keynesians claim is possible given the right policies. However it usefully makes a nonsense of the oft-found obsession many governments have with austerity and ‘balancing the books’, as if the public finances are akin to those of a prudent household. Continue reading

Sources of growth and recovery: from demand to supply and back again

I have just finished reading an interesting and useful book, simply titled ‘Macroeconomics’, now thirty years old, by the late Wynne Godley and Francis Cripps. Godley worked at the UK Treasury and then with Cripps at the University of Cambridge Department of Applied Economics. He was Professor of Economics at King’s College, and was famous for his pessimism about the British economy and its performance. In the early 1990s he was appointed as one of the chancellor’s advisory panel of economists known as the ‘wise men’, after predicting the UK’s turn from the Lawson boom to economic bust and recession. After his retirement from Cambridge in the mid-90s he moved to the USA and worked at the Levy Economics Institute of Bard College, modeling the US economy and analysing its performance and likely prospects. In the late 90s and subsequently in the mid-2000s he predicted that the US was heading for trouble due to its macroeconomic imbalances, and that a major recession was likely at some point. In fact, he also predicted the UK recessions of the mid-1970s, early 1980s and ’90s. Of course, if you are pessimistic about likely future events for long enough, you may eventually be proved right, but in a world in which economists are often wrong in their predictions, Godley was quite often right. He was probably too pessimistic about the UK’s prospects for economic recovery after the ’90s recession, but his methods and forecasts have proved in my view to be sufficiently prescient to merit serious consideration.

The aforementioned 1983 book Macroeconomics presents the results of ten years work building models of the economy in what would now be termed the post-Keynesian tradition, although they argue that their models are not ideological and are non-denominational in terms of schools of economic thought.

One of Godley and Cripps’ central insights is the role of aggregate demand in determining real national income, output and employment, subject to capacity constraints, which are often not binding, especially in the short to medium run. In more detail, in an economy open to international trade, the ‘fiscal stance’ and the ‘foreign trade performance’ are the key factors constraining expenditure flows. The fiscal stance is written as G/θ, where G is government spending and θ is taxation as a proportion of national income. Foreign trade performance is determined by X/μ, where X is the volume of exports and μ is imports as a proportion of national income. The overall constraint can be written as     Y= (G+X)/(θ+μ)   where Y represents national income.

If foreign trade performance improves for whatever reason, exports may increase and μ may fall although it may not. If G and θ remain constant, Y can increase. If on the other hand, G increases and θ falls or remains constant, while X and μ are constant, Y may similarly increase. In this way, the flow of expenditure from an improved foreign trade performance or from a fiscal stimulus, or both, can increase national income and output.

In the long run, the growth of income at some desired rate is constrained by the foreign trade performance or the growth of exports relative to imports. If imports grow faster than exports over time, this implies an accumulation of debt held by foreigners as the current account deficit expands relative to national income. In the long run, ever-increasing holdings of debt by foreigners will have to be repaid, and the current account will have to move back towards balance or into surplus. It is in this sense that foreign trade performance constrains growth.

In the short to medium run, the growth of demand from consumers abroad will affect foreign trade performance and hence economic growth. Other things remaining equal, a given growth rate of the rest of the world economy will increase the demand for exports from our country. This would suggest that growth is determined by demand. However, as Godley and Cripps emphasize, foreign trade performance is more generally determined by supply-side factors.

Supply-side factors represent the ability of companies to sell in expanding markets and to expand capacity to meet growing demand. So demand is not enough. Price and non-price competitiveness are vital, as are the ability to expand production, which may require access to finance as well as labour with the required skills. Despite growing demand, if firms are unable to meet it, then buyers may take their custom elsewhere as supply is unable to respond; in such cases, prices may rise in the short term; alternatively or in addition, there will be shortages. And these supply-side factors are vital for firms supplying both domestic and foreign markets. This would suggest that growth can be determined or constrained by both demand-side and supply-side factors, across the economy. Whichever is the more dominant constraint in any period can vary.

With regards to government policy aiming to improve economic performance, attention should be paid to both demand-side and supply-side factors. In the current crisis, a lot of evidence in the UK points to weaknesses on both sides. Those who see the economy through a Keynesian lens want to see a loosening of fiscal policy to expand domestic demand and accelerate the recovery. The government persists with deficit reduction and token supply-side policies, although it is claiming to be allowing the ‘automatic stabilizers’ to work by not cutting the deficit any faster than it is. However, as the independent watchdog the Office for Budget Responsibility has stated, deficit reduction has ‘stalled’; the deficit in cash terms is forecast to be about the same in 2013 and 2014 as in 2012, at around £120bn. The government has also stated that it wants increased monetary activism on the part of the Bank of England. Allowing the automatic stabilizers to work and relying on monetary policy shows that in fact the government believes that aggregate demand should be supported. Perhaps it is all a matter of degrees and political spin! To date however, demand is not being supported sufficiently. In my view, with the private sector deleveraging despite record low interest rates and the use of quantitative easing to expand the money supply, monetary policy has lost much of its effectiveness and there is now a need for more expansionary fiscal policy to accelerate the recovery. If this were carried out across the advanced world where possible, the effects could prove contagious and minimise leakages in each country through rising net imports.

Returning to the sources of growth considered above, while both demand and supply-side factors can act as constraints on growth, the premature turn to austerity across much of the advanced world has had a depressing effect on growth in the wake of the global financial crisis. Foreign trade performance is a vital consideration, but of course one country’s exports are other countries’ imports, and with a deflationary environment abroad, companies that export their goods and services are having to compete harder to maintain sales in stagnant or shrinking markets. Supply-side factors can determine competitiveness, but taking these factors as given, deflationary policies are acting to constrain growth.

Turning from demand back to supply: given a deflationary environment, each country’s firms competing harder in stagnant markets may improve competitiveness in the longer term, but only if they survive. If they go to the wall, hysteresis effects may mean that demand-deflation over a number of years may reduce supply and make it harder for output to respond when decent rates of economic growth return. So a persistently deflationary environment can damage supply in the longer term, even while it stimulates some firms to become ‘leaner and meaner’. And the application of Verdoorn’s law suggests that buoyant demand conditions can stimulate more rapid productivity growth, especially in manufacturing but also in the more dynamic kinds of service industries, due to economies of scale and learning-by-doing effects. In this way, the growth of demand leads to growth by cumulative causation, as supply responds to demand, leading to increased price and non-price competitiveness, stimulating further demand for output and so on. There must be limits to this process, which could take us beyond economics to social and political factors, but it remains an important element of the growth process and should not be ignored in formulating policy.

Thus demand affects supply and supply affects demand in a number of ways in the growth process and both elements should be considered when it comes to formulating policy at the national and international level. At the moment, deleveraging in many advanced countries and stagnation or recession due to ‘balance sheet’ problems suggests a supportive role for fiscal policy until recovery is underway, allowing government debt to temporarily take the strain, and supply-side policies to aid restructuring of private debt as consumers continue to pay it off, and to encourage the mainly larger firms with financial surpluses to invest in new capacity and employment, while unblocking lending to smaller and medium size firms. Only when recovery is underway should governments attempt austerity policies, as private sector investment and consumption once again become the demand-side factors driving growth in the advanced countries as a whole, and contribute to expanding world trade.