America, the Balanced

When the United States’ current account fell into deficit in 1982, the US Council of Economic Advisers accurately predicted record deficits for years to come, owing to budget deficits, a low national saving rate, and an overvalued dollar. If the US did not adjust, knowledgeable forecasters intoned, it would go from being the world’s largest creditor to its largest debtor. Many of us worried that the imbalances were unsustainable, and might end in a “hard landing” for the dollar if and when global investors tired of holding it.

The indebtedness forecasts were correct. Indeed, every year for more than three decades, the US Bureau of Economic Analysis (BEA) has reported a current-account deficit. And yet now we must ask whether the US current-account deficit is still a problem.

For starters, the world’s investors declared loud and clear in 2008 that they were not concerned about the sustainability of US deficits. When the global financial crisis erupted, they flooded into dollar assets, even though the crisis originated in the United States.

Moreover, a substantial amount of US adjustment has taken place since 1982 – for example, the dollar depreciations of 1985-1987 and 2002-2007 and the fiscal retrenchments of 1992-2000 and 2009-2014. The big increase in domestic output of shale oil and gas has also helped the trade balance recently.

As a result, the US current-account deficit in 2013 had narrowed by half in dollar terms from its 2006 peak, and from 5.8% of GDP to 2.4%. This is a decline of two-thirds when expressed as a share of global output.

A symmetric adjustment has also occurred in China, via real appreciation of its currency and higher prices for labor and land. China’s current-account surplus peaked in 2008 at more than 10% of GDP and has since narrowed dramatically, to 1.9% last year. China’s trade adjustment in some respects followed that of Japan, the original focus of American trade anxieties in the 1980s.

I propose a third, more speculative reason why it may be time to stop worrying about the US current-account deficit. It is possible that, properly measured, the true deficits were smaller than has been reported, and even that, in some years, they were not there at all.

Every year, US residents take some of what they earn in overseas investment income – interest on bonds, dividends on equities, and repatriated profits on direct investment – and reinvest it then and there. For example, corporations plow overseas profits back into their operations, often to avoid paying the high US corporate income tax implied by repatriating those earnings. Technically, this should be recorded as a bigger surplus on the investment-income account, matched by greater acquisition of assets overseas. Often it is counted correctly. But there is reason to think that this is not always the case.

The world has long run a substantial deficit in investment income, even though the correct numbers should sum to zero. The missing income must be going somewhere.

Even for officials as highly competent as those at the BEA, it is impossible to keep track of all of the stocks and flows in the international economy. Everyone knows that errors and omissions are large, especially when it comes to financial transactions. Underfunding of statistical agencies exacerbates measurement problems, but it does not create them.

Less well known, however, is a particular pattern in the revisions of the US international investment position. The currently available historical statistics show that in every year from 1982 to 2000, the initial estimate of the net international investment position was subsequently revised upward, as statisticians found overseas assets about which they previously had no way of knowing. Since then, some subsequent revisions have been positive and some negative. But, despite more frequent surveys of portfolio holdings in recent years, certain new asset acquisitions – for example, some held with foreign custodians – still most likely go unreported.

The numbers are potentially large. The reported US current-account deficits from 1982 to 2013, based on subsequent revisions, total $9.5 trillion. And yet the deterioration in the US international investment position over this period was not much more than half of that amount ($5.7 trillion if measured relative to the revised estimate for 1981).

Certainly a lot of the discrepancy is attributable to valuation effects: since 1982, the dollar value of overseas assets has increased repeatedly, owing to increases in the dollar value of foreign currency and increases in the assets’ foreign-currency value. But part of the discrepancy also reflects the discovery of missing assets, some of which may have originated in the reinvestment of overseas income.

The missing credits also originally could have been earned in other ways. For example, US multinational corporations sometimes over-invoice import bills or under-report export earnings to reduce their tax obligations. Again, this would work to overstate the recorded current-account deficit.

Consider an (admittedly extreme) illustration. If true investment income were double what is reported, the difference was reinvested abroad in the years 1982-2000, and those assets were discovered by 2014, that would explain about half of the upward revision in the US net international investment position.

If something like this under-reporting of reinvested earnings or other balance-of-payments credits has gone on in the past, it may still be going on today – especially with US firms becoming aggressive about arbitraging corporate income tax. And if true investment income is indeed as large as double what is reported, the true US current-account balance entered the black in 2009 and has been in surplus ever since.

Is the US Economy Really About to Go Boom?

Politico asked 8 of us for a prognosis on US growth in the new year. This was my response –

Something important will get better in 2014: Fiscal policy will stop hurting the economy. The results should show up as expansion in such service sectors as health, education and construction.

The biggest impediment to economic expansion over the last three years has been destructive budget policy coming out of the Congress: misguided fiscal drag in the short term (crude cuts in spending, especially under the sequester; the expiration a year ago of Obama’s payroll tax holiday); repeated unnecessary disruptive and uncertainty-maximizing political crises (debt ceiling showdowns and government shutdown); and little progress on the genuine longer-term fiscal problem, which is the 40-year prognosis for U.S. debt (a result of projected rapid growth in entitlement spending). These fiscal failures have together probably subtracted well over a percentage point from U.S. growth in each of the last three years.

Private-sector output and employment have been rising for four years, which is what has made this a period of continued economic recovery. Many of the benefits have come in manufacturing and energy, unexpectedly. But real government spending has been falling since 2010 in absolute terms, let alone as a share of GDP. Government employment has been declining since 2009, especially as a share of total employment. This is the No. 1 reason why the overall pace of the recovery has been frustratingly slow until now.

There are good grounds for optimism in 2014. For the first time in four years, Congress will probably not inflict contractionary fiscal policy on the American people. If the government sector stops making a negative contribution, that will show up as economic growth. True, it would be better if fiscal policy could actually make a positive contribution. This would mean spending some money on priority areas such as roads, bridges and other public investment, while simultaneously enacting legislation to address the long-term issue of debt that will otherwise rise relative to GDP in future decades. But ending in 2014 the negative short-term contribution to growth is itself a political development that deserves to be celebrated.

