Global imbalances and the paradox of thrift

A pedestrian walks past an advertisment featuring US dollar bills in Hong Kong on April 6, 2011. (Photo: AAP)

Author: Max Corden, University of Melbourne

People critical of global imbalances often blame the surplus countries and their currency manipulation. This column introduces a Policy Insight that argues that the basic problem has been the inefficiency of the world’s financial sector, which led to unfruitful investment in the US rather than productive investment in emerging economies.

The global imbalances are widely seen as a problem, especially by the US government and US economists. Read more…

Why the world needs fiscal stimulus

US$ 100 bills. (photo: Reuters)

Author: Max Corden, University of Melbourne

Plenty of people have argued against fiscal stimuli. ‘Don’t call the ambulance!’, they say. Usually these have been political conservatives, but in the United States, strong opposition has also come from some influential economists. In some cases similar arguments were made against fiscal stimulus during the Great Depression.

There are the seven main arguments against fiscal stimuli, which I shall examine below. Read more…

Reviewing the arguments against fiscal stimulus

Author: Max Corden, University of Melbourne

Plenty of people have argued against fiscal stimuli. ‘Don’t call the ambulance!’, they say. Usually these have been political conservatives, but in the United States, strong opposition has also come from some influential economists. In some cases similar arguments were made against fiscal stimulus during the Great Depression.

There are the seven main arguments against fiscal stimuli, which I shall examine below.

1. Recovery of the economy
The first argument is that the economy is already recovering so we no longer need a fiscal stimulus. Perhaps the economy would have recovered without the stimulus. Nonetheless, we should stop the stimulus now.

The central issue here is that success of fiscal stimulus cannot be seen clearly. A fiscal stimulus is successful to the extent that something doesn’t happen, that is, if there is an absence of severe economic turmoil. When judging the success of the fiscal stimulus, one must compare the current situation with the correct counterfactual situation.

The best example here is the Japanese experience in the nineties. In the absence of huge prolonged fiscal deficits there would have been a deep recession, perhaps even a depression. Non-financial companies devoted themselves to reducing their debt (owing to the ending of an earlier bubble) and hence did not borrow, but added to national savings.

This is described in detail in Koo (2008 [LINK]), where the episode is described as a potential balance sheet recession. The net effect of this lack of private sector demand combined with Keynesian fiscal policy was a long period with a low positive growth rate. Did this reflect a failure of the fiscal policy? Koo convincingly argues that the counterfactual situation for Japan would have been a negative growth rate – that is, a deep recession – much worse than the low-growth that Japan experienced.

2. Ricardian equivalence
A Ricardian equivalence happens when a government borrows to finance a deficit and the far-sighted taxpayers anticipate that taxes will go up in the future to repay this debt. Taxpayers will save more to prepare for this extra tax. Thus, cutting taxes now and raising them later will not make taxpayers any richer, and total spending will not change. There is therefore no point in a fiscal stimulus.

While this description is an oversimplification, such Ricardian equivalence is the favourite idea of some modern macroeconomic theorists. It is described and discussed, for example in the textbook by Mankiw, though it is not approved (1994, pp 423-30 [LINK]). But David Ricardo, who formulated the idea, did not regard its key assumption, as realistic. Moreover, the case of the Japanese economy nineties does not support it: household savings as a percentage of GDP actually declined while public debt was accumulating.

The US ‘Reagan’ episode of 1982 to 1987 is very relevant here. Substantial tax cuts led to a big budget deficit. But over the period the household savings ratio actually fell. I analysed this episode ([LINK] Corden 1994, pp 196-97), concluding that a combination of citizens’ lack of concern for the future and their confidence that some kind of remedy would eventually appear, likely influenced both government policy and the private sector’s savings behaviour. This meant that there was both public and private profligacy, rather than the profligacy of the public sector being offset by the prudence of the private sector.

3. Need for prudence, not excess optimism
A third argument is that recession – like the Great Depression – may be caused by a consumption boom or a speculative bubble. The problem is too much optimism and not enough prudence.

It must be wrong to deal with the consequences of this undue optimism by increasing the fiscal deficit. Too much spending – whether for consumption or just speculation – should be answered by corporations and individuals cleaning up their balance sheets, not by the government imitating the follies of the private sector and messing up its own balance sheet.

However, when private spending declines, to maintain or restore aggregate demand either government spending must increase, or tax cuts, handouts and so on should stimulate private spending. That is Keynesian policy. But what about prudence? The answer is that extra spending, whether by government or the private sector, should be directed towards investment rather than towards consumption or speculation. That is, at least, one alternative. The other is that extra demand for domestically produced goods and services could come from higher net exports – more exports and lower imports.

4. Output Gap
Some critics of fiscal stimuli deny that an output gap exists or, more realistically, they argue that the stimulus, including its potential multiplier effects, exceeds the output gap. If the stimulus exceeds the output gap then the measured multiplier in real terms will be low. Inflation may happen instead of the desired increases in output. This is an empirical issue.

Stimulus policy is often designed to forestall an output gap. If such a policy is successful, then it may seem like the stimulus policy was useless, since the output gap never materialized. This is discussed in point 1 above: a mistake may be made in choosing the counterfactual situation to compare the current situation to.

5. Interest rates
Another argument is that fiscal expansion will crowd out private investment (and also consumption) through raising interest rates. This is very clear in the IS/LM model. The LM curve is given, representing a given real money supply, and fiscal expansion shifts the IS curve to the right, so that the interest rate rises while interest-sensitive investment and consumption decline.

