Monday, March 4, 2013

You can’t make a horse drink

The Keynesians are split:  they are split on the effectiveness of monetary and fiscal policy on reigniting the capitalist economy and on whether the size of an economy’s outstanding debt (both public and private) matters or not.  The more conservative wing is worried that the current talk of monetary policy aiming at targeting, not inflation, but nominal GDP growth, along with other ‘unconventional’ measures beyond quantitative easing like having negative interest rates (see my post, is dangerous and might lead to higher inflation and interest rates and thus choke off any sustained economic growth; or even reproduce another credit bubble and financial crash.

A representative of this conservative wing, Paul Ormerod,  put it this way in a recent article ( “So-called Keynesians demand an increase in both public spending and the public sector deficit. What might Keynes himself have said about the current situation? “ Well, says Ormerod, “For Keynes, a crucial policy aim during a slump was to have a low long term rate of interest.  Without it, recovery would just not happen.”   If governments start borrowing too much on top of existing high levels of debt, they risk driving up the cost of that borrowing as lenders demand more interest on their loans.  That lowers the value of existing government bonds and becomes “a powerful depressant of private sector spending, both corporate and individual”.  Ormerod invokes the increased uncertainty this generates – the ‘confidence fairy’, as more radical Keynesians dismiss it: “the less confident you are about your view, the less you will spend.  High interest rates add to uncertainty and undermine confidence.”   So, according to Ormerod, “we might end up even worse off and with a higher deficit to boot.  Policy at the moment is much more about psychology rather than the mechanistic calculations of so-called Keynesians.”  Ormerod claims that Keynes would agree with him and not with the radical wing.

A similar criticism of the more radical wing of Keynesianism has been mounted by the eminent octogenarian Nobel economics prize winner, Robert Solow.  Solow has been a perceptive critic of neoclassical economics and the Austerians.  But in a recent piece, he urges caution on the question of ignoring the size of ‘national debt’ (  His main points are that if foreigners own most of that debt, then that puts the value of the national currency in jeopardy if these foreign investors switch to other country’s assets.  That is less likely to happen for the US because of the role of the dollar as the world’s main reserve currency, but it cannot be ignored.

If the debt is mainly owed to other citizens of the same country, then through inflation and the shifting of the burden of servicing that debt into the future, it can be made manageable now.  But the real problem, Solow reckons, is that rising debt “soaks up savings that might go into useful private investment. Savers own Treasury bonds because they are seen as safe, default-free assets, and the government can borrow at lower rates than corporations can. If there were less debt, and fewer bonds for sale, savers seeking higher returns would invest in corporate bonds or stocks instead. Business investment would expand and be more profitable.”   This is not a problem right now as too much austerity is the issue, but it could become one further down the road.

Comments like these from fellow Keynesians have produced hot responses from the more radical wing.  Randall Wray is one of the leading exponents of Modern Monetary Theory (MMT), which argues that a government can spend just as much as it likes because it can create money to pay for it; so there is no issue of default and no likelihood of rising interest in the current environment of excess capacity in production, high unemployment and cash hoarding by corporations (see my post,
He laid into Solow (  “Solow is a “neoclassical synthesis” Keynesian, the type of Keynesian economics that used to be taught in the textbooks. He was also on the wrong side of the “Cambridge controversy”, as the main developer of neoclassical growth theory.”  Wray answers Solow point by point.  But what is revealing is on nearly every point that Solow raises, Wray does not really dispute: foreigners owning debt, Treasury printing of money for debt, inflation as a way of reducing the real value of debt and the burden of servicing debt to bondholders for the rest of the economy.