[Responses to the question from the others — El-Erian, Bernstein, Kotlikoff, Reich, Chinn, Frieden, and Baker — are at Politico.]

Will Financial Markets Crash Before October 17, or After?

October 4 is the first Friday of the month, the day when the Bureau of Labor Statistics routinely reports the jobs numbers for the preceding month.   Is the havoc created by our current political deadlock over fiscal policy showing up as job losses?   We have no way of knowing.  On October 1 the BLS closed for business, like many other “non-essential” parts of the government.  There will be no more employment numbers until the shutdown ends.

Last week, Wall Street economic analysts responded to the usual surveys as to what they thought the upcoming employment numbers would be.   (These surveys are what the media refers to each month when they tell you that employment rose or fell “more than economists expected.”)    The median forecast in last week’s  Bloomberg survey, for example, was a prediction that the BLS would report that “Payrolls increased by 175,000,” the biggest gain in four months.   But there was no word on how many of the respondents recognized that there would in fact probably be no number at all on October 4, because the Labor Department would have been closed by the government shutdown.

It seems to me that this minor blind-spot is symbolic of a failure of Wall Street to focus adequately, until now, on the long-impending government shutdown and still-impending October 17 deadline for raising the national debt ceiling.   One reason for the lack of concern up until this point is that observers are jaded; they feel they have seen this movie before (with fiscal cliffs, sequesters, shutdowns, and ceilings); that it is “only politics;” and that Washington always averts catastrophe at the last minute. Well, maybe not this time.

Another reason is that the financial markets all summer long were busy over-reacting to developments regarding the Federal Reserve.   The stock market reached a high two weeks ago on the information, which was considered news, that monetary policy was not going to be tightened imminently after all.   Now the fixation is passing from monetary policy to fiscal policy. Not a moment too soon.

Both sides in Washington are firmly dug in, and don’t plan to back down.  If the politicians don’t get their act together  and the debt ceiling is really not raised, the results will be very bad indeed.   I actually mean “if the Republicans don’t get their act together.”  I think President Obama is fully credible when he says he will not let one faction in one party in one house of congress, in one branch of the government, threaten to blow us all  up if they don’t get their way on the Affordable Care Act.

The US has never defaulted on its obligations before.  Some continue to imagine that the government could stay within the debt ceiling but meet its obligations out of incoming tax revenue.  This is wrong.  Even if there were enough tax revenue to service the treasury debt for awhile, there would not be anywhere near enough to meet all the other legal obligations that the federal government has already incurred under the congressionally passed budget.  If the government doesn’t pay Staples the money that is owed for office supplies that it bought last month, that is a legal default just as much as if it fails to service its bonds.

Perhaps, given the desperation of the situation when the time comes, President Obama could try one of the gimmicks that have been proposed, such as minting the trillion dollar coin or taking the position that the debt ceiling violates the constitution or other laws.   These are not attractive options because they would probably provoke a constitutional crisis.   So let’s assume that he doesn’t take them.

It seems to me that this then leaves two possible outcomes: either the financial markets fall before October 17 and the Republicans respond by backing down or the financial markets fall after October 17 and the Republicans respond by backing down.   Precedents for financial markets forcing such a reversal include the delayed congressional passage of the unpopular TARP legislation in the fall of 2008 and the delayed passage of an unpopular IMF quota increase 10 years earlier.   (In the last debt ceiling showdown, in August 2011, default was avoided at the last minute;  but the stock market fell sharply anyway, when S&P for the first time ever downgraded US debt from AAA.)

After a remark by Obama about the markets yesterday, some accused him of “scare tactics,” of fanning Wall Street fears for political advantage.  The reality is almost the reverse:  if Obama thinks like a pure politician, he will let the Republican Party complete the process of committing suicide (suicide by means of binge tea partying).  The way to do this would be to wait until October 17 and let the Republicans take the blame not just for a decline in the stock market or for the inconvenience to anyone who has to deal with the government during the shutdown, but – if there is no resolution in time to raise the debt ceiling – to take the blame for the likely result: a second global financial crisis and global recession.

But that would be a very high price to pay for political advantage.  Even if the Republicans cave in within a few days after October 17, so as to avert the global recession, by then the creditworthiness of US Treasury debt will have been irreparably harmed.  My guess is that Obama thinks it would be much better for the country if the markets were to tank and the Republicans to back down before October 17 rather than after, even though the Tea Party would then live to fight another day.

[I discussed these matters this morning on BBC radio, “US Shutdown Risk to Global Economy,” and Fox Business News, “Who Will Listen to the President’s Warning to Wall Street?” Varney & Co..  One of the Fox team claimed that the stock market has usually gone up in government shutdowns.  It turned out that her statistic referred to the subsequent month;  in other words the market goes up when the shutdown is ended.  In fact it typically goes down during shutdowns, by 2 ½ % in the case of those lasting 10 days or more. It looks to me that this exchange was excluded from the segment posted on the Fox website.]

Japan’s Consumption Tax: Take it Slow and Steady

Japan’s consumption tax rate is scheduled to increase substantially in April (from 5% to 8%).  The motive is to address the long-term problem of very high debt.  (Takatoshi Ito has stated the case in favor of the tax increase.)  Prime Minister Shinzō Abe has apparently decided to go ahead with it.   Many observers, however, are worried that the loss in purchasing power resulting from the sharp increase in the sales tax rate will send the Japanese economy back into recession.

It is very reminiscent of April 1997.   I remember Larry Summers, who was then Undersecretary of the US Treasury, repeatedly warning the Japanese government that if it went ahead with the consumption tax hike that was scheduled for that date, Japan’s economy would go back into recession.  I was in the US government then too.  As the date drew near, I asked Summers why he persisted in offering Tokyo this unwanted advice, given that the prime minister of the day was clearly locked into the policy politically.    Summers told me that he knew he was unlikely to change their minds, but that he wanted to be sure the Japanese would realize their mistake when they went ahead with the tax increase and his prediction subsequently came true – as it did.