Here, an important feature of fiscal stimulus policies must be noted. Constant monetary policy is defined not as a constant quantity of base money determined by the central bank, but as a constant interest rate policy determined by the central bank. When the government increases the fiscal deficit and hence sells more bonds (potentially raising the market interest rate) the central bank is assumed to go into the market and buy sufficient bonds to keep the interest rate at its target level. ([LINK]: Corden, 2009). If one thinks of monetary policy as consisting of management of base money, then one can regard monetary policy as being accommodating to fiscal policy. (This assumption is explicitly made in International Monetary Fund, 2008 [LINK])

6. Real wages too high
The output gap may be caused by real wages being too high. Now, there is a fairly subtle point here, closely related to the model of Keynes’ The General Theory. Can an increase in nominal aggregate demand, whether brought about by monetary or fiscal policy, increase output and employment?

Suppose we have a model with diminishing returns, perhaps because of a fixed capital
stock combined with a varying quantity of labour, or a model in which the quality of labour declines as employment increases. Next, assume given nominal wages but flexible product prices. An increase in aggregate demand will then raise the price level relative to the wage level so that the real wage falls. The real wage and employment are determined simultaneously. This was, more less, Keynes’ General Theory model.

In the Great Depression, the reduction in aggregate demand actually caused the price level in the United States (and also in Australia) to fall relative to the wage level, so that real wages rose. Keynes clearly was influenced by this historical fact. In this case one cannot say that high real wages ‘caused’ high unemployment. Rather, the decline in aggregate demand did so, with real wages being endogenous.

This issue is interesting from an Australian point of view. In the late seventies and early eighties Australia had an unemployment problem which – in my view at least – was caused by bloated real wages. Because real wages were (more or less) rigid because of centralised wage determination and trade union pressure to ensure indexation, any increases in nominal aggregate demand that raised the prices of goods and services would be followed by increases in nominal wages. The employment benefits of nominal demand increases brought about by fiscal or monetary policies would then erode or disappear. Keynesian demand expansion policies would be pointless. I discussed this analytically in Corden 1979 [LINK]. But this has not been the situation in the recent crisis. Real wages are not rigid, and increased unemployment in Australia has not resulted from increases in real wages.

7. Market failure in economic models.
Finally, for completeness I mention one approach that was popular at the time of the Great Depression but is somewhat discredited now. Some economists use models in which market failure is not possible or, more sensibly, in which such failure can happen briefly, but natural forces – without government intervention – eliminate it gradually.

Peoples’ attitudes to active counter-cyclical fiscal policy are influenced by their views on two issues. Firstly, is the weight placed on government failure relative to market failure? Secondly, is the danger of another Great Depression greater than the danger of increased inflation?

This crisis is a major case of worldwide market failure. That can hardly be questioned. But can governments be trusted? It is too early to judge and compare government reactions, and there is important scope for research here. But on the broad issue, let me refer to Keynes.

Keynes was certainly critical of governments. In his view, governments did the wrong thing after the First World War at the Versailles Treaty negotiations – so he wrote in The Economic Consequences of the Peace. The British government did the wrong thing in 1925 when it returned sterling to the gold standard at an overvalued parity – so he wrote in The Economic Consequences of Mr Churchill. And the American, British and other governments failed during the Great Depression, especially by adhering too long to the gold standard, and by remaining preoccupied with budget balancing. But he did believe that governments can get it right, and he believed in his own ability, and indeed duty, to persuade governments to make correct policy.

The other underlying issue is whether one thinks the danger of another Great Depression is greater than the danger of increased inflation. I think that older people (like myself), are likely to weigh heavily the danger of another depression. One’s opinion about this may depend on how much one knows about the Great Depression. I find the concern about inflation in present circumstances surprising, though one has to accept that it is reasonable to focus on the ‘exit’ from the crisis, so as not to lay the foundation for another inflationary or bubble period.

On this subject, it is interesting to reflect on German attitudes. One can understand that at the time of the Great Depression, many Germans were preoccupied with the danger of inflation. They had the recent memory of the socially and economically destructive hyperinflation of 1923. This affected the policies of the Weimar Republic governments, both in encouraging them to adhere to the gold standard and unwisely balance their budgets.

It is harder to understand why, in more recent times, the Germans (or some of them) appear to have been more concerned with inflation than with unemployment, bearing in mind that the unemployment of the later Weimar Republic years, caused by the Great Depression, had such a destructive political effect. This memory cannot have been forgotten. I guess that the answer is that in recent years generous unemployment and other social benefits, combined with the more recent fashion of short-time working, have moderated the extent and adverse effects of unemployment in Germany.

China’s exchange rate policy, its current account surplus, and the global imbalances

A customer is served at a counter inside a foreign exchange storein Hong Kong, November 20, 2009 (Photo: Reuters)

Author: Max Corden, University of Melbourne

In this changing global order, China’s monetary policy has been the target of persistent criticism. Accepted wisdom conjectured that, if the RMB were allowed to float, it would appreciate substantially more, and this would reduce China’s high current account surplus as well as the US deficit. The RMB was fixed to the US dollar in 1997, and then later unleashed in 2005. Until 2005 China was criticised for fixing the value of the RMB to the US dollar. After that it was criticised for not allowing the RMB to appreciate enough. But the real objection was clearly directed towards the large current account surplus.

What does this mean for the world generally, and East Asia in particular? Read more…