Indeed, as this debate goes on, the evidence is mounting up on whether rising debt (public or private) really does matter in the growth of a capitalist economy.  In a recent meeting of the US Federal Reserve in San Francisco, new papers were presented that seem to back up the view of the conservative wing (   Christopher Hanes looked at the impact of monetary policy.  He found that “our statistical analysis shows that higher debt levels would likely lead to higher interest rates, thereby raising budget deficits and debt levels, which in turn would raise interest rates further.  Government bond rates shoot up and a funding crisis ensues. A fiscal crunch not only hurts economic growth because interest rates could rise to unprecedented levels but also because it could make it difficult for the Federal Reserve to control inflation.  Unsustainable fiscal policy can force a central bank to pursue inflationary policies, which is known as fiscal dominance.  If the central bank does not monetize the government debt, then interest rates will rise sharply, causing the economy to contract.  Indeed, without monetization, fiscal dominance may result in the government defaulting on its debt, which would lead to a significant financial disruption, producing an even more severe economic contraction.  Hence the central bank will in effect have little choice and will be forced to purchase the government debt by printing money, eventually leading to a surge in inflation.

So if the government expands its borrowing to try and shore up the economy, it will cause interest rates to rise and choke off growth, unless the borrowing is done simply by printing more money (just as the more radical wing of Keynesians are now advocating).  But if that policy is adopted, it will ‘eventually lead to a surge in inflation’.  Neither way of boosting government spending can avoid damaging the capitalist sector. Indeed, another paper that looked at the impact of nominal GDP targeting in the Great Depression, found that it did not work.

But where Wray is really rankled is by Solow’s assertion that rising public debt “soaks up saving that might go into useful public investment”.  Wray is convinced this is nonsense and runs directly against Keynes’ own view.  Marxists argue interminably about what ‘Marx really meant’.  So do the epigones of Keynes.  And it is just as difficult to know what the great bourgeois economist meant, as he is contradictory and ambiguous.  But whatever Keynes thinks, Wray puts forward a clear view:  “Investment creates saving. Budget deficits create saving. You need the spending before you get the income that you then decide to save.”   This is the Keynesian view that consumption leads the economic process.  From extra spending, we get extra employment and investment and then extra income and saving.  As I have explained in numerous posts (, this analysis of the dynamics of the capitalist economy is flawed because it denies any role for profit in driving investment (and beneath that, the role of exploitation) and assumes that there is just an economy, not a capitalist economy, in the same way as neoclassical theory does.

The reality is the opposite of the Keynesian equation:  under capitalism, it goes from profits to investment to employment to consumption (and saving).  Indeed, in Keynesian terms, savings do drive investment, if we mean corporate savings or profits.  If profitability (relative to existing capital stock) is not high enough and profits (savings) by the corporate sector are hoarded (as now), then investment will not recover sufficiently to restore growth, employment and spending by consumers (workers).  In that situation, no amount of monetary easing or expansion or increase in debt will restore economic recovery.  You can take  a horse to water, but you can’t get it to drink.  It will require the replacement of private investment for profit with public investment for need.

And so pro-capitalist monetary policy remains on the horns of a dilemma, between wanting to boost growth through investment with low interest rates, while also avoiding reviving a new credit bubble and accelerating inflation.  As Ben Bernanke put it this week in his address to those central bankers in San Francisco.  “Let me finish with some thoughts on balancing the risks we face in the current challenging economic environment, at a time when our main policy tool, the federal funds rate, is near its effective lower bound. On the one hand, the Fed’s dual mandate has led us to provide strong support for the recovery, both to promote maximum employment and to keep inflation from falling below our price stability objective. One purpose of this support is to prompt a return to the productive risk-taking that is essential to robust growth and to getting the unemployed back to work. On the other hand, we must be mindful of the possibility that sustained periods of low interest rates and highly accommodative policy could lead to excessive risk-taking in some financial markets. The balance here is not an easy one to strike. “

Indeed!  So far, the effect of Bernanke’s easy money policy has not been to restore significant investment growth or employment, but to take bond and equity prices towards all-time highs in a new financial bubble.  The horses are not drinking so the cash is going elsewhere.

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