Japan’s fiscal problems in recent years have resembled those of the United States and many other countries.   The economy is weak, but the Bank of Japan can’t make monetary policy much more expansionary than it already is.  This calls for fiscal stimulus in the short run.  But the long-term fiscal outlook is troublesome, due to big debts that were run up in the past.    What is required is easy fiscal policy today together with plans to achieve fiscal rectitude in the long run.   The difficulty with this St. Augustine approach — “Lord make me chaste, but not yet” — is of course that announcements of future discipline are normally not at all credible.  Politicians often say that they will achieve budget surpluses in the future, but seldom do so.

What are wanted are steps taken today that are not mere words, but, rather, specific mechanisms to restore fiscal responsibility that are visibly likely to take effect when the time comes.  (Hints:    Raising the retirement age for future pension benefits qualifies as such a mechanism.   Legislating phony sunset provisions to tax cuts, as was done with the Bush tax cuts in the US, does not.)

For Japan, I like a proposal of Koichi Hamada (a Yale economics professor who has advised Abe) and others:  the planned jump in the consumption tax rate should be replaced with a gradual pre-announced path of increases, of 1% per year, for five years.  (The annual increases should probably even continue for more than five years).  A steady pre-announced set of small increases is a better path for fiscal policy than one jump, or two.  Because it establishes long-run fiscal discipline, it will not crash the bond market, as an outright cancellation of the tax increase might.  Yet it does not inflict damaging fiscal contraction in the short run, at a time when the economy is already weak.  Indeed, the expectation that tax-included prices will go up in the future can stimulate households today to buy autos, household appliances, and other consumer goods and thereby help speed the recovery.

The gradual path also has good implications for monetary policy too.  In normal times central banks want to get inflation down.  Pre-announced paths for taxes or administered prices can have the undesirable effect of building annual price increases into public perceptions, thus making it more difficult for the central bank to control inflation.  But current conditions are very different in this regard.  Interest rates and inflation rates in Japan lately have been, if anything, even lower than in the United States.  The most important cornerstone of Abenomics this year has been efforts by the Bank of Japan to ease money further, despite already-zero interest rates, and thus end the threat of deflation.  Under those circumstances, expectations of inflation are not worrisome.  Positive expected inflation would reduce the real interest rate, which is not a bad thing under current conditions.

There are useful analogies for policies in other countries.  The US could legislate a pre-announced path of slow but steady increases in energy or carbon taxes (accompanied by immediate short-term  offsets such as a reduction in the distortionary payroll tax or an end to the damaging spending sequester).    The same arguments regarding the time profile apply as to Japan:  enhancing long-run fiscal sustainability without imposing more fiscal contraction at a time when the economy has not yet fully recovered from the Great Recession.  In addition, the environmental and national security arguments in favor of discouraging fossil fuel consumption work better if the increase in energy prices is phased in over a long period of time, allowing people to plan ahead in making effective decisions about choice of automobiles, installation of home heating systems, construction of power plants, research into new technologies and so forth.

Emerging market countries like India and Indonesia are now being threatened with possible financial crises.  Part of the problem is large budget deficits, of which a major component has long been food and energy subsidies.  Trying to keep domestic prices for food and energy artificially low relative to world market prices has proven ruinously expensive, while yet very ineffective in the supposed goal of helping alleviate poverty.  Some leaders in these countries are aware of the need to reduce the subsidies (and the arguments that they can be accompanied by better-targeted anti-poverty innovations such as Mexico’s conditional cash transfers and India’s Unique ID system).  A credible pre-announced path of gradual phase-out in food and energy subsidies would provide much-needed immediate reassurance to skittish global investors, without imposing immediate hardship on the poor.  At the same time, the ability to plan ahead in anticipation of the price increases would allow more effective responses in decisions by farmers to plant new crops, energy-users to switch to more energy-efficient equipment, and so forth.

Slow and steady wins the race.

[This is an expanded version of a Project Syndicate op-ed.  Comments can be posted on that site.]

Recent Jobs & Growth Numbers: Good or Bad?

This morning’s US employment report shows that July was the 34th consecutive month of job increases.   Earlier in the week, the Commerce Department report showed that the 2nd quarter was the 16th consecutive quarter of positive GDP growth.   Of course, the growth rates in employment and income have not been anywhere near as strong as we would like, nor as strong as they could be if we had a more intelligent fiscal policy in Washington.  But the US economy is doing much better than what most other industrialized countries have been experiencing.   Many European countries haven’t even recovered from the Great Recession, with GDPs currently still below their peaks of six years ago.

US job growth has averaged 186 thousand per month over the last two years, or 167 thousand per month over the last three years.  Most people are aware of the improvement relative to the horrendous job loss during the 2008-09 recession.   But they are probably not aware of how the recent recovery record looks compared to the previous business cycle, the six years of recovery between the end of the 2001 recession and the economic peak at the end of 2007.  Job growth during those six years averaged 100 thousand per month, substantially lower than now.  The difference is even greater if one looks at private sector jobs numbers, because government employment expanded substantially under the Bush Administration whereas it has been contracting in recent years.

GDP growth has fallen well below 2% in the last three quarters.   But I think we know the reason for that:  dysfunctional fiscal policy.  Washington has been the obstacle to a normal robust recovery, through a combination of such factors as spending cuts since 2011, the expiration of the payroll tax holiday in January 2013, the sequester in March, and now business uncertainty arising from new time-bombs in the next two months, once again the needless result of partisan deadlock over passing a budget and raising the debt ceiling.  Given all that, it is surprising that private consumption and investment have held up as well as they have.

The right policy bargain, of course, is fiscal stimulus in the short term, not fiscal contraction, combined with steps today to address the entitlements problem in the long-term.   That would get us back to solid growth.  Our current pattern of pro-cyclical fiscal policy is exactly backwards.

[Comments can be posted at the Project Syndicate site or at Economist’s View.  I have been appearing on Fox Business, where Stuart Varney again today asked why we aren’t achieving high growth.  He also worries about the recent increase in part-week employment, apparently not realizing that this is an effect of the government sequester.]

Does Debt Matter?

“Does Debt Matter?” is the question posed by The International Economy to 20 commentators:

“The recent scrutiny of the popularized version of the Rogoff-Reinhart thesis (that growth plummets when debt exceeds 90 percent of GDP) makes clear there are no simple formulas for determining the risks in the level of a nation’s debt. …Can a realistic guide be fashioned for determining whether a nation’s debt has reached a danger zone? Or are countries from here on expected to pursue fiscal reforms only if and when a crisis sets in?”

My response:

Yes, debt matters. I don’t think I know of anyone who believes that a high level of debt is without adverse consequences for a country. There is no magic threshold in the ratio of debt to GDP, 90% or otherwise, above which the economy falls off a cliff. But if the debt/GDP ratio is high, and especially if the country’s interest rate is also high relative to its expected future growth rate, then the economy is at risk. One risk is that if interest rates rise or growth falls, the economy will slip onto an explosive debt path, where the debt/GDP ratio rises without limit. In the event of such a debt trap, the government may have no choice but to undertake a painful fiscal contraction, even though that will worsen the recession. (The resulting fall in output can even cause a further jump in the debt/output ratio, as it has in the periphery members of the eurozone over the last few years.)

None of that means that austerity in the midst of a recession is a good idea. Reinhart and Rogoff never said it was, either in their research or in their policy advice. Rather, as Keynes said, the time for fiscal austerity is during the boom, not during the recession. Indeed, a good reason to reduce the debt/GDP ratio during a boom is precisely to create the space for budget deficits during downturns.

No; countries should not be told “to pursue fiscal reforms only if and when a crisis sets in.” Rather, high-debt countries should take advantage of periods of growth to eliminate budget deficits before a crisis sets in, so that they do not find themselves in a debt trap. The time to fix the hole in the roof is when the sun is shining. Most European countries failed to take advantage of the growth years 2002-2007, to strengthen their budgets, and are now paying the price. The Greeks spectacularly failed to do so, with the result that they have had to go up on the roof to attempt to fix the hole during a thunderstorm, a task that is unpleasant, difficult, dangerous – and probably impossible.

If you want to identify some research that has misled politicians, go for the papers suggesting that fiscal contraction is not contractionary and that it may even be expansionary. It is true that sometimes a country may have no alternative to fiscal contraction; but that does not mean it is expansionary, especially if the currency cannot be devalued to stimulate exports.

The United States also failed to take advantage of the growth years 2002-07 to run budget surpluses. But fortunately our situation is completely different from Greece’s: our creditors are happy to hold dollar bonds, even at rock-bottom interest rates. They are not imposing on us short-term recession-inducing fiscal austerity. We should not impose it on ourselves while the economy is still weak. Instead, we should take steps now that will restore fiscal discipline in the future.

[Comments on this blog can be posted at the Project Syndicate site. For all 20 responses to the question, “Does Debt Matter?,” see the symposium in the spring 2013 issue of The International Economy.]


On Whose Research is the Case for Austerity Mistakenly Based?

Several of my colleagues on the Harvard faculty have recently been casualties in the cross-fire between fiscal austerians and stimulators.   Economists Carmen Reinhart and Ken Rogoff have received an unbelievable amount of press attention, ever since they were discovered by three researchers at the University of Massachusetts to have made a spreadsheet error in the first of two papers that examined the statistical relationship between debt and growth.   They quickly conceded their mistake.

Then historian Niall Ferguson, also of Harvard, received much flack when — asked to comment on Keynes’ famous phrase  ”In the long run we are all dead” — he “suggested that Keynes was perhaps indifferent to the long run because he had no children, and that he had no children because he was gay.”

There is more to be said about each of the two cases.  (i) Reinhart and Rogoff’s 2010 estimates had already been superseded by a subsequent 2012 paper of theirs written along with Carmen’s husband, Vincent, which used a more extensive data set where the error does not appear.  (ii) The debt-growth causality is debated.  (iii) “Some of Ferguson’s best friends are gay.”   (iv) Keynes was actually bi-sexual.  (v) He tried to have children.  And so forth.  Most of this has already been said many times by now.  Apparently people are even more fascinated by Harvard than they are about macroeconomic theory.

But what does it all have to do with the debate between austerians and stimulators?   Not much.  But the battle lines of the austerians have been wavering lately under the continuing onslaught of facts (most notably the recessions in Europe and Japan’s recent conversion to stimulus), and the stimulators find the missteps of Reinhart-Rogoff and Ferguson to be convenient stones to throw into the attack as well.   But they are barking up the wrong tree.  Sorry;  they are throwing the wrong stones.

The Reinhart-Rogoff controversy is not in fact relevant to the question whether governments should expand or contract at a given point in time.  The basic finding in their papers continues to hold up, that subsequent growth tends to be lower among countries with debt/GDP ratios above 90% than below 90%; but neither that finding nor their policy advice was designed so as to support the proposition that a recession is a good time to undertake fiscal contraction.

The Ferguson controversy is even less relevant, because the phrase “in the long run we are all dead” was neither about fiscal policy when Keynes wrote it nor an argument against deferred gratification.   Nor was Keynes in favor of uninhibited fiscal stimulus regardless of economic conditions;  he argued, rather, “the boom, not the slump, is the right time for austerity at the Treasury.”     Fix the hole in the roof when the sun is shining, not when it is raining.

Neither of the controversies bears on the policy proposition that is important at the moment, which is the Keynesian claim that under conditions of high unemployment, low inflation, and low interest rates (the conditions that hold in rich countries today, as in the 1930s), fiscal expansion is expansionary and fiscal contraction is contractionary.

Some research by yet another highly valued colleague at Harvard does bear much more directly on this important proposition.   Alberto Alesina has not been receiving his “fair share of abuse.”  His influential papers with Roberto Perotti  (1995, 1997) and Silvia Ardagna (1998, 2010) found that cutting government spending is not contractionary and that it may even be expansionary.

It is true that sometimes a country may have no alternative to fiscal “consolidation,” if its creditors insist on it, as has been the case with Greece and some other euro members.  But that does not mean austerity is expansionary, especially if the currency cannot depreciate to stimulate exports.

As with Reinhart and Rogoff, the Alesina papers themselves are much more measured in their conclusions than one would think from the claims of some conservative politicians that academic research finds fiscal austerity to be expansionary in general.  Nevertheless, the conclusions are clear:  “Even major successful adjustments do not seem to have recessionary consequences, on average” (1997).  And “several fiscal adjustments have been associated with expansions even in the short run” (1998).   And “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns. In fact, we uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions” (2010, p.3).   Most recently, a May 2013 paper with Carlo Favero and Francesco Giavazzi finds “that spending-based adjustments have been associated, on average, with mild and short-lived recessions, in many cases with no recession.”

Alesina’s recent policy advice is that the US should cut spending “right away.”  By contrast, the advice of Reinhart and Rogoff seems to favor postponing fiscal adjustment (trim entitlements in the future, but increase infrastructure spending today) and considering financial repression.  In more far-gone cases like Greece, they lean toward restructuring the debt.   If the thunderstorm is too severe and the roof is too far-gone to be fixed, it may be necessary to rebuild from scratch.

A new attack on Professor Alesina’s econometric findings comes from an unlikely source:   Perotti, the co-author of the first two of the five articles, has now recanted (2013a, b).    He points out some problems with the methodology (including the papers that Alesina wrote with Ardagna).  Under the dating scheme, the same year can count as a consolidation year, a pre-consolidation year, and a post-consolidation year.   It turns out that some of what have been treated as large spending-based consolidations, though announced by the governments, were in fact never implemented.  Currency devaluation, reduced labor costs, and export stimulus played an important part in any instances of growth, for example, the touted stabilizations of Denmark and Ireland in the 1980s.  His conclusions:  “the notion of ‘expansionary fiscal austerity’ in the short run is probably an illusion: a trade-off does seem to exist between fiscal austerity and short-run growth” and so “the fiscal consolidations implemented by several European countries could well aggravate the recession” (2013b, p.10).   To me, this is a more powerful indictment of the reasoning behind recent attempts at fiscal discipline during recession than is a spreadsheet error or a too-flippant line about Keynes’ sexuality.

Alberto Alesina, and Silvia Ardagna, 1998, “Tales of Fiscal Adjustment,” Economic Policy Vol.13, no, 27, October, 487-545.
Alberto Alesina, and Silvia Ardagna, 2010,  ”Large Changes in Fiscal Policy: Taxes versus Spending,” in Tax Policy and the Economy, Volume 24 (University of Chicago Press).
Alberto Alesina, Carlo Favero and Francesco Giavazzi, 2013, “The Output Effect of Fiscal Consolidations,” IGIER, May.
Alberto Alesina and Roberto Perotti. 1995, “Fiscal Expansions and Adjustments in OECD Countries,” Economic Policy, October.  NBER WP 5214.
Alberto Alesina and Roberto Perotti, 1997, “Fiscal Adjustments In OECD Countries: Composition and Macroeconomic Effects,”  International Monetary Fund Staff Papers, vol.44, no.2, June, 210-248.
Francesco Giavazzi and Marco Pagano, 1990, “Can Severe Fiscal Contractions be Expansionary?” NBER Macroeconomics Annual 1990, Vol.5, Olivier Blanchard and Stanley Fischer, editors (MIT Press) p. 75 – 122.
Thomas Herndon, Michael Ash, and Robert Pollin, 2013, “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff,” Political Economy Research Institute WP Series 322,University of Massachusetts Amherst, April.
Roberto Perotti, 2013a,”The ‘Austerity Myth’: Gains Without Pain?” A. Alesina and F. Giavazzi, eds.: Fiscal Policy After the Financial Crisis (University of Chicago Press). BIS WP 362.  NBER WP no 17571.
Roberto Perotti, 2013b, “The Sovereign Debt Crisis in Europe: Lessons from the Past, Questions for the Future,” Academic Consultants Meeting , Federal Reserve Board , Washington DC , May 6 , 2013.  Bocconi University.
Carmen Reinhart and Ken Rogoff, 2010, “Growth in a Time of Debt,” AER, 100, May, 573-578.
Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff, 2012, Public Debt Overhangs: Advanced-Economy Episodes Since 1800,” Journal of Economic Perspectives, Vol.26, No.3-Summer, 69-86.

 [Comments can be posted at On Deck of Project Syndicate or on the site of the shortened op-ed version.]

McKinnon’s Claim that RMB-$ Appreciation Would Not Reduce Trade Imbalances

The International Economy magazine (Winter 2013) asks 16 authorities, “Can Changes in Exchange Rate Valuations Affect Trade Imbalances?“   It is referring to the claim in a recent book by Stanford economist Ron McKinnon that pressure on China to let the renminbi appreciate against the dollar is fundamentally misconceived because such a movement in the exchange rate would not reduce China’s trade surplus nor American’s trade deficit.  This is part of an old debate that pre-dates the rise of the China trade problem.  Ron has long claimed that exchange rates don’t determine trade balances because they are “instead” determined by national saving versus investment.   I thought Paul Krugman demolished the argument pretty effectively 25 years ago, with a textbook graph of internal balance versus external balance.   But evidently many still fall for the argument (including some of the experts in the TIE symposium).   So I try again:

Ron McKinnon has made many important contributions to international macroeconomics over the years. But on this issue, he is simply wrong.

It goes without saying that the current account is equal to the difference between national saving and investment. But it does not follow that we should try to improve the current account in the short run by increasing national saving. Under current conditions, that would send the United States back into recession.

The national saving identity is a tautology: it does not in itself imply causation. True, many of the big movements in the U.S. current account deficit can be explained by changes in national saving: the fiscal expansion of the early 1980s, the investment boom of the late 1990s, and the new fiscal expansion of the 2000s. But the important point is that we care about a lot of things besides just external balance (the trade balance and current account). We care at least as much about internal balance (growth, employment, and inflation). To say that an increase in the budget balance and national saving would improve the trade balance does not imply that this would be good policy or that it is the only way to improve the trade balance.

Of course we need to address the budget deficit in the long run, in balanced sensible ways.  But under current circumstances — a still-weak economy, high unemployment, low inflation, rock-bottom interest rates — a reduction in public or private spending would send the economy straight back into recession. That is why the fiscal cliff of January 1, 2013, was such a danger. To observe that the trade balance would have improved if the sharp fiscal contraction had gone fully into effect would have been small consolation for the self-inflicted recession.

The U.S. trade deficit and Chinese trade surplus have diminished and so are today not quite the problems that they were five years ago. But if improving the U.S. trade balance is considered an important goal, then a devaluation or depreciation of the currency is a better tool for the job. (This proposition does not violate the national saving propositions. Nor, on the other hand, does it justify China-bashing.) Because a real devaluation would also raise demand for U.S. products — admittedly with a lag — and thus move us closer to internal balance, it would be a far more appropriate tool for improving the current account under present-day conditions than would cutting national spending or raising taxes.

Can the Euro’s Fiscal Compact Cut Deficit Bias?

Europe’s fiscal compact went into effect January 1, as a result of its ratification December 21 by the 12th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement.   The compact (technically called the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) requires  member countries to introduce laws limiting their structural government budget deficits to less than ½ % of GDP.  A limit on the “structural deficit” means that a country can run a deficit above the limit to the extent — and only to the extent — that the gap is cyclical, i.e., that its economy is operating below potential due to temporary negative shocks.   In other words, the target is cyclically adjusted.  The budget balance rule must be adopted in each country, preferablyin their national constitutions, by the end of 2013.

Will the new approach help?   The aim is to fix Europe’s long-term fiscal problem, which since the date of the euro’s inception has been evident in the failure of the Stability and Growth Pact (SGP), the crisis in Greece and other periphery countries that surfaced in 2010, and the various ways in which these countries were subsequently bailed out.

There is no reason to doubt that the eurozone countries will follow through to the extent of adopting the national rules by the end of the year.  [“The granting of new financial assistance under the European Stability Mechanism is conditional on ratification of the fiscal compact and transposition of the balanced budget rule into national legislation in due time.”]  But after that the fiscal compact will probably founder on precisely the same shoals as the SGP.

Since the inception of the euro, its members have made official fiscal forecasts that are systematically biased in the optimistic direction.   Other countries do this too, but the bias among eurozone countries is, if anything, even worse than that elsewhere.  During a period of economic expansion, such as 2002-07, governments are tempted to forecast that the boom will continue indefinitely.  Forecasts for tax revenue and budget surpluses are correspondingly optimistic and so hide the need for adjustment of fiscal policies.  During a period of recession, such as 2008-2012, governments are tempted to forecast that their economies and budgets will soon rebound.  Since forecasting is subject to so much genuine uncertainty, nobody can prove that the forecasts are biased when they are made.

Fiscal rules such as the SGP ceilings won’t constrain budget deficits, if forecasts are biased.  The reason is that governments can in any given year forecast that their growth rates, tax revenues, and budget balances will improve in the subsequent years, and then next year say that the shortfalls were unexpected.   Indeed, it turns out that the eurozone bias in official forecasts during 1999-2011 can be neatly characterized as responding to the SGP’s 3% limit on budget deficits by offering over-optimistic forecasts each time governments exceed the limit.  In other words, they adjust their forecasts rather than their policies.   (The results described here come from a new paper, coauthored with Jesse Schreger: “Over-optimistic Official Forecasts and Fiscal Rules in the Eurozone,” forthcoming 2013 in the Review of World Economy, vol.149, no.2, from Germany’s Kiel Institute.)

Phrasing the budget rules in cyclical terms, while highly desirable in terms of macroeconomic impact, does not help solve the problem of forecast bias.  It can even make it worse.  In a year when a forecast for the actual budget deficit turns out to have been over-optimistic, the government has to admit that it made a mistake, which can carry some embarrassment.  In a year when a forecast for the structural budget deficit turns out to have been over-optimistic, the government can still claim that its own calculations show the shortfall to have been cyclical rather than structural.   After all, estimation of potential output and hence the cyclical versus structural decomposition is notoriously, even after the fact.

Will it help that under the fiscal compact the rules are to be adopted at the national level, as opposed to the supranational level on which the SGP operated?  A look at the various rules and institutions that have already been tried by European countries shows that some work and others don’t.  Creating an independent fiscal institution that provides its own independent budget forecasts works, in that it reduces the bias in projections.  Euro area governments with an independent budget forecasting institution have a mean bias when making forecasts while in violation of the Excessive Deficit Procedure (EDP) that is smaller by 2.7% of GDP [at the one-year horizon], compared to euro area countries that are in violation of the EDP without such an independent fiscal institution.

It would be better still if the governments were legally bound to use these independent forecasts in their budget plans (thereby borrowing an innovation from Chile).

Regardless how well-designed the rules are, clever and determined politicians can find ways around them.  One of the tricks is the privatization of government enterprises which reduces the budget deficit this year on a one-time non-repeatable basis, but might raise it in the long-term if the enterprise had been earning profits.  Another trick is phony legislated sunsets on tax cuts, in order to make future revenues look larger despite the political intention later to make the tax cuts permanent.

Still, other things equal, the right institutions can reduce the procyclicality of fiscal policy in the short run and help deliver debt sustainability in the long run.    Examples of the right institutions are cyclically adjusted budget targets combined with independent agencies that make independent fiscal forecasts.  Things can still go wrong even if such mechanisms are in place; but, as the history of the SGP illustrates, the risk is higher if they are not.

[The original of this post appears at Project Syndicate.  Comments may be posted there.]

Monetary Alchemy, Fiscal Science

The year 2013 marks the 100th anniversaries of two separate major institutional innovations in American economic policy:  the Constitutional Amendment enacting the federal income tax, ratified on February 3, 1913, and the law establishing the Federal Reserve, passed in December 1913.

It took some time before the two new institutions became associated with the explicit concepts of fiscal policy and monetary policy, respectively.   It wasn’t until after the experience of the 1930s that they came to be viewed as potential instruments for managing the macro-economy.  John Maynard Keynes, of course, pointed out the advantages of expansionary fiscal policy in circumstances like the Great Depression.   Milton Friedmanblamed the Depression on the Fed for allowing the money supply to fall.    [Tools of fiscal policy used by governments, in addition to tax rates and tax deductions, are spending and transfers.  Tools of monetary policy used by central banks include interest rates, quantities of money and credit, and instruments such as reserve requirements and foreign exchange intervention used in various (non-US) countries.]

In subsequent debate, Keynes was associated with support for activist or discretionary policy.  The aim was counter-cyclical response to economic fluctuations: expansion in recessions, discipline in booms.  (It is a myth that he favored big government generally.  He said “the boom is the time for austerity.”)      Friedman opposed activist or discretionary policy, believing that government institutions, whether monetary or fiscal, lacked the ability to get the timing right.   But both great economists were opposed to pro-cyclical policy moves, such as the misguided US tightening of 1937 at a time when the economy had not yet fully recovered.

After World War II, the lessons of the 1930s were incorporated into all the macroeconomic textbooks and, to some extent, into the beliefs and actions of policy-makers.  But many of these lessons have been forgotten in recent decades, crowded out of public consciousness by experiences such as the high-inflation 1970s.  As a result, many politicians in advanced countries are repeating the mistakes of 1937 today.  This despite conditions that are qualitatively similar to those that determined Keynes’ policy recommendations in the 1930s: high unemployment, low inflation, and rock-bottom interest rates.

The austerity-versus-stimulus debate has been thoroughly hashed out.   On the one hand, proponents of austerity correctly point out that the long-term consequences of permanently expansionary macroeconomic policy [both fiscal and monetary] are unsustainable deficits, debts, and inflation.    On the other hand, proponents of stimulus correctly point out that in the aftermath of a recession, when unemployment is high and inflation low, the immediate consequences of contractionary macroeconomic policy are continued unemployment, slow growth, and debt/GDP ratios that go up rather than down.  Procyclicalists, both in the US and Europe, represent the worst of both worlds:  they push in the direction of expansion during booms such as 2003-07 and in the direction of contraction during recessions such as 2008-2012, thereby exacerbating both the upswings and downswings.  Countercyclicalists have it right:  working in the direction of fiscal and monetary discipline during booms and ease during recessions.

Less thoroughly aired recently is the question whether — given recent conditions – monetary or fiscal expansion is the more effective instrument.   This question was addressed clearly in 1937 by Sir John Hicks in a once-famous article titled “Mr. Keynes and the Classics.”  The graphical model is known to many generations of undergraduate students in macroeconomics under the label “IS-LM.”

The answer to the question which form of policy is more effective:  under the circumstances that held in the 1930s and that hold again now – which are conditions not just of high unemployment and low inflation, but also near-zero interest rates — stimulus in the specific form of fiscal expansion is much more likely to be effective in the short-term than stimulus in the form of monetary expansion.   Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero.  (Flat LM curve.)  This situation, labeled by Keynes a liquidity trap, is today called the Zero Lower Bound.  In addition, firms are less likely to react to easy money by investing in new plant and equipment if they can’t sell the goods they are producing in the factories they already have.  (Flat IS curve.)  The hoary — but still evocative — metaphor is “pushing on a string.”  Meanwhile, fiscal expansion is rendered relatively more effective, in that it doesn’t push up those rock-bottom interest rates and thereby crowd out private-sector demand.

Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries.  It is worth trying all sorts of things:  quantitative easing, forward guidance, nominal targets.   Even if the short-term interest rate channel is inoperative, such steps may work through other channels:  long-term interest rates, credit channel, risk premia, expected inflation, asset prices, commodity prices or exchange rates.  But the effects of each are highly uncertain.

That monetary policy is less effective than fiscal policy under conditions of high unemployment and zero interest rates should not be a novel position.  But many economists have forgotten much of what they knew and politicians may not have even heard the proposition.

Introductory economics textbooks have long talked about the Keynesian multiplier effect:  the recipients of federal spending (or of consumer spending stimulated by tax cuts or transfers) respond to the increase in their incomes by spending more as well, as do the recipients of that spending, and so on.  Again, the multiplier is much more relevant under current conditions than in the normal situation where the expansion goes partly into inflation and interest rates and thus crowds out private spending.  By the time of the 2008-09 global recession even those who believed that fiscal stimulus works had marked down their estimates of the fiscal multiplier — intimidated, perhaps, by newer theories of policy ineffectiveness.  The subsequent continuing severity of recessions in the United Kingdom and other countries pursuing contractionary fiscal policies, apparently to the surprise of the politicians enacting them, suggested that multipliers are not just positive, but greater than one, as the old wisdom had it.   The IMF Research Department has now reacted to this recent evidence and bravely confessed that official forecasts, including even its own, had been operating with under-estimates of multiplier magnitudes.

A new wave of econometric research estimates fiscal multipliers using methods that allow them to be higher in some circumstances than others.   Baum, Poplawski-Riberio and Weber (2012) allow the estimate to change when crossing a threshold measure of the output gap.  Batini, Callegari and Melina (2012) allow regime-switching, across recessions versus booms.  Others that similarly distinguish between multipliers in periods of excess capacity versus normal times include Auerbach and Gorodnichenko (2012a, 2012b), Baum and Koester (2011), and Fazzari, Morley and Panovska (2012).  Most of this research finds high multipliers under conditions of excess capacity and low interest rates.  (Few of them have the courage to mention that this is what one would have expected from the elementary textbooks of 50 years ago, perhaps due to fear of sounding old-fashioned.)   Related studies confirm other conditions that matter for the size of the fiscal multiplier in precisely the way the traditional textbooks say, for example that they are lower in small open economies because of crowding out of net exports.

Needless to say, the effects of fiscal policy are subject to substantial uncertainty.   One never knows, for example, when rising debt levels might suddenly alarm global investors who then start demanding abruptly higher interest rates, as happened to countries on the European periphery in 2010.    (For this reason, the United States would be well-advised to lock in a long-term path toward debt sustainability, even while undertaking a little short-term stimulus.)   In the case of stimulus in the form of tax cuts, one never knows how much of the boost to disposable income will be saved by households rather than spent. We are also uncertain as to the magnitude of negative effects of high tax rates, via incentives, on long-term growth.   And it is true that monetary policy is much better understood than it was in the past.

Nevertheless, if the question is whether it is monetary policy or fiscal policy that can more reliably deliver demand expansion under current conditions, the answer is the latter.  One might even dramatize the contrast by speaking of “monetary alchemy and fiscal science.”

A much-admired 2010 paper by Eric Leeper had it the other way around: it characterized monetary policy as science and fiscal policy as alchemy.   It is true that the state of knowledge and practice at central banks, which actually set the instruments of monetary policy, is close to the best that modern society has to offer.    It is likewise true that the instruments of fiscal policy are set in a very political process that is poorly informed by the state of economic knowledge and motivated largely by politicians’ desire to be re-elected.  These political realities may be what the author of “Monetary Science, Fiscal Alchemy” had in mind.

But the ancient alchemists were not in fact stupid or selfish people in general, notwithstanding their search for the “philosopher’s stone” that was to turn lead into gold (of which modern proponents of returning monetary policy to the pre-1914 gold standard are reminiscent).  Nor was the alchemists’ problem that the monarchs of their day refused to listen to them.  It was rather that the state of knowledge fell far short of what the modern science of chemistry can tell us.
The term alchemy could be applied to pre-Keynesians like US Treasury Secretary Andrew Mellon (whose Depression prescription was that President Herbert Hoover should “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate… it will purge the rottenness out of the system”).  It could also be applied to the “Treasury view” in the UK of 1929. (Churchill:  ”The orthodox Treasury view … is that when the Government borrow[s] in the money market it becomes a new competitor with industry and engrosses to itself resources which would otherwise have been employed by private enterprise, and in the process raises the rent of money to all who have need of it.” ).  But in light of all that was learned in the 1930s, it would be misleading to characterize the current state of fiscal policy knowledge as alchemy.


Miguel Almunia, Agustín Bénétrix, Barry Eichengreen, Kevin O’Rourke, and Gisela Rua, 2010, “From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons,” Economic Policy, 25 (62), pp. 219-65.

Alan Auerbach and Yuriy Gorodnichenko, 2012a, “Measuring the Output Responses to Fiscal Policy,” American Economic Journal: Economic Policy, vol. 4(2), pp. 1-27, May.

Alan Auerbach and Yuriy Gorodnichenko, 2012b, “Fiscal Multipliers in Recession and Expansion,” NBER Chapters, in Fiscal Policy after the Financial Crisis, edited by AlbertoAlesina and Francesco Giavazzi (University of Chicago Press).

Nicoletta Batini, Giovanni Callegari and Giovanni Melina, 2012. “Successful Austerity in the United States, Europe and Japan,” IMF Working Papers 12/190, International Monetary Fund.

Anja Baum and Gerritt Koester, 2011, “The Impact of Fiscal Policy on Economic Activity Over the Business Cycle – Evidence from a Threshold VAR Analysis” Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies  number 2011,03.

Anja Baum, Marcos Poplawski-Riberio and Anke Weber, 2012, “Fiscal Multipliers and the State of the Economy,” IMF Working Paper 12/286, International Monetary Fund, December.

Olivier Blanchard and Daniel Leigh, 2013, “Growth Forecast Errors and Fiscal Multipliers,” IMF Working Paper No. 13/1, January.  Forthcoming, American Economic Review, May.

Steven Fazzari, James Morley, and Irina Panovksa, 2012, “State-Dependent Effects of Fiscal Policy,”  UNSW Australian School of Business Research Paper No. 2012-27, April.

Milton Friedman and Anna Schwartz, 1963,  A Monetary History of the United States, 1867-1960 (Princeton University Press).

John Hicks, 1937, Mr. Keynes and the Classics: A Suggested Reinterpretation,” Econometrica, pp. 147-59.

Ethan Ilzetzki, Enrique Mendoza & Carlos Vegh, 2011. “How Big (Small?) are Fiscal Multipliers?,” IMF Working Papers 11/52 (International Monetary Fund.)  Forthcoming, Journal of Monetary Economics.

Eric Leeper, 2010, “Monetary Science, Fiscal Alchemy,” NBER Working Paper No. 16510.

Christina Romer and David Romer, 2013, “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter,” UC Berkeley, January.

Antonio Spilimbergo, Steven Symansky, and Martin Schindler, “Fiscal Multipliers,Staff Position Note No. 2009/11, International Monetary Fund.

[This post also appears at Econbrowser. Comments may be posted there.]